Accounting –
Professor Brotman – Fall 2001
12, 5 pt mult choice; 10, 6pt short answer (more than ½ questions do not even have #’s on them) – keep in mind
DEFINITIONS!! That we spent time on in class. Because those will likely be on there. Looking at old exams is not that great
of an idea – the quantitative issues have been greatly de-emphasized.  go through answers that Brotman handed out – but, no
real need to review each answer key. Meat of the exam comes from last 7 or 8 weeks of the course
MEMORIZE!!:
 Assets, Expenses = Debit Accounts = Left Hand Accounts/Entries
 Liabilities, Owners Equity, Revenues = Credit Accounts = Right Hand Accounts/Entries
Debit
Assets
Credit
=
Liabilities + Owner’s Equity
**Expenses are an intraperiod decrease in owner’s equity, and therefore, they are DEBIT
accounts because owner’s equity is a Right-hand side balance, therefore, expenses appear on
the Left-hand side because they must be credited against owner’s equity.
**Revenues are intra-period increases in owner's equity, and therefore, they are CREDIT accounts.
Therefore, Revenue appear on Right hand side.

Introduction to GAAP - Generally Accepted Accounting Principles result of choices made by Financial Accounting Standards Board (FASB
- “independent” body but close to accounting profession)
REVENUE is the monetary amount of annual sales, including returned merchandise and discounts, i.e., it is the
top monetary figure from which costs are subtracted to determine net income.
B. Different sources of GAAP
1. FASB
2. SEC: Typically adopts GAAP, except when SEC defines accounting principles, in which case
accounting profession adopts SEC principle. SEC has the power since it makes the rules for the
exchange of securities
C. What is GAAP?  Four objectives:
1. accuracy/reliability (trustworthy statements) – Info needs to be an accurate system; no
mathematical errors.

I.e. Statements should be verifiable and tested free from mathematical
bias or calculation bias.
2. relevance (timely basis) – requires that info be recorded and presented on a timely basis so
that it may be used to forecast future performance and to aid in understanding past
performance.

E.g. The definition of “Recession” analogy—we do not want a situation
where we finally know that we WERE in a recession, 6 weeks after it is
already over.
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3.
comparability creating a system that enables a reader of financial statements to compare:
a) external comparability: (able to evaluate company against other companies) and;
b) internal comparability: compare a corp to itself over time (book calls this consistency
4. consistency (must use the same accounting methods from year to year). Requires Stability –
i.e. the entity should use the same accounting methods year to year. Accomplished through



NOTE: Brot suggests that we are currently in a period whre stability is
irreparably damagted because corps have ignored GAAP. Quarterly
earning reports are not the GAAP #’s, but rather, #’s that include certain
GAAP features.
E.g. Nortel Networks, last quarter, they took a $20B write-off, but
assessed it as a one-time charge. SO??
10 principles:
Separate Entity Assumption - entity being reported on is regarded as distinct from those who own it,
whether or not it is a separate entity for legal purposes.

Going Concern Assumption - entity will be operating indefinitely. Not going to liquidate or terminate
operations Critical to understanding the cost principle. Assumes that assets are being used for the business
and not for other purposes.

Time Period Principle - entities activities can be clearly divided into separate time periods, such as
monthly, quarterly, or yearly.

Matching Principle – must allocate to the proper time period.
a. Items of revenue allocated to the period during which effort was expended in generating
them; and
b. Items of expense will be allocated to the period in which benefit from them will
contribute to generating revenue.
c. Use accrual accounting not cash accounting. So deals with the wealth of the company,
not its cash flow. Ex. Problem # 4 in 2A. Interest expense does not accrue until next
month. May have to adjust later for year period report.
d. i.e. match expenses with related revenue when the benefit is recognized
e. EX. NY Ballet Co signs a ballet star with a very significant bonus – paid in Y1 of 3 in
her contract. Revenue associated with this expense will be paid over 3 years. KEY:
revenue is not always equal to cash expenditure and receipt.

Monetary Transactions Principle - Must be based on actual transactions. This is why goodwill is not
typically recorded on balance sheet because it is not directly tied to a recognizable transaction. In order to
record a transaction, the earnings process must be sufficiently completed. GAAP generally follows the title
principle of law. Ex. Problem # 3 in 2A for when orders are cancelable at any time. So you only record
transactions that can use monetary units to measure the actual transaction

Recognition Principle - items of revenue should be recognized only when the entity has completed or
virtually completed the exchange that generates the income. Should not treat something as earnings until
the earnings process is complete.

Principle of Conservatism - Understate, rather than overstate, earnings, etc. example: use of historical cost
is conservative.

Cost Principle - assets to be reported at historical rather than (higher) market cost. This is a hallmark of
financial accounting. See the “going concern” assumption. Because of the going concern assumption, take
into account the usefulness of the asset  assets reported at historical cost.
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o
Ex. IBM buys bldg in Westchester in 1980 for $1M. Report at cost even if the property appreciates
during term of ownership because the company bought it to help with the business and not to make
money. Otherwise, we would be assuming a liquidation and instead we assume a going concern.
Appreciation and depreciation of the building is not relevant to a computer corp who does not sell
real estate assuming the going concern principle.
a. Certain types of assets make this really important. EXCEPTIONS:
i. Cash - unless there was an official devaluation that US never had.
ii. Marketable Securities - FASB decided that since certain of these have such
immediate liquidation value, it would be improper not to treat them as market value
(FMV). Assets could be for use as cash equivalents
b. Generally, don’t value assets at market because problems of appraisal and FMV not
relevant.

Consistency - Within a set of financial statements, apply principles consistently (prefer not to pick and
choose).

Materiality - Info to be reflected in financial statements should be meaningful to users and not too trivial.
This is important because something can be individually unimportant but very important to aggregate (eg,
sale of one pack of cigarettes is not significant to the tobacco co, but the overall sales are significant).

Unmentioned Principle: disclose everything
D. Components of Financial Statements
1. Balance Sheet - like a snapshot of entity at any one point in time. Lists assets and liabilities of a
company as of a given date. Intended to reflect the financial condition of that entity as of that
specific date (what it owns and owes). Assets, liabilities, equity (defined as the residual interest in
assets of an entity after subtracting its liabilities). As a matter of convention, assets are listed on
the balance sheet in order of liquidity. A=L+OE.
a.
Assets: Things of equity value that the company owns (could produce future economic
benefits). Every asset is either creditor equity or owner equity. FASB's Definition: probable
future economic benefits obtained or controlled by an entity resulting from past transactions or
events. Note that all assets are really prepaid expenses.

For every asset there is a cost.

Current Assets: cash / cash equivalents, Accounts Receivable (A/R), Inventories, prepaid
expenses (like rent). Employees are not generally considered assets, though they may be
when, for example, when a sports team buys a contract.




Investing in the training of a future baseball player like Danny Almonte,
this technically fits the definition of an asset, but, we don’t like to talk
about pple as “assets” because of slavery.
NOTE: Research and Development Costs that Drug Co’s allocate to
developing new drugs are NOT an asset.
Long Term Assets: land, buildings / improvements, fixtures / equipment, transportation
equipment, property under capital lease
Goodwill - why would you pay more than FMV of assets for co? company has something
that exceeds asset value (synergy, reputation, relationship). Means ONLY the excess of
purchase price over FMV of net assets in business combination using the purchase
method of accounting. Saying “Goodwill” looks much better on balance sheet than
saying “look how much we overpaid”.
(a) Ex. MS would buy another company to cut competition. Ability to use names of assets is
(b)
important (trademarks). But, since we only record costs, the value of name would not appear
with any value on the balance sheets but would be included in price if sold.
Some valuable assets don’t appear on company’s financial accounting books: people (Bill
Gates), name (Coke).
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b. Liabilities:

probable future sacrifices of economic benefits arising from present obligations to transfer
assets / render services in the future.

current liabilities
(a) Notes Payable
(b) Accounts Payable (A/P)
(c) accrued taxes
(d) contingent liabilities ($ owed if standards are not met)
 NO Judgment Yet – i.e. there is no liability YET, thus, must make a
determination to consiuder whether it is likely enough to consider it a liability
even though it has not yet occurred.
 EX—Ford Motor Corp: and Firestone Tires, they pay to cover Warranties; this
is thus an ex of an expense that may or may not come due, but, in a given year,
it is possible to estimate how much you will owe.
(a) prepaid expenses (tuition for semester paid in August)
(b) warranty costs due in future
(c) bonds issued by the corporation – Debt securities, i.e. “Bonds Payable”
(d) mortgages
(e) long-term debt due within one year
(f) obligations under capital leases due within one year
(g) deferred revenue (services / goods to be provided)

long term liabilities
(a) long-term debt
(b) Employee Retirement Plans – but, there are uncertain and require actuarial analysis;
(c) long-term capital lease obligations
(d) deferred income taxes
(e) deferred revenue (services / goods to be provided)
b. Owner's Equity:

residual interest in assets of entity after subtracting its liabilities from its assets. Equity
represents the net ownership interest in the entity. It represents both initial investments
made by the entity's owners and entity's increases in income that it reinvests in the
business. There are two categories here - contributed / paid-in capital ($ exchanged for
shares) and retained earnings ($ / earnings kept in the company and not paid out to SH's).
(a) preferred stock
(b) common stock
(c) capital in excess of par value
(d) Retained Earnings (RE)
2. Income Statement (“Statement of Operations”, “P & L”) - Like a motion picture  profit &
loss statement, statement of operations; statement of revenue and expenses. Reflects performance
of the entity during a period of time (e.g., 1 yr). Lists revenues generated during the period and
total expenses incurred during that period. They also show the difference between these two items.
Difference between revenue and expense during each reporting period is called entity’s net income
for the period.
a. FASB's definitions
(1) Revenues = increases in equity resulting from asset increases and or liability decreases
from delivering goods or services that constitute the entity's ongoing major or central
operations. Revenues are intra-period increases in owner's equity. Examples include:
sales of merchandise, rendering of services, sales of securities by a securities dealer / of
buildings by a real estate developer, dividends and interest earned by financial
institutions.
(2) Expenses = decreases in equity from asset decreases or liability increases from delivering
goods or services or carrying out any activities which constitute the entity's major or
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central operations. Expenses are intra-period decreases in owner's equity. Examples:
cost of goods manufactured and sold, selling and administrative costs, and interest
expense of financial institutions.
b. Overview
(1) Revenue = increase in equity
(2) Expenses = decrease in equity
(3) Revenues do not equal receipts (i.e., A/R)
(4) Expenses do not equal expenditures (i.e., A/P)
c. Accounts:
(1) Expense Accounts (temporary)
a. COGS
b. Research Expense
c. Library Expense
d. Rent Expense
(2) Revenue Accounts (temporary)
a. Sales
b. Fee Income (services)
3. Statement of Retained Earnings- Historical record of the portion of net income (earnings) not
paid out to owners. For example - statement that lists the beginning balance in retained income,
followed by a description of any changes that occurred during the period and the ending balance.
This is not required by GAAP, but is required by the SEC for all public companies.
4. Statement of Cash Flows - Motion picture too. Lists the total CASH that flowed in & out of
entity. Reconciles balance sheet and income statement. Cash is important because creditors and
employees expect to be paid. This statement is used to determine if entity can generate enough
earnings to pay its obligations. Reconciles income statement with the balance sheet and tries to
give more info on where cash was spent during the given year or quarter. Note that this does not
explain how the company generates (or loses) cash. It just details the flow of cash.
 E.g. Dot com “burn-rate” how fast can you burn your cash.
5. Footnotes - Most information about financial condition of entity available in income statement,
balance sheet and statement cash flows. Where not sufficient, footnotes can elaborate and explain
information therein (eg, Loss contingencies).
E. Auditor’s Resposibilities: to look over all of the company's financial statements and determine how
accurate they were. Audits the financial statements of the company and opines whether these financial
statements are presented in accordance with GAAP.
1. Auditor’s Report - All public entities are required by federal securities laws to get these.
2. Management Letter - Auditor issues a separate letter to entity’s management. These letters advise
the entity’s management of any weaknesses discovered in internal control mechanisms, etc.
F. Hypo - SJ Partnership dissolution - only asset is building - cost $2M. $300k owed. Appraisal says fair
market value is $4M, NYC appraisal $3M (for prop taxes), and $600k tax basis.
1. Q: Which value do you use? Each partner would want to get back more than put in (benefit from
appreciation).
2. What does value mean? Each of these numbers reflects a certain value. Reasonable people
disagree. Purpose: value has a lot of different meanings. Each one correctly identifies a type of
value. Lawyer would look to parties’ intent for value and accountant would look to cost.
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3. GAAP: Financial accounting looks to have a system of reporting and recording financial
transactions. GAAP is a set of rules by which financial accounting is governed (not laws). SEC
(legal force) has its reporting requirements for each company on quarterly, yearly and on asoccurred bases. SEC generally defers to GAAP for its requirements. Significant overlap because
SEC guidelines are usually incorporated by GAAP.
II. The Fundamental Equation: Assets = Liabilities + Owner’s Equity
B/S
A
Left
(+)
=
Right
(-)
L
Left
(-)
+
Right
(+)
OE
Left
(-)
I/S
Right
(+)
Expenses + Revenue
Left Right Right Left
(+) (-)
(-)
(+)
eq cash 200
sales 200
note: i/s – during a period of time covers time between B/S1 and B/S2
Rearranged algebraically:
A - L = OE
Ex. If own house or car – how much is it worth – how much do I owe on it = the amt that I own.
IMP RULE : everything that we do MUST KEEP THIS EQUATION IN BALANCE
A. Fundamental Equation 1. Double Entry Bookkeeping - left side of equation must always be equal to the right side. Therefore,
there are 2 entries for every transaction to be accounted for.
a. Debit = Left Side Entry. An entry that increases assets or decreases liabilities. As verb, means
increase left or decrease right side (**of fundamental equation). (Decrease liability = to debit, e.g.
Accounts Payable). Debit accounts include:

Assets

Expenses
b. Credit = Right Side Entry. An entry that decreases assets or increases liabilities. As verb, decrease
left or increase right side (**of fundamental equation). (Decrease asset = to credit, e.g. Cash).
Credit Accounts include:
(1) Liabilities
(2) Owner Equity - on credit side of fundamental equation. Balances will always be credits.
(3) Revenues
To Debit = to increase the left hand side acct
To credit = to increase the right hand side acct
c. As a matter of bookkeeping, treat items of revenue and expense separately and reflect them as
subcategories of owner’s equity portion of fundamental equation.
d. IMPORTANT ASSUMPTION: every asset a company owns has a claim against it (creditors &
owners claims - liabilities & owners equity).
 ALWAYS MUST HONOR THE FUNDAMENTAL EQUATION – if increase a left hand
side balance, must decrease the right hand side acct.
 To Credit; therefore could mean either: to increase the right hand side acct or to decrease
the left hand side acct.
e. Assets – things of equity value that a company owns: FASB definition – probable future economic
benefits obtained or controlled by an entity resulting from past transactions or events
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(1) accounts receivable
 furniture
 machinery
 inventory
 cash
B. Journal Entries - p. 19. Book of original entry. Debits = Credits (always).
1. Debit / Credit - Debits must always equal credits.
a. Ex. Cash transaction - want to see all cash transactions at once.
“One owner invested $10k in the company.”
Journal Entry:
Cash $10,000
Owner Equity $10,000
What happened: the asset, cash, a debit account, was increased. Owners’ Equity, a credit account,
was credited - increases the credit account.
2. Owners Equity (OE) (or SH equity) - On credit side of fundamental equation. Balances will always be
credits. So in above example we credited, on the right side, owner's equity in the amount of $10,000.
a. Owner Equity = Revenues - Expenses
Revenues increase (credit) owner's equity, so the entry goes on the right side. Expenses decrease
owner's equity, so the entry goes on the left side (debit balance). THIS IS A GOOD WAY TO
REMEMBER WHERE TO PUT REVENUES AND EXPENSES
Watergate Theory of Acoounting – always Follow the Money.
Problem 2a. J & J Inc. p. 24
1 – Jack pays $5000 to J & J in exchange for 100 shares of J & J stock.
 Assets (Cash) increased by the amt of the investment, $5000, (and) OE [the common stock] increased by
$5000.
1A Cash
$5000
Common Stock
$5000
2. J & J buys tools supplies and a large tent from ABC Supplies for $1200 charging
1B Land
$5000
the purchase to its account. Assets increased by $1200 worth of supplies and
Common Stock
$5000
they incurred $1200 of liabilities in the form of promise to pay in the future
2 Supplies $1200
3. J & J orders $5000 worth of products from Xenon, that it expects will last until next
Accounts Payable
$1200
Spring. The terms of the order permit J & J to cancel the order without any obligation
4 Loan
$6000
Nothing happens – no obligations—no effect on either side of the account.
Note Payable
$6000
5 Equipment $5000
4. Assets increased by $6000 (loan) – as of TODAY, even if there is NO prepayment
Cash
$5000
option, because of the matching principle there is NO treatment of the interest of $600 in
6 Accounts Payable $400
this Account because nothing has happened yet. Note payable of $6000
Cash
$400*
7 Note Receiveable $500
7. Selling Equipment (assets); Getting
Equipment
$500 (because we lost this from our debit/assets)
asset in terms of notes receiveable
* Note – we are crediting an account with a left hand side balance therefore, we subtract here
C. Creating the Balance Sheet - Reflects beginning / end of period. Accrual Basis of Accounting (might be
cash, might not).
1. Journalize - At the end of each period, journal entries get posted to the ledger (we use T Accounts).
Always identify where the entry came from. To do this, we make book entry for original transactions.
o Journal also = “book of original entry”
o If do something financially, need to write it down here.
 Transaction – i.e. credit card, cash payments.
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
Non-transaction – i.e. passage of time. Ex. interest accrues every month even though may
not have interest due each month
2.
Post (to Ledger)- we take separate journal entries and put them into the appropriate accounts.
 Ledger = book of accounts, start to put things where they belong.
 Checkbook is a cash ledger – everytime that have a transaction that effects cash –
deposit/withdrawal/writing a check.
3. Adjusting entries are then made in order to reflect economic substance that has occurred without
adjustment. Examples include interest and depreciation. The adjusting entries (for example, addition of
interest) affect the accounts. Also, mistakes need to be adjusted. This is a way to account for activities
that occur without a transaction changes that reflect time or different circumstances
 for example, a pre-paid expense; or accrued but unpaid interest
4.
Close - close out accounts through temporary accounts. Revenue is only a revenue for a given period.
Therefore, the revenue for 1997 does not include any revenues generated in 1996. Revenue and
expense accounts are temporary accounts. We close them out and put them in permanent owner's
equity accounts through the Profit and Loss Accounts (P & L Accounts). (Note that assets and
liabilities are also permanent accounts)
 Permanent
o Assets, liabibily and shareholders equity
 Temporary
o Income and expense – measured temporally and after the given period of time is over,
must start over again. I.e. When Year 2001 starts, must start accounts over – for that
year you have not earned anything yet (i.e. January 1st 2001).
5.
Profit and Loss Accounts - Step before posting entries to permanent accounts. Do not have to use
these accounts, but you can (no theoretical meaning).
a. The P & L account is an owner's equity account, used temporarily for closing purposes only. Only
temporary accounts go into the P & L account.
b. Retained Earnings Account:  accumulated revenues and expenses. RE is permanent account so
want to use P & L as mechanical account where close revenues and expenses. Process results in net
amount in the permanent account.
6. How it works:
Use P&L account by moving everything from temporary accounts into it:
P and L
Closing Journal Entries example:
|
Revenues ####
|
P&L ####
|
P&L ####
Expenses####
THEN:
P&L ####
Retained Earnings/OE ####
Remember that temporary accts are revenue and expense accts for that period. Therefore, for the period, the
revenue and expense accounts must be “zero-ed” out in order to close out the temporary accts and moving those
accounts into ShareHolders Equity
o Revenues are Intra-period INCREASE in Shareholders Equity
o Expenses are Intra-period DECREASES in Shareholders Equity.
 Closing out the revenue and expense accts will accomplish this
At the end of the period, the revenue and expense accts should be zero, having moved those
sums into the retained earnings acct.
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7. After accounts are closed, you can generate financial statements. Always start with Cash.
1) Balance Sheet: heading has three lines
Assets
Cash
A/R
PPE
Total Assets
####
####
####
J&J, Inc
Balance Sheet
As of July 31, 1999
Liabilities
N/A/P
Total Liabilities
####
####
Owners Equity
OE
Total OE
####
####
Total Liab/OE
####
####
2) Income Statement
J&J, Inc.
Income Statement
August, 1999
Fee Income
Expense
Net Income
####
####
####
8. Note on Revenues and Expenses - See Problem 2B. Accounting is about revenues and expenses. GAAP
is not based on cash.
a. Revenue - Does not mean receipt of cash. For example, Bloomingdale’s has revenue when you
charge on their credit card, but not cash.
b. Expense - Does not mean expenditure. Charge on B-dales card. Expense is not incurred until
there is a legal obligation to pay. Expense is a utilization of assets in the conduct of business.
9. Review on Statements:
a. Journalize
b. Ledger
c. Trial balance
d. Adjusting  writing down economic events that occurred w/o transaction
e. Closing  getting revenues and expenses off the books
10. Note: it is possible to end a period with a negative revenue balance. For example, a retailer who ends
his year with a return will have a negative balance in his revenue account. It is also possible to have a
negative expense.
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Accrual System of Accounting:
Cash v. Accrual Accounting - Accrual and deferral are critical elements of GAAP. Cash Basis accounting
violates the matching principal. Revenues are not receipts and expenses are not expenditures
1. Recognition - When enough has happened to record it in books and records. The Physical act
of recording transaction. Ex. transaction, pay cash for inventory = recognition.
2. Realization - the conclusion that, for purposes of implementing the matching principle,
some item of revenue or expense associated with the transaction should be allocated to a
period other than the one in which the transaction occurs and is recognized. Realize
revenue or expense out of transaction. When, under the matching principle, some item of
revenue or expense associated with some transaction should be allocated to a period other
than the one when the transaction occurs and is recognized. This is when some economic
event is recorded onto the income statement. Fundamental element to show whether the
earnings process is complete.
a. Examples:

Easy ex (cash purchase of tv - recognition & realization simultaneous).

