Financial Accounting Mundstock

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PART A: INTRODUCTION
- CHAPTER I: INTRODUCTION -
A. ACCOUNTANCY?
– Accounting: The process of analyzing and justifying one’s actions to another
– Trust Accounting: How a trustee explains their actions to the beneficiaries
– Financial Accounting: How managers of for-profit businesses report to shareholders and others about the
management of the business (by preparing and distributing financial statements
– Lawyers need a working familiarity with accounting, they should understand accounting and the rules of it
– Accounting numbers can be factually relevant to a legal issue
– Accounting terms and concepts can be used in controlling law
– In this chapter:
1. Introduction of accounting and preliminary comments on accounting’s relationship to finance
2. History of accounting (accounting’s role)
3. Current practice of accounting (how accounting plays its role)
4. Reflection on the nature of corporate finance
5. Additional thoughts of the general relevance of accounting to lawyers
B. HISTORY
– Accounting became needed as businesses increasingly used capital owned by others (lenders, shareholders)
– Capital owners required reports detailing how their capital was being used and accountants became necessary to
evaluate management’s performance since capital users could not be wholly trusted to provide faithful accounts
– Public Capitalism: Individuals investing directly in stocks and bonds (developed in the American capital
markets in the early 20th Century)
– Individuals depend on accounting to help them make decisions on where to invest
– Securities laws in 1933 and 1934 created the regulatory regime called the Securities and Exchange Commission
(SEC), which allows the market to set prices while ensuring that it functions properly (corporate insiders are not
allowed to inside trade)
– Accountings of public businesses are filed with the SEC and available tot the public
– Generally Accepted Accounting Principles (GAAP): Rules that control basic financial statements
– Financial Accounting Standards Board (FASB): Responsible for setting out what accounting rules are
“generally acceptable,” originally known as the Committee on Accounting Procedure (CAP)
– The lack of real regulation of accounting rules means that they continue as a common-law discipline, as new
procedures develop into industry customs they get written into professional journals and eventually become
codified in the industry as an acceptable standard
– Recently capital markets are becoming increasingly international, non-U.S. companies are traded in overseas
markets and overseas companies are traded in U.S. markets
– International Accounting Standards Board (IASB): The international version of FASB, headquartered in
London, pushing for an international convergence of accounting principles
– IASB rules are required by the EU for European companies and American companies like the more flexible
rules used by IASB compared to FASB but convergence has had limited success
C. ACCOUNTING
– Financial Accounting: Way in which capital users (business managers) report on hoe they are managing
investors’ money
– Financial accounting consists of financial statements and the procedure for their preparation
– Four financial statements:
1. Income statement
2. Balance sheet
3. Cash flows statement
4. Equity statement (little interest to lawyers and is not discussed in detail)
– Accounts: Basic books and records a business keeps itself
– Management analyzes these records and condenses them into a draft of the financial statements
– Outside independent auditors (public accountants) are then brought in to complete the process
– Auditing firms are similar to law firms, a practice dominated by four enormous firms known as the “Big 4,”
these auditors serve two functions
1. Audit the financial statements to ensure that the facts represented by the management are true,
they check assets and confirm liabilities
2. Condense books and records into financial statements, after determining whether management
has correctly applied the applicable accounting principles that control how the books and
records are analyzed
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– Opinion Letter: Certification that the independent auditors have ensured the facts’ legitimacy subject to two
conditions
1. Certified statements are not what the auditors would have prepared had they done the
management’s job, just that they are not materially different from GAAP numbers
2. Not tested by one standard set of rules, there are a variety of acceptable ways to account for
items
– Arthur Anderson was Enron’s independent auditor and Enron was their biggest client, conflicts of interest
between the two are believed to have led to the misrepresented documentation of Enron’s financials
D. DISCUSSION PROBLEMS: THE NATURE OF ACCOUNTING

(1) Did you expect financial accounting to be scientifically precise? Computer languages are precise because they have a
self-defined, closed function. Is the same true of financial accounting?
(2) What should a business language talk about? Assets? Liabilities? People? Activities? Knowledge? Reputation? Goals?
History?
(3) Do languages usually develop in a common-law fashion? Is this the way that financial accounting principles should
develop?
(4) Would you expect a language developed for businesses centuries ago to be a good way to talk about businesses in the
current, increasingly knowledge-based, economy?
(5) Would you let a business’s management report on themselves? Would you let them hire their own policemen? Would you
let the accountants set their own guiding principles?
(6) Do you think that it was a good idea for the SEC to leave the regulation of accounting principles to the accounting
industry?
E. FINANCE AND ACCOUNTING

– In the broadest sense finance is the study of money and monetary transactions, how businesses get money and
use the money they get
– Public Finance: Examines governments
– Corporate Finance: Examines private businesses and is what is covered in this text
– Not only does finance study the markets but the markets study finance
– Financial analysts look to financial accounting for one number called “profit,” “income,” “net income,” or
“earnings”
– Finance depends on, and therefore necessarily provides support for, financial accounting
F. DISCUSSION PROBLEMS: ACCOUNTING AND FINANCE

(1) Should the same set of financial reports be provided for the public as for market professionals (like pension fund
managers, mutual fund managers, investment advisors, the financial press, and brokers)?
(2) Should the same financial accounting rules apply to privately-held and public companies?
(3) Ina computerized world, do you think that market professionals need businesses to analyze and condense the businesses’
raw financial data into financial statements for the market professionals? Rather, would it make more sense for businesses to
just make their raw financial data available on line?
(4) Should accountants, who are self-interested technicians after all, control the language by which business speaks to the
public (who are not technicians)? Is it likely that technicians can ignore their training and speak clearly to the average
investor?
(5) What kind of accounting rules would you expect accountants to write? Would you expect rules written by accountants
help or hurt their fellow accountants’ investment in current practice? Would you expect rules that limit the risks of
accountants?
G. RELEVENCE TO LAWYERS
– The law, lawyers, and legal instruments frequently make use of financial accounting concepts and, on occasion,
the rules of GAAP themselves
– The general concepts underlying GAAP seem to be a natural way to think about various aspects of business
– The principle purpose of this text is to give the student the understanding and motivation to use, and not use,
GAAP effectively
H. CLASS NOTES
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– Idea of the course is to be able to understand the numbers and value of the business and to talk about business
using accounting and financial information
– Cooperation and partnerships allow people to pool resources together and then divide them up to save time and
money and increase profits
– In a mortgage: Before you or your creditors can get any value out of your house the bank gets the first cut which
means you can get a lower interest rate because it is less risky for them.
– If a company goes broke they owe money first to creditors before shareholders
– Equity holders are shareholders or stockholders, they have an interest in the residue, whatever is left over after
paying the creditors
– Accounting plays the central role in reporting information to the shareholders
– There are a lot of people who can arguably be considered owners of a company, workers, shareholders, etc
– Modern Securities Market: Stocks, bonds, you give money to someone and they use it to give you money back
– You buy stock or bonds originally from a company and then to get out you sell your stock to another guy in the
market who replaces you as the shareholder or bondholder, if there was not a way to get out people would have
to use banks
– Called “Capital Markets” because it allows people to put capital into the market
– The Great Depression
1. Managements of corporations were lying
2. America had to decide how to proceed, they had two options: (i) The European system was
that banks do the investing and the little guys had to put their money into the banks, or (ii)
have a government agency regulate the markets
– To be public is expensive but it allows you to sell stock on the market
– Accounting information is what allows investors to decide if they want to or should invest in a company, it is
the heart of modern capitalism
– The largest market in the world is the foreign exchange, stock markets are the third largest
– Mergers and Acquisitions: One company acquires another for financial or tax reasons by purchasing stock or
buying them out
1. Who or what survives the merger—the management, the name, etc. (in the Bank of America
merger North Carolina National acquired Bank of America but kept the name because it was
better, however the National management was the one that stayed in charge)
2. Frequently destroys jobs
– The books that companies keep are so extensive that an average investor cannot reasonably go through it and
understand it (after the great depression government agencies began going through these books to make sure
that they are right)
– Private companies also go through the books and get them certified, and now companies must have certified
financial statements
– To be a public company you have to get a letter from an audit firm that your books are in standard accordance
with the laws of the US
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PART B: FINANCIAL VALUATION

