Introduction to Accounting and Finance ________ ________ ClassBook

Anthony Webster 5th Edition

Introduction to Accounting and Finance

5th Edition

Anthony Webster
Columbia University

Copyright 2012, Applied Finance, LLC. ISBN 978-1-4507-4872-8

Contents
How to Use This Book Read this first! Part I: Accounting 1. 2. 2a. 3. 4. 5. 5a. 5b. 5c. 6. 6a. Introduction Why Accounting and Finance are so Great Balance Sheet Case Study Fannie Mae Recording Accounting Events Income, Owners Equity and Cash Flow Statements Inventory and Cost of Goods Sold SGA, Depreciation Revisited, Taxes Case Study -- Taxing Hedge Fund Managers Cash Accounting Comprehensive Accounting Example Case Study Q4-2008: Financial Freeze and Causes

Part II: Finance 7. 7a. 8. 9. 10. 11. 12. 12a. 12b. 13. 14. 15. 16. 17. Ratio Analysis Equity Ratios Cash Analysis Time Value of Money Evaluating Investments with Discounted Cash Flow (DCF) Methods DCF Valuation under Rationing or Mutual Exclusivity Introduction to Random Variables Risk Case Study Sovereign Risk Case Study -- Q4 2008 Economic Impacts of Securitizations Financial Projections I Financial Projections II Entity Valuation Case Study Balance Sheet Valuation of an EDP Company

About the Author

How to Use this Book

This book is the primary required text for the "Introduction to Accounting and Finance" class taught at Columbia Universitys Engineering School and at Barnard College. (Class listing: SEAS IEOR 2261). The book covers all of the topics addressed in the course, and provides a comprehensive set of example problems discussed during class sessions. This text may also serve as a standalone, terse introduction to the subjects of accounting and finance, as a review source for those needing a fast-paced refresher course, or as a quick-reference for business professionals that apply accounting and finance in their day-to-day work. The book is designed to be enjoyed in either eBook or printed form.

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To Print this Book: The purchaser of this book may print some or all of it at any time, subject to copyright restrictions 1. The author suggests printing from Adobe Reader with the following settings: Page Scaling: Multiple pages per sheet. Pages per Sheet : 2 or Custom, 1 by 2. (Choices vary by version). Orientation Vertical. or Page Order: (Options vary by version). Auto-Rotate: Selected. These settings will print two eBook pages per sheet of portrait-oriented paper, looking something like this:

1. You may print this book for your own personal use, but you may not distribute any portion of the text, in either printed or electronic forms, without the authors prior permission.
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Introduction to Accounting and Finance

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To use this Text as an eBook: To get maximum enjoyment from this text as an eBook, the author suggests: 1) For use on Tablet PCs Add the AutoInk plugin (available at www.evermap.com) to your Adobe Acrobat software, then view this book in Adobe Acrobat. AutoInk provides Acrobat with pen-based annotation capabilities that are far superior to Adobes pen-annotation tool. Unfortunately, the plugin requires the full version of Acrobat, and will not work with Adobe Reader. 2) For standard Windows PCs Download the free version of PDFxchange Viewer (available at www.tracker-software.com), and view this book from within the PDFxchange program. PDFxchange offers a wonderful set of pdf annotation tools, which are quick and simple enough to use for in-class note taking, and are robust enough for detailed annotating at home.

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3) For Macs Try opening the PDF text with Mac Preview (right click on the text icon, then choose Open With, Preview). Annotate the book by choosing (from within Mac Preview) Tools, Annotate, Add Note, or by simply typing CNTRL+Command+N. Then click where youd like to comment and start typing. Apparently Mac Preview viewer does not properly handle the ClassBook on some Macs. However, the free application Skim seems to work perfectly on virtually all Macs.
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If you have any trouble with Mac Preview, you can get Skim here: http://skim-app.sourceforge.net/

Like PDFxchange for Windows, Mac Previews and Skims annotation tools are quick and simple enough to use in-class, and are robust enough for detailed note-taking at home.