Difficult ex ($2000 paid for tv, tv to be delivered next Tues. Is the accounting
process complete? Tough to say because don’t know if x can cancel the transaction
through a refund, etc). Has title passed? company has money but also still has
inventory. Hinges on title. Industry practice is very important here.

Hypo: Sometimes custom is to record orders before fruit harvested. (e.g. fruit
canning industry). Disclosure is important for GAAP.

Hypo: Comcast Cable - Jan thru Dec accounts. Sports seasons can run through
cutoff. Season ticket money paid in Sept. Do you recognize all revenue at this
point? Earnings process not complete because season services are split over 2
years. Also, pay players, etc over course of 2 seasons.

Retail: Most retail companies end their fiscal year in January or February because
they have huge volumes (of sales) in January and huge returns in January.
Therefore, they want sales and returns matched for season, not the calendar year.
This also makes it easier to take physical inventory.
3. Accrual and deferral: demand company recognizes its earnings cycle (equal fiscal years).

Accrual: the concept of recording a transaction BEFORE the cash comes in.
Recognize revenue before having receipt of payment. Recognize expense before
expenditure (e.g., taxes not paid until April). Accruals generally occur when you
must recognize an expense though you have not yet paid for it. Incur obligation to
pay. Economic event has occurred but for payment. . Ex. Borrow $ and at the end
of the financial period, interest is owed on the principal. Reflecting that interest is
owed, will be “accruing” the expense. I.e. recording the expense BEFORE it is
paid.
 Now, on October 10th, many companies are finally announcing their earnings
for 3rd quarter-end (Sept 30th) This is an example of an accrual because they
wanted to wait for any checks to bounce, etc So, they did not record or
announce cash/revenue that came in until later.
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(a) Example: Theatre Company paid after providing 4 shows
1. Realization
A/R
100
Revenue
100
 Put on first show
2. Recognition
Cash
100
A/R
100
Accrued Expense: Utility Bill/Phone Bill; Taxes. What economic benefit occurred such that we had to accrue
these expenses.
 Materiality: whether it is material; would a reasonable person believe it to be significant When
companies are audited, different entities have different thresholds of materiality.
 Another example of something that requires an accrual are taxes. Because, must show the expense for
the year in which the it relates. For example, don’t report to the IRS until April 15th for the previous
year.
 Yet another example of an accrued expense is a credit card, but, they are a little bit different (because it
is not an adjustment).
(2)



Deferral: NOT recording the revenue that you have already received; or,
Deferred Expense: in the sense of an expense, a “pre=paid” expense, that you
have paid, but you will use up the benefit in the future. Ex. Pre-paying rent and
then getting to use the apartment for the entire month. Prepaid Expenses are
Assets.
Deferred Revenue: i.e. cash that you have received, but you have not provided
goods or services until later, this is a liability because you owe someone
something in the future. Deferred revenues are liabilities.
Receipt without revenue and expenditure without expense. Defer realization of
revenue until earnings are received. This occurs when a transaction is not yet
realized even though cash, in respect of that event, is paid or received in that
period. Deferral is the notion that you have received or spent something before it
is appropriate to record it. For example, when money is refundable. Receipt of
cash that must later be deferred is a liability. Revenue received in advance is a
liability. This generally occurs when you receive cash and do not want to record it
yet. Deferred income is unrealized revenue. This is a liability because you either
have to do the service or return the money. (Note - prepaid expense is an asset.)
(a) Example: Rent an apartment. Usually you pay in advance but you have not yet
incurred the expense (because you have not yet occupied for that month). NOTE: This
is an accepted departure from GAAP.
(b) Example: Record industry. When record store buys records from the label, they
usually have a right of return for 100% refund. Hypo: Warner sells 100,000 at $5
each. Tower pays at delivery. How much revenue does W recognize? In theory, W
cannot fully recognize for the sale until the end of the return period. However,
through estimates, industry custom & predictability, W could record something. If
there is a reasonable basis from experience as to how much will not be returned, than
the company can record based on estimate from historical practice. If there is no
historical practice, wait until end of returns period and then tabulate on the basis of
what actually happened. Then, if there are returns from Tower, you know what has
happened and you can realize the revenue. This is an example of the principle of
conservatism because here we tend to be conservative versus optimistic. You can
always make adjustments later. (**Make sure to understand the difference between
recognition and realization in practice)**.
(c) Deferred Income Tax = asset
11
(d) Example: Buy 4 show tickets in advance:
1. recognize
Prepaid Entertainment Expense
400
Cash
2. realize (after attending first show)
Entertainment Expense
100
Prepaid Entertainment Expense
3. This is an example of deferral  deferring realization on
recognized transactions.
4. Deferral is the opposite of accrual  realize before
recognizable event has occurred.
400
100
Deferred Revenue: for example, cash that you have received but have not rendered the good or service for that
yet.
 Ex. MicroStrategy – software consulting company.
o Signed K’s to perform work and then booked it before they performed the work (which failed
to reflect the costs that they would later incur by actually performing the work). They did this
to demonstrate that they were making revenue.
o Other Co’s paid MicroStrategy cash for the license to use the software even though the
services were owed in the future and the licenses were not secured yet, the Software was yet to
be developed, or, where it was developed they would have to tweak it for a given customer.
Vs.
 MicroSoft: A different approach.
o Sold software operating systems and made the determination that they were giving a license,
and decided to treat 2/3rds of the revenue as deferred revenue – as a part of the earning cycle.
o MicroSoft was criticized for being too conservative; and insuring that they would have
revenue in the future. They were able to manipulate and manage what the accounting
information says. Even with MicroSoft, perhaps the revenues were not what they appeared –
they may have actually been higher at present time (and inflated later on). They started doing
this in 1994/95 and revolutionized the market with Windows 95.
o They had NO idea that everyone would buy new computers and were worried that they would
get So much $ now and feared a huge revenue drop-off in the future.
o Therefore, they developed the concept of spreading the revenue over an expected cycle to
make it seem like the revenue was more stable. Eventually, this did not come to pass and the
deferred revenue account grew so high that people began to look at them cock-eyed.

Philadelphia EAGLE ticket holders – Stadium Builder License (SBL) with the license you have the rt
to use your seats/buy those seats for a period of 20 years. Eagles are making fans pay for these over a
period of years. The Eagles will have to defer that revenue over a period of 20 years. The benefit to
the SBL holder will be over the next 20 years, i.e. the Eagles will be obligated to provide the benefit
for the period of 20 years.

Attorney’s Retainers as it relates to this example. (??)
o Earned Retainer: an initial retainer, a minimum fee that the lawyer has no obligation to return.
You get to keep it regardless of how much or little work is done for it. Brot believes that this
IS recorded as revenue, upfront, but, is not sure conceptually of how to work this.
(2)
(3)
Accrual and deferral deal with variations and judgment issues. Another critical
element is that you can wind up with really different assumptions. There are not
necessarily right or wrong answers here. Companies tend to go with “reasonable
estimates” = highest amount auditor will sign off on unless you know it’s wrong.
Audit process allows for a lot of negotiation as to what the company can get away
with reporting.
Deferred revenue is a liability  payment is received in exchange for a
commitment to deliver goods/services in future
12
(a) Microsoft defers revenue  sell Windows for $120
1)
Year 1
Cash
120
Revenue
40
Deferred Revenue
80 = service they are going to provide
2)
Year 2
Deferred Revenue
80
Revenue
80
Examples:  Objective of accrual device = benefiting the income statement for the period in which the work was
done. Achieve by using only balance sheet accounts in respect of the cash payment and then using income
statement accounts when the work is actually done.
 For deferral events the cash payment precedes the economic event
 For accrual events, the economic event precedes the cash payment.
NOTE: Often an issue in accrual and deferral is when legal title passes from the seller to the buyer. Accounting
follows these general rules of when the transaction is complete.
 “FOB Shipping” means – the title has passed once the goods are passed to the shipping company; i,e, if
the goods are lost during shipping, the buyer is liable.
o Ex. Someone from Seattle selling something to someone in NY, and they put it on the plane,
then, at that moment, for them, the sale is complete. This is a big question for the CPA exam.
 “FOB Destination” – Title does not change hands from buyer to seller until destination is reached.
Price-line.com, i.e. “Brotman’s ‘poster-boy’ for bad accounting practices” – not that they are illegal or not
GAAP, but just that they do not make sense. Internet travel provider and their gimmick is “name your own price”,
if they are able to find you a ticket that meets your qualifications, your credit card gets automatically charged and
the card is charged the moment they accept your bid.
 From their perspective, they check their database to see if something is available. And, at the moment
that you get notified, they charge your credit card. Their arrangement with the airlines is a fixed
amount.
 I.e. Phila to Chicago they call sell for $73 and they get $75 from you. The surplus
goes directly to ARC, a clearhouse that divies up/distributes the $, i.e. pay taxes, their
own fee, the airline, and then Priceline
o Contrast: calling Rosenbluth travel, when ticket is purchased credit card says “Delta”.
However, Priceline, is the Merchant of Record, who appears on your credit card/
 Priceline is the “merchant of record” --> i.e. the risk of loss is on Priceline (where the credit card is
bad or you try to back-charge).
 Priceline treats the entire $75 as revenue. Because they are the merchant of record and bear the intial
loss, they treat the entire amt as revenue, even though they do no even get to keep close to the $75 of
revenue. They, thus, were showing that they had tremendous amount of revenue.
o I.e. they would say we made $1Billion whereas they only had $90M (9 percent of the
announced revenue).
  Also, in order to drum up business for students, sometimes, if you would bid $75 and the best price
was $80, they would pay the difference on a not insignificant amount of tickets. In these cases they
were STILL recording the $75 as revenue even though they were actually reimbursing the airlines $5
and running a loss on that transaction.
  POINT: this is allowed within GAAP, even though Brotman says it is legal, but bullshit,
nonetheless. Therefore, important from a business perspective for investing, to note accrued and
deferred expenses. Really need to look at things qualitatively as a lawyer when doing an IPO for
a company. SEC will issue comments in letters during IPOs. Lawyers should be the critical
professional advisor intimately involved for the client.
13
Problem 13
Debits | Credits
13a) Security Deposit
Cash
$150
$150
13b) Phone Expense
$50
Phone Payable
$50
14) Interest Expense
$50
Interest Payable
$50
15) Prepaid Insurance
Cash
$1200
$1200
15*) Ins Expense (Aug) $200
Prepaid Ins
$200
16) Bonus Expense
$700
Bonus exp payable
$700
13a) J subscribed for cell phone services from Nynex
and paid Nynex a refundable security deposit of $150
in repsct of the cell phone
13b) During August, J incurred phone charges of $50,
for which it is billed on Sept 10, payment due on Oct
10,
14) Interest accrued on the note due to Citybank (6K
note at 5%/year)
15) J purchased a liability insurance policy paying a
premium of $1,200 for coverage from Aug 1 thru Jan
31st
NOTE: this is an adjusting entry to reflect that we have
used the benefit of prepaid insurance for 1 of the
months.
16) J became obligated to pay Jack and Jill bonuses of
$300 and $400, respectively, per their –ee agreements
17) Cash:
$200
Unearned Revenue
$200
17) J agreed to provide repair svcs to the members of a
local club, beginning Sept 1, at a monthly fee of $200.
club paid $200 in advance as its Sept fee
18) Inventory
Cash
18) J paid $1000 for tires and tubes it plans to resell –
the tires and tubes were delivered.
$1000
$1000
Remember, accrued expenses
are DEBIT accts and deferred
expenses increase liabilities.
– Enjoyed econ benefit before
had to pay.
Also, not relevant what day
bill received or due, Must
record for period during
which expenses were
incurred.
This is a Deferred Expense –
i.e. pay for it, but will use the
benefit in the future –
deferred expenses are assets
Deferred Revenue –
which is a liability. This
is the Micro-Strategies
example, above
We want to DEBIT
(increase) ASSET acct of
inventory for $1000
Decrease ASSET of cash
for $1000 by crediting it.
Valuation Principles
A. Time Value of Money - the principle that $1 today is worth more than $1 tomorrow. Due to inflation, an
amount of money today is worth less than that amount of money at some future time. Accounting generally
fails to take into account this valuation information. 100 dollars today, is worth 103 dollars if the interest
rate is 3% -- interest is what you pay to use someone elses $$.
Interest has 2 components:
 Inflation rate – the interest you make on the $ you lend out should beat the inflation rate or else you would
not lend the $$ in the first place
 Utility – or, AKA, the “real interest rate” -- Federal Funds Rate – the rate at which the federal reserve
charges other banks to borrow on an overnight basis (that was 5.5% a year ago); but, the real interest rate
was ??
o Reagan running for re-election in 1984 – Argues that interest rates have fallen tremendously and
that has been great for America (the prime rate was, in 1980 21%, whereas in 1984 it went down to
12%…however, Mondale noted that the real interest rate was actually higher than it had ever
been because of Budget Deficit which caused the interest rate to go up – In 1984 the inflation rate
was 13%, but, the nominal interest rate was 9% -- therefore, the real interest rate was 4% (higher
than it had ever been.
 Spread: the difference b/w the risk-free rate and the market rate – the 1 thing considered to
be risk-free is the US Treasury Bond Instrument (there is no risk associated with this) –
ALL that you are being compensated for is the time value of $$ and a nominal
transactional cost. If buying an instrument from Citibank, there is some type of premium
for taking that risk – so, the difference in the Commercial Loan interest return and the US
Treasury is the spread
14


Ex. Mortgage Interest Rates – beginning of 2001 when the 10 year mortgage was
very LOW – (weighted average maturity of Mortgages went way down from
5.75% to 4.5% -- but, the actual change in Mortgage rate was less – only
.5%)…this created SPREAD
Interest takes away value – (ONLY not true when there is a deflationary period and a
negative interest rate). I.e. effectively, during all periods, prices rise – therefore, interest
takes away value because things will be more valueable in the future.
 October Ford Motor Cars Billion Dollar Debt Offering:
o IMPORTANT: aspect of bond is its pricing – i.e. its coupon rate.
 Road Show: make a presentation to potential investors for equity
or debt offering in order to lend credibility to the investment and
put a face behind the offering. Ford goes out to sell $9Billion of
Bonds at 7% (time-lag b/w registrering the bonds and selling
them) – the interest rate that pple are willing to pay for the Bond is
7.1%
 10 Years; 7%; $1,000 --> what if investors ask for the
bonds at the 7.1% interest rate? The price of the bonds
will go down –as interest rate (yield) goes up, the price
goes down. As interest rates go down, price of bonds
go up.
  This is important in accounting because most Co’s do
not issue the bond at par – i.e. face value. --> if Ford sells
the bonds AT PAR, then, the interest rate has NOT
changed at all—i.e. it has stayed at 7%. This almost never
happens because, on a $9B bond offering a change in the
interest rate of .01% is worth $9M.
 Discount: when you pay or receive less than face value. If
interest rates have gone up, the difference in the price is
named the discount. (i.e. the company issued bonds for
$990 instead of $1000)
o  KEY PT: Level Yield – the interest rate that
an instrument is sold at or issued/ NOT its face
value– this is amortized over the life of the loan –
where, every year, the person will get $70/year
over 10 years to total $1000—the extra $10
represents the change in interest rate on the day
you purchased the bond. The interest rate is
based on how the instrument was priced on the
day of issuance at the issue rate and NOT the face
value – i.e. in this case, if the interest rate goes up
to 7.1%, then the bond is issued at a discount and
the 7.1% level yield is used to determine the
payments you receive.
 Original Issue Discount (“OID”) this
means that you will be taxed on revenue
that you do not receive until later on.
This was to counteract cheating through a
loophole in the 1980’s interest yielding
instruments issued at a VERY low price
(getting NO return on their investment for
10 years – then, getting the return based
on capital gains (MUCH LESS than) at
the rich pple’s marginal rate.
15

o
4.
Premium: when you pay or receive more than face value
– this is good if you are the buyer of the bond.
o Extreme example: a 1 year bond – today, can buy
it for $1000 (1 year until maturity) – therefore, 1
year from today, you get $1100. If everyone else
is willing to give you a 20% interest rate i.e. 1200
1 year from now. Ask self: now, how much less
do I have to invest to yield $1100 (much less than
$1000).
o Pension Funds or Insurance Companies may buy
bonds – Insurance Co figures out when you are
supposed to die and then buys a bond, an annuity.
 Registration Statement: meeting State Blue-Sky filings even for
private placements.
HYPO: 10/29/01 – Brot; says it exposes some of the deficinies in accounting. – That Accounting
does not take into account that Time Value of $$, becomes a BIG problem when you are in a
period of much higher inflation – NOTE: Beginning of 1980 where the price of gasoline exploded
and the inflation rate went crazy – in 1980 it was at 20% when, in 1982 it was 14% (in a period of
4-5 years, prices doubled, and, in a year of 2-3 years, prices went up 50% -- This becomes an issue
because you have inventory that you may be holding for 10 months – therefore, for prices to
increase 20% (like in 1980 when it went up that much in 1 year), it would normally take 3-5 years
to increase that amount.
 Another Weakness Example: High-Value low margin business (sell a lot of product, but,
do not make a lot on each sale) – i.e. make legal pads and sell 20M of them 1 month – sell
1M per month and make $.10 on each. --> Imagine that you make the 10% margin and
you’re in an environment in which prices are increasing 20% per month. From an
accounting p.o.v. that is NOT reflected. Accounting makes NO effort to distinguish b/w
doubling your $$ in 1 year or in 15 years. --
Why do people generally prefer earlier payment of money to deferred payment?
a. Utility - Immediate possession of the thing satisfies immediate desire.
b. Risk - Risk of non-payment of future sum.
c. Opportunity Cost -- some opportunities are mutually exclusice… -- what amount of $ to be paid
in the future would lead you – or most pple – to opt for future sum instead of the present sum.
Present Value  tells us what the right to receive a certain sum at some point in the future is worth to us today.
And, allows us to determine the rate of return we will receive on our investment if we anticipate receiving a
particular sum of $ in the future. By determining the present value of an investment we can compare it not only
with the right to receive a sum of $ today, but with the present value of other investments that are available
to us.
2. Interest Rates: at a certain level, the cost of money is the interest rate.
a. Base Rate - component of Interest rate that compensates for inflation. There is no profit here,
just full repayment of a debt owed. Business people need to be able to compare cash flows,
compare opportunities. Ex. Someone lends $1000 today. If 3% inflation, when you pay them
back in 1 year, they need $30 more.
b. Real Rate:
1)
2)
3)
Risk.
Inflation
a) minimum interest charged has to equal rate of inflation
b) real interest rate is rate without inflation rate factored in (??)
Cost of Money
16
a) risk that inflation will increase
b) cost of transaction
c) inability to use the money for something else
4) Accounting ignores interest rates  We use historic cost instead of market valuation
c. Concept of Present Value allows valuation in understandable, comparable way by converting
future payment to value today. Therefore, you can understand what a payment of $5000 in 5
years would be worth to you today.
d. Compound interest: earn interest on the interest
B. Future Value - What a dollar saved today is worth in n years. What is the FV of $X in n years, using
interest rate of K% [See Tables ch. 10]
1. Formula: FVn = x (1 + k) n
[ FUTURE VALUE FACTOR]
x = amount started with;
k = interest rate;
n = number of years
-- Note that the higher the interest rate, the greater the future value **
-- Use the formula or just refer to the tables in the book at p. 183. To use the table, just
multiply X by value on table.
2. Compounding - earn interest on interest that you have accrued over time (part of computing future
value). FVn = x (1 + k/m) mn
m = number of times per yr interest will be paid;
mn = number of times compounding will occur,
so if semiannual, divide k/2 and multiply n(2).
a. Example: X wants to buy $1000 item in one year. How much $ does X need today to have to
get it?
FV = $1000, interest rate (k) = 10%, n = 1, x= ?
x + .1x = 1000; 1.1x = 1000; x = 909 (Note that no taxes are assumed here.)
b. Can still use chart, just adjust % and periods (by using mn vs. n)
c. Future Value will be higher if compounded more than annually because each time you
calculate the value, you have a higher number from which to begin the next calculation.
C. Present Value - Tells us what the right to receive a certain sum at some point in the future is worth today.
Take payments that will occur in future, discount for PV and calculate how much they are worth today. [
What is the PV of $X to be received at end of year n, assuming discount rate of k%]
1. Formula: PV = xn / (1 + k) n
[PRESENT VALUE FACTOR]
k = discount rate



