会计学课程笔记

Chapter 1 Accounting Information for Decision Making

1.1 General Frames for Accounting

1.2 Core of Accounting

Four key statements of the financial report:

• Balance sheet
• Statement of equity
• Income statement
• Statement of cash flows

Two key questions for a company’s financial position:

1. What is the financial condition of an organization at a point of time?
2. How does an organization perform over a period of time?

The statement of cash flow and income statement are created mainly to answer the second question. The balance sheet is about a company’s financial condition at a given point of time, while the income statement reflects its performance over a period of time. Statement of equity comes as a way to connect the balance sheet with the income statement.

Balance sheet, income statement and statement of equity altogether form the accrual system. As opposed to the accrual system, there exists a cash system.

1.3 Accounting Standards: US-GAAP / IFRS

IFRS is more principle-based while US-GAAP is more rule-based. The structure of IFRS has to adapt to different countries, and when each country adopts IFRS, necessary revisions are inevitable. IFRS has to accommodate various circumstances across countries.

1.4 Auditors

Auditors have specializations. However, auditors only have access to a limited amount of documents, so they won’t be absolutely accurate. With the judgement of auditors, companies will be more confident and competent.

1.5 Accounting Systems

1.5.1 Accrual-Based System and Cash-Based System

• Accrual accounting: record financial effects in the period when they occur — more relevant.
• Cash accounting: record transactions or events with cash involvement — more reliable.

1.5.2 Accrual Accounting and Judgement

\[\text{The Accrual Accounting} = (\text{Economic})\ \text{Reality} + \text{Measurement Error} + \text{Biases}\]

When accrual accounting depicts the real world, you have to adopt some assumptions or estimations, which will introduce measurement errors. Although the errors might be cancelled out as a whole, the error itself might have an impact on managerial decisions, or due to biases, errors might be comprehended in different ways, thus causing influence on the accrual accounting. In some ways, we have to adopt the accrual accounting system, which although is not perfect, is relevant. Despite the fact that the cash accounting system does not have the last two parts, it cannot reflect the economic reality like the accrual accounting system does, so we prefer the accrual one.

1.6 The Balance Sheet: A Snapshot

What is the financial condition of an organization at a given point in time?

• What do they have? (resources) → assets
• Where do they get them? (claims on the resources) → liabilities, owners’ equity

The use of financial statements by external parties is measured mainly by:

• Profitability — measured by the company’s revenue or net income.
• Liquidity — measures the ability to pay obligations expected to be due next year.

Current liabilities are obligations companies are to pay within the coming year or the operating cycle, whichever is longer. Usually, notes payable is listed first, followed by accounts payable, with other items following in order of magnitude. Current assets are assets that a company expects to convert to cash or use up within one year or the operating cycle, whichever is longer. Operating cycle is the average time it takes from the purchase of inventory to the collection of cash from customers.

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Chapter 2 Basic Statements & Double Entry System

2.1 General Structure of Financial Statement

• Balance sheet — describes where the enterprise stands at a specific date.
• Income statement — depicts the revenue and expenses for a designated period of time.
• Statement of Cash Flows — depicts the way cash has changed during a designated period of time.

2.2 Double-Entry System

Each transaction affects at least two accounts (accounts, classification vehicles). It is designed to maintain the balance sheet equation (i.e. the accounting equation):

\[\text{Assets} = \text{Liabilities} + \text{Shareholders' Equity}\] \[\text{Shareholders' Equity} = \text{Contributed Capital} + \text{Retained Earnings}\] \[\text{Net Income} = \text{Revenues} - \text{Expenses}\]

Note: Revenue and Expense are a kind of temporary accounts which keep track of the change of Retained Earnings and will be closed out by the end of the accounting period.

2.3 T-Accounts: Debits & Credits

Comprehension:

1. Expense is the offset for Retained Earnings, while Revenue induces increment to Retained Earnings; therefore the rule for recording or recognizing expense and revenue seems natural and does not need extra capacity for remembering.
2. When sales are made, revenue and expense are recorded separately and they reflect the net income altogether.
3. Different sides are used to discern positive or negative effect. Consequently, “+” or “-” shouldn’t be added in front of the numbers. On the table or statements, numbers wrapped in “()” are negative.

2.3.1 Comparison between FSET and T-accounts

FSET is used to determine the effect of a transaction (both actual and hypothetical) on a firm’s financial statement. T-account is used to calculate certain items that are typically not disclosed in a firm’s financial statement. And dynamic changes of the company’s financial information over a period of time are clearly shown by T-accounts.

Notes: Notes payable is a warrant for when and how much a company is to pay back the loaned money, with interest involved and a contract as reference. Accounts payable is more of an agreement between companies of approximately when and how much the cash is to flow, due to the deal between them.

2.4 Income Statement Components: Revenue & Expense

Notes:

1. The main activities run by the company can be recorded in the revenue, while the side activities — such as the disposal of tools and equipment in a computer company — should not be attributed here (inventory-involved transactions will be recorded).
2. Investments by and payments to the owners are not included on the Income Statement (e.g. contributed capital and dividends paid out). Transactions with shareholders will not be recorded in the income statement either.

2.5 Statement of Cash Flows

Components of SCF (Statement of Cash Flow):

• Operating activities — cash effects of revenue and expense transactions.
• Investing activities — cash effects of purchasing and selling assets.
• Financing activities — cash effects of transactions with the owners and creditors.

Note: the cash earned from interest should be classified into “other income”, instead of the operating part or even the revenue part, because it is not the main activity run by the company.

Financial statement articulation: the Statement of Cash Flow and the Income Statement will serve for the ultimate take-on of the balance sheet.

2.6 Key Concepts

2.6.1 Assets

Definition: Arising as a result of past transactions or events, a probable future benefit controlled by the firm can be measured with a reasonable degree of precision.

Examples (judgements needed):

1. A manufacturer places a non-cancellable order for 1 million dollars in material. No. The order has not been fulfilled yet and no results are accumulated from past transactions through the statement. The non-cancellable nature is not the sufficient condition for defining such probable benefit as an asset, which is just the warrant of the contract.
2. A firm spends 1 million dollars on salaries and material building a highly customized piece of equipment for its production line. Yes. The equipment is owned by the company to make profit, and all expenses related to the acquirement of the equipment (necessary) are added to the value of such asset (such as salaries involved, transportation fee etc.). At the same time, the cash-based records lay the foundation for the subject or the conservative principle of accounting, which is a kind of “reasonable” precision. Moreover, regarding this as an asset is a kind of “capitalizing”.
3. A firm spends 1 million dollars on salaries for staff working on R&D. No. Above all, staff are not owned by the company, so the investments on them should not be classified as assets, while those on stuff can be. Under the current accounting rules, R&D investment should go into expense, as an offset for income.

2.6.2 Liabilities

Definition: Resulting from past transactions or events, a probable sacrifice arises from present obligations the firm cannot avoid, which can be measured with a reasonable degree of precision.

Examples (judgement needed):

1. A fitness center receives 600 dollars for an annual membership. Yes. It is recognized as an unearned revenue.
2. A firm establishes a revolving line of credit for 1 million dollars with its bank. No. It does not necessarily mean that the company will borrow that much money or that the company owes that amount. Under such a case, only when money is borrowed is liability recorded. Or according to the definition, the 1 million is not the present obligation.
3. A firm gets sued for 2 million dollars by a former employee for wrongful termination. No. The result of the suit is not decided yet so there is no such thing as “reasonable” estimation or precision of such event. No liability is recorded. By the way, all related law issues that are in progress should be disclosed in the notes followed up on the statement.

2.6.3 Revenue

Definition: Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major operations. Revenue should be recognized when “earned and realized”. (Note that the receipt of cash is neither necessary nor sufficient to recognize revenue.)

Examples (judgement needed):

1. A food delivery business sells its car used for delivery. No. The car-selling activity is not the major operation of the company.
2. A car company sells a car to a customer. Yes. It does fall into the territory of major operations of the company and the obligation is already fulfilled.
3. A magazine publisher receives subscription fees before providing any services. No. It does fall into the territory of major activities run by the company, but the obligation is not fulfilled yet, although the money has been received. It is recognized as “unearned revenue” and can be realized only when the service or good is provided, or so to say “earned”.

2.6.4 Expense

Definition: Outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. Recognized when “incurred”.

Matching principle:

a. When a revenue is recorded, the cost necessary to generate that revenue should be recorded as an expense at the same time. b. If a cost is not associated with a particular sale, then record the cost as an expense in the period it was incurred.

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Chapter 3 The Accounting Cycle

Timeline of the accounting cycle:

• A transaction occurs — record transactions in a journal (journal entries).
• Periodically — post journal entries to ledger (T-accounts).
• At end of period — prepare trial balance; journalize and post adjusting entries; prepare financial statements; journalize and post closing entries.

Note: before the closing step, the retained earnings are not updated until it is done. So, on the trial balance, the retained earning remains unchanged. However, that has nothing to do with whether or not it will balance.