- CHAPTER II: TIME VALUE OF MONEY -
A. INTRODUCTION
– Corporate Finance: Studies how businesses acquire and use money
1. Issuing stock
2. Borrowing goods or services
3. Selling goods or services
4. Buying property
5. Buying services
1. Finance’s basic approach to valuation
B. A BASIC EXAMPLE
– The closer an asset is to resembling cash the easier it is to determine the valuation
– “Money today is worth more than money tomorrow”: Money today can be invested and earn a return so as to
grow to a larger sum tomorrow
EXAMPLE
$1000 Bank Account Growth at 10% Interest
Year Opening Balance Interest Earned Closing Balance
1 $1000 $100 $1100
2 $1100 $110 $1210
3 $1210 $121 $1331
4 $1331 $133 $1464
5 $1464 $146 $1611
– Principal: The amount originally lent, increased to reflect subsequent additional lendings, and decreased for
payments
– Interest: Paid by the borrower to the lender to compensate the lender for borrower’s use of the lender’s funds
– Amortization Schedule: The terms of a loan that control when principle is to be repaid
– Compounding: Interest that is reinvested and earns interest (compounding period in the example above is one
year)
– Three Concepts of Interest:
1. Payment of interest: When the borrower is required to provide cash to the lender
2. Compounding of interest: How interest is calculated
3. Earning of interest: What is owed if the borrower defaults on its obligations under the loan
terms
– Types of Interest:
1. Accrued or Economic interest: Earned interest regardless of its payment date
2. Prepaid interest: Interest to be paid before it accrues
3. Deferred interest: Interest to be paid after accrual
4. Simple interest: Interest determined without compounding (interest to be paid as it accrues)
C. NOMINAL AND EFFECTIVE INTEREST

– Nominal Interest Rate or APR: The annual interest rate before compounding
– Effective Interest Rate or Yield: The interest rate after the nominal interest rate has been compounded
EXAMPLE
Nominal interest rate of 10% compounded daily is 10% / 365 days = 0.0274% each day
Day Opening Balance Interest Earned Closing Balance
1 $1000.00 $0.274 $1000.27
2 $1000.27 $0.274 $1000.55
365 … … $1105.20
The effective interest rate on a nominal interest rate of 10% compounded daily is therefore 10.52% per year
– Annual Percentage Rate (APR): Computed by multiplying each compounding periodic rate by the number of
compounding periods in a year, an APR of 17.4% means that each month 1/12 of that percentage is owed
(1.45% per month) so the effective rate on 17.4% is 18.86% (APR is an effective rate displayed in its nominal
form)
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– Adjustable-rate or Variable-rate loans: Loans that provide for interest rate adjustments that reflect the current
market conditions
D. DISCUSSION PROBLEM: THERE’S INTEREST AND THEN THERE’S INTEREST

A fad in very active (“bubble”) real estate markets is buying homes using money borrowed under mortgage loans that
provide for variable interest (currently, quite low) and require only interest payments monthly until the entire principle is
due in 20 years. A friend comes to you saying that this creative financing makes it possible for him to buy more home: The
current payments under such a borrowing are so small that he can handle borrowing more. What do you tell him?
As interest rates increase peoples’ interest-only loans increase and people are shocked by the amount they
owe. People have to foreclose because they can not afford the double in cost when interest rates double.
You are also not getting any investment from the house because you are still paying off the interest. In 20
years you will still have to come up with the principle of $300,000 because with interest-only loans, over
the years, you have not been paying off any of the principle, you have only been paying off the interest.
E. PROBLEM: USURY
Another interesting context where compounding can have legal significance is under state usury statutes. Many states have
statutes that outlaw “usury:” lending to individuals at a rate of interest above a statutorily-prescribed rate (today, usually
between 16% and 18%). These statutes are intended to protect individuals from taking on debt that they cannot handle. The
sanctions for usury vary from the lender losing any excessive interest, to the lender losing the principal on a usurious loan,
to criminal sanctions. Given the potential bite of such sanctions, measuring interest is quite important in usury law. At
common law, many states held compound interest against public policy per se. This old law flew in the face of customary
business practice. Thus, today, most states try to accommodate some compounding with the policy against charging
individuals unduly burdensome interest. The following two cases suggest how the New York courts have dealt with it.
State usury statutes are designed to prevent predatory lending and keeping people from buying houses that
they cannot afford. If you have to pay a really high rate of interest then you probably shouldn’t borrow.
Usury law allows the credit card companies to bring suit in the state the card is issued (usually DE), which
allows them to charge more interest than what most states usury statutes allow.
CASES
Giventer v. Arnow “Effective Interest Exceeds Usury Limit but Nominal Does Not”
Without quarterly payments, quarterly compounding was only a means to get around the usury limit and illegal
The maximum rate of interest was 7.5% but the promissory note that indicated the interest rate set it at a nominal 7.5%
interest compounded quarterly which was an effective interest rate of 7.72%. Since no payment was due until “one year from
date” and no quarterly payments were ever due the compounding was solely a means of increasing the interest rate and must
be considered usury.
Estate of Jackson “Compounding Interest”

Compounding is legal if a debtor has the option of paying interest as it accrues or when the principle is due
No agreement to pay compound interest was made. The borrower had the option of paying interest as it became due or
waiting until the end of maturity, in which case the interest would be added to the principle and future interest computed on
the new sum. Compounding interest is a legitimate method of computing interest when the debtor has the option of not
paying interest until the principal balance is due.
Under these cases (which are not a complete picture of even New York law), when is compounding reflected in determining
whether interest is usurious? Does this rule make finance sense? How does it fit with a policy of protecting debtors from
running up debt?
F. PRESENT AND FUTURE VALUE OF ONE PAYMENT

– The two most important finance application of the time value of money:
1. Present Value – The future value shrunk to reflect the time value of money, “discounting”
2. Future Value – The value of the present value of money in X number of years
– Based on the 10% interest example in three years $1000 would be worth $1331 so it would be foolish to pay
any more than $1000 for a promise of $1331 in three years time
– Written as an equation the future value of money would look like this: FVn(PV) = PV x (1 + r) n , which
translates to the Future Value after “n” compounds of the Present Value equals the Present Value times the
interest rate “r” compounded “n” times
– Present and future values mirror each other, if Y is the future value of X, then X is the present value of Y, which
makes it possible to reverse the future value formula to get a present value formula: PV(FVn) = FVn / (1 + r)n
EXAMPLE
If r = 0.1 (10%), what is the future value of $1 one year from now?
FV1($1) = 1 x (1 + 0.1)1 = $1.10
If r = 0.1 (10%), what is the present value of $1.10 to be paid one year from now?
PV1($1.10) = $1.10 / (1 + 0.1)1 = $1
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Since the future value in one year of $1 today is $1.10, the present value today of $1.10 in one year is $1.
G. PROBLEMS: TIME VALUE

(1) Many employees set up their income tax withholding so that their employers withhold more than is legally required and
the employees get an interest-free refund when they file their return. What does finance say to such employees?
Withholding money is only worthwhile if you lack the self control to manage your money throughout the
year and invest the extra money, for these people the system is forced savings which can help them payoff
debts when they get a large tax return
(2) A student has substantial student loans. A relative of the student dies and leaves her a few thousand dollars. When does it
make finance sense for her to prepay the student loans?
The student should pay back her loans if the amount of interest she would pay by paying off her debt over
the longest period of time allowed would be less than the interest that she would earn by holding onto and
investing the money that she inherited, it all depends on the terms of the loan which may not allow you to
pay off the principle or penalize you if you do.
(3) An appliance store has a sale. If a consumer opens a charge account and buys using such credit, no payments are due for
one year. Is the store doing consumers a favor?
This all depends on the terms of the card, yes, if the card does not charge you interest over the period that
you do not have to make payments and you are able to keep your money invested in order to earn interest
on it for the year, then at the end of the year they can pay off the debt and keep the interest they earned but
if the card accrues interest its probably not worth it.
H. PROBLEMS: PRESENT VALUE OF A SINGLE PAYMENT