The higher the discount rate, the lower the present value.
Calculate this according to the formula or use the table at p. 181 and just
multiply x by the number given in the table.
PV will be lower if compounding is done more frequently than annually.
2. Present Value of an Annuity (ie, present value of a stream of payments) [What is the PV of the right to
receive $X at end of each of the next n years, assuming a discount rate of k%]
 xn / (1 + k) n
a. If an investment contains a lump sum and a promise of an annuity, then use table (p. 181) for lump
sum component and table (p. 183) for the annuity component. THEN add the two PV’s together. -Note the 3 steps here.
b. Bonds: company says it will pay you a certain amount of money. If interest rates go down, present
value goes up and if you only want an 8% return on money, you can invest more than $1000/yr
because still would get $100/yr at 8% (and $1250/yr). Bonds do well when interest rates fall.
17
c. Need to separately account for those amounts. When you figure a bond, figure lump sum and
annuity, then add them together. Annuity = $100/yr, every yr for 10 yrs. Constant, regular.
d. To compare investment alternatives, need to be able to reduce to present value. Also, the higher
the interest rate, the lower the PV and vice versa. GAAP's weakness / failure is that it is in nominal
dollars (historical price). We don’t change the balance sheet to recalculate receivables at new
present value.
e. PV is objective (mathematical certainty), whereas appraisals are subjective.
3. Compounding and Present Values - PV = xn / (1 + k/m)mn
n = 2 , PV = x, k = 10%, FV = 1000
x + .1x + (.1x (1.1x)) so x = $826 (essentially 909-82.60).
The more time you have, the less you have to save.
a. Most critical factor: Higher the interest rate (price to use $), less $ you get to keep. More you
pay for interest, the more present value declines. As interest declines, present value increases.
b. ex. if k = 8%, PV will be higher than if 10%.
D. The Rule of 72's:
1. To determine how long it takes to double your money, you can divide the number 72 by the rate of
return.
2. Therefore, if you assume a rate of 8%, then it takes 9 years to double your money.
3. If you divide 72 by the number of periods, you get the interest rate it takes to double your money in
that amount of time.
4. This works most accurately at the center of the curve (8-9 / 9-8).
E.
When assets are not interest bearing, we tend not to account for future and present value. This is true
even though an amount contracted for now may be worth less by the time it is ultimately paid.
So, if you contracted to receive $ for your services over time and got $100K up front and $10K each of
the next 5 years, how would interest rate affect that – i.e. it is NOT worth the entire $160K <<<
INVENTORY – CHAPTER 4
A. Bookkeeping Issues - Evolution of U.S. into manufacturing society created a need for accountants because
of concerns about the flow of goods. Accounting assumptions about inventory do not necessarily
correspond to flow of goods. Now we are much more of a service economy. Inventory is recorded at cost
in accordance with the cost principle.
B. There are three components to inventory - raw materials, finished goods and works-in-progress. All of
these elements have to be factored into an evaluation of inventory's value. Also, you must / may
incorporate labor costs, overhead (rent, security, real estate cost), etc. into the value of inventory. The more
you allocate to inventory the more of your "costs" are counted as part of an asset - here inventory. For
example, could Pfizer charge part of the research and development costs of making Viagra to inventory?
C.  When we value our inventory, how and when do we take the Cost of the Goods Sold (COGS) and put
it into the expense column . . . – When do we make entry to inventory –
a. Once we determine what the COGS are, we will make an entry debiting COGS and crediting
Inventory – the question is : do we do this EVERY TIME we sell a unit or – just at the end of
the period.
o Shift into manufacturing society, there became a huge emphasis on inventory – for car dealership,
each piece of inventory is very expensive and unique (with a vehicle ID #) – therefore, it is worth it
to keep track of all pieces of inventory sold.
o Contrast with Coca-Cola who makes soda and bottles millions of bottles of soda a day. – The
question of how to measure inventory is more murky here.
18
D. The other important element of inventory is that computerization has allowed better maintenance of
inventory. Almost everyone uses a perpetual inventory system now rather than a periodic inventory system.
 Inventory is in certain respects the ultimate prepaid expense because it will be converted into cost of
goods sold (COGS), like insurance, etc.
a. Perpetual inventory system: from a pratical business standpoint, this is better because, from a
managerial perspective it is VERY important to know how much inventory you have. Just about
everyone uses this now – before (like 15 years ago, this was not the case).
Periodic Inventory system: See below. Count up the costs at the end, and figure out what Costs of
Goods Sold was.
The following things “inventory spoilage” must be accounted for under COGS, not under the separate
expense of “Inventory Spoilage”. – this goes back to the “Going Concern Principle” – damage and theft
should be part of the cost of the inventory because they are a necessary part of doing business. Therefore,
spoilage is a part of COGS. Unless, of course, there is an anomalous event like an earthquake for which
you do not have insurance.
 Theft – a certain amount of this goes on in every business and MUST be
accounted for w/r/t inventory
 Damaged items – must account for it as well.
Is inventory an asset or expense? The reason a company has assets is because it is in the business of selling goods
and services for $ -- inventory, when it is sold, stops becoming an asset and becomes a cost.
We don’t know
whether it is an asset or an expense, though. It’s just something we use in the interim.

Efficient Market Theory  assuming full information all information is reflected in the market  effect on
accounting: markets are not efficient, thus FIFO and LIFO can show the same info in different ways. If
efficient market theory was true, people would not care about which accounting methods a company used.
1. General: Inventory is goods produced for sale or purchased and held for the purpose of sale.
a. OVERALL: What you start with + What you add = What you still have available – what
you finish with = what you used
b. Formulas:
(1) COGS: BI (beginning inventory) + P (Purchases/production) – EI (ending inventory)
(2) GP (Gross Profits on Sales) = S (sales) – COGS
HYPO Roommate and 6-pack of beer that you’ve brought home>>>based on the formula, there were 2 beers to
begin with; COGS = 2 + 6 - 3
COGS
5 (debit)
Inventory
3 (credit) [Ending Inventory -- 3 beers left over after we have sold 5]
Purchases
2 (credit)

NOTE: even if we engage in Perpetual Inventory, we still have to engage in this formula.
2. Periodic System - Bring inventory / COGS up to date periodically. Neither the Inventory account nor the
COGS account are kept up to date during a period. Instead, they are brought up to date at the end of the period
(which involves a physical inventory). Also, rather than making an entry directly into asset account of inventory,
use asset Purchase Account where inventory is bought from others and Production Account where the inventory
is produced internally. Main difference here is in the steps used in making closing entries. Historically,
everyone used this method because otherwise it was too hard to do inventory by hand. No separate entry made to
COGS when sales are made. Instead, you just figure out COGS at the end of the period.
a. Procedure:
(1) Step 1: When you acquire inventory, make a right side cash or A/R entry and a left side entry
to either Purchases or Productions (as appropriate);
(2) Step 2: When you make a sale, make a left side entry to cash or A/R as appropriate and a right
side entry to sales.
19
(3) Step 3: Do a physical inventory to find your ending inventory (EI). Then, you can determine
the value of COGS from the formula: COGS=BI + P -EI. [To calculate the value of COGS,
you begin by crediting inventory by the amount that was originally there (BI), debiting
inventory by the amount left at the end (EI), and you end up with the inventory reading the
value of COGS. (Note that you also have to zero out purchases.)]
b. Examples:
Periodic Purchase
Purchase/Production
XXXX
Cash
XXXX
Periodic Sale
Cash XXXX
Sales Revenue XXXX
At end of period need to count EI to determine COGS
3. Perpetual System - All elements of every merchandising transaction are recorded when they occur.
So sale and inventory reduction are recorded simultaneously. Accounting records, without regard to
merchandising activities, are constantly being updated during the reporting period to reflect all
merchandise-related activities. Under this system, there is no purchases account because any time you
purchase inventory, you immediately debit inventory and credit cash or A/R. Also, when you sell, you
debit cash and credit sales and you would also debit COGS and credit inventory simultaneously.
a. Procedure:
(1) When goods are purchased or produced (whether by cash payment or on credit), a left-side
entry is made to an asset account called Inventory (amount it cost to produce or acquire the
inventory) and a right-side entry is made to Cash or Accounts Payable for the same amount.
(2) When goods are sold, whether for cash or credit, make a left side entry to increase the related
asset account, either cash or AP, and a right side entry to the revenue account (Sales).
(3) Also, upon sale of goods in inventory, make a left side entry to the expense account (COGS),
and right side entry to the asset account (inventory).
(4) At end of period, do a physical count of the inventory and account for any difference
(shrinkage) in the number on paper and the number in reality. Make a left side entry to
COGS and a right side entry to inventory. Then. close these out through the P&L account as
usual.
b.
c.
Example
Perpetual Purchase
Inventory
XXXX
Cash
XXXX
Perpetual Sale
Cash (A/R)
XXXX
Sales Rev
XXXX
COGS
XXXX
Inventory
XXXX
At end of perpetual, need to count to determine breakage / spoilage / theft  Goes into COGS. 
use:
Inventory shrinkage XXXX (amt missing) [QUESTION IS THIS AN EXPENSE ACT?}
Inventory
XXXX (amt missing)
4. Users / Just In Time:
a. Types of users: Boeing Perpetual, Pencil maker Periodic
b. Inventory costs:
i. Four Costs
20
(1) interest (lost)
(2) warehouse (space, insurance)
(3) theft
(4) obsolescence
ii. JIT: Just in Time  saves these costs
(1) You want Perpetual if you use JIT
(2) Dell uses this and keeps margins down because less warehouse space is needed
(3) Under this theory, you only buy the inventory when you know you are ready to
sell it / when you have essentially already sold it.
c. Technology has led to use of perpetual increasing use, periodic could one day cease to be
GAAP
5. Under either system, you still have to count because you need to determine shrinkage - theft and other
damage losses. Two reasons for counting inventory:
a. Asset recorded.
b. Determine COGS during period (how much inventory should be converted into expense). COGS
includes stolen goods because going concern assumption dictates it’s a cost of being in business.
We have inventory in order to sell it so if it shrinks, that’s part of COGS. Natural assumption in
most biz that there will be shrinkage.
i. Hypo: Assume Sales $3000. (BI) 500 - (P) 1500, so available 2000 - (EI) 800 = (COGS)
1200. Hypo: B has $1000 in bank at the beginning of the year. Gains $25,000 over course of
year. End year with $6000. $20,000 spent.
ii. Formula - used whenever you need to determine COGS or EI and different prices of same
goods in inventory (inflation, eg). (Ex see 3d and 4th step under perpetual system). BI+P-EI
=COGS
B. Determining the Cost of Goods Sold (COGS) - 4 Assumptions (all acceptable by GAAP under certain
circumstances). We don’t really care if actual flow of goods matches inventory method:
1. Specific Identification Method  most companies do not use this method, except for extremely
unique, valuable items, for example, airplanes, homes, or artwork.
a. Ex. A is $100, B is $200, C is $300. Sold Item B, Cash debit $300, Sales Credit $300. COGS
debit $200, Inventory credit $200. Amount sold minus cost = GP (Gross Profit).
b. What kinds of goods would use this method? Unique, expensive goods (housing developer, Rolls
Royce, Jewelry). Expensive is not enough because could be fungible.
2. Weighted Average Method - Brotman says “poor” method
a. Typically used for very small, extraordinarily fungible and stable cost items. You can use this for
GAAP but almost no one does.
b. For example, imagine the gas station's tanks. Tanks are continually refilled with gas that came in at
different prices at each refill. Once in the tank, the gas mixes together and it is not possible to
separate the gas at price X vs. gas at price Y Therefore, use a weighted average (based on amounts
at each price).
3. Cost Flow Assumption Methods:
Sales
- COGS
= GROSS PROFIT (AKA “Gross Margin”) this reflects the concept that, if you buy something for $1 and sell
it for $10, the amount you lose on the margin when the price goes down is less
Gross Proft - Selling, Genral and Administration (incluiding taxes, etc. = NET INCOME
21
a. LIFO - Last in First Out (Book off top of stack, eg. - Barrel). Best in inflationary times because
highest cost items are sold first. Therefore, LIFO lowers the bottom line and therefore is best for
tax purposes. Don’t have to use same method for GAAP and tax purposes unless you use LIFO for
tax purposes in which case you must do the same for accounting. Once you’ve elected LIFO, can
only switch away 1x.
- (Note: Important in 70’s, early 80’s because of high inflation and corps wanting to decrease taxes
for corps who were getting killed by inflation. Accounting policies can evolve because of
lawyer-sponsored class action suits). Early 80's everyone switched to LIFO, early 90's, some
switched back because FIFO is a more honest method because it sells the oldest goods first.
With FIFO, cost of using method in this economic environment is really low.
- It has been said that FIFO is intellectually honest to the balance sheet and LIFO to the income
statement. On the day that the income statement and balance sheet are issued, an item of
inventory costs a certain amount. Inventory that is on balance sheet is oldest inventory and not
reflective of what it would cost to replace it today, so FIFO is better here. The income statement
is LIFO-oriented because want to reflect gross profit today.
- LIFO is better for tax purposes when prices are rising. With LIFO, you have lower profits and
therefore have to pay less in taxes.
b.
FIFO - First in First Out (Rotate Inventory - Pipeline). Gives higher profits when prices are
rising and therefore requires higher taxes. The assumption that the first good you buy is the first
good you sell - -and , in turn, the last ones you buy are the last ones you sell.
i. This is the preferred means for financial accounting.
c.
NOTE  Regardless of the Method Used, the corp has done the same business – and sold the
same amount. But, important corollary is that if LIFO is used for Tax purposes – it MUST be
used for business purposes as well.
d.
1980’s and early 1990’s, many companies switch back to FIFO because inflation goes down and
companies were NOT carrying as much inventory.
e.
Brotman’s classic Milk ex of the difference b/w FIFO and LIFO – FIFO is what the supermarket
wants to do with the Milk (first in, first out) – As the Consumer BUYS milk, he practices LIFO
(last in, first out) – we choose the milk with the most distant expiration date.
i. W/r/t inventory, must decide which method, FIFO or LIFO to use.
ii. In certain industries – i.e. Rolls Royce Dealer or Real Estate (large estates) agent –
then, you should use Specific Identification Method
f.
NOTES:
- With lower inflation / tax rates companies are now switching back to LIFO



5.
FIFO is a more balance sheet accurate method, while LIFO is truer to the
income statement.
FIFO – most recent units show up with most accurate cost
A company may only switch between LIFO and FIFO one time for tax
purposes, according to IRS rules. If you use LIFO for tax purposes, you
MUST use it for book purposes and vice versa.
IMPACT on balance sheet - consider this first choice among accounting methods: Ex Prob 4A.
IMPACT on income statement - statement on Gross Profit on Sales (GP = S-COGS)  this is the
amount by which sales exceed COGS or price charged less cost of acquiring.
b. Assuming the system that we have for accounting for inventory is a good one, the only number we
have to keep track of at the end of the period is spoilage.
c. The reason for this is because inventory is a major component of big theft and big fraud – as goods
get sold, people skim off the top [i.e. they fake the sale and then screw the books at the end by
making inventory higher than it actually was]
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Problem 4a (p. 64/65) make the following calcs first under FIFO, then under LIFO: A) the ending inventory; b) the
cost of goods sold (COGS); and c) the gross profit on sales
DATE:
UNITS
BI
100
1/15
200
6/15
200
8/15
100
EI
200
Assume net sales were $12,000
UNITS
BI
100
P
$500
EI
(200)
COGS
$400
Unit Cost
$20
$21
$25
$30
?
FIFO
$2,000
$12,000
(5500)
$8700
Total Cost
$2000
$4200
$5000
$3000
?
LIFO
$2,000
12,000
(4100)
$10,100
FIFO: the 400 units sold (out) were the FIRST 400 in, which were the 100 @$20 from BI, 200 @ $21
purchased on 1/15 and 100@ $25 purchased on 6/15. The 200 remaininf are the other 100 purchased @ $25
on 6/15 and the 100 purchased at $30 on 8/15. Thus, EI = (100*$25) + (100*$30) = $5,500.
 If BI = $2000, P = $12,200 and EI = $5,500, then COGS = $8,700. This can be confirmed by
seeing that the 400 solf (out) were equal to (100*20) +(200*21) + (100*25) = $8700;
 Gross Profit = Sales – COGS = $12000 - $8700 = $3300
LIFO: The 400 sold (out) were the LAST 400 in, which were the 100 @$30 on 8/15, 200 @$25 on 6/15
and 100 @$21 on 1/15. The 200 remaining were the other 100 purchased @$21 on 1/15 and the 100
valued @$20 that was in BI.
 Thus, EI = (100 * 20) + (100 *21) = $4100.
 If BI = $2000 and P = $12,200, then with an EI of $4100, COGS was $10,100
 This can be confirmed by seeing that the 400 sold (out) were (100*30) + (200*25) + (100*21) =
$10,100.
 Gross Profit = Sales – COGS = $12,000-10,100 = $1900
**NOTE: Regardless of the method, we sold the same amount**
Inventory is HUGELY important as a measure of fraud:
 Texaco Example: Texaco cheating the books by where manager would fill some of the oil tanks with water
and then add inches of oil on top of it – after this came out and the accountants got sued, accountants
started doing core tests on oil barrels (testing from the middle).
 Also: Crazy Eddies’ electronics approach – Eddie knew which order the accountants would audit his stores.
He made sure that the first stores were loaded with inventory and then when the accountants left, the
inventory would be immediately shifted to the next group of stores. Therefore, accountants have started to
spot check and use different serial numbers.
 Lila Inc. Copy machine business – went out and bought really good top of the line machines and released
them. Also manufactured 300 serial plates. Have 10 machines for 10 clients in 10 cities and ask Citibank
to borrow against these 100 machines, for example. The bank would search the UCC for serial numbers
and make sure it was OK and Lila Inc would get the $$.
Additional question – what are the respective concerns b/w buying a private company versus a public company
w/r/t FIFO and LIFO and skimming off the books?
o Private Co may be much more concerned with taxes and therefore, may try to understate their
inventory – they may not care as much about what their gross profits look like, especially if they are a
closely held company.
23
o
Brotman and Pharmacies Co buy-outs – lot of times, private companies, when sold, are valued too
high because they misrepresent their costs because the under-report inventory (in an effort to reduce
taxes). This makes the buyer 1) pay more [because reporting less inventory than there really is] and 2)
distorts the efficiency of the company management [amt of dollars earned in gross profit relative to
overall inventory] -- Therefore, as a lawyer, put into the formula of when to buy – make a carve out
where, if the inventory comes out 5% differently than expected on either side, you may delay closing.
C. Additional Accounting Issues for Inventories – SEE SUPP HANDOUT 10/16/01, p. 2 and INTEL Hypo
1. Lower of Cost or Market Rule - In line with GAAP’s principle of conservatism (no over-statements),
accounts devised for inventory use the LCM rule.
a. Rule requires that inventories be reported at cost, or market value if that market value is lower. This
is in line with the going concern assumption as well because assume we are going to use the assets as
for the use we bought them. Market = replacement cost.
b. RULE: Adjust Inventory valuation to replacement Cost when replacement cost is lower than
original cost if such impairment is permanent.
c. However, you cannot adjust value below a floor equal to Net Realizable Value less Expected
Profit Margin, or above a ceiling equal to Net Realizable Value.
 Purpose of the ceiling – to make sure that co’s write down enough for inventory – b/c of some
blip in the market where replacement cost is higher than net value.
 Ceiling ONLY kicks into place when it takes more to sell the inventory than to replace
it.
 ex. Manual Typewriters Phenomena – could not get new ones to sell for a while and
ended up in a situation where it cost you more to sell one than to acquire one.
 Purpose of floor – keep pple from manipulating inventory rates so low as, when you sell it, you
make more than the Expected Profit Margin. (this would manipulate future periods to reflect
future profits as:
  Don’t want to incentivize a company to take a 1-time charge in anticipation of
future exaggerated benefits.
 This is more likely to occur because of a dislocation in the market system
 Ex. Allegation regarding CISCO – pple thought that they were merely taking a HUGE
charge right now, so that, in future periods they would have a large # of inventory on
the books so as to create the appearance that profits and efficiency were robust.
Intel had 1,000,000 Pentium 3 chips (P3s) in its finished goods inventory as of 1/1/01. They had cost $22 each to make and
were valued at that amount. Intel had typically sold each P3 for $45 and incurred selling costs of $3.00. However, by 9/30/01,
the most that Intel could sell a P3 for was down to $26 with selling costs of $4. The cost to make a new P3 was $9. What
entry should Intel make as of 9/30/01?
Original Cost: $22; Original Sales Price: $45; Original Selling Costs: $3
Expected Profit Margin = Original Price (45) – Original Cost (22) – Original Selling Costs (3) = $20
Replacement Cost = $9
Current Sales Price: $26; Current Selling Costs = $4
Net Realizable Value (NRV) = Current Price (26) – Current Selling Costs (4) - $22
Rule: Adjust Inventory valuation to replacement cost when replacement cost ($9) is lower than original cost ($22) if
such impairment is permanent; however, you cannot adjust value below a floor equal to NRV less expected profit
margin ($2) or above a ceiling equal to NRV ($22)
In this example, since Replacement Cost is lower than ceiling ($22) and greater than floor ($2), we use it.
If it were above ceiling, we’d use ceiling (as long as ceiling were less than original cost).
If it were below floor, we’d use floor.
24
ENTRY:
Inventory Impairment Expense:
Inventory:
$13,000,000 (1,000,000 * (22-9))
$13,000,000
Q: ** Why did selling cost go up (from $3 to $4) at a time when cost and replacement cost goes down?
A: Intel pays a subsidy to the box-maker for running an ad or selling a computer with an Intel sticker on it.
Therefore, in times where they want to market a P4 chip, they will have subsidies of $3 for P3s and $.50 for P4s to
try to get the old ones off shelves more quickly.
Intel and CISCO – get to the point where sell more units than thought they would in calculating the depreciation
figure so that, when they sell the same
d. Obsolescence – [did we do this in class 2001?] events occur which render goods obsolete. When
inventory becomes obsolete, a company cannot keep it on the balance sheet. You cannot show it on
books if it is worth less than current market value - therefore you must make an adjusting entry.
We are willing to have balance sheet too high as opposed to the income statement too high because
we do not want to show higher profit margin than really have - so we incorporate any lower market
value. (Ex. important right now because of struggles in Asian market). To the extent that market
value declines below cost, an adjusting entry is made at end period to show decline. Make a right
side entry to inventory and a left side entry to COGS. (Note how this process is similar to the process
of making adjustment for shrinkage).