3.1 Adjusting Entries

a. Reflect changes in circumstances not associated with explicit transactions but occurring with the passage of time. b. Associated with either Revenue or Expense account now or later. c. Explicit transactions are recorded as they happen; adjusting entries for the implicit transactions are recorded at the end of each reporting period.

Four categories of adjusting entries:

• Converting assets to expenses — prior period: cash paid in advance; current adjusting: portion consumed recognized.
• Converting liabilities to revenue — prior period: cash collected in advance; current adjusting: portion earned recognized.
• Accruing unpaid expenses — current adjusting: recognize expense incurred and liability; future transaction: cash paid in settlement of liability.
• Accruing uncollected revenue — current adjusting: recognize revenue earned not recorded and receivable; future transaction: collect cash in settlement of receivable.

Timing of cash flows relative to recognition:

Type of transaction	Before	After
Inflow (revenue)	Unearned (deferred) Revenue	Accrued Revenue
Outflow (expense)	Prepaid (deferred) Expense	Accrued Expense

Notes:

1. Costs that benefit more than one accounting period are recorded as assets initially (e.g. unexpired insurance or prepaid insurance, consuming with the passage of time). On the balance sheet, the relative accounts reflect the cost of assets that benefit future periods; meanwhile on the income statement, the expense adjusted are costs of assets used this period to generate revenue.
2. Revenues that benefit more than one accounting period are recorded as liabilities initially (e.g. unearned rent revenue or subscription revenue). The revenue is recognized as it is earned.
3. Most of the time, the tax is not levied immediately, so the income tax expense and income tax payable are needed in the adjusting entries.
4. The adjusting entry is to record the implicit “transactions” influencing the financial position of the company, instead of the explicit ones.
5. The costs are matched with revenue in two ways: a. Direct association of costs with specific revenue transactions. b. Systematic allocation of costs over the “useful life” of the expenditure.

Materiality: importance of items depending on their influences on financial statements. The costs of immaterial items are charged immediately to expense once incurred.

Note: after these adjustments are posted to the ledger, the company’s ledger accounts will be up-to-date except for the Retained Earnings account. Then it is time to prepare the financial statement.

The income statement:

\[\text{Income before Income Taxes} = \text{Revenue} - \text{Expenses}\] \[\text{Net Income} = \text{Income before Taxes} - \text{Income Taxes}\]

The statement of retained earnings:

\[\text{Retained Earnings} = \text{Past Retained Earnings} + \text{Net Income} - \text{Dividends}\]

Notes:

1. Net income appears both in the income statement and the statement of retained earnings.
2. The “net” number is the usual form of amounts on the balance sheet, and the corresponding number involved to deduct is omitted and shown on the footnote.

The closing process gets the temporary accounts ready for the next period:

• Close Revenue accounts to Income Summary.
• Close Expense accounts to Income Summary.
• Close Income Summary account to Retained Earnings.
• Close Dividends to Retained Earnings.

Complements: For companies that have developed their own online apps, it is more convenient for them to collect money and to earn extra fortune from the “deferred” revenue part. Therefore, the online platform makes the cash flow stronger and steadier, as well as creating possibilities for the company to collect extra unearned revenues, based on the benefit that it renders convenience to customers.

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Chapter 4 Cash and Accounts Receivable

Accounts Receivable: money owed to the corporation for goods sold or services rendered.

Collectability: major business problem associated with accounts receivable.

Uncollectable accounts (bad debt expense / provision for doubtful accounts): a cost of doing business.

Two methods for recording uncollectable accounts:

• Specific write-off method — wait and see which receivable will not be paid and write off then.
• Allowance method — make estimates of the uncollectable receivables.

4.1 Specific Write-off Method

(Credit Accounts Receivable; Debit Bad Debt Expense.)

• Pros: simple and easy to implement without estimation, with only discretion with respect to when to write off the receivables involved.
• Cons: overstates the Accounts Receivable balance on the balance sheet. Moreover, it results in bad matching on the income statement — the bad debt expense in the same period does not match the revenue generated previously.

Note: firms are permitted to use the Specific Write-off Method only if bad debt expense is immaterial.

4.2 Allowance Method

Make a best estimation of the future uncollectable accounts and recognize an expense under the estimation to offset the revenue.

• Pros: better matching of expense and revenue; does not overstate the accounts receivable on the balance sheet.
• Cons: estimation of the uncollectable is needed, with discretion involved.

\[\text{Gross Accounts Receivable} - \text{Allowance for Bad Debt} = \text{Net Accounts Receivable}\]

When recording the estimation: Debit Bad Debt Expense (or Provision for Bad Debt), Credit Allowance for Bad Debt.

If the estimation takes real effect: Debit Allowance for Bad Debt, Credit Accounts Receivable.

Note: under the conceived scenario or factual scenario, the net of Accounts Receivable holds the same.

Comprehension: the process of making the allowance for bad debt is a kind of making a reservoir for the possibly-uncollectable accounts receivable, which stands for the matching expense at the point when the revenue is earned. When the scenario really hits, since the expense has been recorded, only the adjustments to accounts receivable and the provision for bad debt are needed. The former means the amount is confirmed to deduct, while the latter means the level of the reservoir falls accordingly.

Monthly estimates of credit losses: at the end of each month, the probable amount of uncollectable accounts receivable should be re-estimated and the Allowance for Doubtful Accounts adjusted accordingly.

The Balance Sheet Approach

1. Year-end Accounts Receivable is broken down into age classifications.
2. Each age grouping has a different likelihood of being uncollectible.
3. Compute a separate allowance for each age grouping.

The Income Statement Approach

\[\text{Net Credit Sales} \times \%\ \text{Estimated Uncollectible} = \text{Amount into Journal Entry}\]

4.3 Recovery of an Account Receivable Previously Written Off

Subsequent collections require that the original write-off entry be reversed before the cash collection is recorded.

• Debit Accounts Receivable, Credit Allowance for Bad Debt.
• Debit Cash, Credit Accounts Receivable.

Four of the mentioned at the same amount.

4.4 Some Parameters for Computing and Estimating

\[\text{Provision for bad debt as a percentage of credit sales} = \frac{\text{Provision for Bad Debt}}{\text{Credit Sales}}\] \[\text{Allowance for doubtful accounts as a percentage of Gross Accounts Receivable} = \frac{\text{Allowance for Bad Debt}}{\text{Gross Accounts Receivable}}\] \[\text{Accounts Receivable turnover} = \frac{\text{Credit Sales}}{\text{Average Net Accounts Receivable}}\] \[\text{Days to collect Accounts Receivable} = \frac{365}{\text{Accounts Receivable turnover}}\]

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Chapter 5 Inventory and the Cost of Goods Sold

5.1 Pre-class Knowledge

5.1.1 Manufacturing and Merchandising

• Manufacturing: raw materials turned into processed products.
• Merchandising: purchase ready-to-sell inventories.

5.1.2 Categories of Inventory

• Raw materials
• Work in process
• Finished goods

5.1.3 “Cost” of Inventory Account

Necessary costs related to the acquiring of inventory are added into or regarded as part of the Inventory account and spread out in all, like PPE or some noncurrent assets.

From the buyer’s view, Transportation Costs on Purchases is not simply categorized into expenses that are one-off. They are part of the cost of assets — meaning that they are worthwhile when acquiring the asset and should not be missed out.

From the seller’s view, Delivery costs incurred by sellers are debited to Delivery Expense, an operating expense. (The issue is not the same as the former, essentially.)

As for taxes, usually sellers are levied and businesses collect sales tax at the point of sale. When selling: Debit Cash, Credit Sale, Credit Sale Tax Payable. Sale Tax Payable is based on the amount of Sale, which is then based on the price tag, and the amount of Cash is the sum of the two items.

5.2 Benchmarks of Inventory Operation

5.2.1 Cash Conversion Cycle

\[\text{Cash conversion cycle} = \text{days to collect from customers} + \text{days to sell inventory} - \text{days to pay suppliers}\]

5.2.2 Days to Collect from Customers

\[\text{Days to collect from customers} = \frac{365}{\frac{\text{Revenues}}{\text{Average Accounts Receivable}}}\]

5.2.3 Days to Pay Suppliers

\[\text{Days to pay suppliers} = \frac{365}{\frac{\text{Purchases}}{\text{Average Accounts Payable}}}\]

5.2.4 Days to Sell Inventory

\[\text{Days to sell inventory} = \frac{365}{\frac{\text{COGS}}{\text{Average Inventory}}}\]

5.2.5 Equation of Inventory

\[\text{BB Inventory} + \text{Purchase} = \text{COGS} + \text{EB Inventory}\]

Notes:

1. The error of the inventory account would be passed down to subsequent financial statements and may have far-reaching influences.
2. Just-in-Time (JIT) Inventories — this can refer to purchases of raw materials just in time to process, or completing goods just in time to ship to the customer. The inventories should not be kept at a high level for lack of efficiency and the shortage of cash flow.
3. For goods in transit, some inventories are recorded at FOB (free on board) shipping point or FOB destination point. Taking which method as standard depends on certain companies and materiality.