The following table shows numbers that are useful in discounting by a 10% annual yield.
1 / 1.1 = 0.9090
1 / (1.1)2 = 0.8264
1 / (1.1)3 = 0.7513
1 / (1.1)4 = 0.6830
1 / (1.1)5 = 0.6209
(1) What is the present value today determined using a 10% annual yield of $1 to be pad in 3 years?
$0.7513
(2) What is the present value today determined using a 10% annual yield of $1 to be pad in 5 years?
$0.6209
(3) What is the present value today determined using a 10% annual yield of a promise to make two payments: $1 to be paid
in 3 years and another to be paid in 5 years?
$1.3722
I. CLASS NOTES
– Time Value of Money: You would rather have a dollar today than have a dollar tomorrow because either (i) you
can enjoy it today, or (ii) put it in the bank and earn interest
– Dollars in the future have to be discounted because the present value of a future dollar is less than its current
amount (you would be willing to take less dollars now, so that you can put it in the bank and watch it grow to
the future amount)
– Nominal or Named Rate: Stated rate dependant upon compounding
– Yield: The percentage that you are actually owed (in a 10% nominal interest rate compounded yearly, after 3
years your yield would be 33.1%)
– Future Value after 1 year at 10% interest = 1000 + (0.1 * 1000)
= 1000(1 + 0.1)
= [1000(1 + 0.1)] + [0.1 x (1000[1 +0.1])]
= 1000(1 + 0.1)2
FV after n years at 10 % interest = 1000(1 + 0.1)n
– FV = PV (1 + r)n
– PV = FVn/ (1+ r)n
– Prepaid Interest: To an economist it is just reducing compounding; you can pay the interest before it is due
– Amortization: The rate at which you pay down a loan
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– Positive Amortization: Pay some of the principle plus the interest to avoid compounding
– Negative Amortization: Low payments with a high interest rate which gets added to principle and increases
compounding
– To get the effective rate (EFF) you must divide the nominal rate (NOM) by C/Y add 1 and square it
– CREDIT CARD EXAMPLE
NOM = 19 (nominal interest rate)
C/Y = 12 (compounding periods per year)
EFF = 20.75 (effective interest rate)
– HOME LOAN EXAMPLE:
NOM = 6
C/Y = 12
EFF = 6.17
– The more compounding periods the more interest, however adding a little bit of compounding periods makes a
big difference but a lot of extra compounding doesn’t make much more of a difference
– NOM = 19 ; 19
C/Y =4 ; 365
EFF= 20.7 ; 20.9
– Equity Loan: Buy a house (500,000) and borrow (300,000) with a (200,000) down payment, at the closing the
bank gets a mortgage on your house so that if you sell the house they get paid before you do and if you default
on your loans they can force you to sell your house if you default, if the house goes up to (1,000,000) you can
sell the house, pay off the loan, and keep the extra 700,000
– Mortgage backed securities market (Second largest market in the world, bigger than stock market): Banks sell
the loan and collect your interest but the real owner would be an investment banker who sells it on the market,
the bank then makes another loan with the money they were paid by the investment bankers.
– GIVENTER v. ARNOW: Compounding is not okay, because it is a was being used to make the interest
payments higher then the 7.5 threshold.
– ESTATE OF JACKSON: Compounding is okay, the plaintiff was not locked into the burden of the
compounding because he can pay off the interest.
– Withholding: During WWII the US decided the best way to pay for the war was to tax wages, companies would
money from paychecks under the Federal income tax withholding and send it on your behalf to the federal
government (small businesses got in trouble for not sending the money, they would use the money instead to
fund the business, and were charged with felonies), now many people purposefully withhold extra money so
that when they get their refund they get more money
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- CHAPTER III: ASSET VALUATION -

A. INTRODUCTION
– Debt Instrument: Proves the holder case payments at one or more specifies future times
1. Expanding the time value of money analysis in order to value debt instruments like bonds and
annuities
2. Introduction to financial valuation generally
B. VALUING A BOND
– A bond represents a long term borrowing (usually by a corporation or government), the lender gives the
borrower money and the borrower issues the bond to the lender, the interest is specified and a payment schedule
is provided (often the borrower will be required to retain certain assets in case of default)
1. Interest only: Interest is paid at specified intervals with all of the principle due at a specified
future date
2. Level payments: The same amount consisting of interest and principle is paid at the specified
intervals
– Default: The failure of a borrower to fulfill an obligation, at which time the lender may impose the sanctions
specified in the lending contract
– Many loan contracts allow the lender to sell their rights, with the buyer stepping into the shoes of the original
lender with the same rights
EXAMPLE
Market interest is a 10% annual yield and a five year bond has a face value of $10,000: Using the interest only method the
bond pays $1,000 at the end of each five years and the $10,000 principle at “maturity” or the end of the fifth year
Year Payment Present Value
1 1,000 909
2 1,000 827
3 1,000 751
4 1,000 683
5 11,000 6,830
Total 15,000 10,000
The finance analysis does not distinguish between principle and interest, it simply reduces the stream of future payments,
whether principal or interest, to present value
– The higher the interest rate the less a bond is worth

1. At an 8% effective market annual discount rate the bond is worth $10,799
2. At a 12% effective market annual discount rate the bond is worth $9,279
– The longer the remaining term, the more that discounting is reflected in the present value, and the more that the
value is sensitive to the interest rate used in discounting (a four percentage point difference causes a $1,520
change in value for the 5-year bond but a $2,472 change for the 10-year bond)
1. 5-year bond at 8% is worth $10,799 and at 12% is worth $9,279
2. 10 year bond at 8% is worth $11,342 and at 12% is worth $8,870
C. ANNUITY VALUATION
– Simple Annuity: Pays a fixed amount per year (or other time period) for a fixed number of years (or other time
period)
EXAMPLE
A ten year annuity allowing for 10 withdrawals of $10,000 at 10% annual yield, works by opening an account that will earn
enough interest each year to withdraw $1000 each year for 10 years:
Year Opening Balance + Interest - Withdrawals = Closing Balance
1 6,145 614 1,000 5,759
2 5,759 576 1,000 5,335
3 5,335 533 1,000 4,868
4 4,868 487 1,000 4,355
5 4,355 435 1,000 3,790
6 3,790 379 1,000 3,169
7 3,169 317 1,000 2,486
8 2,486 249 1,000 1,735
9 1,735 174 1,000 909
10 909 91 1,000 0
Starting with $6,145 and a 10% yield, you can withdraw $1,000 a year for ten years or $10,000
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– Annuities are similar to bank accounts so buyers and sellers should compare the rates available and price them
accordingly
– A level payment loan would work the same way paying $1,000 each year for ten years to pay off a $6,145 loan
D. PROBLEM: A LEGAL PRESENT VALUE ISSUE

You are a lawyer. You have a client who hopes to start a new business as a proprietorship. A store is willing to sell her
equipment that she needs for $250,000. She can pay $50,000 down. The seller is willing to lend the remaining $200,000 at
20% interest, requiring 10 years of level, year-end payments of $47,705 per year. Drafting the loan this way, however,
violates the applicable usury statute, which prohibits interest in excess of 18% per year.
The lawyer for the store suggests taking advantage of present value analysis to avoid the usury problem. The purchase price
would be changed to $343,126. The resulting loan of $293,126 would bear 10% annual effective interest. With the new loan
amount and interest rates, level payments would be $47,705 per year. Each payment would be the same as above, but reflect
more nominal principal and less nominal interest.
As a lawyer, what is the difference between the documents saying $200,000 at 20% or $293,126 at 10% when either way the
annual payments are the same? In particular, how are the burdens of your client different under the 10% documents? On the
basis of the New York judicial opinions in Section II.D, above, do you think New York courts would find usury in the
restructured sale?
If the document says 20% interest it is a violation of the usury statute, where if it says 10% it is not. A
seller can charge whatever they want for the item so having a higher price is not illegal where having a
higher interest rate is. The problem would be if your client defaulted and the value of the item needed to be
turned over to the seller, instead of having to give them $200,000 she would owe $293,126. On paper she
owes more money than she should technically (so if she defaults she gets screwed).
E. BASIC LEASING
– Legal terms of leases can vary widely from the amount of time they are for to the burdens they place on the
parties
– Net Lease: Requires that the lessee provide repairs, maintenance, taxes, etc. in regards to the leased property
– Residual Value: The value of leased property at the end of the lease period
– The fundamental financial difference between a loan and a lease is that in a lease the property is returned to the
lender at the end of the agreement, it follows that the final “payment” in a lease includes the residual value
– To calculate a non-net lease all that is required is the rent, residual value, and interest rate
F. PROBLEM: LEASING
You are negotiating a lease for new office space for your law firm. The rent seems high. In negotiations, the landlord offers a
“rent holiday,” under which no rent is owed for the first six months. How so you analyze this offer?
Figure out the present value of the two sets of rent and compare them to find out which is lower. Compare
some hypothetical law firm lease rates, which is the better deal: (1) 5 years $10,000 a month at 8% APR or
(2) 5 years no rent for first 6 months and $10,500 thereafter at 8% APR
1. $496,000
Find the PV of the $10,000 payments over 5 years
N = 60
I% = 8
PV = [SOLVE] = $496,000
PMT = 10000
FV = 0
P/Y = 12
C/Y = 12
PMT: BEGIN
2. $459,000
Subtract the PV of the first 6 months from the PV of the $10,500 payments over 5 years
N = 60
I% = 8
PV = [SOLVE] = $521,000
PMT = 10500
FV = 0
P/Y = 12
C/Y = 12
PMT: BEGIN
N=6
I% = 8
PV = [SOLVE] = $62,000
3
PMT = 10500
FV = 0
P/Y = 12
C/Y = 12
PMT: BEGIN
$521,000 – $62,000 = $459,000