Current Replacement Price must be between the ceiling (net realizable
value if sold with no profit) and the floor (net realizable value minus
normal profit margin)

Obsolescence Journal Entry:
Inventory write down expense XXXX
Inventory
XXXX
Example
Buy 100 Units at: historical cost
15
Normal Selling Price
25
Normal Selling Cost
2
Cost to Buy now
8
Current Selling Price
11
Normal Profit Margin
8
25 – (15 + 2) = 8
Ceiling = 17 (net realizable value if sell with no profit) 15 + 2 = 17
Floor = 9 (net realizable profit value minus normal profit margin 17 – 8 = 9
Current Replacement Cost = 8
8<9
Write down = 7 (historic cost – cost to buy now) 15 – 8 = 7
ENTRY:
Inventory write-down expense 7
Inventory
7
2. Footnotes usually disclose which method used to determine COGS (Specific identification or cost flow
assumption like LIFO, FIFO or some average - though GAAP does not allow an average of LIFO and
FIFO).
3. Component parts of final product are separately costed and tracked on the internal books.
4. See class notes from 10/19/99 for example of writing down inventory in relation to lower replacement
costs  changing the books. There is also information here about ceiling and floors for costs.
V.
Depreciation: Accounting for fixed assets (FA)
A. Relationship to Other Concepts - Accounting for fixed assets is one of the greatest aberrations between
accounting and real life. The systematic allocation of the cost of fixed assets to expense. – NOT
25
intended to mirror actual value. For instance, a Co buys a manufacturing facility that it will use over
many years – cost $100M – if took the expense immediately you would have a $100M expense in Y1 and
no expense later. However, this means that you are NOT systematically allocating the cost of the expense
over its useful lifetime. The reason is because it is simply not practiceable given many different fixed assets
and given the difficulty and subjectivity associated with conducting periodic or continuous appraisals.
1. Fixed Asset - the assets a company buys to use over a long time to generate revenues (copy machine,
eg). (over 1 year). Matching Principle governs decisions about how to account for the acquisition and
use of FA. FA contribute to earning power of entity over entire useful life, so MP says cost of acquiring
FA’s should be allocated over that period of time. – something that you are buying as part of that asset
(going conern presumption – the reason you acquire an asset – a car – whether or not you bought the
floormats with it – it is inseparable to the car, conceptually. It is PART of the acquisition of the car –
floor mats, radio, undercoating.
 Buying a building example: lighting fixtures – ask: what is a fixture – not only is it inseparable,
but, it is part of the use of the building for the purpose of the building (ex. wall-to-wall carpeting) –
ASK: is it intended to be removed during its useful life. Furniture may or may not be intended to be
removed from the property.
 Refridgerators: when buy a house have to contract in whether the refridgerator with you. Contrast:
stove, garbage disposals, which are fixtures. However, if you are a LL, it is VERY hard to rent an
apt without a refridg – therefore, as a LL of a residential apt, some of the things become fixtures
that were not were you to be a normal owner. – the way this is reconciled with the depreciation of
the building itself (because the items have different useful lives) – is to a) use a blended useful life
table and b) re-capitalize or expense it to repair.
 Soft costs: attorney’s fees, architect fees, out of pocket insurance – any costs associated with
acquiring the asset.
 Ie. ANYTHING that is part of your cost in acquiring the fixed asset is a part of the fixed asset
(though, not counting things that are separable from the fixed asset).
2. Depreciation - Systematic allocation to expense long-term assets / the systematic charge against
earnings of the acquisition cost of fixed assets. Allocating the cost of a FA over its expected useful life.
We do not care what happens in real life as far as real declining value. Similar to accrual system
conceptually because prepaid expenses, inventory and depreciation are all employed in conduct of
business to generate revenue from period to period. (Otherwise, there are all sorts of timing problems).
NOTE - land is NEVER depreciated. Depreciation enables entities to charge against revenue on a
regular and periodic basis the cost of the Fixed Assets it uses to produce its revenue.
a. Systematic allocation of the cost of fixed assets to expense over the anticipated economic life of the
asset
(1) No relation to practical obsolescence
(2) Anticipated economic life is how long you plan to use it for the purpose for which it was
obtained.
(3) Longer / Shorter: Want longer depreciation for purposes of showing earnings, but want
shorter depreciation for tax purposes.
(4) For depreciation, unlike FIFO / LIFO, IRS and GAAP allow accelerated depreciation.
b. Accumulated Depreciation: accumulates all of the negative entries against and asset over time
(1) contra-asset  credit asset BUT on asset side -- a contra account is a temporary account
that is tied to a particular asset account; with contra accounts, you will have a left side
expense to which the contra account is the corresponding right side account - and this right
side account will be an asset.)
(2) Allows you to always see historic cost
c. Journal Entry:
Depreciation Expense XXXX
Accumulated Depreciation (contra account)
26
XXXX
B. Judgments Required for Depreciation Exercise - 3 preliminary judgments with significant consequences:
1. Historical Cost - Includes adaptation and installation costs plus historical cost. Use reasonableness



test to determine if maintenance costs should be included (ask: is this maintenance expense for ordinary
operation or extension of useful life?). TEST: whether the $$ should be deemed part of the historical
cost of the fixed asset and therefore allocated to its useful life ovder time or whether it should be
treated as a one-time expense. Capitalized costs v. expensed costs.
2. Scrap / Salvage Value - Portion of FA that will not be used up as such during its life. (RULE: you
cannot depreciate an asset below its salvage value). Book value = cost of asset minus amount it is
depreciated (at end will be same as scrap value but can be measured each year by subtracting
accumulated depreciation from net cost). Historical cost should exclude scrap value and include only
net cost, or depreciable base. -- the historical cost to be allocated over time should exclude that
amount – it is an amount that is not used up during the normal course of usage.
3. Expected Useful Life - This will be the time frame used for depreciation. Useful life refers to useful
life for context in which asset is being used. Compare historical experience of similar assets. Often use
IR Code.
Depreciating Costs over time rather than expenseing them when incurred therefore increases reported
income in the period of actual outlay and decreases reported income in the periods to which the outlay is
charged.
The lower the scrap value placed on a fixed asset, the greater its depreciable base and therefore, the greater
the burden on reported income.
The longer period of time over which the allocation is made the less the impact on reported income will be
in any given period. Thus, the longer the expected useful life placed on a FA, the less impact on reported
income it will have in any given year, but such impact as there is will extend over a longer period of time.
C. Bookkeeping Mechanisms for Depreciation - 3 Phases (for matching principle and cost principle)
1. Acquisition - Record FA at cost in left side entry under specific asset account (eg, copier). Make a
right side entry to cash or A/P. Include installation, etc. in cost because those are all acquisition
expenses.
2. During Useful Life - Each year, a portion of the cost is allocated as a depreciation expense. (ex. Copier
cost $11,000 to acquire; it has a 4 year useful life and a $3000 scrap value; so $2000/yr straight line
depreciation).
a. Must make adjusting entries each year: To do so, make a left side depreciation expense entry of
$2000 and a right side entry to the contra account - a marker - here called Accumulated
Depreciation. (Do not make an entry to the asset itself because we need to report the expense over
time.) This is effectively a decrease in the value of the FA on the books of the company. This is a
written way that enables us to show the histical cost of the copier on the balance sheet , together
with its accumulated depreciation over time.
b. End Y1 - Long Term Assets - Record book value which is copier cost less the accumulated
depreciation = book value (this is on balance sheet). You do not have to put the amount of
accumulated depreciation on balance sheet but in notes and the amount on financial statement is
net, without accumulated depreciation. See p. 73 and p.71-2 for examples.
3. After Asset’s Life - Both asset account Copier and contra account Accumulated Depreciation will be
affected.
a. End Y4 - Long Term Assets - Book value left = scrap value.
b. To account for sale for scrap value, make left side entries in cash for scrap value and in
Accumulated Depreciation for entire depreciated amount. (Note that the balance sheet now looks
like the example on p. 73). Consolidated balance sheets only report net income, not accumulated
depreciation (except in notes). Then make a right side entry to the asset (Copier) account for the
historical cost of FA to reflect that it is gone - i.e. sold and therefore no longer on the company's
books.
27
c. If a FA is sold for more / less than book value, you must record gain on sale or loss in the sale
accounts. This extra amount gained or lost affects the entity’s bottom line but is separate because
it comes from something not in the co's ordinary or central business.
i. Gain - Increases in equity generally from non-owner sources, which result from peripheral or
incidental transactions.
ii. Loss - Decreases in equity from same as above.
iii. These 2 categories are distinct from Revenue and Expense. Further, they can be used to
reflect incidental interest received or produced, profit / loss on incidental sales of investment,
etc. or profit / loss from litigation, etc.). Gains can also include dividends on investments.
iv. Ex. If copier sold for $5000 when it had a listed book value of $3000 then make a left side
cash entry, a left side accumulated depreciation entry, a right side $11,000 entry to the asset
account (copier), and a right side gain on sale entry in the amount of the gain - $2000.
v. If instead of a gain, the copier sold at below book value - therefore for a "loss," (sold for
$2000 when book value was $3000) make a left side entry to cash in the amount of the loss
($2000); a left side entry to accumulated depreciation for the full amount depreciated over the
useful life of the FA ($8000); a left side entry to the loss on sale account for the amount of the
loss ($1000); and a right side entry to the asset (Copier) for the value of the asset ($11,000). S
d. Mid course changes - if, in mid course, you discover that one of your depreciation assumptions is
wrong, (e.g. machinery becomes obsolete), you can change the values, but not historical
statements (i.e. statements from past years). Use the cost not yet depreciated and then change the
information from that point onward. You must disclose this action in a footnote. You only make
changes when your original estimates were significantly off base - for example, when a machine
you thought would last 20 years become completely obsolete after 2 years.
e. Always keep in mind expenses for Repairs, Replacements. – ex. tires that you buy to put on the car
you’ve had for 3 years already. The car cost $30K; Salvage value of $9000 you depreciated $7K
in Y1; 7K in year2 and then purchased tires for $1K. – this expense needs to be capitalized – it is
an expense that is added to the fixed asset which may or may not added to the expected life in
years of the asset. Ask 2 questions: 1) is it part of the cost of the asset[same question as
beginning]/i.e. a fixed asset; 2) does it make the estimated useful life longer?/Does it change the
salvage value.
D. Methods of Depreciation - See schedules in book
1. Straight Line Method: Most commonly used
Depreciation Expense = Cost - scrap value/useful life. Under this method, an equal portion of FA’s
cost, less scrap value, is allocated to each year of its useful life. (e.g., during a 5 year useful life,
allocated 1/5 per year). Then you need to adjust entry. (See Problem Five.) Example: Assume a
$30,000 acquisition cost and a $5000 salvage cost over a 5 year useful life. DE = (30,000 - 5000) / 5 =
5000 = depreciation expense / year. Method: Net cost (cost - salvage value) x straight-line percentage
each period. or (net cost - salvage value) / number of years. eg 25 x 1/5 - 5000.
Accumulated Depreciation Contra Account = the place where you put all the negative entries for a
larger account – a special type of account that keeps or tracks all of the negative entries to the
particular asset that which you depreciating .. FOR EX. SEE SUPP NOTES and Car. – It’s purpose is
to give us more information. . . For example, if you look at thebalance sheet of a company and it says
Building – 100M; versus Building – Accumulated Depreciation 96M – this shows that the building has
gone through 96% of its useful life. Contra acct is therefore a sub-acct of whatever it goes with – it is a
tracking account for certain types of entries.

Depreciation expense = (cost-scrap) / useful life
Other Examples of Contra Accounts? (think of the type of negative entries that you want to keep
track of): An allowance for bad debt – for example, if there is an account for Accounts Receiveable,
then, it is a good place to use a contra account. Or, Companies will use a contra account for sales –
28
because, they want to know both how much is sold, and more importantly in this case, is how much is
returned. Therefore contra accts should be used anytime when a business wants to determine its
net value. Any place where you care about a net #, you may want to use a contra acct to keep track of
the entries to the main account.
2. Accelerated Methods (lower earnings and lower asset values sooner than straight line. This can be
good for tax purposes. -- NB - we do not need to know these methods as per class on 10/23/01)
a. Sum of the Years Digits (SYD) - Increase portion of net cost of FA to be expensed in early years
and decrease for later years. (e.g., 5 year useful life  add the number for each year in a period (5
+ 4 + 3 + 2 + 1 = 15) to get the number which will become the denominator of the fraction. To
calculate the numerator of the fraction, use the next digit in line / the opposite number (therefore,
year one  5/15, year 2  4/15, year 3  3/15, etc.). See p. 78. Note that you still use net cost.







depreciation expense = (# of years / sum) * cost – scrap
This method is NOT used to reflect the computer or car phenomena
where depreciation takes place immediately – because, that reflects
actual value. There IS NO theoretical background behind this, says
Brotman.
Accelerated Depreciation  is given to Corporations such that they can write
off the costs of fixed assets now and use the $$ to reinvest
There is no real justification, though, it is really just a practical effect of it being
too complicated to make 2 separate books allocating assets differently for both
purposes.
Most corps use the straigt-line method OR, the UNITS of PRODUCTION
method, and this only works where fungible assets are sold
UNITS OF PRODUCTION METHOD for fungible assets -- If you know, when
you buy an asset, how many units you will sell, then, you can charge each unit
with an amt of depreciation – ex. figure out at the end of each period how
many units sold and multiply that by the amt of depreciation for each unit.
a. Example: a photocopy machine – it says how many units it can
produce over its lifetime and when it is sold to you, they advertise
that – therefore, after 100M or so copies, it may not have a useful
life anymore
Remember, salvage value is just an ESTIMATED USEFUL LIFE! –
contrast Brotmans refridg which lasted 26 years vs. old cell phones
whose useful life ends after several months.
b. Declining Balance Method - usually “double” declining balance method. Depreciate to salvage
value. This is an even more accelerated method that SYD. Here, you take double the straight line
percentage or fraction - or, for example, if the fraction under the straight line method would be 1/5,
then take 2/5. The MAJOR POINT HERE is that 40% is applied NOT to net cost but to remaining
book value subject to rule not allowing depreciation below the salvage value. Therefore, when get
to the point where the remaining amount of book value above scrap value is (less than 40%) not
sufficient to encompass a complete depreciation, just subtract the final amount above scrap value
leaving the entry at salvage value and then subtract zero for all remaining years in useful life.
Record opening balances.
c. Units of Production Method - can estimate how much use you will get out of a fixed asset and then
depreciate on the basis of that estimate. This would, for example, base the depreciation on the
predicted amount of product that a machine would make. Then divide the cost of the asset by the
number of products made so that during each period, you would depreciate for the number of
products you would make during that period.
29
4. These methods seem arbitrary so why do we not just take the real declining value? Because we need to
take into account the use to which we are putting the asset (useful life). When we talk about market
value, we are talking about liquidation value, which we do not care about if we are not going to sell the
asset. These co’s are not in the going concern of selling these assets - that is why they are classified as
fixed assets.
5. Justification for SYD and DDB:
a. Mimics real depreciation - equipment is worth more at the beginning.
b. Ease of computation
c. Accelerates tax deductions
d. Compromise in which one of the methods accepted by GAAP is friendly w/r/t tax.
6. Now, almost no one uses SYD and DDB because new system incorporated into tax code  schedule
system, Accelerated Cost Recovery System. -- that is why we do not have to know them - and they are
not GAAP.
E. Consequences of Conventions - Management of entity chooses method. Driven by impact on reported
earnings.
1. Financial Reporting v. Tax Reporting - Unlike COGS, management can use 2 different methods
(despite consistency principle) for tax and financial reporting. Therefore, companies usually use
straight-line method for financial reports and an accelerated method for tax purposes (so as to lower
liability (lower earnings)).
2. Consistency Principle - entity should avoid changing the method of depreciation for a particular asset
from period to period. GAAP prohibits change from straight line to accelerated for particular asset
(though not vice versa). However, not all assets must use same method.
3. Disclosure - Footnote should state the method, range of useful lives for asset categories, method of
calculating depreciation base - expensing v. capitalizing costs), method of treating FAs upon
disposition, etc.
F. Depletion and Amortization 1. Depreciation - technically applies to FA having physical existence (machinery, etc) and not those that
are literally consumed over their lives (oil, etc).
2. Other kinds of assets a. Depletion - depreciation equivalent for assets literally consumed (mineral, etc). Cost of assets
allocated based on units).
b. Amortization - intangible asset equivalent. (Deals with such things as patents and trademarks).
Carrying value reduced directly by amount of amortization expense without using a contra account
as accumulated amortization. There is a maximum of 40 years on goodwill.
HYPOTHETICAL with Handout on 10/23/01 (depreciation) – INTEL and Flashchips.
NOTE 1 – because at some point in Year 2000, we are not charging depreciation any longer (because we have sold
more goods than we expected) therefore, we have greater cash flow. But, even though we are selling more products
than the year before, we have a lower Gross profit percentage because of the high cost of goods sold.
Most companies choose alternative A – so that they may reach the sweet spot – i.e. by estimating their # of units
sold, if they underestimate that amount, they will, at some point when that amount has been exceeded, reach the
sweet spot -- -- this way, the gross profits will not fall off significantly in later years. Therefore, always ask
what the component of the gross profit percentage, how did it come about, and, is it a result of not fully
depreciating all of the expenses.
ASK BROTMAN MORE ABOUT THIS CRAP.
10/30 – Chapter 6 (A/R, Intangibles and Loss Contingencies)
VI.
Other Asset and Liability Issues This is an important topic.
30
A. Receivables - Accounts Receivable (A/R) - Amounts due from customers in respect of sales on credit. All
receivables are considered current assets. Example: X using a credit card is not an A/R to the bookstore,
but is an A/R to the bank issuing the credit card. Therefore, the bank would make a left side entry to bank
receivable in the amount of the transaction ($200) and a right side entry of the same amount to cash. More
typical with regard to businesses whose clients are other businesses. For example, receivables: make a left
side entry of $1000 and a right side entry to equity also for $1000.
Uses a lot of the same logic as Loss Contingencies.
Basic Principle of Acct = Matching Principle = match expenses to the periods in which they relate
 Bad debt (just like spoilage in inventory) is a cost of doing business.
 At the end of each period, we must make a determination as to what out accounts are. For instance, if
we have extended a lot of credit in 2001 and it subsequently goes bad in 2002; we NEED to make an
adjusting entry to our book.
 When is an appropriate time to not make an adjument and instead just write-off the bad debt when it
becomes due:
o Immateriality (i.e. – the de minimus exception)
o When you cannot make a reasonable estimate of the write-off amount –
 For ex, you have a lot of A/R in a NEW business era. For example: beginning 1999,
Nortel, CISCO, Lucent who had sold MASSIVE amts of goods to dot.coms and
telecom companies and nobody had any idea how much to write off for the receivables.
In the first year, when the Co’s. were paying for everything, they were paying off the
purchases based on IPO’s and in anticipation of Y2K there was a need for this.
Instead, estimates were not based on any particular historical significance and then
when the bad times came, there were HUGE charge-offs.
1. Hypo: Y sells $100,000 worth of plumbing fixtures on 2/10 on terms of net 30 days, with a special
provision that if payment is received within 10 days, he would receive a 2% discount. How do you
account for this? Assume this is the industry standard. Also assume that 94% of customers pay within
10 days.
a. Net Method: make a left side entry to A/R for $98,000 and a right side entry to sales for $98,000
OR
b. Gross Method: make a left side entry of $2000 to the account of discounting expense, a $98,000
left side entry to A/R. and aright side entry of $100,000 to sales. In this hypo, the net method
would be preferable. This method is generally used either after one has taken the discount or when
there is uncertainty about whether the discount will be given.
c. How many take discount? Assuming that most buyers will take the discount, then the issue is what
is recorded as sales. If a company normally has sales at a discount, then record as discount. If
only half of one's customers use discount (uncertainty), use left entry $100,000 to A/R and right
side entry of $100,000 to Sales. Then if the customer does pay within the 10 days to qualify for the
discount, then make a right side entry to cash for $98,000, a right side entry to discount expense for
$2000, and a left side entry of $100,000 to A/R - gross method.
2. Charge offs - uncollectible accounts that are not longer assets but represent expenses or the cost of
doing business by extending credit. Entity is taking enough risks if average expense here is at industry
average. Matching principle says that charge-offs must be allocated as expenses to the period in which
related sale on credit occurred, therefore, company's must make an estimate at the end of each period
as to what portion of A/R generated that period will eventually be deemed charge-offs (uncollectible).
If you underestimate to any substantial degree and the amount set out in the allowance has been used
up, you should debit bad debt expenses for the additional amount over the allowance. In making these
estimates, companies rely on past experience and current economic conditions. Under the principle of
conservatism, companies should err on the side of overestimate and not underestimating.
In order to do this, the company must make an adjusting entry to reflect this estimate:
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a. Costs of Doing Business  Allowance methods of Allocating Charge offs :
i. percentage of sales (based on historical sales) - Matching Principle
ii. percentage of credit sales (based on history) - Matching Principle
iii. percentage of receivables
Example:
Start with 100,000 A/R:
A/R
Sales
100,000
100,000
-- Collect $60,000 in cash on accounts due:
Cash
60,000
A/R
60,000
-- Allow 2% of A/R to be considered uncollectible:
Bad Debt Expense
800
Allowance for Doubtful Accounts
800
-- Next year, sell $150,000 on account:
A/R
150,000
Sales Revenue
150,000
-- Take in cash for $160,000
Cash
A/R
160,000
160,000
-- Now, write off $600 in uncollectible debts in A/R:
Allowance for Un-collectable Accounts 600
A/R
600
-- Now make an entry for the 2% estimated amount of uncollectible money owed. Here,
this is an allowance of $588. Because we already had an allowance balance of $200
remaining, we only need to deal with the $388 not yet covered.
Bad Debt Expense
388
Allowance for Doubtful Accounts
388
Actual write off to account is a debit to contra account and a credit to the corresponding asset.
Therefore, this really does not change the balance sheet at all and there is no change to net income.
If you underestimate to any substantial degree and allowance is gone, you should debit bad debt
expense for the additional amount over the allowance. An estimate must be "right when made," not
"right."
Note that on the balance sheet, you take A/R - allowance = net A/R.
Here 
A/R
29,400
Less allowance
588
Net A/R
$ 28,812
32
b. A/R aging (most commonly used and based upon how old the accounts are). As the accounts
become more aged, the percentage of the accounts that will go bad is higher. When Businesses ask
banks for a loan based on their A/R – the bank will ask for an aging sheet and then base how much
they lend as a percentage of the business’ aged accounts.
Ex. Credit Sales: $100K
A/R - $40k
 0-30 DAYS -- $25K
 31-60 DAYS -- $10K
 61-90 days-- $3K
 91 and above -- $2K
*2.5% of total accounts receivable = $1000 – we do not know which account is going to go bad, but, have credible
evidence based on estimations that $1000 will go bad.
This is a contra account which accumulates the
negatives from A/R
Bad Debt Expense (Debit)
$1000
Allowance for Doubtful Accts (Credit) $1000
Allowance for Doubtful Accts $600
In actuality, the amt of write-offs for 2002 was $600 (we overestimated)
A/R
$600
Estimating the amount for write-offs is a place where businesses can really hide things. In early 1990’s
banks were actually able to bear the brunt of economic down-turn because of the write-offs (estimating
how much of their A/R would be bad debt.)
Enron example now and $Billions of write-offs. Allegedly, Enron performed a Ponzi Scheme. Related
party situations – where entities were created and they booked a receiveable. Company A would buy
something in Fair Market to Company A for $100 and Enron would re-sell the item for greater and greater
prices to subsidiaries controlled by them… In turn, their A/R looked incredibly good.
How does an auditor come in and find out if the accounts are good – i.e. whether they are made up?
A: Run the A/R list through a computer and sends letters to other companies to determine whether the
amount owed is accurate…If a genuine third party is notified that their A/P to Enron is overstated, then
they will yell.
Ex. On 12/97, ABC Inc. has an A/R balance of $70,000.
On 12/31, A/R breaks down as follows according to how long $ is outstanding:
0-30 days
$50,000
33
31-60
61-90
91-120
121+ days
$10,000
$5,000
$3,000
$2,000
Allowance for bad debt = 100