5.3 Inventory Recording Systems

5.3.1 Perpetual Inventory System

Journal entries under perpetual inventory system:

• When purchasing inventories on account: Debit Inventory, Credit Accounts Payable.
• When selling inventories, consider two steps of retail and cost:
  • Retail: Debit Accounts Receivable, Credit Sales.
  • Cost: Debit Cost of Goods Sold, Credit Inventory.
• When the customer pays the money back: Debit Cash, Credit Accounts Receivable.
• When the merchandising company pays back: Debit Accounts Payable, Credit Cash.
• When taking a physical inventory: Debit Cost of Goods Sold, Credit Inventory. (Shrinkage incurred.)

Notes:

1. Most of the time companies sell inventory on account, instead of receiving cash directly.
2. In order to ensure the accuracy of their perpetual records, most businesses take a complete physical count of the merchandise on hand at least once a year. Reasonable amounts of inventory shrinkage are viewed as a normal cost of doing business (for breakage, spoilage and theft etc.). If the shrinkage of inventory is a significant event, it should be recorded into Other Incomes or explained in notes attached.

5.3.2 Periodic Inventory System

Key: No entry is made to Inventory!

• When purchasing inventories on account: Debit Purchases, Credit Accounts Payable.
• When selling inventories, consider two steps of retail and cost:
  • Retail: Debit Accounts Receivable, Credit Sales.
  • Cost: No entry is made to Inventory! (No cost record within the accounting period.)
• When the customer pays the money back: Debit Cash, Credit Accounts Receivable.
• When the merchandising company pays back: Debit Accounts Payable, Credit Cash.
• When taking a physical inventory, consider two parts — “availability” and difference:
  • Availability: Debit COGS; Credit Inventory (beginning of the year) and Purchases.
  • Difference: Debit Inventory (end of the year); Credit COGS.

Comprehension:

1. When taking a physical account at the end of the accounting period, use the equation “BB Inventory + Purchase = COGS + EB Inventory” to get the COGS, and then make the following two entries of availability and difference.
2. COGS can be regarded as an account ready to offset the potential inventory cost. And the BB Inv. is thought of as “cost available”, and then the EB Inv. is thought of as the remains of the cost that didn’t incur in the year. Within the year, no entry is made to COGS and Inventory — all journal entries hit Purchase.

5.3.3 Selecting an Inventory System

Application	Perpetual Inventory System	Periodic Inventory System
Company scale	Large company with management and the timely information is worthwhile.	Small company and records of inventories are not needed.
Per-unit cost	Material high per-unit cost.	Immaterial low cost.
Volume of sales	Low volume of sales transactions.	High volume of sales transactions.
Accounting system	Computerized accounting system.	Manual accounting system.
Storage	Merchandise stored at multiple locations separate from the sales sites.	All merchandise stored at the sales site.

5.4 Credit Terms and Cash Discounts

5.4.1 Background Knowledge

When manufacturers and wholesalers sell products on account, the credit terms are stated in the invoice. There are two different ways to record purchases under perpetual inventory system.

5.4.2 Purchases Record

5.4.2.1 Recording Purchases at Net Cost

Take the discount primarily, and if couldn’t make it later, record it afterwards.

Event	Journal Entry	Amounts
Purchasing inventories on account	Debit Inventory	Discounted price
	Credit Accounts Payable	Discounted price
Paid within the credit terms	Debit Accounts Payable	Discounted price
	Credit Cash	Discounted price
Not paid within the credit terms	Debit Accounts Payable	Discounted price
	Credit Cash	Invoice price
	Credit Purchase Discounts Lost	Discount

Notes:

1. If the company couldn’t pay back within the discount-available date, then the Accounts Payable should be debited at the discounted price because it was credited at the discounted price initially. And this can also be comprehended in the way that the company should have just paid in the discounted price, and the number on the Accounts Payable is the amount the company could have owed under optimistic expectation. However, the company couldn’t make it. Therefore, it should bear the Purchase Discount Lost additionally.
2. The Purchase Discount Lost is regarded as Non-operating Expense and should be part of the financing section of the company.

5.4.2.2 Recording Purchases at Gross Invoice Price

Event	Journal Entry	Amounts
Purchasing inventories on account	Debit Inventory	Invoice price
	Credit Accounts Payable	Invoice price
Paid within the credit terms	Debit Accounts Payable	Invoice price
	Credit Cash	Discounted price
	Purchase Discount Taken	Discount
Not paid within the credit terms	Debit Accounts Payable	Invoice price
	Credit Cash	Invoice price

Notes:

1. This method of recording takes the obligation of paying in full price as given, and if paid within the discount-available date, it is thought of as something better.
2. The former has the function of “warning” and plays a more positive part in the management of the company and even the cash flow, because the 2% discount (usually) is tempting to be a good deal and financing activity.

5.4.2.3 Returns of Unsatisfactory Merchandise

Core: The corresponding amounts on the entry should be the price the company bore when purchasing in. What’s more, different from the cost-recording principles, returns and sells are two matters so they follow different rules of recording. The records of returns can be understood as the specific identification method in the cost-recording part.

5.5 Inventory Selling (Perspective Changed)

All entries on the selling side should be recorded at the invoice price.

5.5.1 Sell Inventory

Step	Journal Entry
Sell	Debit Accounts Receivable, Credit Sales (at invoice price)
Cost	Debit COGS, Credit Inventory

5.5.2 Sales Returns and Allowances

Step	Journal Entry
Return of Inventory	Debit Sales Returns and Allowances, Credit Accounts Receivable (at invoice price)
Cost-Elimination	Debit Inventory, Credit COGS

Sales Returns and Allowances is a contra-Revenue account, which plays a role of alarming as Purchase Discount Taken and Purchase Discount Loss do. The relative value between Sales Returns and Allowances and Revenue is a sign for assessing the company’s operating quality.

5.5.3 Sales Discounts

Sales Discounts is the specific contra-Revenue account for recording discounts taken by buyers within credit terms. If Sales Discounts is regarded as the reverse of Purchase Discounts Taken, then the journal entry is exactly the reverse process of Buy’s.

Step	Amount
Debit Cash	Discounted price
Sales Discounts	Discount
Credit Accounts Receivable	Invoice price

5.6 Inventory Cost Methods

Under perpetual inventory system, there are 4 inventory cost methods.

5.6.1 Specific Identification

It provides flexibility for managers to beautify the profit by recording the low-cost ones selectively, and at the same time overestimate the financial status of the company. (Although these effects don’t work long, they do work in a shorter period of time.)

5.6.2 LIFO and FIFO

Taking inflation into account, the revenue looks greater under FIFO. However, under LIFO there will be a smaller number on the balance sheet and thus less tax is levied. (Most companies in the US now adopt LIFO.)

A company should keep consistency of the inventory cost method. (It is doomed impossible to switch from FIFO to LIFO, but possible from LIFO to FIFO though extremely complicated and no influence in the long time.)

LIFO is prohibited under IFRS, however allowed under US-GAAP. However, US requires the disclosure of LIFO reserve:

\[\text{LIFO reserve} = \text{Inventory}_{\text{FIFO}} - \text{Inventory}_{\text{LIFO}}\]

Example: LIFO is usually adopted by oil companies. However, it would be an extremely hard thing to transform their inventory cost method to another. Nevertheless, under LIFO, managers have the right to decide when to clear out the inventory bought earlier to make the revenue “higher”.

5.7 LCM and Other Write-Downs of Inventory

5.7.1 LCM: Lower of Cost or Market

Lower of Cost or Market means adjusting inventory value to the lower of historical cost or current replacement cost (market).

LCM can be applied on the basis of different dimensions such as individual items, inventory category and total inventory. With different dimensions, discrepancy exists.

5.7.2 The Gross Profit Method

1. Cost of goods available for sale:

\[\text{BB Inventory} + \text{Purchase}\]

1. COGS estimated:

\[\text{Net Sales} \times \text{Cost Ratio}, \quad \text{Cost Ratio} + \text{Profit Ratio} = 1\]

1. EB Inventory:

\[\text{BB Inventory} + \text{Purchase} = \text{COGS} + \text{EB Inventory}\]

The Gross Profit Method takes the cost ratio as constant estimator, which can help skip (or replace) the process of physical counting.

5.7.3 The Retail Method

1. Value of ending inventory at retail prices — take a physical count to obtain this number.
2. Cost Ratio:

\[\text{Cost Ratio} = \frac{\text{Goods available for sale at cost}}{\text{Goods available for sale at retail}}\]

1. EB Inventory estimated:

\[\text{EB Inventory} = \text{Value of ending inventory at retail prices} \times \text{Cost Ratio}\]

Note that Cost Ratio is obtained from history.