The best option turns out to be option number two which will cost $37,000 less than option number one,
thanks to the 6 months free at the beginning of the lease
G. AUTO LEASING
– The difference between higher monthly costs for a loan to buy a car versus to lease it is just the fact that at the
end of the lease the lessor will retain the residual value
– When pricing a car lease, it is important to make the dealer disclose the car’s price, interest yield, and the
estimated residual value used to determine the rent
– Factoring in mileage and damage adjustments can become burdensome
H. FINANCIAL VALUATION OF NONFINANCIAL ASSETS

– Economic Value: The estimated value of the use of the machine
– Risks with owing a leased machine include nonpayment, difficulty finding lessees, technology making the
machine obsolete, theft or damage
I. VALUING A PERPETUITY
– Pure Perpetuity: Promise to pay a periodic sum certain in perpetuity (forever)
– Under a discounted present value analysis, a perpetuity does not have an infinite value; the present value gets so
small so fast that their sum is finite
– Beginning-of-period payments have a higher present value
– The higher the interest rate the smaller the discounted present value of the perpetuity is needed to generate the
desired return (and vice versa)
– End of the Period Payments: VALUE = PMT / r, where r is the periodic return (interest rate) and PMT is the
periodic payment (VALUE x r)
– Beginning of the Period Payments: VALUE = (1 + r) x (PMT / r), where r is the periodic return (interest rate)
and PMT is the periodic payment (VALUE x r)
J. PROBLEMS: PERPERTUITY
(1) Assuming a market rate of interest (yield) of %5 a year, what is the value of $1 a year at year end forever?
VALUE = PMT / r
1 / .05 = 20
$20 = $1 / 5%
VALUE = $20
(2) Assuming a market rate of interest (yield) of %20 a year, what is the value of $1 a year at year end forever?
VALUE = PMT / r
1 / .20 = 5
$5 = $1 / 20%
VALUE = $5
(Putting $5 in the bank at 20% interest is worth the same as $20 at 5% interest if you wanted to pull $1 out
of the bank at the end of each year)
K. LIMITATIONS (RISK EFFECTS, IN PARTICULAR)

– Limitations on the finance analysis include the risk and the interest rate
– Higher interest rate compensates investors for taking greater risk
– Investors generally do not like being locked into investments because it decreases liquidity and increases risk
– Risks include those related to the transaction like a borrower going bankrupt and those related to the market in
general like better options becoming available
– Long-term debt usually pays a higher interest than short-term debt
– In a long-term debt instrument the yield is a time-adjusted average, of which the true value is only really
reflected at the mid-point of the instruments life
L. LEVERAGE
– When borrowing to acquire an asset, one must take into account the economics of the entire transaction not just
the ownership of the asset
– Leverage: Borrowing to buy an asset
1
– In leverage the borrowing aspect multiplies the potential profit and loss (if you have $100 dollars and can invest
it, borrowing an extra $100 doubles your potential gain or loss)
– Short Sale: An investor borrows stock from his broker and sells it, then at a later point the investor must return
the same amount of stock as was originally borrowed (if the stock goes down or their investment goes up the
investor will make money, if the stock goes up or the investment goes down they will lose money)
– Interest charges compensate the broker for the time value of money and any dividends that the stock pays must
be paid to the lending broker
M. DERIVATIVES AND OTHER HYBRID INSTRUMENTS

– Derivatives: Financial instrument whose value derives from something outside the bargain
– Option Contract: The “holder” has the right to buy from or sell to the “writer” certain property at a set price at
some point in the future, however the holder is not required to exercise their right while the writer must comply
– Call: Option to buy (increases profit as value goes up)
– Put: Option to sell (increases profit as value goes down)
– The risk to the writer of the holder not exercising their right to buy is offset by a fee designed to compensate
him
– Forward Contract: One party unconditionally agrees to sell to the other party (and the other to buy) a fixed
quantity of some asset at a fixed price at some point in the future (i.e. airlines agreeing to purchase X amount of
fuel at Y price over Z years)
– Hedge Fund: Investors buy shares of the fund, which invests in primarily dividends
N. CLASS NOTES
– Bonds issued with higher interest rates are worth more (you would pay more for a bond that pays 10% then one
that pays 8%)
– Annuity means level payments
– Home loan for $500,000 at a 7% APR:
1. Payments of $2,917 a month if you do interest only and pay off the $500,000 principle at the
end
2. Payments of $3,327 a month if you pay off the principle and interest over 30 years
– At the end of a loan you pay off more principle because the interest is lower since you have been paying off
principle bit by bit
– Sample Exam Question: Assume you know how much money you can come up with each month how long
would it take you to pay off your loan? Some calculator examples:
1. (A $10,000 loan with 19% interest and payments of $300)
N = [SOLVE] = 47.76 Months
I% = 19
PV = 10,000
PMT = -300
FV = 0
P/Y = 12
C/Y = 12
2. (A $10,000 loan with 19% interest and payments of $400)
N = [SOLVE] = 32.08 Months
I% = 19
PV = 10,000
PMT = -400
FV = 0
P/Y = 12
C/Y = 12
– For cars the difference between leasing and lending is that at the end of the lease you return the car to the lessor (if
you do not return the car in good condition you can end up owing more than the car is worth when you return it),
serious work is covered by the manufacturer but the lessee is responsible for maintenance and insurance
– A lessor has better rights than a lender because they can take the item back whereas a lender must wade through
bankruptcy rules
– How to convert nominal to effective (APR of a 5% yield): ►Nom(5,12 [ENTER] = 4.89
1. First number (5) = percentage
2. Second number (12) = compounds per year or C/Y
– How to convert effective to nominal (yield of a 19% APR): ►Eff(19,12 [ENTER] = 20.75
1. First number (9) = percentage
2. Second number (12) = compounds per year or C/Y
– Lease examples on the calculator:
1. What payment will you owe at the beginning of each month paying an $18,000 loan with a
10% yield over 3 years with a $16,000 residual value?
1
►Nom(10,12 [ENTER] = 9.57

N = 36
I% = 9.57
PV = 18,000
PMT = [SOLVE] = $190.21 Monthly Payments
FV = -16,000
P/Y = 12
C/Y = 12
PMT: BEGIN
2. What payment will you owe at the end of each month paying an $18,000 loan with a 10%
yield over 3 years with a $16,000 residual value?
►Nom(10,12 [ENTER] = 9.57
N = 36
I% = 9.57
PV = 18000
FV = -16000
P/Y = 12
C/Y = 12
PMT: END
3. What payment will you owe at the beginning of each month paying a $25,000 loan with a
10% yield over 3 years with a $16,000 residual value?
►Nom(10,12 [ENTER] = 9.57
N = 36
I% = 9.57
PV = 25000
FV = -16000
P/Y = 12
C/Y = 12
PMT: BEGIN
4. What payment will you owe at the end of each month paying a $25,000 lease with a 15%
yield over 2 years with a $16,000 residual value and $7,000 down payment?
►Nom(15,12 [ENTER] = 14.06
N = 24
I% = 14.06
PV = 18000
FV = -16000
P/Y = 12
C/Y = 12
PMT: END
5. What payment will you owe at the end of each month paying a $25,000 lease with a 15%
yield over 2 years with a $16,000 residual value and no down payment?
►Nom(15,12 [ENTER] = 14.06
N = 24
I% = 14.06
PV = 25000
FV = -16000
P/Y = 12
C/Y = 12
PMT: END
6. What payment will you owe at the beginning of each month paying a $25,000 lease with a
15% yield over 3 years with a $12,000 residual value and no down payment?
►Nom(15,12 [ENTER] = 14.06
N = 36
I% = 14.06
PV = 25000
FV = -12000
P/Y = 12
C/Y = 12
PMT: BEGIN
– Make sure that future value is negative when it is residual value (left over value at the end of the lease, i.e. value
of car)
3
– Perpetuity is the amount (Value) you would be willing to pay to be paid a different amount (PMT) over a
certain period of time and can be viewed as PMT = Value x r (where r is the rate for the period) or Value =
PMT / r (assuming PMT is at the END of period)
– What would you be willing to pay someone now in order for them to give you a dollar every year forever: The
Value should be the same as putting Value into the bank at r interest and taking out a dollar a year at the end of
every year, therefore to fine the VALUE you divide the yearly payment by the interest rate
– Leverage: By borrowing to buy you increase the risk of gains and loses, the lender gets interest and commission
– Short Sales: Borrowing stock from your broker and selling it, X months from now you must return the same
amount of shares, so if it goes down you make money but if it goes up you lose money (usually you cannot go
out more than a year)
– Put: Option to sell something at a fixed price at a future date (if the underlying stock goes down then the value
of the put goes up), when buying a put you are betting that something will go down, known as a short position
– Call: Option to buy something at a later date at a set price (you are betting that the stock will go up) no capital is
invested in the property, it is a pure bet
– In a forward contract the seller is short the commodity and the buyer is long the commodity
1
- CHAPTER IV: BUISNESS VALUATION -