Companies will take different percentages for each of these age-based
categories because there is a greater chance that a newer debt will
ultimately come in than that an older one will. For example, a company
might take only 1% of the amount outstanding from the 0-30 days period
($500), 2% of that from the 31-60 category and so on  a total of $3100.
Adjusting Entry at end period: make a left side entry to the expense
account called Un-collectable / Doubtful Accounts Expense. (That
expense will be closed out into the P & L Account at the end of the
period with all other expenses.) For the right side entry, we could just
reduce A/R by the amount of the estimated charge-off, however, then the
sum of the individual accounts would not equal the total amount of the
A/R reported. Therefore, for the right side entry, we use a separate
account, called Allowance for Doubtful Accounts. (This is a contra
account that matches up with A/R.)
Example:
Step 1: Allowance for Doubtful Account = contra account. Make a left side entry into
allowance for doubtful accounts for 3,100 and a right side entry to bad debt (or
uncollectible accounts) expense for 3,100. (If you used the percentage of credit sales, you
would not use allowance account). On balance sheet, A/R - Allowance = Net A/R
($66,800).
Step 2: When account goes bad, make a right side entry to A/R in the amount of $2700
(credit) and a left side entry to the allowance account for $2700 (debit). This write off
reallocates between primary and contra accounts though the net effect on balance sheet is
nonexistent.
c. Direct write off method: rarely used; done when you know that an account will not be paid off;
then you write it off. Note, this is not GAAP. For example, make a left side entry to bad debt
expense for $100,000 and a right side entry to A/R for $100,000. This method only works / is used
if the business is very small / the money in A/R is not substantial or if this is not a real business
(A/R few and big) can use this method.
d. Methods tell us when to record the expense:
i.
ii.
iii.
When it is probable and amount is fairly estimatable
Most business use allowance method  which requires an estimate
Direct write off is used when you cannot estimate or amounts are not material
B. Financial Assets - Investments in other businesses.
1. Marketable Securities (p. 89) (current on balance sheet) - NOTE - FOLLOW CLASS, NOT BOOK
HERE -- the book is wrong here and it DOES NOT FOLLOW GAAP…. Liquid Assets invested in
when company has more cash than necessary for current and near term business purposes. Historically
had to be reported at lower cost or market but problematic because of short term investments. For
34
example, companies have marketable securities for different reasons (See 3 categories below).
Companies generally favor things like income yielding securities, such as US bonds or other bonds and
stocks. Liquid assets like this appear under Marketable Securities in Current Assets section of balance
sheet.
NOTE: See Class Handout 11/6/01
a. Classification of Securities: Marketable Securities = securities that a company plans to hold for less
than one year from the balance sheet date. These are securities that not only can the company
readily convert into cash, but the company intends to do so. If the company plans to hold these
securities for a longer term, then they are called Investment in Securities which are listed as a long
term asset on the balance sheet. For the purposes of the published financial statements, all MS are
grouped together into a single line on balance sheet as current assets. These securities are listed
between current assets and other assets like property, the plant, etc. The accounting convention
here depends on the type of security (debt / equity) and the firm's purpose in holding it.
b. Valuation of Securities at Acquisition - Securities are initially recorded at cost, including
purchase price, commission, taxes, etc.
- Example: make a left side entry to marketable securities (MS) for $10,300 and a right side entry
to cash for 10,300.
- Dividends become revenue when they are declared.
- Interest on bonds becomes revenue when earned.
- So, if you have a dividend of $250 and interest of $300, make a left side entry in Dividend and
Interest Receivable account and right side entries in each of Dividend Revenue and Interest
revenue accounts.
c. Valuation Subsequent to Acquisition - Departs from strict acquisition cost accounting. 3 GAAP
required categories of securities: bonds (investments) held until maturity; securities available for
sale; and marketable securities. At the end of each year, the company will mark its securities to
market value - called "marking to market." (This is to mark the value on the books either up or
down, depending on what happened to the value.) If it is a trading security, the unrealized gain /
loss is an income statement item which affects your current year's earnings. If gain / loss if for a
security available for sale, then this is an owner's equity account and therefore it affects the balance
sheet and not the income statement. (This distinction makes sense with the going concern
assumption.)
- Example - if a company buys a stock for $95 / share and then its value goes up to $110, then you
would deal with the gain differently if you bought the stock for a business purpose (goes into an
owner's equity account for unrealized holding gain and not only the income statement) than if you
bought the stock for trading purposes (then it goes on the income statement). -- Note that to have a
business purpose, the asset does not go on the current year's income statement because it is not
income if it is part of a going concern for the business.
i. NOT MS: Debt securities for which a company has the positive intent and ability to hold until
they mature (ex. Bonds, Debentures, that buy for the purpose of holding to maturity)(example
- Coned buys US government securities whose periodic payments and maturation value exactly
equal its own outstanding bonds.) (ex. enter into a Settlement Agreement with a corp that you
35
have a Contractual Dispute with – the other party may insist that you buy a bond and assign it
to them collaterally. Recorded at amortized cost and then if there is a discount or premium it
has to be recorded at the discount/premium over the level yield (see, above) Here, debt
securities appear on the balance sheet at amortized acquisition cost. [Start with what you paid
for (+ premium or – discount  if you paid more than face value (premium) or less
(discount).) Then amortize the premium (expense) / discount (income) over the life of the
security. (Note that a premium reduces the income interest, while a discount raises income
interest.)] Must amortize difference between acquisition cost and maturity value over life as an
adjustment to interest revenue.
- Example of entries for a $1000 bond with an interest rate of 15% over 10 years:
Bond
1000
Premium
100
Cash
1100
Cash (interest)
140
Premium (amortization expense)
Interest Revenue
10
150
Ending book value after first year = 1090
ii. MS: Debt & equity securities held as active trading securities actively traded for short term
profit potential. (Ex. A Mutual Fund) These securities are held for the purpose of selling (not
for a business purpose). This category covers every security that is not a debt security or
security available for sale  so purpose matters. Include MS in current asset section of
balance sheet. These MS are reported at market value because that provides the most objective
value measure and the best information. Income Statement records loss (debit) and gain
(credit) for decreases / increases in market value in an account called Unrealized Holding
Loss or Unrealized Holding Gain on Valuation of Trading Securities. So therefore, if goes up
in value get gain in revenue and if goes down in value, take a revenue loss. (Note that these are
separate account from revenues and expenses).
- Process: make a left entry into MS at market price, a right side entry into cash;
make an adjusted market value entry at the end of the period through a left side MS
entry (increase amount) and a right side entry to Unrealized Holding Gain.
-
Entries:
I/S account
closes out at end
of period posted
to revenues.
Doesn’t carry over
to next period
Trading securities
1,000,000
Cash
1,000,000
Trading securities
200,000
Unrealized Holding Gain
On Trading Securities
200,000
Cash
1,300,000
Trading securities
1,200,000
Gain on sale
100,000
Cash
1,300,000
Unrealized Holding Gain
200,000
Securities available for sale
1,200,000
Gain on Sale
300,000
Effect I/S
36
iii. MS: Debt & Equity held as securities available for sale (SAS) (Active markets traded). (ex.
CISCO makes investments in Company’s whose products affect them directly—this permits
CISCO to sit on many boards, to be privy to info and to potentially influence a company not to
go public – ex. Serin who CISCO purchased after owning 10%) Usually acquired for
operating purpose, business purposes, with no restrictions on selling them. These are recorded
at market value in the MS section of the balance sheet. Unrealized gain / loss is not included in
net income, but goes only in separate owners equity account.
- So this entry goes directly into the Owner's Equity Account and does not effect the income
statement until it is actually sold.
- Entries
Securities available for sale
1,000,000
Cash
1,000,000
Writing up asset for change in its
value based on last day in period
Securities available for sale
200,000
this is an Owner’s Equity Acct that
Unrealized holding gain
accumulates the increase or
on securities available for sale
200,000
decrease in the Security…it is similar
to a “contra” account.
[Example: make a left side entry to Unrealized holding gain on SAS $10 and a left side entry to
cash of $115. Make a right side entry to marketable securities for $115 and a right side entry to
gain on sale of SAS $10.] When you actually sell it, any gain or loss goes on the income
statement. See handout. We delay reporting gain / loss until sold because of the volatility of
the market. Companies have an Incentive to have securities treated in this manner because
companies do NOT like not to be able to control their NET INCOME…therefore, because this
type of security does NOT effect the income statement until it is sold, it is more predictable
And, when companies buy trading securities, the shareholders may complain that they bought
shares of a software co for example, and did not want such a mixed portfolio.
iv. Disclosures are required each period
2. Long Term Investments: there are different methods for accounting for investments when they
amount to more than 20% of a company's outstanding shares.
a. Investment Method: Use when acquisition is less than 20% of outstanding voting stock.
(1)
account at acquisition cost
(2)
dividend:
Cash
XXXX
Dividend Income
XXXX
b. Equity Method of Accounting - 20 - 50% of outstanding voting stock. The other company is called
the investee and the investing entity is the investor. The investor reports the initial investment in
the investee at cost. The investment is then adjusted each year to reflect changes in the owner's
equity of the investee. Receipts of cash dividends are treated as converting a part of the investment
from an interest in the investee's owner's equity to cash. (Such investments are not subject to the
lower cost or market theory. However, if the market value of the investment falls below the
carrying value of the investment, then this must be disclosed in the footnote.)
(1) Allocate to balance sheet an amount equal to portion of income of the company
c. Consolidation Method of Accounting - 50% or more. Parent/subsidiary arrangement. Separate
financial statement and then consolidated to show aggregate condition, possible textual discussion.
37
d. Example:
Legend: company has 2 million in assets, 1.5 million in liabilities  0.5 million in OE. You own 60% of
the co
A
2 mil
=
L
1.5 mil
+
OE
0.5 mil
0.3 mil = our interest (60% 0f 0.5 million)
0.2 mil = minority interest in subsidiary
B/S
I/S
Show all 2 million on your assets
Show all revenue and expenses
Show 1.5 on liabilities
4 million in revenue
OE show negative .2 for minority interest in
3 million in expenses
sub
1 million in total net income
BUT negative 400,000 in our I/S for minority
interest in income from subsidiary
3. Other Financial Instruments - reduce risks
Example: Derivatives - value of financial instrument derived from some other benchmark such as an
interest rate swap. . So far not required to be reported as an asset / a liability.
C. Intangible Assets - reported at cost (i.e. the amount at which the Company paid for them) together on
balance sheet. For example, you buy a patent, that how much the cost of the asset is, for example, NIKE
bought the swoosh for only $70 and they keep it on their books at that amount. It becomes more
complicated when Cos develop their own IP stuff. Research and Development costs, for example, can
ONLY be capitalized and put onto the cost  when the drug becomes an identifiable product. Otherwise,
it must be chalked up to GENERAL Expense. For example Pfizer spent up to $300M to develop a cure for
male impotency, but, did not have an indetifiable product until they had already spent $260M. Therefore,
the only expense that can be amortized is the $40 spent once Viagara became an identifiable product. Can
only charge-off/amortize an asset over one of the shortest period of time:
1. the specific legal life of the entity (ex. a license)
2. the reasonably expected economic life (max is 40 years)
See HYPO in handout  this is a multiple choice exam style question. Pepsi bought Quaker Oats specifically for
the asset of Gatorade.
#2 – For Pepsi, because it would’ve had to be fully amortized over 40 years, the amount on the balance sheet,
currently would be $0. For Gatorade, the amount “properly allocated” was $2 Billion.
Remember, the limitation of accounting is that the time value of $ is ignored by accounting. Limitation of Cost
Assumption is that you do not write-up value of assets as they increase on the open market. For example – were
Nike to buy Reebok, it would not be allowed to record ANYTHING on its books for the increased market value of
the Nike Swoosh, but, would nonetheless, have to record all its costs to purchase Reebok. For Pharma Cos, their
products are almost always undervalued because cannot expense the full amt that spent on R and D; and, once it
actually becomes a useful product, the value soars.
These include intellectual property, etc. This is essentially identical to fixed assets. These are amortized
(which is the same as depreciation) which is the systematic charging to expense of the acquisition cost of
intangible assets. Only directly attributable acquisition costs can go on the balance sheet. Cost of research and
development are current charges to earnings and cannot be allocated to specific assets. You only amortize the
value when you acquire the intangible asset. If you create it, you cannot claim it over time because research
and development are current charges to earnings.
3. You do not list / show a TM on a financial statement as an asset, but you would show it as part of
purchase price if you bought it.
a. Therefore, think about the financial statements of Coke and Pepsi: no value for TM of Coke but
millions for Pepsi TM because Coke has never been sold and Pepsi has.
38
b.
c.
This value must be amortized because it is part of generating revenues for the business as a going
concern.
Patents are amortized over their life expectancy
TM’s / ©’s are capped at a maximum of 40 years
Entries:
(Debit) amortization expense XXXX
(Credit) intangible asset
XXXX
4. Goodwill - difference between purchase price paid and the fair market value of the net assets acquired
in a business combination, using the purchase method of accounting. (book value, going concern
value) Due to the Monetary Transaction principle, good will is not recorded under GAAP.
a. Purchase Method - x corp acquired y corp. The amount by which the purchase prices exceeds
book value is the value of good will. (Here, you may do those things which are not ordinarily
allowed under GAAP because it is no longer subject to the going concern assumption; therefore,
evaluate goodwill at fair market value - and amortize it for no more than 40 years.)
b. If purchase price is less than net assets, debit owner's equity.
c. Historical Cost Principle - Deficiency of intangible asset is that it usually has a higher value.
This would be at proper value only if sold. Goodwill may only be recorded BY ITSELF (separate
from cost reporting of patent, for example) if the entity is sold. Good will must be amortized therefore it is similar to depreciation. Always use straight line method (40yr limit on goodwill;
patent -only life of patent; copyright ??). Now, good will is tax deductible.
i. Example: TM is worth $100,000 and it has a life of 20 years. To account for this, make a left
side entry to Trademark for $100,000 and a right side entry to cash for $100,000. Then, each
year, make a left side entry to Amortization Expense for $5000 and a right side entry to
Accumulated Amortization (a contra account) for $5000.
ii. Example of accounting for goodwill without a contra account: Make a left side entry to
amortization expense for $5000 and a right side entry for goodwill for $5000.
D. Leases and Other Long Term Obligations
1. Leases - Use of goods / property for a period of time and payment regarding that use. Companies
would prefer to call something they bought a lease because then they can deduct payments. Also, then,
for GAAP purposes, you do not have to list it as an expense when you buy it, but you can spread the
rent out without taking a depreciation expense. Also, don’t need to have lease on your books as a
liability.
a. Operating Lease - authorizes tenant to use property for defined period in exchange for rental
payments over that time. This goes on the lessor’s books as an asset and not on the lessee’s
balance sheet. Lease payments are treated as expenses when paid. Short term leases are always
operating leases because they do not have any indicia of ownership. The advantage of this kind of
lease is that it has little impact on the balance sheet. Most "regular" leases fall into this category.
b. Capital Lease - Treated as if Lessee acquired property and owns it. Appears as an asset on the
lessee's balance sheet. The asset and liability must be reported on balance sheet. The liability is
reduced over time by the full amount of the lease payments less some portion thereof (the
appropriate amount to account to interest given the context).
At time you acquire the asset, you must:
Debit present asset account
XXX
Credit liability for it
XXX
-
Each time you pay "rent," you must:
Debit liability
Debit interest expense (depreciating the asset)
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XXX
XXX
Credit Cash
XXX
2. 4 prong test: The significant difference between these 2 kinds of leases is the different kind of impact
that each of these has on assets and liabilities on the lessee's financial statements. A lease having any
one of these characteristics will be deemed a capital lease: Basically asking whether the Tenant is
Actually buying the property.
i. Lessee ends up owning property at end term (transfer at any time during lease).
ii. Bargain Price: Lessee has the right to purchase for option price that is clearly a bargain price
and the parties know that the price is a bargain when they signed the agreement. I.e. for $1, for
$1000. Defintion: a purchase option such that the exercise of that option buy the optionee is
extremely likely at the time the lease is signed
 Ex, 1975 where cost of property is $2M and give the persion the option to buy after
2000 for $4.8M – rule of 72’s indicated that in 25 years something even at 3% inflation
rate will double in value… This can sometimes be a difficult determination and very
subjective determination (Note that even if this prices does not turn out to be a bargain,
what counts was the intended bargain at the time that the "lease" was executed.)
 Ex. 2 When sale, the average of 3 apprasials and then get 10% off of the average of
those 3 appraisals – is this a Bargain Price or NOT? Brot: says NO because 10% is
really not that much of a discount in terms of transactional costs, real estate sales taxes,
etc. Therfore, at 10% off the option is not extremely likely to exercise. 25% is more
likely to be exercised.
iii. How Long is the lease? – is it 75% or more of the remaining useful life of the property?
NOTE: make all determinations at the time the lease is signed. Note also, in calculating
when the term is, have to include …Are the options such that the other party is extremely
likely to exercise…i.e.: a) huge penalty for not exercising; b) below market rate for signing
it… Term lease covers period of time that is greater than 75% of the useful life of the property.
To qualify, the term must be guaranteed. and the fact that the lease covers such a portion of the
useful life of the property must be evident at the time that the lease was signed.
iv. Present value of total payments of rent due under minimum lease must add up to 90% or
more of the fair market value of the property on the date that the lease is signed—NOTE:
assume that any renewal periods that are so extremely likely to be exercised, then, they must be
included. The numbers that count in this evaluation are all rental payments that are guaranteed
(i.e. those that will clearly be made) and therefore, this may include all rents due during any
renewable terms that qualify as “very apparent” under #3.
NOTE: if ANY of these 4 factors are met, the cost of the lease is incurred as a liability and then as rent is paid, it
can be expensed and depreciated. However, as Brotman explains immediately below, remember that a lease that
does not actually meet these factors may, effectively, still reflect significant obligations of the target company.
v. Kmart Example – Example of how changes in how something is written down (accounting
rules) changed the way business behaves “the tail wagging the dog”)Presgie (former
KMART) decides to compete with WoolWorth’s. Wants to compete with Woolworth’s by
going into the suburbs and providing free parking etc. At the time, there were not too many
free standing shopping malls. Real Estate Syndication: Kmart would get someone to buy a
store and lease it to them. Ex. buy a store for $1M and take out 30yr Mortgage pymet at
$25K/month. KMART said that they would rent out the store for $26K/month which would
then permit the buyer to secure the mortgage from the life insurance company (because the
buyer was guaranteed a price that exceeded the $25K/month.) This was very favorable to
KMART because they did not have to show it on their Income Statement as a Loan. GAAP
comes in and devises a 4-prong test wherer, if any one of 4-conditions are satisfied, then it
must be considered a capital lease.(See above) In early 70s, decided they did not want to have
to depreciate the properties in which their stores were located. Nor did they want these
liabilities on their books, so they structured leases as operating leases and made sure that they
would not be forced out of the space at the end of their terms. Lease, eg, for 29/40 years of
life. Syndicator buys land and builds building, sells to pension plan (nontaxable entity) for
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$30k. Sell property to syndicator for $400k. Every one invested with tax deduction in mind
(FMV $400k). IRS blew these out
vi.  (Be Wary of): OFF-Balance Sheet Financing  even though it is an obligation of the
company, it is not an obligation for GAAP purposes, even though it may be a very significant
obligation. For example, leases that are still operating leases can still have HUGE obligations
attached to them, even if they do not actually qualify under the conditions for a capital lease.
Therefore, we must keep in mind these VERY significant legal liabilities that MAY have
serious implications on valuation of companies when we are buying/selling corps or lending
$$.
3. Long Term Debt - Include long term borrowing on bonds or bank loans, include mortgage on FA. Set
forth as a long term liability on balance sheet. Any portion of a long term debt payable within the next
accounting period (year) should be set forth as a current liability under “Current Portion of long term
Debt.”
 NOTE: 11/6/01 – a lot of accounting is determining what adjustments need to be made at the end of the period
E. Retiree Benefits - Pension Plans Not actually a “contigent liability” because it may actually be a
contractual liability. To qualify as a contigent liability, it must be BOTH probable and estimable. In the
case of Retiree Benefits, the liability is often times definite.
1. Defined Contribution Plan - system where the employer would pay in a set amount to the employee's
retirement / health plan. Driven by tax considerations. There is no guarantee of what you will get.
Dependent on employer's contribution. Require or allow employee to contribute. Expected value of
payout (i.e. the eventual benefit to you) changes as compensation levels and eligible employee’s do.
There are only a few of these plans left. Most 401(k) matching plans do not show up on the balance
sheet.
2. Defined Benefit Plan - system where the employer would contribute a fixed percentage to an
employee's final salary. For ex. get an amt equal to 1and 2/3 of your annual avg. salary, multiplied by
the # of years you have worked there – that was equal to your annual payment upon retirement.
HYPO: a law firm hires a 25 year old…
(1) Must record the present value of the estimated pension return. Assumptions:
1. How long is someone going to work at a given firm?
2. Salary trends over a certain amt of years?
3. Discount rate?
 Ex, Companies in the early 70’s realized that they could declare bankruptcy and then fuck over the
pensioners. Now, we have the Pension Benefit Guarantee Board. Since the advent of this board, the
assumptions that corps have made have changed. 1) pple live longer and work longer. 2) great rate of
inflation (where working pple is not increasing as much as the $$ that is invested  what resulted is that
Corp’s had A LOT more $$ in their pension funds than they needed. This led to a lot of corporate raiding
of over-funded pension accounts in the 80’s. See The Movie Wall Street where the airline had a hugely
over-funded pension account.
 Prior Benefit Cost must be attended to when a Co starts a pension plan. For ex. Corp starts a plan that is
1.66% x years of service x avg. salary of last 5 years of service. If had to put that amt of $$ in at the outset,
it would bankrupt the corp. In this scenario, GAAP looks like legislative and policy setting law. Liability =
future obligations based on prior actions. If Corps had to take massive expense on day 1, they would never
be incentivized to start pension plans. Therefore, GAAP says that prior service costs can be amortized
over the career life of the employee as a charge against earnings over the remaining term of service for a
given employee. POINT HERE: There are elements of GAAP that are theoretically justifiable, but stand
more for the proposition that they are political compromises (i.e. here, Pension Funds are good). This
demonstrates that much subjectivity and judgment and even political compromise goes into what
accounting numbers say.