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Chapter 6 Noncurrent Operating Assets

6.1 Pre-Class Knowledge

Noncurrent Operating Assets are assets actively used in operations that are expected to benefit future periods beyond next year. Operational assets can be classified with the criterion of tangibility. Note that natural resources are classified into tangible assets.

6.2 Plant Assets

Plant assets represent a bundle of future services and can be thought of as long-term prepaid expenses. (Long-term or prepaid expenses are naturally assets.) The cost of plant assets is the advance purchase of services. As years pass and the services are used, the cost is transferred to depreciation expense.

6.2.1 Accountable Events in the Life of Plant Assets

The events can be drawn simply from three dimensions: before use, in use, and after use — namely Acquisition, Depreciation, Sales or Disposal.

6.2.1.1 Acquisition

Acquisition Cost:

\[\text{Cost} = \text{Asset price} + \text{Reasonable and necessary costs}\]

Reasonable and necessary costs include costs for getting the asset to the desired location and for getting the asset ready for use. For example, tax levied, transportation cost, fees caused by the settlement of the asset (adjustments to the environment), setting-up and testing fees.

Subsequent spending:

1. Cost of improvements are capitalized (increase to Gross PPE) and subsequently depreciated.
2. Maintenance costs are expensed as incurred.

The difference of the previous two kinds is the difference between capital expenditure and revenue expenditure.

Special Considerations:

1. Land: Cost includes real estate commissions, escrow fees, legal fees, clearing and grading the property. Improvements to land such as driveways and landscaping are recorded separately. And Land Improvements are also thought of as long-term assets.
2. Buildings: necessary costs are included in the cost, similar to assets.
3. Equipment: related interest, insurance and taxes are treated as expenses of the current period.
4. Lump-sum purchase: the total cost must be allocated to separate accounts for each asset, which is based on the relative Fair Market Value of each asset purchased.

6.2.1.2 Depreciation

Depreciation is a contra-asset account that represents the portion of an asset’s cost that has already been allocated to expense.

\[\text{Book Value} = \text{Cost} - \text{Accumulated Depreciation}\] \[\text{Gross PPE} - \text{Accumulated Depreciation} = \text{Net PPE}\]

Straight-Line Depreciation:

\[\text{Depreciation Expense per Year} = \frac{\text{Cost} - \text{Residual Value}}{\text{years of useful life}}\]

Depreciation for fractional periods: if an asset is acquired during the year, depreciation in the year of acquisition must be prorated using the Half-Year Convention. The rule is that, in the year of acquisition, record six months of depreciation.

Declining-Balance Method: the method is under the assumption and the calculation that depreciation in the early years of an asset’s estimated useful life is higher than in later years.

\[\text{Depreciation Expense} = \text{Remaining Book Value} \times \text{Accelerated Depreciation Rate}\]

The double-declining balance depreciation rate is 200% of the straight-line depreciation rate, which is (1 / useful life):

\[\text{Straight-Line Depreciation Rate} = \frac{1}{\text{useful life}} \times 100\%\] \[\text{Accelerated Depreciation Rate} = 2 \times (\text{Straight-Line Depreciation Rate})\]

Under the straight-line method and the declining balance method, the ultimate result keeps the same, which is equal to the residual. The plug year exists as the last year and heals the difference.

Notes:

1. Depreciation is an estimate, for both useful life and residual life are predicted numbers. New information may come to light that indicates the original estimates need to be revised:

\[\text{Revised Depreciation Rates} = \frac{\text{Book value at date of change} - \text{Salvage value at date of change}}{\text{Remaining useful life at the date of change}}\]

1. Accumulated Depreciation is not closed annually, and it can be recognized as a long-existing contra-asset account. The items of depreciable assets, if not labeled as “net”, then the numbers are Gross ones without consideration of depreciation — namely, the reflection of the original cost.
2. Percent of PPE depreciated:

\[\text{Percent of PPE depreciated} = \frac{\text{Accumulated depreciation}}{\text{Gross depreciable assets}}\]

Most of the time, PPE is recorded at historical cost. Land is not depreciated and construction in progress is not depreciated until ready for service. Thus, they are not included in the “Gross Depreciable Assets”.

1. Impairment of Plant Assets: If the cost of an asset cannot be recovered through future use or sale, the asset should be written down to its net realizable value.

6.2.1.3 Disposal of Plant and Equipment

The gain or loss should be obtained from the comparison of book value and cash inflow. Remember that the depreciation should be updated. The disposal of PPE, most of the time, is part of investing activities, instead of operating activities.

Additionally, for trading in used assets for new ones: gain or loss goes into the account “Gain (or Loss) on Disposal of Asset”, and tag the used and new assets to go into the entry.

6.3 Intangible Assets

Intangible assets are noncurrent assets without physical substance whose useful life is often difficult to determine. They are usually acquired for operational use and provide exclusive rights or privileges, such as patents, copyrights, goodwill, trademarks and trade names. Intangible assets are recorded at current cash equivalent cost, including purchase price, legal fees and filing fees.

6.3.1 Amortization

Amortization is the systematic write-off to expense of the cost of intangible assets over their useful life or legal life, whichever is shorter. The straight-line method is used to amortize most intangible assets.

Journal entry: Debit Amortization Expense, Credit Intangible Asset.

6.3.1.1 Patents

Patents are exclusive rights granted by the federal government to sell or manufacture an invention.

Cost and amortization: Cost of patent is the purchase price plus legal cost to defend. Cost is amortized over the shorter of useful life or 20 years.

Notes:

1. Rules for patents, trademarks, trade names, and franchises work in the same way. So do natural resources, but the “depreciation” or “amortize” attributes to depletion (with accumulated depletion), while the substance holds the same.
2. If the patent is internally developed, then the cost of it cannot be regarded as assets because there is no standard and objective foundation for its cost; therefore it is attributed to expense and cannot be amortized.
3. All expenditures classified as research and development should be charged to expense when incurred. So for tech companies, all of the R&D costs will really reduce the net income!
4. If the cost is capitalized, then the income statement will look more decent. However, monopoly suits may be involved.

6.3.1.2 Goodwill

Goodwill is the amount by which the purchase price exceeds the fair market value of net assets acquired, which is undoubtedly an intangible asset. And goodwill will only occur when a company buys another. Note that net assets is equal to the shareholders’ equity. Goodwill is not amortized. However, it is tested annually to determine if there has been an impairment loss.

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Chapter 7 Liability

Accrued liabilities: Accrued liabilities arise from the recognition of expenses for which payment will be made in the future. (Often referred to as accrued expenses.) Examples: interest payable, income taxes payable, accrued payroll liabilities.

Notes: Gross pay (= payroll liabilities) − deduction = Net pay. Deductions include social security and medicare, income tax and so on.

Unearned Revenue: cash is collected before obligations are fulfilled. The fulfillment of obligation is to transform unearned (deferred) revenue into earned revenue.

7.1 Present Value of an Annuity

If you are to receive a steady flow of money in the future, what is the PV of that stream in total in present? The formula can be extended to the installment of loans or the interest created by bonds.

Note: we also have the table of the PV with parameter Interest Rate and Period. The total money to be paid back under installment can be attained from it directly.

7.2 Installment Notes Payable

Each payment covers interest for the period and a portion of the principal.

Allocating installment between interest and principal:

\[\text{Interest expense} = \text{Unpaid principal} \times \text{Interest rate}\] \[\text{Principal paid} = \text{Installment payment} - \text{Interest expense}\]

Comprehension: the installment for all periods can be recognized as a steady flow of cash, and the primary ones correspond to the ones in the farther time-distance which devalue the most, and the subsequent ones correspond to ones in the nearer time-distance which devalue the least. We can get the amortization table for the installment which indicates that the interest portion gets smaller and the principal portion gets larger with the passage of time.

Note: the final payment should be distributed to the principal and then the interest.

7.3 Bonds Payable

Bonds are often denominated with a par value, or face value. The principal is paid back as a lump sum at the end of the bond period, and within which interest is generated semiannually. (Suppose that the bonds are issued at face value without discount or premium.)

• When bonds are issued: Debit Cash and Credit Bonds Payable.
• When interest of bonds is created: Debit Bond Interest Expense and Credit Cash.

Notes:

1. Bond prices are usually quoted as a percentage of the face amount. (e.g. a $1000 bond priced at 102 would sell for $1020.)
2. At the year-end bond interest adjusting entry is to be made, transforming bond interest payable to bond interest expense.

\[\text{Selling price of the bond} = \text{Present value of the bond} + \text{Accrued interest since the last interest payment}\]

Comprehension: the company collects money primarily due to the discrepancy between the issuing time and the printed interest date, and then the money will be paid back to buyers.

Note: the principle also holds for the transaction between buyers. But the required-to-repay accrued interest is a little unfair for the buyers for there is no interest.