A. INTRODUCTION
– A business’s value is not as simple as the sum of the value of its assets, assets are only a part of the business
valuation picture
– Stock is a thing that is distinct from the business’s assets
– Finance values stock and does not try to relate that value to underlying business assets
1. How finance values businesses
2. Finance methodology and its limitations
3. Relationship of the finance methodology to financial accounting
B. THE PERPETUITY APPROACH

– Finance values businesses by analogizing them to a perpetuity
– A business throws off cash flow each year and the more consistent the level of cash flow the more it resembles
a perpetuity
– If one share of stock provided the shareholder with $1 worth of dividends each year, forever, assuming a 10%
annual yield that share would be worth $10 (disregarding capital gains, taxes, etc.)
– Capitalizing: A stream of future payments reduced to the discounted present value
– Capitalization Rate or “Cap Rate”: The interest rate used in capitalizing future payments (VALUE = PMT /
CAP RATE, therefore, CAP RATE = PMT / VALUE)
– Multiple: Ratio of the capitalized value to the annual future payments
1. MULTIPLE = 1 / CAP RATE
2. A 10% annual yield (1 / .10) has a multiple of 10, a 5% annual yield (1 / .5) has a multiple of
20
– Net cash flow is not perpetuity-like because cash must be set aside for value preserving purposes (replacing
assets and funding debt obligations)
– Cannot value stock by only looking at recent dividends, corporations frequently grow by retaining money that
could have been paid out as dividends, and the stock goes up with anticipation that company growth means that
dividends will increase in the future
– A company’s total stock value should equal their total net (of debt) value
– Ex-Dividend Day: Day on which holders of stock are locked in to receive a dividend regardless of if they sell it
before the day the dividend is actually paid, stock usually drops on this day, while retained earnings build up
stock value until paid out
– Companies historically paid small dividends, but the 2003 reduction on the tax rate may change that
– Profit: Measure of how much better off the owners of a business are as a result of that business’s operations
over a period of time (usually a year)
– Finance needs the information that accounting provides in order to value businesses, finance is the most
important consumer of accounting information and accounting tries to accommodate this use
– Finance attempts to predict the future, the present and past are just forecasts of a business’s future, accounting
by contrast looks exclusively to the past
– A business can announce a profit but have its stock go down if it is not what finance had predicted, while a
company can announce a loss and have its stock go up if it is less than finance predicted
C. THE FOUR APPENDIX COMPANIES

– The market is impossible to predict with 100% accuracy or security
– The market was wrongfully optimistic about Enron and not pessimistic enough about WorldCom in the time
prior to their collapse
D. GE RESEMBLES A PERPETUITY?
– Strong support for the discounted present value analysis comes from the “efficient capital markets hypothesis”
1. Market prices rationally reflect all available information, and irrational factors (those that
cannot be captured in a discounted present value analysis) do not affect prices
2. Hypothesis is that it is not possible for an investor over time to beat an effective market, that
is to have higher returns than the market as a whole
1. This is the theory behind having a highly diversified portfolio or alternatively “index
investing” (buying mutual funds that track market indexes like the S&P 500)
2. By buying one index the investor reduces transaction costs of having to buy all the individual
stocks that index owns and therefore over time should have more returns than active
investment strategies like day trading
E. DISCUSSION PROBLEM: WHAT A SHAREHOLDER BUYS
1
Think about buying a share of stock of a public company. What do you see yourself as buying? How do you decide if the
stock is a good buy? What analysis do you use? What information do you use? What additional information would you like?
Who do you talk to? How do you think that others value stock? How do you think that the market values stock? Do you think
that you can beat the market? If you accept the discounted present value approach, do you believe the large multiples seen
with the four companies whose financial statements are in the Appendix?
F. THE MARKET DON’T NEED NO STINKIN’ ACCOUNTING?

– The market looks to financial statements for information, not for measurement
– The market was fooled by bad accounting in the case of Enron, even though most of the information needed to
discover the bad accounting was publicly available
G. CLASS NOTES
– Valuing a business:
1. There is a big difference between owning one share of stock and owning 51% of the stock,
because if you have 51% you have most of the say in what happens within the company
2. There is a difference in value between the total value of a business’s stock shares and what
one would pay to buy the whole company
3. Dividends: Money that the company does not need is paid out to its investors in the form of a
dividend
4. Value = PMT / r … Value = PMT / Cap Rate
5. Cap Rate = PMT x Multiple… 1 / Cap Rate = Multiple
6. In the late 1970’s companies would retain cash and buy back stock rather than pay out
dividends, the advantage of this to investors is that those who don’t want cash get an increase
in stock value and those who want cash can sell shares
7. On Dec. 31, 2000 Enron was trading at 71.1 times its earnings, why was the market so
optimistic: They tricked the market into believing they were a high tech company that had a
high prospective for the future despite a shaky past, investors were gambling on their growth
ability
8. On Dec. 31, 2000 GE and Microsoft were more stable companies that had proven themselves
consistent in earnings so their price-earnings ratios were more conservative at 17.2 and 18.7
9. On Dec. 31, 2000 WorldCom was a pessimistic 9.7 because of the telecommunications trouble
– Accounting is necessary when companies open separate facilities in order to keep track of the business as a
whole or when the owners (investors) are not directly involved in the organization and running of the business
1. In-house accountants take the raw information and condense, analyze, and present it
2. Account: Running record of transactions affecting one item (a bank account, a building, etc.)
3. Asset Account: Record in respect to an asset (with student loans, as you take money out the
asset goes up as you pay them back the asset goes down)
4. Equity: What is left over for the shareholders when the creditors are all paid off
5. Most of the difficulty in accounting is figuring out which accounts to put the transaction in
6. Presentation is a way of organizing the information in order to condense it into something
easy to review, similar types of accounts are added together (instead of listing every bank
account businesses lump them all into one group called “cash”)
7. Balance Sheet: A useful way of summarizing all the accounts at an instant in time
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PART C: BASIC ACCOUNTING

- CHAPTER V: THE BALANCE SHEET -
A. INTRODUCTION
– The previous three chapters have laid out the basics of finance as business valuation using information
organized by financial accounting
– Financial accounting is very different from finance, finance is a mode of analysis for answering questions while
financial accounting tries to describe the information
– In order to start a discussion of accounting it is necessary to explore the nature of information that motivates the
discipline
1. A business’s core information, its financial records
2. Introduction to the analysis, organization, and presentation of that information
3. The historical heart of financial accounting, the balance sheet
B. THE BASIC IDEA

– A business transfers their informal information to centralized, formal journals that record transactions in
chronological order
– Businesses keep ledgers that contain the central accounts of the business
– An account is kept for every asset, liability, or the like for as long as they continue to be relevant to the business
– Three basic types of accounts:
1. Asset: Shows all items affecting an associated asset (i.e. bank accounts)
2. Liability: Shows all items affecting an associated liability (i.e. loans)
3. Equity: Value of assets minus the value of liabilities
– Financial accounting is how the business analyzes and organizes the accounts in order to present this massive
amount of information in a concise and useful form
– Four basic financial statements:
1. Balance Sheet: A snapshot of the amounts in the financial accounts of a business at an instant
in the past, prepared at the end of each reporting period (most commonly the fiscal year,
based on the calendar year or another approximately 12-month period)
2. Income Statement:
3. Cash Flow Statement
4. Equity Statement
– Balance: Amount in an account at a given time
– EQUITY = ASSETS – LIABILTIES (for example your equity in your house would be the amount you would
receive from selling the house and paying off any mortgages from the sale proceeds)
– From the previous equation we can extrapolate that ASSETS = LIABILITIES + EQUITY to form a more useful
equation
– Customarily assets are listed starting with the most liquid and ending with the least liquid, while liabilities are
listed by the earliest due to the last due
EXAMPLE
The following balance sheet is of a a small corporation that manufactures bolts:
BALANCE SHHET
The Bolt Company
Assets Liabilities
Cash 100,000 Payables 300,000
Receivables 300,000 Notes 100,000
Inventory 500,000 Bonds 750,000
Property, Plant 1,150,000
and Equipment 1,200,000
2,100,000 Shareholders’ Equity
Paid-in 100,000
Retained 850,000
950,000
– To reduce the number of accounts shown on the balance sheet, the balances in many accounts of the same type
are usually added together and presented as one balance in a more general account
– Cash: Amount of cash in the bank
– Receivables or Accounts Receivable: Amount a business is owed for products and services delivered but not yet
paid for
– Payables or Accounts Payable: Amount a business owes for products and services received but not yet paid for
1
– The two sides of a balance sheet must balance, the right side must equal the left side (ASSETS must equal
LIABLITIES + EQUITY), which should be automatic because of double-entry bookkeeping requires that each
transaction be reflected in both sides of the exchange (for example when $100,000 is spent on a machine, the
cash account must go down $100,000 and the machine account must go up $100,000)
– Debit: An adjustment in a pair of entries that increases assets or decreases liabilities or equity
– Credit: An adjustment in a pair of entries that increases liabilities or equity or decreases assets
– A debit increases assets while a credit decreases assets, contrary to our general notion of a credit and debit since
debit and credit card usage is named from the banks perspective not the customers
– Left-Hand Entry: A debit, so named because asset accounts appear on the left-hand side of the balance sheet
– Right-Hand Entry: A credit, so named because the liabilities and equities appear on the right-hand side of the
balance sheet
– Double-Entry Bookkeeping: Assures that the balance sheet balances by providing a limited check on arithmetic
and transcription errors but says nothing about whether the entries are correct
– The most important adjustment to equity is for profits and losses a profit is booked as an increase to equity and
losses are booked as decreases (a common adjustment is payment of dividends to shareholders, which reduce
cash but also reduce equity so the balance sheet balances)
C. PROBLEMS: READING BALANCE SHEETS