This type of plan was not particularly popular because worker does not get more if his level of compensation rises
because payments are set. Still exists in a lot of union run industries. Can calculate how much the employer needs
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to contribute on an actuarial basis and at the end of each year, calculate the present value of what is needed. GAAP
says that you cannot account for it on a pay as you go method. Presumed interest rates in actuarial assumptions
resulted in over funded pension plans.
a. Over funded Pension fund - assets are greater than liabilities. In 1980's, corp raiding involved
taking over funded pension funds - accounting for this as free asset on balance sheet allowed
people to take it (over required ERISA amount). Should put in separate trust, not cash and not
free asset.
3. Post Retirement Health Benefits: Accounting was developed on pay as you go system. The theory was that
the amount to be paid in was small. Change in GAAP - show in account by promises made. In 1995,
someone figured out that in 2009, most baby boomers would retire  significant liability. FASB decided
that companies should have to account for these future costs and every company was given the chance to
spread this hit out or to take a one-time hit to their financial statements because the country was in
recession anyway. For example, Looking back to IBM over 1 year in early 90’s their 1 year earnings
dropped off tremendously. 1992-93 Historical Financial Statements: Large Corps used to pay for retiree
medical benefits. 65+ yrs old all Americans get Medicaid (and, the additional cost above Medicaid is not
that significant). The expense was not booked and future liability not anticipated…Soon, when someone
erecognized that the baby-boomers would retire and create HUGE costs, GAAP passed a rule that declares
must book the actual expenses (medical) of retirees. Can amortize the costs over 10 years OR take a 1-time
cost. Companies chose the one time hit. Trend is now for co’s to stop making these promises.
4. Effect of Charging Employee Medical Benefits against cost Many Corps, including: Unisys Corp:
stopped paying for employee benefits (medical) and sued by Employees. Ct found that these employees
were employees at will the corp not obligated to pay medical benefits…
5.
When a company pays out benefits, it reduces a liability. Accrual of liability is consistent with GAAP.
6. Massive evolution of retirement benefits - As workers get older, took pension off balance sheet (401(k))
money gets invested in stock market (because can’t breach fid duty to self) and added liquidity to stock
market.) Shows importance of accounting.
7. Today, companies must take an estimated charge to earnings and then, when actual numbers come in, they
just reduce the liability
F. Loss Contingencies - contingent liabilities, such as lawsuits. For example, lawyers get letters from
auditors each year asking for any pending litigation and then asking how probable and for what amount the
litigation is likely. Also, note that being sued is also part of doing business. Any time that potentially
selling a dangerous product into commerce, products liabilities suits are a cost of doing business.
Accidents at Walmart OR at Public transportation companies (for example estimate the amount of litigation
pending, the percentage victory and the amount of insurance deductibles that will be lost). This is money
that you will likely owe to someone for something in the future. You will either not know whether you will
owe it, when it will be due, or how much it will be (total value). You only accrue this as a liability when
the loss is both probable and reasonably estimable. 3 possibilities under GAAP:
1.
Liability is both a probable and reasonably estimable amount (e.g., warranties by Ford). Therefore,
companies must book these amounts.
Example: Warranties/Guarantees: Brotman says that it is amazing how precise their warranty
expenses will be  most of the time the recall will not be as expensive as Ford or Firestone in previous
years.
GM give three year Warranty  it has a good idea of how much it will have to pay over time. GM
records liability at the time of the sale
Ex: GM knows warranty will be 5000  make the following entries:
Debit -- warranty expense
5000
Credit liability -- (warranty cost to be paid)
5000
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 When company has claim of XXXX made under the warranty:
Debit liability – “Warranty Payable” (warranty cost to be paid) $4000
Credit – “Cash” cash/other assets
$4000
This reflects the cost
of paying off the
warranty liabilities in
CASH
2. Liability is probable but not estimable  no entries are required but disclose in footnote.
3. If only estimable within a range, book it at the low end of range. (This is not an attempt to take a
conservative approach but because using estimates, only the low end is probable and estimable.)
4. If less than remotely possible, do not do anything.
5. Another type of example would be money likely to be owed in lawsuits, however, you don't ever want
your financial statements to reveal that you expect to be "wrong" in a given amount because that could
be perceived as an admission of guilt.
6. This has been a tremendous source of Company’s “fudging” the books  for example, every company,
when they do a merger, they take a loss contingency expense now and write it off – they will then
tremendously over-estimate and use that initial write off to cover operating expenses later on.
Brotman’s Peach Bottom Nuclear Electric Plant while at Dechert Example:
 The NRC (Nuke Regulartory Commission) shut the Power Plant down because of fuck up
 PECO was sued by MANY Cos that were guaranteed electricity from PECO under contract who
had to go elsewhere and purchase the electricity.
 Problem: how the disclosure is made>>>you may need to take an exception to GAAP in this
scenario and simply say: we were sued, we are vigorously defending it, we believe we will win.
This is called a qualified opinion and companies do not love to issue it because markets, lenders,
etc do not like qualifications. The Going Concern Qualification is the worst qualification because
it implies that the company may NOT continue with its revenue earning activities. For example,
some of the airlines this year may have going concern qualifications this year because they are
doing so badly. Instead, they like unqualified opinions.
G. Stock Options - options give one the right to buy a certain number of shares of a stock at a certain price at
some time in the future. Options have intrinsic / face value and can be sold on the open market. Options
typically have an expiration date. Options are commonly used as executive compensation and are a way to
create incentives for executives to increase the value of the company's stock, thereby increasing the value
of one's option. One makes a profit on the option when one cashes it in and buys stock at a below market
price. Difference between an employee stock option and a warrant granted to a vendor that is a right to buy
a number of shares at a set price before a certain date: employee gains the motivation to make the company
have a higher value while the vendor may only gain the incentive to give the company better treatment and this is not as strong of an incentive
--- When the company grants an option to an employee, the company must only account, on its
financial statements, for the difference in value, if any, between the strike and market prices.
This is done through a charge to the company's earnings. Otherwise, the company does not have to
charge anything to earnings. Brot: says that this may be a little fishy because executives are actually
employees and they want to be able to be granted as many options as possible and not have to record
them as a charge against the earnings statement until exercised.
 Ex. When Microsoft had many outstanding options to employees (when the NASDAQ collapsed),
there were many hidden costs that were not theretofore accounted for. To ascertain hidden costs,
think about it in terms of YOU owning the entire company and subtract the value of options issued
at strike price from net value.
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--- With an option / warrant granted to a vendor, that must be charged to earnings as an expense (warrant
expense). Later, when the outside vendor exercises the option, there is no charge to the earnings because it has
already taken that expense in. Any company that grants options is therefore overstating its earnings to a certain
degree because of these outstanding and unaccounted (on the balance sheet) for options. This is a pretty substantial
departure from GAAP's general principles. Therefore, companies have to account for most of this through
disclosure in footnotes. Why is this generally un-acounted for? Because they are not ordinarily required to be
recorded on the balance sheet as a liabiloity or on the income statement as an expense.


VII.
Example: at the end of the year, you have the right to buy 70K shares of CISCO at $20/share
(the current price as of today, 11/6/01) and have the right to exercise that option over the next 5
years. Options on CISCO are regularly traded on the open market and, to buy an option to
trade CISCO at $20 can be purchased at $3, for example. What amount of compensation can
be determined? Black-Shoal Option Valuation Equation.
o
Is it different if we give Stock i.e. 10K shares at $20 – should we record this
expense
o How about when you are an outside employee and granted stock options, should this
be expensed.?
BROT: notes that all these things should be expensed because, of course they have value
because they have been negotiated. All 3 of these things are COMPENSATION – the
company has given away something of value.
Capital Accounts - Accounts in which owners’ interest in entity is represented.
Balance of Capital Accounts = Total Asset Accounts minus Total Liability Accounts (function of
fundamental equation)
A. Groups of Capital Accounts:
1. Contributed directly to entity.
2. Generated by operation of entity’s business over time.
3. Reflect adjustments that arise from non-operating events
4. Comments: Limited Liability Corp (LLC) - Flexibility of a corporation but taxed as a partnership. No
liability for corporate owner. As a result, not as many partnerships anymore, except for those that are
small and real-estate related. S-Corp - Pure corporation that elects to be taxed as partnership and where
all income passes through the corporation and goes directly to the shareholders.
B. Capital Accounts Reflecting Contributed Capital: Par Value and Legal Capital (problem is recording
and adequately protecting creditors' rights so the legal capital regime was created.)
1. Legal Capital Regime - created to protect creditor’s reliance. Legal capital is the total par value of the
shares issued. A required base amt of $$ in the co. So that pple who deal with the Co can look at
certain books and know how much $$ were there. Accounting itself negated the need for legal capital.
– when Corporations were created i.e. a fictitious legal creation, we wanted pple to know what was
there. Therefore, b/c the corp had to register with the state, it had to register how many shares of stock
were to be issued—Par was just a # -- a stated/base amount of stock. Legal capital was the par amt of
stock. For example, in the past, the amount in the funds of the corp could NOT go below the amt of
legal capital. Moreover, no funds could be used from legal capital to be paid to shareholders or other
creditors. Why would someone want to pay dividends rather than salary? (No Federal Income Tax
until 1916). Concept of legal capital is important today because there are still some states that have
bizarre legal capital laws i.e. restrictions on dividends that are based on historic notions of value of
legal capital. No dividends may ever be paid out of par value. The requirement was designed so that
companies would always have money on hand with which to pay debts (concept of equitable solvency not letting corps pay out dividends that would leave them with no money to pay debts).
Be very careful as to what types of dividends can be allowed w/ smaller companies.
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2. NOT COVERED IN CLASS 2001 (DE went further - companies may only pay dividends out of
current year's net income and prior year's net income. This is called a nimble dividend.) However,
with the help of creative lawyers, companies began to lower par value and then sell stock at a premium
over par, functionally destroying this purpose.
3. Note that legal capital has nothing to do with GAAP. Today dividends are not that important because
most companies have stopped / never started to pay them out to shareholders because corporations can
use that money to reinvest in the corporation, making it more valuable and individuals can sell stock
when they need to realize some cash.
a. Stock can’t be issued by corp for an amount of consideration less than the par value of the stock.
b. Discretion of BOD to declare and pay dividends is constrained by amount of legal capital. Can’t
pay out legal capital.
c. Limits kind of consideration that can lawfully be paid for shares (cash and other tangible property).
DE retains vestiges of this but 40 states have signed onto RMBCA (gives corps more latitude).
Capital = Resources from which to run your business – the $$ or other readily available assets from which a
company operates. The reason you need capital is to continue your profit making operations. Can be: cash in the
bank, lines of credit, debt. Capital can be secured in various ways. I.e. ask how businesses may be capitalized.
Today, companies are capitalized through BOTH Debt and Equity Financing. One of the reasons for this is taxes.
If $$ are put in to the corp in the form of equity, in order to get a return, you would have to get that in a dividend
(which is subject to double taxation). Corporate tax rate (35%) + individual income tax rate on the dividend (27%)
 therefore, 100$ of income is reduced to $28.
 Another example is making a loan to your company in debt. Assume the Corp makes $100 and they pay
you interest on the $100 you lent them. The Corp takes an interest deduction as an interest expense and
then you get taxed for the interest they pay you as income (at 40%) therefore, there is NO double taxabtion
system here.
The double taxation system has incentivized investment in Corps in non-traditional, non-equity ways.
Venture Capitalists = pple who provide capital, early on to early stage ventures and they also provide a lot of
business support (how to hire employees and run the business.) BROT: “pple who steal your business” Usu, the
goal is to get the Corp more profitable so that there is an IPO or something else. Therefore, the VC’s get their
original $$ back and they have a stake in the new company. Ex. Internet and VC crazes. Paul Allen’s VC firm
“Vulcan”. Today, VC’s take convertible debt in the Corp. They make a loan to the corp at a fairly low interest rate
(not payable until later) AND it can be converted, i.e. the Corp can change the obligation into an equity status.
Convertible debt is good because it ties you in to the upside risk but provide protection if the investment (corp)
fails. VC’s are happy now that they have debt obligors because this comes first in bankruptcy over equity holders.
This is important because a lot of the transactions that we work on will relate to how companies secure their
capital i.e. their operating resources. Business issues are more important here than the Accounting Issues.
KEY: The traditional types of shareholders’ equity are not what they used to be – look at the balance sheet
carefully! – for example: subordinated debt; preferred stock;
Undercapitalized = you do not have enough resources to run you business as a going concern. Eg. Airlines after
Sept 11 attacks, there was news that they only had enough $$ to get them through a certain date.
What is par? Originally intended to be legal capital. [par = legal capital] What you would initially sell the share for.
Corporation could never sell stock for less than this stated amount per share of stock. Most states had laws
prohibiting people from paying dividends out of par value (must have earned surplus). But, then someone had idea
that selling share for more than par value would bring additional paid-in capital. Par value does not really mean
anything anymore. Sometimes franchise tax is tied to the number of shares issued, but this is bad for corporations
and explains why they usually move to Delaware.
2. RMBCA eliminates concepts of par value and stated capital and eliminates the earlier rule declaring
certain kinds of property ineligible (any tangible / intangible property are ok). No distribution may be
made if:
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i. Equity Insolvency Test - corporation would not be able to pay its debts when they become due
in the usual course of business. [fair value of assets > fair value of liabilites] OR
ii. Balance Sheet Test - If corporation assets would be less than sum of liabilities plus amount
needed if dissolved for preferences of senior equity securities
iii. Delaware has not yet adopted RMBCA. RMBCA has 2 tests because it largely dispenses with
any reliance on GAAP - good.
4. Delaware comes up with nimble dividends - You do not have to have owner’s equity to pay dividends you can pay out of profits made in prior 2 years. (This system was designed so that creditors could
know that the corporation would be able to pay its debts as they become due and would not be able to
pay itself before it paid its creditors).
5. Other Tests  Many states use Insolvency approach (i.e., when company is insolvent, look back at
transactions to see what happened).
i. Uniform Fraud Conveyance Act
ii. Uniform Fraud Transfer Act
iii. Example: make a transfer of property for less than it’s worth when you’re insolvent. Law will
say this has enough attributes to be fraud. Created entities that seemed insolvent even when
they were not.
6. Fundamental component is shareholder equity. Shareholder equity in accordance with GAAP is not
necessarily the most meaningful figure: GAAP Components (a and b are contributions to capital):
a. Common Stock
b. APIC (Additional Paid In Capital -aka Contributed Capital in Excess of Par Value).
i. Example: If stock has par value, multiply # of shares outstanding times the par value. 100
shares with par value for $5000. Make a left entry in Cash of $5000 and make right entries
in common stock for $100 and in APIC for $4900.
ii. No par value, either BOD states amount for stated capital account or left cash entry and
right common stocks (no par value). See p. 117
c. Other Components:



Retained Earnings
Unrealized Holding gains
Minority Interests
C. Capital Accounts Reflecting Earned Capital: Retained Earnings - seeks to reflect amounts contributed
by corporation over time. Cumulative Earnings - Dividends to SH = Retained Earnings. P&L account gets
closed into the R&E account.
D. Capital Accounts Reflecting Adjustments to SH Equity: Most activity is readily shown on Capital
Accounts Reflecting Contributed Capital (par value and legal capital) and Capital Accounts Reflecting
Earned Capital (retained earnings) because they deal with contributions to Shareholders and Retained
Earnings. But, activities unrelated to asset / liability or income / expense accounts are recorded directly
onto the SH equity account (not run through income statement or balance statement first). (For example,
currency is devalued in country where company operates; SH equity reflects drag on contribution of
earnings to Shareholder Equity.)
E. Stock Splits / Dividends: these have no effect on the value of the company
Cash Dividends and Stock Dividends.
When the Dividend is issued the Company:
DEBITS: “Retained Earnings”  one of the OE accts that we have – the prior earnings of the corp.
CREDITS: “Dividend Payable”  this has been a legal obligation – a liability vis a vis the corp.
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When the Dividend is Paid:
DEBIT:
Dividend Payable (to increase liability)
CREDIT:
Cash (to reduce the asset of cash) and increase the liability
NOTE: that Dividends can be paid out of Retained Earnings or Additional Paid in Capital (APIC)
APIC: Amount that you sell your stock for in excess of capital. Amount that exceeds the par value.
 Ex. CISCO – Common Stock $7M, and Contributed $ in excess of par (APIC) = the amount that the
company received from stock issuing – Dividends awarded.
 EQUATION COMMON STOCK + APIC = Amt received from stock issuance - Dividends
a.
Dividend Process - Entries:
On effective/declaration date (when stock goes X – dividend):
RE
100
Dividend Payable
100
If you have run out of RE, may have:
APIC
100
Dividend Payable
100
On Pay Date:
Dividend Payable
100
Cash
100 (if this was a cash dividend) – affect SH equity
OR
Dividend Payable
100
Common stock
5
APIC
95 (If this was a stock div.) – does not affect SH equity
b. More on Splits
With true stock splits, there are no accompanying journal entries because  100 x 2 par now 200 x
1 par - there is no resulting change in value. There is NO CHANGE to journal entries – have not
changed balance sheet or legal capital – just now, everyone who had 1 share, now has 2 shares.
ii. BUT companies can do stock split in form of stock dividend (100% stock dividend - where for
every share of stock, another share of stock is issued)  entry becomes same as above then. This
avoids SH vote to change articles of incorporation which contain authorized number and par
amount. You could authorize a lot of shares at SH meeting, but par change cannot be done before
hand.
iii. Why give stock dividends?