Bonds Issued at a Discount or a Premium

The selling price of the bond is determined by the market based on the time value of money. When calculating the PV of the bonds, two types of cash flows are involved — annuities and lump-sum payment:

\[PV = P \cdot \frac{r'}{r} + P \cdot \frac{r - r'}{r(1 + r)^n}\]

Note that however much the company receives from the creditor, the company should pay the face value back at the maturity date.

If the bonds are issued at a discount: Debit Cash and Discount on Bonds Payable, Credit Bonds Payable. Cash at issue price (carrying value) and Bonds Payable at par value.

The discount should be amortized over the term of the bond to increase Interest Expense each interest payment period, using the straight-line method.

• When amortizing discounts: Debit Interest Expense, Credit Cash and Discount on Bonds Payable.
• When repaying the principal: Debit Bonds Payable, Credit Cash.

Comprehension:

1. The discount of the face value is a loss to the company which is allocated evenly to each interest period. It won’t have explicit effect until the maturity date when the principal is repaid. As for the situation of selling at premium, the process works in the same way.
2. The Interest Payment accords to the stated amount on the bond (need to pay), while the Interest Expense corresponds to the amount the market expects (ought to pay). If there exists a mismatch in between, there will be a liability account to make it balanced.
3. For bonds issued at discount (premium), as we record an interest expense higher (lower) than the actual interest payment, the carry value of the bond liability is gradually walked up (reduced) to approach face value.

Notes: the number of Discount on Bonds Payable is the Maturity Value. The issue price is also called Carrying Value, which is not always equal to the face value, or namely par value.

Valuation Approach: Historical Cost and Fair Value Option

• Historical Cost: the effective interest rate at the time of bond issuance is used throughout the maturity. The book value still varies and gradually approaches the face value as the bond matures. (“adjusted historical cost”)
• Fair Value Option: the value of the bond payable should reflect the most recent effective interest rate, rather than the effective interest rate at issuance.

Comprehension:

1. Fair Value Option is allowed for most financial liabilities such as bonds. The option should be elected when the liability first occurred.
2. Company gets no gains or loss from the Fair Value Option even with fluctuation with the bond EIR, which is just an illusion of accounting.

7.4 Investments in Government and Corporation Bonds

Entries are made to record:

1. The acquisition cost — includes all expenditures necessary to acquire the investments, such as the price paid plus commission.
2. The interest revenue — calculate and record interest revenue based on the carrying value of the bond, interest rate and the portion of the year. If the bonds were issued at the face value, then the stated rate is equal to the market interest rate. If not, calculate with market rate.
3. The sale — credit the investment account for the cost of the bonds and record gain or loss.

Investing in securities means interest earned during the period and principal gained back; therefore it is safer compared to investing in stocks. However, the risk is still involved in securities investment, for the interest rate might change.

7.5 Evaluating the Safety of Creditors’ Claims

\[\text{Interest Coverage Value} = \frac{\text{Operating Income}}{\text{Interest Expense}}\]

This ratio indicates a margin of protection for creditors. The higher, the better.

\[\text{Return on Total Assets} = \frac{\text{Net Income}}{\text{Average Total Assets}}\] \[\text{Return on Stockholders' Equity} = \frac{\text{Net Income}}{\text{Average Common Stockholders' Equity}}\]

Leverage and Debt: Using borrowed money to finance business operations.

Special Types of Liabilities: Leases, Post-retirement Benefits, Deferred Taxes, Loss Contingencies.

Notes: Two factors for reporting loss contingency as a liability — the likelihood and the estimated loss amount (if can’t, then no).

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Chapter 8 Shareholders’ Equity

8.1 Corporation

Corporation, either privately (or closely) held or publicly held, is an entity created by law whose existence is separate from owners and has rights and privileges. Incorporation has advantages such as limited personal liability for stockholders and continuity of existence, as well as disadvantages such as heavy taxation, greater regulation, and separation of ownership and management.

Note: the costs associated with incorporation are usually expensed immediately but amortized over 5 years for tax purposes. (The tax authority earns more tax here.)

8.2 Shareholders’ Equity Accounts

a. Paid-in Capital (Contributed Capital):

\[\text{par value} + \text{additional value} + \text{additional paid-in capital}\]

b. Retained Earnings (Earned Capital): Net income over the life of the company less distributions (in the form of dividends and share repurchases) to shareholders. c. Accumulated Other Comprehensive Income: Cumulative gains and losses not included in Net Income (e.g. changes in fair value of “available-for-sale” securities due to fluctuation in prices).

Note that dividends paid should not be part of net income, but should be part of retained earnings. So the company should balance between whether or not to distribute dividends, because on one hand, it is a signal that the company is doing well and has extra income over costs, or that the company cares about the welfare of its stockholders; on the other hand, the dividends paid would be an offset for the retained earnings, and that number shown on the balance sheet is an important indicator for outsiders. (Note again that whether or not there is any dividend payment would not have any impact on net income, but on retained earnings.)

8.3 Authorization and Issuance of Capital Stock

• Authorized Shares: the maximum number of shares of capital stock that can be sold to the public.
• Issued shares are authorized shares of stock that have been sold; Unissued shares are the rest of the authorized shares.
• Outstanding shares are issued shares owned by stockholders; Treasury shares are issued shares that have been reacquired by the corporation.

Note: usually shares are sold through an underwriter.

• Par value is an arbitrary amount assigned to each share of stock when it is authorized.
• Market price is the amount that each share of stock will sell for in the market. (Par value has no determining relationship with the market price.)

Issuance of Par Value Stock

Record:

1. The Cash received.
2. Total par value of stocks issued in the Common Stock:

\[\text{number of shares issued} \times \text{par value per share}\]

1. The difference is assigned to Additional Paid-in Capital.

Note that additional paid-in capital can be either positive or negative.

8.4 Two Approaches to Record Repurchases

8.4.1 Retire the Shares

Cash, Common Stock, Additional Paid-in Capital, Retained Earnings change for this entry, and the difference goes to the Retained Earnings.

Notes:

a. It is similar to the reverse recording of issuance of par value stock. If there is any price fluctuation over the period, besides the reverse recordings, the difference should go into the Retained Earnings. (cover the additional or saved money) b. This is why some companies have negative RE, because large amounts of shares have been called back by them. c. Companies repurchase shares in order to get greater hold of the operation, and the rest of the shareholders have greater claims to the company, who will have more dividends and rights. d. Sometimes it is used as a means to prevent itself from being acquired from the external part which is gaining control by purchasing the shares. e. Stock option plans are an important part of employee compensation for many companies. Thus, Treasury Stock purchases are an effective means by which the company can have available the shares of stock needed to satisfy the requirement of stock option plans to issue the shares of stock to employees.

8.4.2 Lock the Shares in Treasury Stocks

a. Repurchase stocks as treasury stocks: Debit Treasury Stocks, Credit Cash. Treasury is a contra-equity account which is recorded at cost. Treasury shares have no voting or dividend rights when repurchased. This method works differently than the former. Under this method, the treasury stock should be regarded as a reservoir of stocks, which is in a “ready for sell” state, so the repurchase of them should not have impact on the retained earnings. b. Reissue Treasury Stocks: Debit Cash, Credit Treasury Stocks. The difference goes to Additional Paid-in Capital.

Comprehension: Treasury Stocks can be understood partly as the Common Stock priced at the repurchased point of time, and apart from it the rest of the recording principles stay the same as common stocks. (Contra accounts follow suit.)

Notes: gains or losses in transactions with your own shareholders cannot be recognized.

8.5 Preferred Stock

A separate class of stock, typically having priority over common shares in dividend distributions (rate is usually stated) and distribution of assets in case of liquidation, as well as cumulative dividend rights, no voting rights.

• Cumulative: dividends in arrears must be paid before dividends may be paid on common stock, taking the dividends unpaid previously into account.
• Noncumulative: undeclared dividends from current and prior years do not have to be paid in future years.

Notes:

1. Some preferred stock is convertible into shares of common stock.
2. The primary source of corporate equity is composed of Preferred Stock ($\text{par value} + \text{additional paid-in capital}$) + Common Stock ($\text{par value} + \text{additional paid-in capital}$) + Retained Earnings. (Remind that the shareholders’ equity is composed of contributed capital, retained earnings and AOCI.)

8.6 Book Value per Share of Common Stock

\[\text{Book Value} = \frac{\text{Total Stockholders' Equity}}{\text{Number of Common Shares Outstanding}}\]

Notes:

1. Preferred stock and preferred dividends in arrears are deducted from total stockholders’ equity.
2. $\text{book value} \neq \text{market value}$; both of the terms take different aspects into account.

Notes: For the issuer, common stock is carried at original issue price. For the investor, investments in marketable securities are carried at market value.

8.7 Market Price

• Market Price of Preferred Stock: factors affecting price — dividend rate, risk, level of interest rates. Dividend yield is the return based on the market value.
• Market Price of Common Stock: factors affecting price — investors’ expectations of future profitability; risk that this level of profitability will not be achieved.

Attention: changes in market value have no impact on the books of the issuer, and the issued shares are represented on common stock at historical cost.