These problems concern the balance sheets in the Appendix.
(1) At book value, what was Enron’s most valuable asset? Based on its property, plant, and equipment, what business
was Enron in?
Risk Management, Gas & Electric.
(2) On its balance sheet, which were the bigger part of Enron’s business : (a) property, plant, and equipment or (b)
investments?
PP&E.
(3) What were Enron’s biggest liabilities and how had they changed from 1999 to 2000?
“Risk management” increased $8.7 billion (from $1.84 billion to $10.5 billion), “accounts payable”
increased $7.6 billion (from $2.15 billion to $9.78 billion), and “short-term debt” increased $3.8 billion
(from $44 million to $4.28 billion) that is around a 10,000% increase.
(4) The GE financial statements break GE into two big pieces: regular GE and GECS (GE Capital Services). (Chapter
XIII discuses how the pieces fit together on the consolidated financial statements. Do not be concerned about
consolidation at this point.) On GE’s books, which piece had more assets? Which piece contributed more to the overall
consolidated GE equity? What was the biggest asset of each piece?
GECS; GECS; GE: Goodwill, GECS: Financial receivables.
(5) How much did GE’s shareholders’ equity change from 2001 to 2002?
Up $8.9 billion.
(6) What was Microsoft’s biggest asset on its balance sheet? What was Microsoft’s long-term debt? Does this resemble
any of the businesses previously examined?
Cash; $6 billion.
(7) At book value, what was WorldCom’s most valuable asset? How much of the property, plant, and equipment was not
in progress?
Goodwill (88%).
D. WHAT THE BALANCE SHEET SAYS

– Balance sheets contain a wealth of information
– The left-hand side show the assets or resources of the business, the right-hand side shows the claims to these
resources, many people can have claims to a businesses assets
1. Short-term trade creditors with no specific instrument evidencing the debt are owed payables
2. Short-term creditors who hold instruments are owed on notes
3. Long-term creditors (evidenced by instruments) are owed on bonds
4. Business equity owners receive whatever is left over of the assets after the creditors claims are
paid off
– As far as accounting is concerned only creditors (with fixed legal liabilities) and owners (with equity) have
claims on business resources
– Balance sheets help value businesses by providing information that allows one to determine the amount that
would be left over for the shareholders (equity) if the business’s assets were sold at their book value and the
liabilities paid off at their book amount
– Equity is in this sense the value of the shareholders’ stock
1
– Book Value: Historical cost with some adjustments for things like wear and tear, obsolescence, or depreciation
– The liabilities section of the balance sheet can run into problems when the value of a fixed rate interest loan
varies based on interest rate increases and decreases
– Overstating assets overstates equity and vise versa, while overstating liabilities understates equity and vise versa
– Company’s Market Value: Determined by multiplying the number of shares outstanding at the end of its most
recent fiscal year, by the market price for one share on that day
– Few take the equity section of a balance sheet seriously as a precise measure of the market value of the
business’s total equity
– The balance sheet is useful, even when it measures value badly, because it provides much important information
about a business that is available nowhere else in as useful a form
E. PROBLEM: BOOK VS. MARKET VALUE

You are a divorce lawyer. Your client is the impecunious soon-to-be-ex-spouse of the woman who is the sole shareholder
of The Bolt Company, whose balance sheet appears in Section V.B, above. The company has been paying dividends of
$200,000 per year for as long as your client can remember and probably will forever. The property settlement
negotiations have begun. The woman’s divorce lawyer has given you the most recent balance sheet of Bolt, as above.
She argues that this process that her client’s stock is worth $950,000. What do you tell opposing counsel? (A market rate
if interest is a 10% annual yield.)
In a divorce the goal is to split up resources not just divide current monetary value. The book value is
only the value of the stock at that point in time, the future value from dividends and gains are not taken
into account. At a 10% market rate, a stock that pays $200,000 annually is worth $2,000,000; so there
is clear reason to believe that The Bolt Company is worth more than the $950,000 book value.
F. CLASS NOTES
– The balance sheet shows a snap shot of the company’s standing at 11:59PM of the fiscal year
– Partnership: a group of people getting together, buying property together and cutting a deal of how to split up
the property use or profits
– If a Company goes under, its investors and debtors receive payments in this order:
1. Secured Debt (an asset such as a machine the lender holds the title to)
2. Unsecured Debt
3. Preferred Stock
4. Common Stock
– For every action there is an equal and opposite reaction: If you borrow $1 million, cash goes up $1 million and
liability goes up by $1 million, conversely, if you pay down debt, cash goes down $1 million and liability goes
down $1 million
– If the company buys an asset for $100 and sells it for $150 it doesn’t balance, what has happened is that the
company made money, to compensate equity has to go up by $50 (the company has made money meaning the
shareholders have made money)
– Liabilities: Money owed to creditors
– Equity: Residual money owed to shareholders
– Credit: Increase in a liability (bad thing)
– Debit: Decrease in a liability (good thing)
1
- CHAPTER VI: THE INCOME STATEMENT -

A. INTRODUCTION
– Accountancy and finance focus on the income statement as a better way to get a handle on a business’s
valuation rather than the balance sheet
– The numbers on the income statement provide good, if not great information to use in a finance-type perpetuity-
like valuation
1. Basics of the income statement
B. A RECORD OF CHANGES
– Profit and loss represent adjustments to the equity section of the balance sheet, but businesses do not directly
adjust equity for each item of profit and loss
– A business only determines profit or loss and adjusts equity yearly (or on another periodic basis)
– During the year a business keeps track of “revenue” and “expense” and records them in non-balance sheet
accounts
– Revenue: A gross amount earned from the sale of a good or service
– Expense: A cost of earning revenue
– Cost Accounting: A business’s internal accounting that measures profit on a product or service line
– A business with a string of losses can deplete assets so much that liabilities exceed assets and equity is negative
– At year end the business “closes” its books for the year and the profit or loss is entered into the equity
– When revenues exceed expenses the business has earned a profit
– When expenses exceed revenues the business has incurred a loss
– The income statement is a presentation of the calculation of profit or loss for the year, a summary of changes to
equity over the year
– Only consequences of business and investment are reflected on the income statement, no changes resulting from
transactions with the equity owners (dividends, new stock issuance, stock bought back) are included
– Net Income, Net Revenue, Income: Other ways of referring to profit
INCOME STATEMENT
The Bolt Company
(Fiscal Year Ended 12/31/2007)
Revenues
Sales 1,250,000
Services 250,000
1,500,000
Expenses
Cost of Goods Sold 500,000
Selling Expense 150,000
Executive Salaries 400,000
Compensation 100,000
Depreciation 27,000
Interest 10,000
Taxes 85,000
Supplies 5,000
Utilities 10,000
Insurance 13,000
1,300,000
Profit (Loss) 200,000
– This income statement contains considerable information:

1. Compensation – Only compensation not included elsewhere on the income statement (mostly
wages charged for services)
2. Costs of Goods Sold and Depreciation – Discussed in next chapter
– Income statements can vary in form considerably
– The income statements in the appendix break down the total earnings into “earnings per share,” which is the
portion of the income attributable to one share of stock and are of great importance to financial analysts but
little use to lawyers
– Borrowing (principal) and repaying (principal) loans have no impact on profit or loss
– Interest represents a service charge for the use of money which is treated as an expense in most cases
C. PROBLEMS: READING INCOME STATEMENTS