No taxation for Shareholders on receiving a dividend
Increase Shareholder value
Increase the float  the amount of shares outstanding and traded goes
up. The greater the float the more liquid the market and the more that
people will want to buy the shares - therefore easier to trade
NO economic difference however for the co.
EXAMPLE: assume a 100% stock dividend  we are paying out $1.40 / share (value of stock) times the
number of shares being issued:
-- Debit retained earnings by 2,800,000; credit common stock by (2 million shares at par value of $0.10) 
$200,000 and credit APIC by 2,600,000.
-- Adjust balance sheet #'s  (NOTE - method here is for small stock dividends - i.e. less than 20% of the shares p. 128)
400,000 in common stock (200,000 + 200,000)
3,400,000 in APIC (800,000 + 2,600,000)
200,000 in retained earnings (3,000,000 - 2,800,000)
-- Result is the same $4,000,000.
47
Large Stock Dividend Method: i.e. anything above 20% of the outstanding shares.
(this is how most stock splits are actually effectuated)entry:
Retained earnings
200,000
Common stock
200,000
Common stock (add 200,000)  400,000
APIC= same 
800,000
Retained earnings (-200,000)  2,800,000
-- Result is the same
$4,000,000.
Small Stock Dividend: Corp has 1M shares of stock outstanding trading at $100/share (this is value) – it issues a 40,000
share dividend to its shareholders – show the entry
DEBIT: Retained Earnings:
$4,000,000
CREDIT: Common Stock (amt of shares issuing X par) $40,000
CREDIT: APIC (balance of value of dividends)
$3,960,000
**Market valuation is used here because there is such a small amount issued that it, in theory, adds real value to the
shareholders.
SAME HYPO  but, now a 400,000 share dividend – which has a value of $400,000
DEBIT: Retained Earnings: $400,000
CREDIT: Common Stock: $400,000
Note: we do NOT look at the market valuation at all.  Brot: says that there is no real rationale here.
Company Valuation: Brotman argues that often times it is not based on real time/real life valuation—rather than how
business is operating on a day-to-day basis. Or does it?
  Stock-based Compensation:
 Now, from 1995 to March 2000, this was one of the most explosive period of stock markets in the world – more
pple than ever owned stock and prices shot up. This type of cultural domination, corporate execs as celebrities, is
unheard of before 10 or 20 years ago. After long prolonged period of no recession, pple started leaving the law
profession and no one wanted to go to a firm. Everyone wanted to go to a Dot.Com with Stock Options.
Companies became so focused on stock because they used it as currency to buy other companies, to attract and
retain personell. The perception of how a co’s stock performance affected the company became a HUGE issue.
The glitz, then, was related to the value.
 Perception is that a stock-split IS important – how pple perceive a co is important – i.e. low stock prices may
signify more liquidity.
o Now, the popular companies may change: i.e. Walmart, has gotten VERY big in the stock market.
Reason why going public was SOO crucial in the past 4 years.
 1) Never underestimate the “Keeping up with the Jones’ Factor”  i.e. rich want to get richer
 2) Pple needed to go public in order to keep up with the pace at which other corps were earning capital.
Persisting Question: How will the continued intereaction b/w public markets and capital investments change the way
company’s operate?
 Coringware (Symbol: GLW) – went public a while ago and stock price went from $80 and then they split many
times after getting into high-tech firber-optics. They leveraged up a lot of $$ to get into this business of
fiberoptics.
 As lawyers, have to understand that the reaction of capital markets is huge in order to represent clients.
48
19 months ago, Yahoo had a higher market value than Phillip Morris even though its real assets were worth crap. Phillip
Morris was distributing Dividends to its shareholders each year of $2Billion
Chapter 9 has been on the test before – Financial Statement Ratios.
Exam – 120 points
2 sections; 12 multiple choice questions
10 short answer questions (really short answers – do a journal entry, explain a journal entry, etc)– a couple in
sub-parts. Use the amount of space that Brotman provides.
Book is not used at making or grading the exam – class notes are far more important…he does not give a
shit what the book says. If there is a conflict, go with what Brotman says. Do not look at old exams for
substantive knowledge…
For example – Depreciation – focus on UNITS of PRODUCTION – that is the most typical method used
in manufacturing today.
VIII.
Statement of Cash Flows (SCF) -- know what is in the statement of cash flows, not how to do it!!!
Balance sheet is what you have on a given date at a given moment
Income statemnt -- does not relate at all to asset position or cash position b/c GAAP takes acct of accrual and deferral
Statement of Cashflow (very imp) is a reconciliation of sorts of Balance sheet and Income statement – if do not have the
cash or assets or borroabwle against assets, may not have the capital to run the business – yet, you can still have a strong
operating position. Indirectg Method shows how it is a reconcilitation – start with Net Income and then add back those
items that did not cost cash, but reduced net income. Concept is to go from net income and then add to the figure from
net income those items that reduced net income but did not use cash AND to subtract those items that increased net
income but did not generate cash.
 Ex . Depreciation Expense (a non-cash expense) ADD back to NET income – Alternatively: Accrued Revenues you
SUBTRACT from NET INCOME.
 It says: we will take a business and break it into 3 activities:
o Operating Actitivities – the most important of the 3
 Basic profit generating activities, taxes, interest, administrative etc. does not include payments of
principal – normally would think that if borrow $$ and make payments on the loan this would be
in the same acct category – this means simply, cash to operate, pay bills, buy inventory and
generally run the business. Getting and re-paying that $$ (the principal) is not really the cost of
doing business, therefore, not an operating expense, rather a finance activity. Cost of maintaining
the headquarters, taxes, interest etc.
o Investing Activities –ex. buy property plant or equipment – making an investment in capital assets. Cost
of buying a building for headquarters
o Financing Activities – cashflows of financing activities – basically, buying and selling capital assets
 Ex. last week we had different concepts of having capital – liquid resources from which they
need to run the business ex. A co that sells stock – the cash that comes in is a Financing Activity;
ex. getting $$ from bond issue; ex repaying $$ from a bond issue. Ex. buying stock in another
company.
 And try to determine how much cash it generated or spent in a given period
Understand how cashflows work – things that we may think are good actually can have a negative impact on cashflows.
Ex. a Corp has an INCREASE in Accounts Receivable (A/R) – balance at end of year is higher at the end. Therefore, you
have extended more credit than you have been repaid. Therefore, if start with concept of net income (asales from cash
AND credit), then, if A/R increases, this means that a portion of your sales did NOT generate cash.
For example:
Balance of $0 at beginning of year and balance of $100K at end of the year (you have not been paid yet )
49
If only look at income statement, would have no idea whether there was cash generated from A/R or not.
Analysts look at cashflow and determine Quality of Earnings Ratio—ie. How much of the earning generate cash. You
may have a company that is ery profitable but does not generate cash. On the other hand a company may look terrible
profitability wise, but generates A LOT of cash. Ex. Dot.coms – there was a HIGH positive cashflow from HUGE
financing activities (IPOs, etc) – therefore, the danger of these companies would be looking at the balance sheet only
because you would see strong cash position, few liabilities and it may appear to be a very strong company. If only looked
at Income Statement, you would not be able to determine the tremendous amount of investing activities that these
companies had. For example, the Telecom companies, Windstar, McCloud who raised HUGE amts of capital and did not
have a lot of operations where they sold stuff and had a lot of revenue – a lot of them buildt big fiberoptic network and
engaged in other INVESTMENT ACTIVITIES> if looked at INCOME STATEMENT, you may think that they were sort
of profitablt, but, if looked at STATEMENT OF CASH FLOWS, you would realize that most of their $$ were being spent
on investment activities and most of their cash was generated from Financing Activities – not operating activities.
BURN RATE: which means the amount of cash expended during a defined period (DOTCOM spends $800K
per month) –
BROT: pple have to focus again on cash because there has been a sig drop off in activity that it is very important to look
at cash.
 TELECOM industry: Fall 1998, there were 3 leaders: Lucent (the largest), Nortel Networks, CISCO systems
(which was the smallest in terms of sales and assets).
 During the build-up over the last couple of years, the 1st 2 invested tremendously in investing in new companies.
CISCO instead bought things with their own stock instead of Vendor Financing -- . CISCO is now dominant
because they have SO much cash. During the build-up years where, all companies appeared to be profitable, but,.
Lucent was spending and utilizing the cash while CISCO was hording the cash and will bear the econ downturn
better and be able to move forward more easily.
o Vendor Financing (what Lucent did): Seller financing – i.e. sell stock. CISCO sells $1M of routing
equipment to telephone co, CISCO may provide them for the financing. Therefore,
 DEBIT: A/R $1M
 CREDIT: SALES $1M
o A trick that the companies did to get around vendor financing is to go to a LEASING Company where the
Corp goes to the Leasing agent and asks the leasing corp to take referrals from customers who do not
have the cash to pay for CISCO equipment. CISCO then guarantees ABC leasing that the equipment will
be repaid m—i.e. gueanratees them in debt.. Then ABC leasing pays CISCO in cash.
 Then, because debt only needs to be recorded if it is “reasonably estimable and probable” under
GAAP – when the telecom boom occurred, the debt was not very probable and therefore, it would
not show up on CISCO’s financial statement.
 Catching “Stealth” Vendor FinancingTherefore, as a lawyer, you must ASK what
guarantees the company has – i.e. determining the obligations that may not show up on
the Income statement or Balance Statement
BE CAREFUL –
Do not confuse Income from Operations with Cashflows from Operating Activities
 1) EDITDA -- Earnings before interests, taxes depreciation and amoritization. -- “EDITDA” – a synonym many
times for “Operating Income” – i.e. if I were to buy this business, what would I have to service my debt.
Example, Brot represented a leasing company who had reasonable access to capital. The buyer company had a lot
more access to capital and therefore the interest cost of the company was much less significant to them. This
indicates that, as far as profitability goes, interest and taxes are relative depending upon the purchaser.
o Depreciation and Amortization are non-cash expenses that relate to assets that have already been
purchased – do not really effect the company’s profitability – does not really measure economic worth.
 2) But, on Statement of Cashflows, interest and taxes are taken into acct.
“Be skeptical about pple who analyze rather than do” -- Jack Grubman and the telecom burst. He was the guy who
was considered the most brilliant analyst in the entire industry saw VERY little of the burst. Therefore, be skeptical about
what analysts say.
50
THE EQUITY METHOD AND CONSOLIDATION: How do you account for investments in other companys – there are
3 methods:
 1) If a corp owns stock in another co, if own LESS THAN 20%, account for it as an Investment in Marketable
Securities
o Exception – if have less than 20%, but have effective or substantial control, then still use equity, one-line
approach.
 2) Equity Method (1 line approach) -- If own AT LEAST 20% but NOT MORE than 50% (20% to 50%,
inclusive) use the Equity Method. Unde rthis method, include in income statement, amount that is equal to
proportionate share of your investment in that company. For example, if own 1/3 of a subsidiary who earns
$300K for the year, then write down $100K
o Ex, buy 1/3rd of a company and pay $1M in cash.
 ASSET Acct:
 Pay $1,000,000 for 1/3rd ownership stake in a company
Investment in S:
$1,000,000 (debit)
Cash:
1,000,000 (credit)
Investment in S:
$100,000
Income from S:
$100,000
If receive a dividend from S in the amount of $30,000 – ordinarily, the receipt of the dividend would be the income
event – but, because you own more than 20% of the company, you must use the Equity Method of Accounting and
therefore, any cash that you receive DECREASES your investment in the company
Cash:
$30,000
Investment in S
($30,000)

3) If own more than 50% Consolidated Financial Statements – show all the income, sources of revenue and
expenses on your I/S and show all of the assets and liabilities on the parent company’s statement. IF own
more than 50% you MUST considate and if you own less than 50% you CANNOT consolidate.
o Ex. Investment in S – but, you own 60% -- instead of the above method – add all of S’s assets and
liabilities to your balance sheet and therefore you, effectively have 100% of the Owner’s Equity on
your balance sheet . Then, at the end of the period, create a CONTRA Account to subtract 40% of the
assets and liabilities and name it
o Minority Interest in Subsidiary – if own a subsidiary more than 50%, you show 100% of assets and
liabilities on Income statement – therefore, on balance sheet, this entry reduces the proportional
amount of the company that you do not owe. And, on the income statement, you remove the
proportionate share of net income that you do not own. Conceptually, the NET amount is equal b/w
the Equity method – 1 lined approach (which shows your proportionate share of the bottom line) vs.
this method, which effectively is the same thing on the Income Statement, but shows Dramatic
changes on the Balance Sheet. The concept here is that you should only show on a net basis the
same percentage that you own in a subsidiary, but, when you own more than 50%, you must show all
of it. Therefore, if you own more than 50% i.e. 51% of a company, you can create the appearance of
increasing your SALES tremendously on your Income Statement. On the other hand, if own 49%,
only show 1-line on your Net income sheet (as above) . The thought there is that if you have more
than 50% of the ownership, then you have control, and if you control more than 50% of the assets
and income, then you are allowed to show it.
Side Note: Until 1994 – the non-homongenous rule allowed you not to consolidate a subsidiary with your own company even if you
owned more than 50%, if the function of the companies were extremely different. Pre-1976, US car dealer try to compete with
Japanese and therefore create non-homogenous companies who finance car sales. This would create losses, but, no investors cared
because GM was technically a different corp than GMAC (the financing subsidiary that was losing a lot of $$). By 1994, so many
companies were abusing this exception that the governent got rid of it. Therefore, NOW, if own more than 50% of a subsidiary, it
MUST be consolidated.
Interesting Point – in a true 50-50% joint venture, the assets of the joint venture never show up on either company’s financial
statement. Companies will try to avoid Consolidating with start-ups, etc. because they do not like their Financial Statements being
51
affected by factors outside of their control. Therefore, in Agreements and Warranties, there will be statements such that a partner is
unable to acquire more than 50% of another company.
A. Rationale and Organization - Used to only need income statement and balance sheet to understand financial
condition of entity. Then developed the Statement of Changes in Financial Position. Problem with this
(reconciliation of balance sheet and income statement) is that it did not reconcile by category the different types of
things that can cause a change. The statement of cash flows shows mgmt of cash.






About 9 yrs ago, FASB changed to Statement of Cash Flows. Basic purpose is
to take cash and show how that account has changed during the year.
Involves cash and cash equivalents (short term marketable securities, other
liquid assets). SCF is so recent that people do not focus on it. Result is that
people do not use it.
Can be used to detect end of the quarter window dressing, when a company
might take loans or sell a poorly performing stock, etc. to try and show the
company with more cash on the end of period financial statements. The
balance sheet does not tell you what the company looked like on the day
before the period ended or on the day after the end of the period. This practice
would be disguised in the balance statement or the income statement.
The income statement does not tell you how the revenues and expenses relate
to the assets or how the assets are used to generate the revenues and
expenses, and it does not tell you if the company is generating any cash. If
there is a lot of accrued income - may have negative cash flow.
Reconciliation between income and balance sheet - takes the net income and
breaks it down to where the income comes from.
We do not have to worry too much about the direct vs. indirect method - just
care about what ends up on the statement.
Also presents liquidity matters that are not reflected in balance statement or
the income statement.
1. Changes in Cash in 3 different categories now:
a. Operating - Operating Cash Flow = transactions that generate items of revenue and expense. Only
includes companies opportunities in its primary area of business (ordinary course). This is the most
significant aspect of the cash flow statement. This category covers most of what is significant in the daily
operation of the business.
i. Includes:
(a) Sales - paid in cash or on credit
(b) Expenses - includes payroll, cost of purchases, accounts payable, and other uses of cash
(c) Other revenue sources
(d) Taxes
(e) Depreciation on Property
(f) Interest on borrowed money
(g) Collections on accounts receivable
(h) $ on returned merchandise
(i) Operating Lease but NOT a capital lease
(j) Interest Expense on a loan  despite the fact that getting a loan is part of financing activities
(k) Interest paid on capital lease  despite the fact that capital lease is part of investing activities
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ii. What does company earn from operations? Operations Income is not in SCF, but rather, Cash from
Operations is. Operating income as used has no relationship to Cash from Operations because CFO
takes interest, taxes, etc into account, unlike operating income
iii. Example: Net Income plus Non-cash Expenses (amortization, depreciation) plus increases in
Operating Liability (salaries payable) minus increases in Operating Assets (accounts receivable
increase, for example). Received other types of assets rather than cash = reduces cash in income).
Can tell company’s inherent profitability.
b. Investing - Includes buying or selling a building (although depreciation does not show up because it is a
non-cash asset), buying inventory, investing in capital assets and, usually, making loans to others.
Includes elements in a transaction of purchase / sale for generating returns not directly related to daily
operations of the business.
i. Includes: Buying / selling marketable securities, buying and selling long term assets like buildings,
buying machinery, and making loans (NOT GETTING THEM)
ii. Capital Lease is also investing. BUT interest paid on it is an operating activity. Prevents operating
cash flow from being as low as with operating lease some payments are investing activity
c. Financing - Transaction in which company raises capital / borrows money (for example, debt and equity
offerings). These are activities that would typically involve an investment banker. Typical activities are
borrowing, raising capital through debt or equity, company buying or selling its own or someone else's
stock.
i. Includes selling / issuing your own stock and borrowing money, AS WELL AS  Payment of
dividends (which is not part of operations, is not an expense or an income statement event and not
like interest on a loan)
ii. Specialty Finance Industry pays attention to this. [Very popular on public market lately.
Decentralization of banks for borrowing activities (home equity or credit card loans). Loans sold as
securities on Wall St.] Uses aggressive accounting. Often co’s were operating by issuing / selling
more stock during the ‘80s. Then, industry standard began to focus on SCF. Now people will think of
ways to get around it and SCF will become meaningless.
iii. Example: AOL, through aggressive accounting, counted the amount it took to lure customers in and
then capitalized this marketing expense over several years. You would not notice that they were
doing this unless you looked at their SCF and saw that they were only showing that they had
negligible cash from operations. Would say marketing expense could be amortized, etc. If you did
not look at the SCF, you would have said that the company had strong net income.
2. TAX - example of operating or financing expense? Every company either has deferred tax liability or
deferred tax asset.
Deferred Tax Asset 5,000
Tax Expense
30,000
Cash
$35,000
Example: Net Income = $100,000 at tax rate of 30% so tax expense is $30,000. Amount due to the IRS
$35,000.
a. Tax Expense 30,000
Cash
20,000
Deferred Tax Liab
10,000
Ex. Tax Due IRS = $20,000
B. Preparation and Presentation Using the Direct Method - p. 133. Reports each account where there is a change in
cash during that period. Look for cash transactions and report them.
53
C. Preparation and Presentation Using the Indirect Method - Financing and investing are the same as direct. Starts
operating account with net income and only records transactions affecting net income. (For example, accrual /
deferral, investment / depreciation). How to do it:
1. Start with Net Income
2. Add back non-cash expenses 
3. Subtract increases in current assets (examples include marketable securities and A/R) 
4. Add increases in current liabilities 
5. Add decreases in current assets 
6. Subtract decreases in current liabilities = statement of cash flows.
 We increase A/R when we sell something but have not yet received cash for it.
 Net income includes sales revenue. We take out of A/R the amount that we receive when cash comes in.
 If A/R goes up, then that is a net amount of revenue reported on the income statement for which we did not receive
cash.
 If you up A/P, you have an expense on the income statement that you have not yet paid for. Therefore, you have to
add cash back to reflect this.
 If you pay on an account, you are now more poor, but that fact has not yet appeared on the income statement because
you have not yet had to pay that cash so you need to deduct that amount (of the decrease).
 If you have a high net income but no sales at all, then there is no cash flow at all. You need to back out of net income
anything appearing in investing or financing activities. If you sell fixed assets, the profit or loss could be part of net
income - part of investing.
 Example - you sell a building for $1,000,000 and bought it for $200,000. Take out the $800,000 for investing - the
$200,000 also is taken out and put into the investing part of the SCF.
X. Financial Statement Analysis - Why do people look at financial statements? Chapter 9
GOAL: to understand what ratios are, why they are used, what used for and why they have become less important
because of a revert back to the Wild, Wild West principles:
To answer questions about the company and often to assess its condition = To learn @ it; one who knows it well may
check predictions made; SEC may check for adequate disclosure to public investors. Financial ratios are a tool used to
analyze (misused at times). Ex. IBM, has ratio 3:1 = no meaning because need more facts. People pick up rules of
thumb like Liability / SH Equity ration should be more than 1:1. This is simply not true anymore because people don’t
want dividends like they used to. Debt is a much more popular concept now. So, avoid rules of thumb and include
context. Income and Debt (front and back-end) ratios may be used as screening tool but can’t depend on them rigidly.
A. Balance Sheet Ratios
1. Profitability Ratio – trying to determine whether you are beating the rate of return on a T-bill; what is the rate
of return on your assets. (PROBLEM A)
o Problem A: comparing balance sheet items with income statement items. Hearkens to the difference
b/w a B/S and an I/S where an I/S is a snapshot. Income stream and expenses occur over an entire
year and balance sheet items are measured over a couple of days. This can create REAL distortions.
o PRoBLEM B: whenever comparing something at book value, it may have no relation to current
value of those assets or equity. Only tells you return of book value, not current value.
 This is Book value: i.e. the book value of a corp
2. Profit Margin Ratio – want to see how much $$ we make, out of everything that we sell, how much of that
do we get to keep – basically, what is the bang for our buck?
3. Expense Ratio – try to determine of what percentage of sales, where does that dollar go.
o
1/3; 1/3 1/3 rule of lawfirms  1/3 should go to person who generated the business (the partner); 1/3
goes to person who did the work (associate); last 1/3 should go to firms overhead and profit.
4. Turn over ratios: how often you can turn something over = turnover ratio; how compared to industry; how
compare to your own expectations.
 Inventory Turn-over Ratio – if COGS = $200K and average Inventory was $1M; then, turn-over ratio is 5
times. I.e. 5 times during the year, you sell out everything.
54
o

Shows: Not carrying a lot of inventory. BUT.. if have a VERY high ratio, it is probably too good to
be true and the Corp is probably carrying too little inventory. Therefore, if carried more inventory,
this corp, overall, may be more profitable.
Accounts Receivable Turn-over Ratio – Net sales on account and then how much was average accounts
receivable. Sell $1M on account and average A/R is $200K. If Turn over’s are high, this means you are
getting a tremendous return.
o SHOWS: Not having to chase down so many accounts receivable; BUT, if ratio is too high, probably
demonstrates that you are not loaning out enough and not pursuing an aggressive enough lending
policy.
o Just-in-Time Inventory: try to order inventory just-in-time in order to utilize, have smaller retail
and warehouse space, and, hopefully, this efficiency will enable you to be a more productive operator,
even though, from time to time, you would lose out on some sales, because you did not have the
inventory.
 Ex. Dell computers: until a few weeks ago, you could call and they would assemble it right
there (holding NO inventory) – sometimes it ships in 1 day, sometimes 5 days where they
have to re-order the part.
 PROBLEM: when there is a rapidly growing economy, JUSTin time is perfect because you
have an idea of how much you can produce (all goods produced will be purchased
immediately) and therefore, as Dell, you know how many monitors need to be delivered each
day. If work at full capacity, you can predict how much inventory you need day to day.
HOWEVER, not all economies expand at the same rate and you get:
 Lack of visibility: when not working at full capacity, no idea when that phone-call
will come to requiring you to get more inventory.
 Brotman says this the fall of Just-in-time Inventory is like a Ponzi Scheme: When
economy breaks from being very busy to NOT busy VERY quickly, this is great for
Dell (it does not use any inventory). But, not great for Intel, because they are
building up from orders that they expect from Dell and other computers.; further on
up the chain, this totally screws up pple like Corning, or Fiber-optic makers because,
as the poor economy travels on up the chain, the pple at the top get screwed the most.
With big items, suppliers get totally burned.
 Internet + Just-In-Time Inventory: thought that we would fail to become a retail society,
but, this has not completely come to pass.
5. Return on Avg Common Shareholders Equity -- trying to see what kind of return we are getting on the net
equity of the company;
 Problem A
 Problem B: the net income does not tell you what the return on equity is. If you buy stock of a
company, you don’t care about this #. You care about the percent return on YOUR own equity.
Return on equity when you are dealing w/ book value is bad because there are so many components
that determine what end up on someone’s books
o E.g. if s corp takes a major hit because of Goodwill (see below), does this really affect their
equity and the return you are getting per equity share? How compare if have 2 drug corps and
1 has paid a lot for trademarks and therefore has very high levels of assets.
o KEY:
6. Leverage Ratio: Shows (assets/equity) – how much asset you are able to get per each dollar of invested
capital. This is slightly more meaningful than #5 because both numerator and denominator are in book value.
This gives you some assessment of how good or bad the investment will be.
7. Working Capital = Current Assets (expect to turn into cash in 1yr) minus Current Liabilities (expect to have