Introduction to Accounting and Finance Anthony Webster

Chapter 1 Why Accounting and Finance are so Great

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Introduction to Accounting and Finance

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Why Accounting and Finance are so Great Healthcare Properties (HCP) Example
Healthcare Properties (HCP): Health Care Real Estate Investment Trust (a REIT). Acquires, develops, leases, sells and manages healthcare real estate. Provides mortgage financing to healthcare providers. Well diversified Geography: CA, IL, TN. HQ in San Francisco. Segments: Medical office, hospital, senior housing, life science.
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HCP Example
Bond of HCPs is for sale in marketplace (3/16/2009):

Market price = $94.50/bond Bond matures 9/15/2009. (HCP must pay holders $100/bond, plus interest of $2.80/bond)

Should we buy HCPs bond?

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Buy the Bond?

Compare to US Treasury Bond maturing same day:

Market price today = $100/bond Treasury will pay holders $100 + $0.42 per bond on 9/15/09

Comparison Table: Bond HCP T-bond

What we get / What we pay $102.80 / $94.5 = 1.0878 $100.42 / $100.0 = 1.0042

HCP looks much better (8.8% return in ~ 6 months) Whats the catch?
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The World is Coming to an End

Recall March 2009: S&P 500 down 19% year-to-date, after falling 39% in 2008.

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The World is Coming to an End

Retailers expected to begin a wave of bankruptcy filings, altering the landscape at malls and on main streets across the country. WSJ. (REITS ) General Growth Properties DeathWatch. (REITS )

S-Street Seaport

The next shoe to drop will be the implosion of the commercial real estate market. Atlanta Jrnl. Consititution. (REITS )

Our largest banks are insolvent and need to be nationalized Paul. Krugman
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Buy HCPs Bond?

Lets make our own independent assessment: A. Qualitative prospects for HCPs business: Even in terrible economy, is demand for medical office, hospital, senior housing going to collapse?

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Buy HCPs Bond?

B. Quantitative Analysis: Look at HCPs Financial Statements (Yahoo Finance) 1. Check Balance Sheet: Reports HCPs assets (cash and cash-generators) and liabilities (obligations to pay cash in future), at a particular point in time (snapshot).

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Buy HCPs Bond?

HCP Balance Sheet ASSETS Cash And Equivalents Accounts Receivable Notes Receivable Other Current Assets Total Current Assets Property, Plant & Equipment, net Other Long-Term Assets Total Assets LIABILITIES Accounts Payable Other Current Liabilities Bond maturing 9/15/2009 Total Current Liabilities Long-Term Debt Other Non-Current Liabilities Total Liabilities
Introduction to Accounting and Finance

As of

Dec 31 2008 $MM UON 57.6 794.5 1,076.4 50.5 1,978.9 8,710.1 1,160.8 11,849.8

Current assets (CA) = cash and assets that can be converted to cash within a year. Current Liabilities (CL) = obligations that must be paid within a year HCP has CA >> CL

308.1 356.2 102.8 767.1 5,382.0 499.5 6,648.6

Looks like HCP may be able to meet bond obligation.

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Buy HCPs Bond?

What if HCP is burning thru cash at terrific rate? 2. Check Cash Flow Statement (CF Statement)

Reports HCPs cash inflows and outflows, measured over a period of time (12 months in this case) CF Operations ~ net flow of cash from day-to-day business CF Investing ~ net flow of cash from purchases/sales of plant and equipment (long term maintenance and upgrades) CF Finance ~ net cash flow from HCPs stakeholders: Issue stock for $, issue bonds, repay bond principal, etc.
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Buy HCPs Bond?

Cash flows from (used in) 3 months 3 months 3 months 3 months Q1 Q2 Q3 Q4 Mar-31-2008 Jun-30-2008 Sep-30-2008 Dec-31-2008 131.7 (21.3) (52.6) 57.7 141.0 450.6 0 591.6 182.7 27.4 (30.9) 179.2 113.3 (29.3) (143.5) (59.5) Totals

Operating Activities Investing Activities Financing Activities Net Change in Cash

568.7 0 427.3 0 (227.0) 769.0

Operations are generating cash. Investments in (maintenance of) plant etc. probably require less cash. Paying off bonds and/or paying big dividends.

No evidence of big cash burn (outflow)

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Buy HCPs Bond?

1. Balance Sheet shows: HCP currently has capacity to meet bond obligation (and all its near-term $ obligations). Cash Flow Statement shows: HCP will almost certainly not lose capacity to meet bond obligation before it is due. Price of HCPs bond was probably driven down by generalized panic of the moment. Probably want to Buy the Bond.
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2.