8.8 Stock Splits

Outstanding shares increase, but par value is decreased proportionately. Companies use stock splits to reduce market price to attract more small-scaled investors.

8.9 Cash Dividends

Declared by Board of Directors and was not legally required. When paying dividends, sufficient retained earnings and cash are required.

a. Date of Declaration: Board of Directors declares the dividend and records a liability. Debit Dividends. Credit Dividends Payable. The recording works as the adjusting entry of transforming expense to liability. For the company, the declared dividends are expenses already incurred, but have not fulfilled. b. Ex-Dividend Date: The ownership cut-off point for the receipt of the most recently declared dividends. (No entry.) c. Date of Record: Stockholders holding shares on this date will receive the dividends. (No entry.) d. Date of Payment: Record the payment of the dividend to stockholders. Debit Dividends Payable. Credit Cash.

8.10 Stock Dividends

Distribution of additional shares of stock to stockholders. Under stock dividends, all stockholders remain the same percentage of ownership. NO change in total stockholders’ equity and NO changes in par values.

a. Date of Declaration: Board of Directors declares the dividend and does NOT record a liability. Debit Retained Earnings. Credit Stock Dividends to be Distributed and Additional Paid-in Capital: Stock Dividend. b. Ex-Dividend Date: the ownership cut-off point for the receipt of the most recently declared dividend. (No entry.) c. Date of Record: Stockholders holding shares on this date will receive the dividend. (No entry.) d. Date of Payment: Record the payment of the dividend to stockholders. Debit Stock Dividends to be Distributed. Credit Common Stock.

Comprehension:

1. Reasons for stock dividends: management often finds stock dividends appealing because they allow management to distribute something of perceived value to stockholders while conserving cash which may be needed for other purposes. Stockholders like stock dividends because they receive more shares, often the stock price does not fall proportionally, and the dividend is not subject to income taxes (until the shares received are sold).
2. Distinction between stock splits and stock dividends: the difference lies in the intent of management and the related price of the size of the distribution. A stock dividend usually is intended to substitute for a cash dividend and is small enough that the market price of the stock is relatively unaffected.
3. The process works like capitalizing the retained earnings into the stocks. Though a reduction may hit the retained earnings, the stock issued additionally can be viewed as part of the capital of the company itself, therefore the resources in a way aren’t spread away.
4. The steps related act as if the company is using its own money as an external party to buy the certain amount of common stocks at the par value.

Item	Stock Dividend (20% is the dividing line between small and large)	Stock Splits
Total shareholders’ equity	No effect	No effect
Common stock	Increase	No effect
Paid-in capital	Increase	No effect
Retained earnings	Decrease	No effect
Number of shares outstanding	Increase	Increase
Par value per share	No effect	Decrease

Warning: Common Stock refers to the amount of money on the account, instead of the numbers issued.

8.11 Prior Period Adjustments

The correction of an error identified as affecting net income in a prior period. Retained Earnings should be adjusted retroactively. The adjustment should be disclosed net of any taxes.

8.12 Restrictions of Retained Earnings

Notes:

1. Loan agreements can include restrictions on paying dividends below a certain amount of retained earnings. And the company cannot distribute dividends below the settled level of shareholders’ equity.
2. No gain or loss can be generated in transacting with shareholders.

8.13 Stock-Based Compensation

• Stock Option is an option (but not the obligation) to purchase a share of the company’s stock at a specified price (“strike price”) in the future. If and when the option is exercised, employee pays strike price to company and receives a share.
• Restricted Stock Units are a promise to deliver shares to the employee at a future date (accounted for as options with $0 strike price).

8.14 Comprehensive Income

Three ways that financial position can change: Issuance of new shares of stock, Net income or net loss, Payment of dividends.

GAAP excludes some unrealized items from income, such as the change in market value of available-for-sale debt and equity investments. GAAP requires that unrealized items that are normally reported on the balance sheet be added back to compute “Comprehensive Income” (as an element of stockholders’ equity).

8.15 Statement of Cash Flows — Structure

Structure	Brief Definition	Explained in Detail
Operating	Directly related to ongoing operations	Operating activities include all transactions and other events that are not defined as investing or financing activities.
Investing	Acquiring and disposing of long-term assets	Making and collecting loans and acquiring.
Financing	Acquiring and repaying funds (debt and equity including dividend payments)	Obtaining cash from owners and providing them with a return on their investment; borrowing money and repaying amounts borrowed.

• Direct Method: directly classify all activities that involve cash into operating, investing, and financing sections according to the definitions.
• Indirect Method: Operating section is presented indirectly while the investing and financing sections are the same as the direct method. a. Start from Net Income (NI). b. Present items that reconcile the difference between Net Income and Cash Flow from Operations.

Notes:

a. Both methods result in the same amount of “Cash from Operations”. b. Under US-GAAP, companies usually use the Indirect Method anyway because it is required to report the reconciliation between NI and CFO.

Underlying Rules of Thumb:

a. Is this an operating-related cash transaction? b. Is it reflected in the income statement?

If the answers to the two questions are all “No” or all “Yes”, then no reconciliation is needed; otherwise, the reconciliation is needed to reflect the difference.

Examples:

1. A company spends cash to purchase inventory: it is an operating-related cash transaction and not reflected in the income statement.
2. A customer bought inventory from us on account: we record revenue that hits the income statement and accounts receivable, but it is not an operating-related cash transaction.

Notes:

a. The changes here are only related either to the non-operating cash-involved section or to the non-cash operating activities. b. Changes in cash are included in the delta of operating assets, because it is reflected in the CFO, CFI and CFF:

\[\text{Changes in cash} = \text{CFO} + \text{CFF} + \text{CFI}\]

c. Depreciation is the most typical non-cash item listed separately. There can be other non-cash items, such as stock-related compensation (companies are incurring these expenses when operating without the involvement of cash flow). d. The logic of indirect approach comes from the equation “Assets = Liabilities + Shareholders’ equity”, from which we take the “delta” and break the change of shareholders’ equity into Net Income and other parts. e. We can construct the Direct Cash Flow Statement from the Indirect Approach.

Exemplary Formulas:

\[\text{Customer Purchase} = \text{Revenue} + \Delta\text{Unearned Revenue}\] \[\text{Receipts from customers} = \text{Revenue} + \Delta\text{Unearned Revenue} - \Delta\text{Accounts Receivable}\] \[\text{Payment for rent expense} = \text{Expense} + \Delta\text{Prepaid expense} - \Delta\text{Rent payable}\] \[\text{Interest Paid} = \text{Interest expense} - \Delta\text{Interest payable}\] \[\text{Cash paid for Inventory} = \text{COGS} + \Delta\text{Inventory} - \Delta\text{Accounts payable}\]

Notes:

1. Under US-GAAP, interest expense (of cash related to interest) is regarded as expense related to the operating section, while under IFRS, there is more flexibility.
2. Income taxes are definitely part of the operating section.
3. Depreciation is non-cash at all, so the change in the depreciation expense should not affect the cash from operations. Moreover, the depreciation is not an operating part — it is from the disposal of assets, which belongs to the investment part. However, when calculating net income, depreciation really acts as an offset. So, the first step when applying the indirect method that focuses on the operating part, we should add back the depreciation expense (change of that).
4. Under US-GAAP, both interest received and dividends received are regarded as operating part.
5. For wage not paid in the form of cash, such as stock-based wage expense, it should be deducted when getting the total amount of cash wages paid.
6. Expense is not always referred to as the money really spent, and it should be viewed from different angles in the adjusting entry and the cash flow method. Using the indirect method, we tend to focus on the money really spent.
7. For noncash investing and financing activities, they should be included in the notes to the statement because they will not be shown in the balance sheet.
8. The cash paid for interest should be listed separately because there are discrepancies in the methods adopted.

Cash flow statement classification points:

1. Interest expense is classified as an operating activity, but issue or repayment of debt is classified as a financing activity.
2. Cash received from interest and dividends on firm’s investment is treated as part of operating activity. However, purchases and sales of the underlying securities are classified as investing activities.
3. Dividends represent distributions “out of retained earnings” and are treated as financing activities.

Noncash investing and financing activities: Noncash activities (barter transaction) which are not directly involving cash, in investing or financing transactions, do not appear in the statement of cash flows. They must be listed separately. e.g. purchase a building with a 100% mortgage, convert debt to common equity.