These problems concern the income statements in the Appendix.
3
(1) What were Enron’s revenues and expenses? (The student should note that the second biggest private bankruptcy in
history is buried in the word “other,” as discussed in Section XIII.D.)
“Other” is the sole source of profit.
(2) From an income statement point of view, which is bigger: GE’s sales of goods or its sales of services?
Sale of goods (Revenue – Costs and Expenses); Goods = 16,000, Services = 7,000 (pg 321).
(3) What do Microsoft’s expenses say about how the business makes money?
Marketing, research and development (pg. 374).
(4) What were WorldCom’s Principal items of expense? (The student should note that the biggest private bankruptcy in
history is buried in these expenses, as discussed in Sections VIII.C and XII.H.)
Line costs (pg. 397).
D. PROBLEM: CLOSING
RETAIL, Inc. sells goods at retail from a small store that is rented. No dividends were paid (or other transaction with
shareholders engaged in) during the year. After reviewing its books (to assure that all accruals and deferrals are proper, as
discussed below, but not relevant here), but prior to closing revenues and expenses into equity for the year, RETAIL’s
accounts and their balances are as follows:
Cash $50,000
Cost of Goods Sold Expense 75,000
General, Selling & Admin. Exp. 40,000
Inventory 75,000
Misc. Expenses 15,000
Paid-In Equity Capital (Equity) 20,000
Payables 40,000
Property, Plant & Equipment (Net) 30,000
Receivables 25,000
Retained Earnings (Equity) 100,000
Sales 150,000
Prepare RETAIL’s year-end balance sheet and income statement.

Income Statement:
Revenue
Sales: 150,000
Expenses
Misc: 15,000
CGSE: 75,000
GS&AE: 40,000
(The business made 20,000)
Balance Sheet:
Assets
Cash: 50,000
Inventory: 75,000
PP&E: 30,000
Receivables: 25,000
Liabilities
Payables: 40,000
Equity
PIEC: 20,000
RE: 120,000
For “RE” you add in the profit from the income statement.
E. WHAT THE INCOME STATEMENT SAYS

– The income sheet and balance sheet tell two very different stories
1. The Balance Sheet – Has a liquidation-value perspective, it shows what the equity would be
worth if the assets were sold (at book value) and the debts paid (at book value), it is a static,
historical, view of business
2. The Income Sheet – Focused on a going-concern and shows how the business is doing, it is
dynamic and by showing change, suggests the future
– Income statement information is useful in financial valuation
– Profit is a measure of the net growth in resources generated by business operations throughout the year
3
– Profit can be pulled out of the business without depleting it and if things continue, profit approximates the net
excess cash flow that the business could use for perpetuity, and a financial analyst can value a business by
viewing income as a perpetuity and capitalizing it
F. PROBLEM: THE BOLT INCOME STATEMENT

Reconsider your analysis of Problem V.E in light of the additional information reflected on The Bolt Company’s income
statement shown in the preceding section. (The sole shareholder is also the sole executive.)
G. REVENUE RECOGNITION
– The most important issue in modern financial accounting is when revenues and expenses are taken into account
for financial accounting purposes, known as “recognized” or “realized” so as to be booked
– Revenue and expenses are not necessarily recognized at the same time that cash changes hands, the best time to
recognize revenue from sale of goods is when the sale occurs (regardless of whether or not cash changes hands
at that point)
– Accruing: Booking a revenue or expense for the sale of goods before cash changes hands
– Deferring: Booking a revenue or expense for the sale of goods after cash changes hands
– GAAP uses accrual accounting
H. BOOKING ACCRUAL
– Under GAAP, if revenue is booked as cash is received, equity increases by the amount of the cash and if an
expense is booked as cash is paid, cash and equity go down in tandem either way the balance sheet balances, but
if revenue or expense is booked at some time other than when cash changes hands an adjustment to an asset
other than cash or a liability is required to make the balance sheet balance
– At the time of sale two accounts increase, “Receivables” and “Sales Revenues,” thus assets and equity both
increase and the balance sheet balances, later when the cash is received the “Cash” assets increase and the
“Receivables” decreases by the same amount again balancing the balance sheet (the cumulative effect being
cash assets and revenue increase by the sale amount, with the change to receivables being temporary)
– “Realization” and “Recognition” have the same meaning to accountants but have different meanings in tax law
– Employers treat wages as a loan from the employee or borrowing the services to be paid at a later date
I. PROBLEMS: INTEREST ACCRUAL

(1) How should the bank in the basic example in Chapter II Account for the borrowing represented by the customer’s
account? How should a business depositor?
(2) A “zero coupon” bond provides for no express payment of interest. Rather, a huge payment is due at maturity. For
example, using the assumptions in the basic example in Chapter II, a corporation could issue today a bond that pays $1.331
three years from today for $1,000. (The present value of the $1,331 is $1,000.) The $331 discount between the issue price
and the amount owed at maturity represents hidden, unstated, economic interest. How should the investor of such a bond (the
borrower) account for it? How should a buyer (the lender)?
J. SELLER FINANCING
– When a seller agrees to wait for payment the seller provides two functions:
1. Selling: The goods sold
2. Lending: The purchase price to the buyer
– These two functions can be and are frequently blurred together by increasing the purchase price and reducing
interest or vice versa
– Installment Sale: A seller financing, since the price is to be paid in installments over time
– A high price is more attractive to a seller looking to book a high profit, since the sale price would be booked
that year while the interest would be booked in later years
– GAAP accounts for this manipulation by making the sale price the present value of all future payments
discounted at roughly the rate of interest the buyer/borrower pays on similar borrowings
K. DEFERRAL
– Deferral: Cash changes hands prior to the time when revenue or expense is recognized
– Magazine publishers operate by deferral, they accept payment for future delivery of the goods
– Expenditure: Any amount incurred, some are deferred and not currently charged against revenues, expenditures
not deferred are “expenses”
– Deferred revenue is a liability
– Deferred expense is an asset
– Accrual and deferral are central to GAAP, and rest on a central assumption that the business will continue since
items can only be deferred into the future or accrue them from the future
L. PROBLEM: RECOGNITION AND FINANCE
1
From an accounting point of view, booking revenue and expense only as recognized makes great sense. These numbers also
are going to be capitalized by financial analysts in valuing companies, however. Is the moment when GAAP recognize
revenue the time when the associated positive (negative) cash flow most resembles a perpetuity, so that it should be taken in
account in a financial valuation of the firm?
M. THE LAW MEETS ACCRUAL AND DEFERRAL OF REVENUE

– It is useful to look briefly at how the law looks at accountant’s numbers
– Herzfeld pertains to how an investor reads and understands financial statements, specifically, the accrual and
deferral of revenue
– Contract and tort law make it difficult for anyone but the business for which the financial statements are
prepared to sue accountants for fraud
– Federal securities law provides the most important source of accounting liability, under which buyers and
sellers of the business’s securities may sue accountants who prepare the financial statements
– The SEC requires that businesses file GAAP financial statements but compliance with GAAP is not an absolute
protection from liability
– Herzfeld is a lawsuit against (at the time) one of the premier accounting firms in the U.S.
CASES
Herzfeld v. Laventhol, Krekstein, Horwath & Horwath “Accounting Firm Misleads Investor with False Finances”
Misleading omissions and misrepresentations of financial figures are a violation of the SEA
Laventhol, a firm of certified public accountants, is appealing a judgment against them for $153,000. Herzfeld sued
the firm after spending $510,000 on Firestone Group, LTD (“FGL”) stocks and bonds based on representations made to him
by Laventhol that were materially misleading and omitted material facts. The balance sheet and income statement that
Laventhol prepared for FGL purported that the company was strikingly profitable with over $20,000,000 in assets, a net
worth of over a million dollars, $17,000,000 in sales, a deferred income of $2.7 million and an after-tax income of $310,000.
Based on these figures Herzfeld decided to purchase the units of FGL. The basis for Herzfeld’s claim is the misrepresentation
of two real estate transactions: (1) FGL’s agreement to purchase 23 nursing homes from Monterey Nursing Inns, Inc.
(“Monterey”) and (2) FGL’s agreement to sell the 23 nursing homes to Continental Recreation Company, Ltd.
(“Continental”). In the end the two transactions were calculated to produce a $2,030,500 profit for FGL. Neither of these
transactions had been consummated by the time FGL published the documents yet they generated them as if they had been.
Neither transaction ended up going through and FGL eventually filed bankruptcy. As per the Securities Exchange Act of
1934 Laventhol was required to make available all the facts that they had which would help investors make intelligent
investment decisions. Herzfeld was not required to prove that Laventhol was the sole cause of his action only that it was a
substantial factor. Accountants should not represent on an audited statement that income and profit exist without facts
justifying it and revenue should not be booked until the earning process is complete. The Laventhol report contained
materially misleading omissions and misrepresentations and nor does Herzfeld’s failure to read an opinion letter or
“explanatory” footnote violate his reliance on the figures since they were just as misleading as the report.
N. NOTES AND PROBLEMS: HERZFELD