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Buy HCPs Bond?

Other Real-world Considerations:

Check news on HCP Future event will cause massive cash bleed this year? Check notes to financial statements (www.sec.gov) Etc.

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Buy HCPs Bond?

Epilogue 9/15/2009: Bond matures HCP meets obligations associated with this bond.

Buyers on 3/15/2009 realized 8.8% return over 6 months (~ 18% annualized return).

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What Accounting Is
The language of business. Universally accepted method of:

Identifying Measuring Reporting

an entitys financial information

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What Accounting Does

Provides financial information on entities:

Amounts of financial resources How resources were financed (paid for) Financial results achieved by using resources

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Who Uses Accounting Info

Anyone who needs to evaluate an entitys financial state. Parties inside or outside an entity:

Branch manager, CFO, CEO Stockholders (owners) Potential investors and lenders

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Accrual vs. Cash Accounting

Cash accounting:

Record changes to entitys cash Keep track of total cash Report on these two things Done

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Accrual vs. Cash Accounting

Accrual accounting:

Measures financial events as accrued, regardless of when cash transactions happen. Recognizes revenue when earned (accrued) and expenses when incurred (accrued), rather than when payment is made or received.

Provides much more info:

More useful to managers and investors. We will primarily use accrual accounting.
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Introduction to Accounting and Finance

Accrued Definition

Websters Online Dictionary:

To come into existence To accumulate or be periodically incremented (interest accrues on a daily basis)

Verb form: Accrue vacation time

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Accrual vs Cash Accounting Example

Accounting For Apple Date Actions Taken by Apple Accrual Accounting Impact on Apple Record "revenue" or "sales" of $100,000 ?3 Cash Accounting Impact on Apple ?2

6/15/2008

Ship 1,000 3G Iphones to AT&T; send AT&T invoice for $100,000 Order 1,000 3G Iphone chipsets from Infineon for $50 each. Pay $25,000 cash for heating oil. ordered on same day.

6/18/2008

?4

7/21/2008

?5

?6

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Concepts Governing Accounting

1. Accrual 2. Money measurement 3. Duality 4. Entity 5. Going concern 6. Cost 7. Accounting period 8. Conservatism 9. Realization 10.Matching 11. Consistency 12. Materiality
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Accrual Concept

Measure financial events when accrued (when experienced or as accumulated), regardless of when cash transactions happen Examples (Apple): Record revenue when products/services delivered Record expense as soon as obligation is created (NOT necessarily when payments are made or received)

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Money Measurement Concept

Consider only items and transactions that can be conveniently reported in $ or other currency. Apple should measure and report: Cost in $ of buying 1,000 chipsets Cost of paying Steve Jobs salary Skip:

Steve Jobs value to Apple Fact that FoxConns assembly workers just went on strike Value of the apple logo

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Money Measurement Concept

What if Lenovo bought Apple? (Lenovo bought IBMs Thinkpad laptop business) Would Lenovo then report the value of the Apple logo?

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Important Accounting Quantities

Assets Liabilities Owners Equity

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Important Accounting Quantities

Assets: Valuables owned or controlled by entity Cash, Things to be converted to cash, Things used to generate cash. For Apple: Functioning iPhones in warehouse Unpaid invoices to AT&T Land and buildings Not: 200 Macs in parking lot, completely destroyed by rain. Head of R&D department. For HCP: Cash, property plant and equip, etc.
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Important Accounting Quantities

Note: Assets usually measured at cost (or cost minus wear): Functioning iPhones in inventory (at cost paid to Foxconn) Land (price paid) Exceptions Cash and other currencies (current value) Stock options, commodity futures (current value)

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Important Accounting Quantities

Liabilities: Financial obligations of an entity Items representing future cash outlays For Apple: Unpaid invoices from Foxconn (supplier) Outstanding mortgage balance on HQ building Salaries earned but not yet paid. For HCP:

Accounts payable (amounts owed to suppliers) Bond principal and interest owed Etc.
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Important Accounting Quantities

Owners Equity (or Book Equity or Book Value) Two ways to understand Equity (must know both) 1. Owners Equity 2. Owners Equity == Assets Liabilities = Cash infusions by owners + Net Income - Dividends paid to owners ( means sum over life of entity)
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