Warning: be careful of other factors that may affect the balance sheet accounts, such as mergers and acquisitions, as well as non-cash transactions.

\[\therefore\ \text{changes in certain assets on SCF} \neq \text{changes calculated from BS}\]

Complements:

1. The customer purchases is the sign of the company’s performance because the deferred revenue may change due to the performance and sometimes plays a role of compensation.
2. When using the indirect method, more information is disclosed actually. And customer purchase is not affected by the accounting method.

\[\text{Working capital} = \text{Current assets} - \text{Current liabilities}\]

1. 「现金流量表」中的「现金」采用广义现金的概念，包括库存现金、银行存款（但不包括不能随时支取的定期存款）、现金等价物（支付能力与现金相近的非现金，基本特征为期限短<三个月内>、流动性强<易变现>、价值变动风险小<明确变现的数额>，短期股票投资不算在内）、其他货币资金等。

2. 现金流量的分类： a. 筹资活动：筹集资金 —— 借债（偿债），发行股票和债券（分股利）； b. 投资活动：对企业所需资源的选择 —— 购买（卖出）固定资产、无形资产、股票或债券； c. 经营活动：运用资源生产、分配和销售 —— 收回账款、支付货款、支付工资等。

   注：经营活动种类较多，先判定筹资活动和投资活动，剩下的归入经营活动！

3. 现金流量表可以认为是在现金收付制下的结果，利润表可以认为是在权责发生制下的结果。如果两边计算的方式能统一，那么对比时会比较方便。

8.16 Earnings vs. Cash Flows

Earnings	Cash Flows
I/S explains changes in retained earnings	SCF explains change in cash and cash equivalent
I/S is accrued-based, recognizing property rights	SCF is cash-based, emphasizing “actual possession”
I/S requires estimations	SCF does not need estimation
I/S is prone to manipulation	SCF is so to a much less degree
Firms can survive a long string of negative earnings	Firms go bankrupt with a long string of negative cash flows (outflow). 〈资金链断裂〉
Report only operating activities	Report three business activities

注：SCF 也会被操纵，如部分企业会改变现金的分类，把筹资活动和投资活动计入经营活动中。现金还可以通过构造实际的交易来影响，比如在年末拖欠账款，减少订单等。又如，在美国，R&D 的支出要求费用化，而有的公司将其资本化，操纵了利润表（记为长期资产），同时也操纵了现金流量表（并入投资活动）。

Every reported number has three components:

1. Economic truth
2. Managerial fudge
3. Random bounce (measurement error or “noise”)

Earnings and cash flows play tradeoff between (1) and (2).

8.17 现金流量表编制与分析

编制的基本原则：

a. 区分经营活动、投资活动、筹资活动产生的现金流量，分别列示； b. 每一类现金流量，均应首先按「流入」「流出」的「总」额反映，往后再计算并反映现金流量「净」额； c. 不涉及现金的投资和筹资活动（比如债转股），不在现金流量表的「正」表中反映，但是要在附注中展示。

间接法的逻辑：assumption —— 所有的变化都用现金来 cover，或者尝试用加加减减的经济实质来理解，哪些经济活动有助于现金流的增大，哪些会分散现金流。

在计算经营活动的现金流时，要在净收益的基础上加上处置长期资产的损失或者收益，因为处置长期资产并不算在经营活动中，而是算在投资活动，但是其中的收益或者损失会直接影响到净利润，因此在用间接法时应该先除去这一部分。实际的现金流是在投资活动的现金流中得以体现，项目为 sales of PPE，记录的是交易的时候获得的资金。

注：

1. 固定资产占比很高的行业，比如航空行业和住宿行业，利润表上折旧可能占据很大的数额，利润值不高，但是现金流不一定衰弱；
2. 摊销费用本质上也是折旧费用，如果有摊销费用，也应该先加上；
3. 间接法便于理解「经营活动的现金流量」与「净收益」为何存在差异，但是不够直观，可能需要专业的会计知识才能理解。我国采用「直接法」，但是要在附注中用「间接法」表达。国际会计准则也鼓励使用直接法。

造成「净利润」和「来自经营活动的现金流」之间的差异主要是来自于折旧，因为如果公司稳健运营，中间四项的变动不会太大。如果粗略计算的话，可以只考虑折旧的影响。

8.18 Analysis of Cash Flow Statement

\[\text{Cash realization ratio} = \frac{\text{cash generated by operations}}{\text{net income}}\]

理解：经营活动的现金流在现金收付制下相当于「实际赚到的钱」，净利润在权责发生制下相当于「应该赚到的钱」，二者在数值上接近，认为企业的经营状况是良好的。粗略估计前者等于后者加折旧费用，因此一般预期净现比大于 1 是合理的。如果现金流是负的，一般是企业的商业模式、企业在链条中的地位决定的，比如高水平的应收账款，低水平的应付账款，高增加的存货水平。

8.19 “Free” Cash Flow 自由现金流

\[\text{Free Cash Flow} = \text{Operating Cash Flow} - \text{Capital Expenditures}\ (-\text{Interest Expense}) - \text{Cash Dividend}\]

注：在 US-GAAP 中 interest expense 在计算 operating cash flow 中已经扣除了，而在 IFRS 中 interest expense 算作投资活动的现金流，因此要再减去。

在 US-GAAP 中各项在现金流量表和利润表中基本保持相对一致。

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Chapter 9 Investments

Inter-corporate Investments: accounting method depends on the level of influence.

• Passive and Debt securities (less than 20%):
  • Fair Value with unrealized holding gains recognized in Net income → “Trading Securities” / “Fair Value Option”
  • Fair Value with unrealized holding gains recognized in OCI → “Available-for-sale Securities”
  • Based on Historical cost → “Held to Maturity”
• Significant Influence (Active) (20%–50%): Fair Value Option or Equity Method.
• Effective Control (Greater than 50%): Must consolidate (No Fair Value Option).

9.1 Trading Securities

a. Purchase: Debit Trading Investment, Credit Cash. b. Revaluation to reflect the current fair value: Debit or Credit Trading Investment, Credit or Debit Unrealized Gain (or Unrealized Loss) in Revenue correspondingly. c. On sale: Debit Cash, Credit Trading Investment, and the difference goes to Debit (or Credit) Gain (or Loss) on Sale.

Note:

1. The fluctuation has already hit the income statement and is thought of as part of the shareholders’ equity. The unrealized gain or loss account is a kind of reservoir to hold the fluctuations in the market.
2. For the purchase step, adjustment is needed for the cash flow changes while the cash is for the investing part. For the revaluation step, adjustment is also needed for the revenue (and the net income) increases while the cash flow is held unchanged.
3. This method matters because it alerts managers of the income and fluctuations.

9.2 AFS Securities

a. Purchase: Debit AFS Investment, Credit Cash. b. Revaluation to reflect the current fair value: Debit or Credit AFS Investment, Credit or Debit Unrealized Gain (or Unrealized Loss) in AOCI correspondingly. c. On sale: Debit Cash, Debit or Credit Unrealized Gain or Loss in AOCI correspondingly, Credit AFS Investment, Credit or Debit Gain on Sale in Revenue correspondingly.

Note:

1. The fluctuated ones only hit the balance sheet while only the realized ones can hit the income statement.
2. AOCI is used to absorb the most updated price change and appears only on the balance sheet, instead of the income statement.
3. When the deal is made eventually, the AOCI is kind of “closed” and the realized amount goes to the Gain (or Loss) on Sale (a revenue/expense account), which is the difference between the historical price and the selling price.
4. This method gives the manager more control over the income statement. Because not all the fluctuations are reflected timely on the income statement, thus the manager can “shape” or beautify the income statement by holding the investment or throwing it out instantly.
5. Adjustment is needed for the purchase step while not for the revaluation step, under the indirect method. For the purchase of securities is an investing activity, while cash flow happens. And for the revaluation step, there is no involvement of cash, and it is an investing part.
6. The AOCI and Unrealized Gain or Loss (in the trading security part above) is frequently updated, but are not updated perpetually. When selling securities, the AOCI and Unrealized gain or loss hold the “latest” number, and based on this, entries are made. There’s no need to update them initially before making entries.

9.3 Income Effect of Trading vs. AFS Securities

With Available for Sale classification, market fluctuations are recognized in the asset values on the Balance Sheet at the end of each period, but only realized gains and losses (usually from sales) hit the Income Statement. However, Unrealized gains and losses reside in an equity account on the Balance Sheet — Accumulated Other Comprehensive Income.

9.4 Held to Maturity (H2M) Securities

Historical Cost records the investment at its original purchase price and then ignores fluctuations in the security’s market price. When the security is sold, its Realized Holding Gain (or Loss) is recognized in the Income Statement.

9.5 Summary — Passive Investment

1. Historical Cost: the market fluctuation is ignored and only purchase and sell is recognized and actually hit the Income Statement.
2. Trading method: Unrealized gains and losses are recognized in the Income Statement as they occur.
3. Available-for-sale: Hybrid. Works like Trading on the Balance Sheet and Historical Cost on the Income Statement. Market fluctuations are recognized in the asset values as they occur, but only realized gains and losses go into income.

Attention: Interest and dividends on all passive investments go to the income on the income statement.

9.6 Fair Value Hierarchy

Fair Value: amount at which a company can exchange financial instruments in a current transaction between willing parties, other than in a forced or liquidation sale.

• Most Objective — use quoted prices from active market for identical assets/liabilities.
• Less Objective — use quoted prices for similar assets in active markets.
• Most Subjective — construct present values using estimated default rates, discount rates, etc.