to pay in 1 yr). Doesn’t say how much capital needed so not useful. Need ratios. Working capital = current
assets - current liabilities.
Concenpt: how much stuff do you have that you will be able to turn into cash/how much stuff you need to
continue doing business.
Acid Test = ??
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8. Cash Flow From Operations to Current Liabilities Ratio: this is more meaningful than immediately below.
9. Current Ratio = Current Asset (ie cash w/in one year) / Current Liability(ie due with in one year). 1.65 ratio
means 165% of its current liabilities in current assets. What’s wrong with this when trying to determine
operating capital? Ratio remains constant. Be careful only to pull current. Optimal = 2. Current Ratio =
current assets / current liabilities. More of a liquidation figure – worst case scenario. How are we going to pay
for our debts if they come due.
i. Snapshot - Not reflective of fluctuations (Very rough).
ii. Co’s can “window dress” their balance sheets to defer losses to the next fiscal year. (Japan)
iii. Cash can be committed and not show up with liabilities. (liab due Jan. 2 and assets Due Dec. 2)
3. Quick ratio = Current Assets – [inventory + deferred income taxes + Others] / Current Liabilities. Acid test
 exclude inventory and prepaid assets. Use QR as filtering device. If ratio 10:1 focus on other area because
looks ok. (Need to know something about industry). Looking for minimum ratio of 1 and probably around 2.
4. Inventory Turnover Ratio- helpful. Prob 9: Look at # times inventory turned over in x amount of time.
Formula: Current Year’s COGS / [Beginning Inventory + Ending Inventory] / 2. Rule is usually that if 3 or
better times/yr good, if less then bad. BUT, If high profit margin, could be ok to have low turnover (jewelry,
eg) but if low profit margin need high inv turnover (Rx eg). What’s fundamental problem with operating
gross margin? Turnover can be ltd, eg, in retail if 2/3 done in 1 season (inventory spurts) and doesn’t tell what
real inventory is. Can create appearance of turnover if don’t use true weighted average. Also anytime you
mix b.s and i.s., you’re mixing things not the same so get misinformation.
Gross Profit margin = sales minus COGS
5. Accounts Receivable Ratio - For amount of sales made on account, how quickly do you collect? In effect,
how often do you turn over accounts receivable? Credit Sales / [Beginning AR + Ending A/R] / 2 = # days
outstanding (on average)  if divide into 365, get average turnover of AR. Know due date of AR. Flaws:
Have to assume all credit sales because no info so ltd utility of ratio. Want to know if credit not popular
because otherwise why have it. Important to know cash/credit mix. Can differ even w/in same industry.
6. Accounts Payable Ratio = GET THIS!!
7. Debt / Equity Ratio - 2d most widely used (next to price / earnings). Means 1 of 3 things:
a) total debt (liability) / by total SH equity. (p. 156)
b) LT debt to equities (total liability minus current liability divided by equities). Deals with capitalization
(more theoretically correct). Can be manipulated by characterizing ST liability as LT liability. People
like to see 1:1 historically, [i.e. do not want to see a corp that had more debt than equity] but now 2:1 ok,
have to do research. (4:1 typical because highly leveraged more acceptable.)
c) This is useful: because lenders like to make-sure that borrowers have a stake in something; if you
have something to fight for in equity. Lenders love to see equity behind them
d) Capitalization Ratio - Total Liability / (Total Liab + SH equity). 2:1 standard. Also called Debt/Capital
ratio.
7. Times Interest Earned: ask what out net income is – what is our total flow and ask how many times we can
cover that. Someone can give you a loan; Lender wants to make sure that you have enough cash-flow from
earnings that you are 20% cushioned so that if your earnings get screwed for a certain period, you may still
pay for this. 1:1.2 ratio.
a. In housing market, lenders are more aggressive.
b. Back-end ratio – Total debt Service/Gross income not more than 36% -- 40%
B. Income Statement Ratios
1. Gross Operating Profit Margin: Gross Profit on Sales / Total net sales. Trend and variation analysis
important here.
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2. Profit Margin: NOTE THIS IS BROTMAN'S WAY: (Sales - COGS) / Sales = Gross Profit Margin.
Brotman considers the following terms to be interchangeable: gross profit margin, profit margin, and gross
margin.
3. Interest Coverage Ratio - Not really a coverage ratio, similar to debt / equity. Earnings / interest payment
obligations. Can also be shown as EBITDA / Interest Expense. (EBITDA = earnings (net income) before
interest, taxes, depreciation, and amortization.) Measures how much company has to pay in interest (# x’s
interest obligation covered by earnings). Net Income / Interest Expense  but net income doesn’t tell
anything about cash. Much more useful to banks is Cash Debt Coverage Ratio (or, Debt Service Coverage
Ratio: amount of loan / FMV of securing collateral). Ratio = Cash flow of borrowing entity (from
operations)/debt service payments (principle and interest).
4. Price to Earnings Ratio = Market value of a share of company’s stock / Earnings per share. Published PE is
actual # and Forward PE is analyst’s projection (useful in comparing co’s). Shd be based on prior year.
Earnings per share is widely used ratio itself. EPS = net income / # shares outstanding. When we calculate
EPS, we take into account the options, etc for a fully diluted EPS. Generally, only assume options convert
into common stock if it’s likely (w/in 10%) - follows principle of conservatism. Inaccurate theory re: EPS is
to require %age return inverse of EPS ratio- only has use if compare w/in industry and base off prior yr.

Try to compare PE ratio of 1 corp to another or corp to itself, but, we must question how reliable this is
currently
5. Return on Equity = Net income (current year) / Equity (end prior year).
6. Return on Assets = Net income / Assets.
7. Quality of Income Ratio / Quality of Earnings = Cash Flow from Operations / EBITDA
C. Cash Flow Ratios 1. Cash Interest Coverage ratio: Cash Flow Provided by Operating Activities / Total Interest Expense.
2. Cash Debt Coverage Ratio: Cash from Operations - Cash paid in dividends to SH.
3. Cash Dividend Coverage ratio: Cash Flow provided by Operating Activities / Cash Dividends.
4. Quality of Income Ratio: Cash Flow Provided by Operating Activities / Operating Income.
5. Cash flow per share = Cash / Outstanding Shares.
6. Cash Return on Assets = Net Increase (Decrease) in Cash (Current Period) / Total Assets (Prior Period).
XI.
Accounting for Business Combinations & Auditing & the Lawyer’s Role: Chpt 12:
Accounting for an acquisition was either in Purchase Form of Pooling Form
 Purchase – simple – figure out what you are paying and then fig out what you are buying.
o Mark to Market – take all assets of underlying Corp and value them at FMV (all semester because
of the going conern principle, we have not taken FMV) – here, you add all assets up and value them
at FMV
 Valuations for equipment, IP, etc.
o ADD FMV of assets acquired – liabilities assumed = NET FMV of assets acquired.
 To extent that purchase price exceed NET FMV of assets acquired, this is GOODWILL
 Goodwill– the excess of the purchase price over the NET FMV of assets acquired in a
business combination using the purchase method of accounting. 
 This is a compromise of cost accounting – always accounting for asset at historic cost; with
GOING CONCERN principle – all assets are required as going concern and expended in
some way – now, goodwill is a permanent asset unless it has been impaired. Before, by not
accounting for goodwill at all, we were violating both of these principles because goodwill
would not appear on the balance sheet OR the income statement.
 Note: this is a technical definition. It does not have to do with the reputation of the
corp, the synergies, etc.
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

If you are the acquirer, you would rather put “Goodwill” on balance sheet rather than
“Amount by which we Overpayed for the Asset”
o When you acquire assets, every asset is, in effect, a pre-paid expense
 Machinery must be depreciated
 Intangibles such as goodwill must be amortized over time.
 This was really abused in the S & L crisis in the 1980’s, where, essentially – if buy
Long term loans received and buy at a time where interest rates much higher than
price at issued. As interest goes up, price goes down, and therefore, you would be
buying those assets at a Discount. Must take this profit into income over-time as
additional income. What many pple did was, after this business combination, they
would take this goodwill, they would pay $75K above the price and, they would
write off the Goodwill over 40 years.
o Goodwill Expense $7500 (non-cash expense)
 Goodwill used $7500
 This lead to a change in how to amoritze goodwill cannot be amortized less than the
LESSER of 40 years or the average useful life of the goodwill.
o Ex. If purchase IP (patents and trademarks) and avg will last for 15 years,
cannot amortize for less than that 15 years.
o WAM (weighted average maturity)/Weighted Avg Coupon – is weighted
average interest on the assets
o Cannot borrow against Goodwill anymore.
 Ex. CISCO and Serum (CISCO acquired SERUM) for $7B – this was A LOT of goodwill.
If have to amoritze this over even 40 years, this are HUGE charges against earnings. Corps
did not want to do this, so, they lobbied and said that in certain situations, this purchase
method is bad, and instead, you have amerger of 2 equals. Therefore, put all assets and all
liabilities of both corps, and put on balance sheet of surviving corp at BOOK VALUE; no
mark to market and NO goodwill.
 1) not have to amoritze goodwill over time
 2) If other Corp has appreciated assets (a building, for ex.), do not have to write-off
assets that have appreciated in value and, book value here is MUCH smaller than
FMV.
 These deals were abused such that Serum had only $25K in cash but paid $7B for it.
CISCO’s market share was worth MUCH more than this, and, because it was allowed to be
pooled, the interests were pooled and CISCO got to avoid the problem of goodwill and pool
the assets.
 CISCO probably bought SERUM because the latter had assembled an incredible
team of engineers in the Telecom sector. CISCO did not pay cash for this, they only
paid 2% of their paper. Therefore, they gave back $1.60 of the $70 that your stock
has gone up over the years, this is not such a bad deal
o TESTS so that may use POOLING METHOD:
 1) (most imp) NO cash purchases, need at least 90% voting rights stock for voting rights
stock
o  Pooling does not accurately reflect what happened – not show asset value of what happened on the
books. Distort the assets. You ARE actually buying another corp and therefore, you must show costs
at historic cost. Therefore, pple wanted to get rid of pooling method.
 Tech Corps were VERY against this because they did not want to take charges against
earning. BUT>>>
SINCE 7/01, there is no such thing as pooling of interests; every business combo must be accounted for as a
PURCHASE of INTERESTS.
o In return, you NO LONGER have to systematically write off Goodwill as a cost. You just have to,
from time to time, determine whether there has been a “permanent impairment” of that goodwill.
Brot has no idea what the hell permanent impairment means. [this was the concession to the Tech
corps]
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
This has created an analytic analomy: Ex. PEPSI bought Quaker Oats – in order to get Gatorade name
brand – this new theory means that if Gatorade has been doing well, PEPSI need no account for the cost,
above book value, of obtaining Quaker Oats. It is not charged against earning on the books
o Land never depreciates as well—because, by definition, it stays as land and they are not making any
more of it. It is considered 1 supreme asset, cannot create it.
o Brot: this may mean that we may not really know what financial statements mean
 It will help certain companies who have been amortizing goodwill, they no longer have to do
this.
 Predition: Brot feels that corps who must take the “ permanent impairment” cost and
categorizing it as an EXTRAORDINARY ITEM – one that is not reflected in Net Income.
Corps who end up doing this will be categorizing as a 1-time charge and therefore, it will not
appear on income statement.
 Extraordinary Item Definition: “something that is both unusual and infrequent.”
o Ex. for corps that are in Hurricane zones, you cannot call this extraordinary
because it is seen as relatively common.
o Continuing Question: whether a permanent impairment of Goodwill can de
considered an Extraordinary Item
 This depends on whether you are a corp that acquires a lot of other
corps or one that has never acquired a lot of corps.
 These ambiguous terms threaten the very principles of Reliability and Consistency in Accounting: At
the end of the day, the more of these items, that the timing and amt can be subjectively determined by the
Corp, w/in the realm of GAAP, w/o cheating, it becomes harder to compare an corp to itself over time
(consistency) and to others (reliability).
A. Methods Compared and Illustrated - methods seem insignificant but important (e.g., LIFO v. FIFO, depreciation
methods, leases, etc). Can be enormous differences in results / presentation
1. Nothing is more important than comparing the difference b/w Purchase Method and Pooling Method of
Accounting. Over past 15 years, how to account for business combinations has become really important.
2. Business Combinations
c. A + B  A (this is usually what happens)
d. A + B  C
3. Factors: Economic transformation where tech changes affect productivity (defined as amount of production in
fixed dollar amount of labor); Political adjustment period (deregulation, mergers - e.g., interstate banking);
changes in worldwide economy = Major trend toward consolidation. Increasingly important is how to
account because it’s how you figure out what something is worth (not most important because valuation, not
accounting focus unless don’t qualify for pooling):
i. Pooling Method - very few companies acquired other than as purchase. See p. 216. Almost all mergers where
public companies try to use pooling. Pooling avoids having charges to earnings (advantage). Focuses more on
income statements. This is an accretive transaction. This method allows increases in earnings, not burdening of
earnings. 2 types business combination:
(a) A buys B (economically even if not legally).
(b) Merger - true where 2 corps become one. (Ex. GE and RCA. Realize that should account for it differently
because not purchase).
Ex. Pooling: Price doesn’t matter because it is not reflected in the books here. Higher net income than purchase method.
(Because no increase for depreciation / amortization expense, for example.) Recorded assets and liabilities of each are
pooled at historical book value.
FMV = 175
Buyer: Assets 100
Liabilities
70
SH Equity
30
Seller: Assets 100
Liabilities
70
S/E
30
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ii. When SEC and accountants realized pooling had become so highly preferred, they came up with criteria which must
be present in order to account for a business combination with the pooling method. Designed to make sure it’s 2
companies combining:
(a) has to be completed within 1 year.
(b) has to be at least 90% of acquired company
(c) cannot have any changes in equity - IMPORTANT - neither company could have been another company's
subsidiary during the past 2 years.
(d) cannot reacquire existing shares - Poison Pill - company builds in trigger shares so auto reacquire shares to
prevent pooling in hostile takeover. Also, Cash Settled Stock Options - let people tender old shares for new
shares. Clears a pooling.
(e) voting rights must be maintained
(f) NO CASH - cannot pay for the combination in cash - Most important rule (private co’s want cash so don’t do
pooling).
(g) No contingent consideration
(h) No plan for liquidation or depreciation
(i) No reacquiring of shares issued in combination
(j) no other financial arrangements (guaranty of loans secured by stock issued, e.g., because it negates exchange
of equity securities).
(k) autonomy
(l) independence
iii. Purchase Method - Assets, e.g. Entity acquired is no longer a going concern. Have to do a mark to
market (mark assets up from book to market value). Difference between amount paid and fair market
value = goodwill which is treated as an asset and which will be amortized. (If using purchase method
and pay more than net value of assets in an arms length transaction, synergies, etc). Goodwill needs to be
amortized over time. Cannot exceed expected economic life of assets attributable to goodwill and cannot
be more than 40 years. (S & L - many believe GAAP encouraged overpaying for S &L because paying for
sound where unsound = future expense). For a long time, people focused on balance sheet and liked
purchase method. SEC said no, if pooling is what you’re doing, need to use that method. Preferences
changed. Problems with purchase method: increases value of asset side; we don't want inflated
intangibles (i.e. trademarks like Coke); have to amortize things like goodwill; takes away from income;
goodwill, to a certain extent, shows how much you overpaid.
Ex. Purchase: Price $225
Buyer: Assets 100
Liabilities
70
S/E
30
Seller:
Assets 175
Goodwill 50
Liabilities
70
S/E
155

Move assets over at FMV and price excess will be goodwill. Amortization and
depreciation = new exp. Higher total assets because FMV. Higher expenses.
Acquiring entity records acquired entity’s assets at FMV.
iv. Earnings Accretive - Increases in earnings/share on going forward basis. People want to know if this
will happen when combine. If you account for something as a purchase, you have a lot of hits in the
future. You don’t have to under pooling.
Ex. Before: $5000/1000 shares outstanding =$5/share = EPS
After: $8400/1200 = $7/share
$8400 earnings reduced by depreciation and amortization so under purchase method earnings can never be as
accreted as under pooling.
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ii. Pooling is huge focus. Often deal-breaker. Shows how powerful accounting is. Selling one company
afterward can prevent pooling. A lot of distortions happen here.
iii. How use of accounting can cause economic problems: S&L’s regulated heavily historically. In the late
1970's, there was a massive rise in interest rates following a rise in inflation. The S&L's were in trouble
because they received less return on their assets due to their governmentally set interest rates being below
national rates. In the early 1980's, S&L's were deregulated so that they could compete with regular
banks. 2 bad things then happened: S&L's did not know how to make the same kind of loans and
regulators know nothing about bank loans. S&L’s then made efforts to attract customers. Not profitable
institutions because expenses exceeded revenues. Approved loans for low interest rates so liabilities
higher rate than assets. S & L’s amortized goodwill over period of time beyond life of assets and each
year showed signs of profit. Huge bonuses taken by executives. Didn’t care about cash. Would do crazy
deals for income. Charged huge fees that came out of loan. Would acct for these so able to show good
credit but using your money. Would clean up future income statements. CHANGE: now cannot
amortize goodwill beyond life of assets (As a result of S&L). SEC will review if you file to amortize
over long period of time. One accounting firm went bankrupt and another lost license in CA.
Balance Sheet of S&L:
Asset $1000 (10 year loan with 5% interest per year)
Liability $1000 (30 year bond with 9% interest per year.
This created a cash flow problem because they needed to pay our more than they were taking in.
[Assume a going interest rate of 9%.] Therefore, they essentially created a shell into which the
old S&L would merge. They would do this using the purchase method.
New S&L Balance Sheet:
Loan
400
Goodwill
600
Bonds
1000
Now, one year later: collect $50 on loan and write up loan by 60 ($60 per year to get to $1000) and have
interest revenue of 110
Cash
50
Loan
60
Interest Revenue
110
Interest Expense (bonds) 90
Cash
90
Amortization Expense 15
Goodwill
15
Now, S&L is turning a profit: 110-105=5. Now, bank makes new, risky loans to cover the money it will
need to have when it can no longer amortize goodwill. This is where the crash began.
iv. 4 Imporatant things Learned:
(a) Lack of response of accountants to changing events.
(b) lack of understanding by people who use accounting procedures
(c) significant impact where get artificial factor
(d) Complicity of S &Ls and tendency of accountants to hide behind GAAP. Accounting profession
cannot be responsive enough. Communication and info much more widely available now and people
are more aware. Lawyers can’t hide like accts.
XII.
Valuation Techniques:
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A. Purchase Method - May disregard legal fictions/realities. Can have this where entity continues to exist (owned by
another) but only in legal / economic sense. Retained Earnings - only makes sense in terms of going concern
assumption.
B. Appraised value/Book value (you should not favor this, tells nothing about current value). Merger using purchase
method  arms length transaction, at this point entity would equal market value).
C. How do people use GAAP to value a public company? PE ratio- take fully diluted EPS (e.g. on NYSE 24:1=very
high historically). PE growth - market multiples are always up when interest rates are down. Stocks are attractive
because rate or return is comparable to cash return on bonds. Also, of three financial statements, income stmt
typically used to come up with value of company (balance sheet gives only book value and SCF doesn’t come up
with total).
D. Private Co’s are totally different in valuation. Estate taxes are very high and concern here is low basis so value
biz for this purpose. Focus on EBITDA (or operating income) which represents cleanest starting point because
focus on profitability. If, eg, think people demand 8% rate of return, 12.50 is result. Capitalize earnings - divide
earnings by desired rate of return. The lower the cap rate, the higher the price. Lower the interest rate, higher the
price. Is there any discount on comp value because of lack of control? Benefits of GAAP - system of accounting
for events that all understand (predictability and consistency); Means you understand the basis, historic cost, and
allows you to compare it to other comparable industries; Will give book value.
E. With banks - people care about book value. Bank sells for higher than book value (multiple like 4x).
F. Auditor’s Role - make sure financial statements prepared in accordance with GAAP. Positive confirmation makes somebody do something. Negative Confirmation - don’t have to do anything.
G. Lawyer’s Role - auditors send letters to lawyers “tell us about any pending liabilities of the co” and lawyers worry
about whether answer will be public, accountant / client privilege (depends on state and generally not so destroys
attorney-client privilege), and trying to be evasive (never say “probable”). Tension b/w auditors and accts. Acct
approaching things from very conservative perspective but business lawyer is not. Lawyer & accountants should
get auditor advice ahead of time because lawyer has expansive view while accountant has narrow view.
XIII. Notes (Last Class) 1999:
A. Purchase Method: assumes, regardless of the actual form of the transaction, that the transaction is one where one
company is the acquirer and the other company is being acquired. The acquirer's financial statements will be the
surviving ones. Under this method, assets are valued at their FAIR MARKET VALUE (FMV) and liabilities are
at FMV. Purchase method requires increasing values on books to fair market value at the time of the
combination. You must also amortize these amounts. This is why companies do not like this method.
B. Goodwill = amount paid - FMV. This is strictly a technical term. Companies do not like goodwill because it is
an illustration of how much you overpaid. You also have to amortize that amount over time, which is not
desirable.
C. Pooling Method: uses the books of both entities to make a new set of combined books.
D. Example: Coke and Pepsi are to combine. Each has their trademarked name on the books for $100, though they
each have a value of $10,000,000.
1.
Purchase Method: assume Coke's books will survive. The Pepsi TM goes on the
books at $10,000,000  total TM on books will be $10,000,100. Then the company must deal with this
expense over time.
2.
Pooling Method: TM value on books will be $200.
E. Since everyone wants pooling, there are strict requirements that must be met in order to qualify for pooling. The
2 most significant are that (1) there was a stock-for-stock transfer and NOT a cash transfer; and (2) absence of
plans to break up the company.
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F. Employment agreements may also interfere with the ability to qualify for pooling. Therefore, today, many
employment agreements say that if a provision would prevent pooling, that provision will become void. This
places the ability to qualify for pooling above the employment contract
G. Pooling: all numbers are listed at historic cost, on own depreciation schedules, with no reflection on the balance
sheet of what the company actually paid for them in the merger transaction. With pooling, you never charge
against earnings the amount you paid for acquiring the other company.
H. OUR S&L Example: create a merger so that you create the asset of goodwill  create artificial profits  make
the S&L look better than the true state of its financial health.
Goodwill
560
Loan Receivable
1000
Discount of L/R
Note Payable
560
1000
Next year: amortize goodwill over 40 years and loan over 20 years
Cash
60
Interest Revenue
60
Interest Expense
Cash
90
Amortization expense
Goodwill
11
90
Discount
22
Interest Revenue
11
22
TOTALS:
Revenues = 80 + 22 = 102
Expenses = 90 + 11 = 101
So, we end up with revenues > expenses and we have created falsely high revenues by amortizing the goodwill
over a longer period than the loan. This is a temporary solution. While doing this to make the books look ok in
the short term, the S&L's went out and made risky loans, hoping to take in enough money so that when this
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scheme was no longer possible, they would actually be taking in enough money to stay afloat. However, this did
not work when loans became uncollectable.
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