9.7 Equity Method

Equity method is used when one company (“investor”) is assumed to exert significant influence over the affiliated company (“investee”), generally when the investor holds between 20%–50% of the outstanding shares of the affiliated company.

Impact on financial statements:

1. The investor’s share of investee’s dividends is not recognized as investment income. Instead, it reduces the Investment (an asset account on the Balance Sheet). Intuition: it is as if the investor is holding its piece of the investee’s shareholders’ equity as an asset. (Under Investment on Balance Sheet.)
2. The investor recognizes as investment income a proportionate share of the investee’s net income.
3. Market fluctuations in the investee’s stock prices are not recognized.

\[\text{Net adjustment of Equity Method on the cash flow statement} = \text{equity inv. Dividends} - \text{equity inv. Income}\]

Comprehension:

1. When the investee distributes dividends, the process works like that the investor plays its important influence and gets the money invested back. So the investment should be credited.
2. If the investee pays dividends instantly after we invest in, it should be thought of as a payback of investment (instead of the “real” dividends 〈清算性股利〉), which in fact are capital we just contributed. In such a case, we should debit Cash and credit Investments.

9.8 Consolidation — Effective Control

50% is a guideline to define an effective control. The general objective is to present financial statement as if the parent and subsidiaries were one economic entity. Under this view, the parent purchases a bundle of assets and liabilities rather than shares of stock. The general approach is to add together the financial results of the parent and subsidiaries while eliminating those items that would not have been recorded if they were one entity (prevent the parent from hiding losses in child).

Note:

1. 50% is not the absolute benchmark for defining effective control for the term itself is a relative concept.
2. If inner transactions are not eliminated, then the revenue may be inflated because of them, let alone all the items being adjusted according to your favorite. For instance, the parent sells inventories to the child to make revenue high while clearing out the inventory, and from the view of the whole it is the process of turning cash to revenue. Moreover, the elimination matches with the view of taking as whole.

Consolidation at Acquisition

1. What had happened? The parent company records the Investment at the purchase price at the initial acquisition.
2. Add the parent and child.
3. Eliminate Intra-company transactions if any.
4. Eliminate Investment in child.
5. Eliminate child’s shareholders’ equity that is owned by parent.
6. Record fair value changes in assets and liabilities.
7. Solve for Goodwill. (Always a plug.)
8. Recognize noncontrolling interest if any. (Only arises with less than 100% acquisition.)

Comprehension:

1. The prelim sum constructs the consolidated balance sheet.
2. Step 0 is a preparation step where the parent is making investment to buy the child before acquisition or the consolidation starts.
3. Steps 3 and 4 work as a sign of consolidation.
4. Step 5 is the initial and necessary preparation before calculating goodwill.
5. If the parent and the child are taken as a whole, it doesn’t make sense that you can invest in yourself and the shareholders’ equity is owned by yourself.

9.9 Goodwill

Goodwill is the acquisition price of a business less the fair value of all separately identifiable net assets acquired. It reflects non-identifiable assets such as human capital, growth opportunities. It is non-transferable and cannot be bought as a separate asset. Goodwill is considered to have an indefinite life (not amortized but tested annually for impairment) which cannot be “written up”.

Goodwill plays a role of balancing the consolidated balance sheet. Moreover, it can be calculated in different ways: Goodwill is the overpayment of net assets. From the “overpayment”, we can recognize it as the media to balance the balance sheet, which is the difference between total assets and total liabilities & SE, if any. From the “net assets” side, we can take the number from the definition to take total assets minus the total liabilities. We can also get the number from the total of shareholders’ equity. Both of the two ways include the fair value changes.

Total GE shareowners’ equity is the part actually owned by the parent, while the noncontrolling interests is the remains owned by the minority. Net earnings is the part belonging to the consolidated company while the net earnings attributable to the company is the part actually owned by the parent, whereas the difference in between is the net earnings attributable to noncontrolling interests.

Comprehension: under consolidation, assets and liabilities are combined as if 100% owned by the parent while the minority really exists and was included. Therefore, in the shareholders’ equity section and statement of earnings, there should be a separate item to reflect ownership of less than 100%.

For acquisition of less than 100%: The shareholders’ equity should be wiped out proportionately to reflect what is purchased or owned by the parent. The unwiped part of shareholders’ equity should be clarified independently and be attributed to the noncontrolling interest.

Comprehension: during consolidation, the 100% of the child is merged into the financial statement with the minority-owned part, except for the wiped-out shareholders’ equity. Due to the efficient control of the parent, the assets and liability can be thought of as 100% owned by the parent while the net asset, namely shareholders’ equity is not the case. Therefore, the shareholders’ equity should be deducted accordingly.

9.10 Appendix — Investment Taught in Chinese Class

保险资金是低成本的长期稳定资金，而且不会像发股票一样稀释股权，构筑以保险为核心的综合金融能力能够更良性地促进投资。

分类维度：

• 无控制：金融资产
• 重大影响：权益法
• 共同控制：取决于合营安排的类型
• 控制：合并财务报表

Holding of Less than 20%

Companies use the cost method. Investment is recorded at cost (the fair value when purchased) and revenue recognized only when cash dividends are received.

\[\text{投资收益} = \text{利息收入} + \text{股利收入} + \text{买卖价差}\]

Holding Between 20% and 50%

Equity method: record the investment at cost and subsequently adjust the investment account each period for the:

1. Investor’s share of the associate’s net income: Debit Investment, Credit Revenue from Share Investments.
2. Dividends received by the investor: Debit Cash, Credit Share Investments.

Holding of More than 50%

• Parent company — a company that owns more than 50% of the ordinary shares of another entity.
• Subsidiary (affiliated) company — entity whose shares the parent company owns.

Parent generally prepares consolidated financial statements.

9.11 Categories of Securities

Debt investments are classified into two categories:

1. Trading securities
2. Held-for-collection securities

Share investments are classified into two categories:

1. Trading securities
2. Non-trading securities

These guidelines apply to all debt securities and to those share investments in which the holdings are less than 20%.

• Trading securities are ready for transactions and classified as current assets, recorded at fair value.
• Non-trading securities (shares only) should be recorded at fair value with changes reported as other comprehensive income in the comprehensive income statement.
• Held-for-collection (debt only) should be recorded at amortized cost, if the bonds were purchased at premium or discount.

Trading securities: “Trading” means “frequent buying and selling”, and they are held by companies with the intention of selling them in a short period (generally less than a month). Therefore, they should be reported at fair value and changes are reported as part of net income.

Non-trading securities: They can be classified as current or noncurrent assets depending on the intention of management. Procedure for determining fair value and the unrealized gain or loss for these securities is the same as for trading securities. Companies report securities at fair value, and report changes from cost as a component of equity.

Notes:

1. The classification of the securities varies in the impact of changes from cost. In the comprehensive income statement, the former affects the net income while the latter affects the other comprehensive income. The result of the comprehensive income is the same under the two categories.
2. The difference attributable to unrealized gain or loss should be based on the most recently adjusted cost (last year) of the securities, instead of the original historical cost. (Due to the fact that last year, as an end of past accounting period, has updated the account of investments or securities.)
3. Accumulated other comprehensive income is not closed at the end of each year! (By the way, the depreciation account is not closed at the end of each year. Usually, it is closed with disposal of assets.) So the unrealized gain or loss of non-trading securities is a kind of accumulated number over the past few years since purchase. The corresponding numbers on adjusting entry should be based on the difference between the two sequent years of OCI or unrealized gain or loss.

Short-term investments (marketable securities) that are:

1. Readily marketable
2. Intended to be converted into cash within the next year or operating cycle, whichever is longer.

Investments that do not meet both criteria are classified as long-term investments.

In the income statement, companies report gains and losses in the non-operating (or the investing) activities section under the categories listed with:

• Interest Revenue
• Dividend Revenue
• Gain on sale of Investments
• Loss on sale of Investments
• Unrealized Gain — Income
• Unrealized Losses — Income

9.12 Consolidated Statement of Financial Position

Core: transactions between the affiliated companies are identified as intercompany transactions and are eliminated in consolidation. The long-term investment in the child is a kind of purchasing back its own shares, which is treasury stock. In the consolidated financial statement: debit treasury stock, and credit cash.

So, when consolidating the parent and child, the treasury is the offset account to equity, which is a kind of deducting shares equity in the child and at the same time, taking away the long-term investment. (The “investment” is to purchase “its” shares back, which is not investment at all.)

〈If there exists any long-term investment on the consolidated financial statement, it means that the company has invested for 20%–50% in other companies.〉

9.13 金融资产三分类

• 摊余成本（Amortized Cost, AC）—— 后续计量仅反映利息收入或费用。
• 公允价值计量，变动进损益（Fair Value Through Profit and Loss, FVTPL）—— 后续按公允价值重新计量，变动全部进当期损益。
• 公允价值计量，变动进其他综合收益（Fair Value Through OCI, FVOCI）。