– Client pressure on accounting firms to cook books is not unusual, Laventhol was careful not to roll over
completely but had they not agreed to include the figures in some way Laventhol would have fired them and
sued them, while shopping around for a firm that would have done it
– Herzfeld was harmed when he bought FGL securities without having the proper information required to
evaluate the investment
– Most investors are not capable of deciphering financial records to the point that failure to follow GAAP
requirements would automatically be misleading, therefore technical violations of GAAP should not be relevant
O. THE LAW MEETS ACCRUAL OF EXPENSES

– Herzfeld involves the booking of revenue in financial statements that are subject to the federal securities laws,
which impacted an investor’s decision
– Guernsey Memorial Hospital deals with expense issues
– Guernsey deals with the Department of Health and Human Services’ reimbursement of a hospital for the costs
of care provided to Medicare patients
– As interest rates dropped the burden of the old debt increased in present value, the GAAP booked this loss when
realized through the advance refunding, if there had been no advance refunding this loss would have been
realized over time up until the retirement of the old debt
CASES
Shalala v. Guernsey Memorial Hospital “Health Care Provider Challenges Medicare Reimbursement”
GAAP guidelines that are set in stone, the alternative set forth for reimbursement is sensible and a legitimate alternative
Guernsey Memorial Hospital (“Hospital”) is challenging the Medicare regulations, set for the by the Secretary of
Health and Human Services (“Shalala”), on the basis that they do not comply with the generally accepted accounting
principals (“GAAP”). The court held that the reimbursement did not need to follow the GAAP guidelines.
Hospital’s refinanced its bonded debt by issuing new bonds, while a future saving of $12 million was expected, it
incurred an accounting loss of $673,000, and was entitled to $314,000 in Medicare reimbursement for the loss. Hospital
1
contended that it should receive the refund in one year since the accounting loss took place that year, while Shalala argued
the reimbursement should be amortized over the life of the old bonds (in accordance with an informal Medicare
reimbursement guideline). It was required that Hospital maintain sufficient financial records and statistical data for proper
determination of costs payable under Medicare, and even if those records are interpreted to mean GAAP standards, the Court
does not interpret it to mean that the Secretary must also reimburse by per GAAP.
While a one time payout is more valuable to investors’ understanding of the business’s year, Shalala determined that
amortization was appropriate to ensure that Medicare only reimbursed its fair share. Shalala must calculate how much of
Hospital’s total allowable costs are attributable to Medicare services, which entails calculating what proportion of the
provider’s services were delivered to Medicare patients. If hospital took all the money in the first year it is possible for them
to drop out of the program and not provide the services that Medicare beneficiaries are entitled to.
Financial accounting is not a science and GAAP is only generally accepted not a hard and fast rule. The framework
followed in this case is a sensible structure for the complex Medicare reimbursement process.
Dissent (O’Connor):
The Medicare reimbursement must follow the GAAP. Courts are to hold unlawful and set aside an agency action
that is arbitrary, capricious, and an abuse of discretion. It is important to give deference to an agency’s interpretation of its
own regulations but it cannot be sustained when that interpretation is plainly erroneous or inconsistent with the regulation, as
in this case. After reviewing the regulations that Shalala adopted, it is concluded that Shalala has incorporated GAAP as the
reimbursement default rule.
P. NOTES AND PROBLEMS: GUERNSEY

(1) Both opinions in Guernsey miss the point that, financially, the defeasance loss occurred prior to the advance refunding.
In other words, the Justices, while talking accrual accounting, were assuming GAAP-like recognition-based accounting, and
not full economic accrual accounting. Applying this economic view rigidly, the portion of the loss, whenever realized, subject
to reimbursement should be measured by Medicare patient usage in the past, not by usage in the future (Justice Kennedy) or
in the year of the refinancing (Justice O’Connor). This analysis may be too rigid, however, since the defeasance loss did not
relate to the ordinary business operations of the hospital prior to defeasance.
(2) Justices Kennedy and O’Connor have fundamentally different views of accounting indeterminacy. Justice Kennedy sees
GAAP, and all accounting, as indeterminate, and, thus gives the regulators considerable slack. Justice O’Connor sees the
GAAP as fairly well defined, so that she wants the regulators to at least follow GAAP until something better comes along.
Which view is right? Was it appropriate for Justice Kennedy to resolve this factual issue by judicial notice?
(3) As a policy matter, how should Guernsey account for borrowing, including the defeasance loss, for purposes of
determining Medicare reimbursement? Your analysis should reflect that Medicare patient usage of hospital varies over the
years. Also think about the accounting if Guernsey had not engaged in the advance refunding and if it had used variable-rate
debt.
(4) Note how these issues require the lawyer to understand both finance and accounting. How many lawyers (or Supreme
Court Justices) do you think are up to the challenge?
Q. CLASS NOTES
– Income statement shows change in equity, during a period of time (usually a year)
– Items of revenue are booked when earned
– Items of expense are booked when incurred
– Deferral: Book the transaction after cash changes hands
– Accrual: Book the transaction before cash changes hands
– Booking accrual:
1. Accrual revenue:
Assets Equity
Sale:
Receivables +60 Revenue +60
Payment:
Cash +60
Receivables -60
2. Accrual expense:
Assets Equity
Sale:
Expense: +10
Payables: +10
Payment:
Cash -10
2
Payables -10
3. Deferred revenue (liability), for example a magazine subscription:
Assets Equity
Sale:
Cash +12
Deferred Revenue -12
Payment (Monthly):
Revenue -1
Deferred Revenue -1
4. Deferred expense:
Assets Equity
Sale:
Cash -1,000
Deferred Expense +1,000
Payment:
Expense -1,000
Deferred Expense -1,000
– HERZFELD: Accountants were liable if the knowingly painted a false picture
1. FGL was going to buy the nursing homes (from Monterey) and they expected to get paid by the
company they were selling them to (Continental)
2. Continental was only worth $100,000 however and could not come up with the $5,000,000 to pay FGL
for the nursing homes, and defaulted on the contract
3. FGL ended up going bankrupt and Herzfeld received 10 cents on his dollar in liquidated dividends
4. The only case in the book about regulation of accounting (accrual of revenue)
– Administrative law overview:
1. Congress cannot right laws to cover every situation, judges have no power to make law (but
common law was judge made law) they only have the power to interpret and apply the laws
that Congress creates.
2. Administrative agencies of the executive have the first cut at interpreting the law, the judicial
polices the executive when someone claims that they have interpreted the laws incorrectly and
in violation of their rights
– Regulations: Filing in the gaps in the statute
– Adjudication: Act like judiciary and decide the laws meaning
– SHALALA: Deals with when to book expenses, the issue is a defeasance loss
1. Borrowed a bunch of money and put it in the US treasury
2. Instead of looking to the hospital for payment they released the hospital and made the treasury
pay
3. Interest rates went down and they could not afford the interest on the borrowed money
because the interest of the treasury bonds were not high enough
4. They would have had to add a substantial amount of money to the account to pay off the debt
they were incurring
5. Loss in defeasance is calculated by the present value of the difference between the interest
rate borrowed at and the interest rate they are receiving on the money
6. The hospital could not pay off their debt
7. There was no prepayment allowed
8. In this case the manual that the administrative agency released was not a rule it was a press
release, they did not have regulations directly on point so they were held to the press release
9. Kennedy dissent: There is nothing right about GAAP it is not a concrete way of doing things,
and is meant to apply only if the Secretary does not specify their own rules, there is irony in
the idea that the secretary has bound herself by the rules in GAAP and is unable to diverge
from them when she feels they are wrong (accounting is not a science and GAAP is generally
accepted rules not the only acceptable rules, there are 19 different GAAP sources, any number
of which may create different accounting solutions)
– Defease: Release the original borrower from the debt, usually done when interest rates go up
– Ideal income statements are perpetuity like and would show things that the company can do again and again
2
- CHAPTER VII: MATCHING AND INVENTORY -

A. MATCHING
– GAAP only reflects revenue and expense when recognized, which can lead to misleading numbers when timing
of the recognition does not coincide with the underlying economic activity
– Income is a net number, it is the difference between revenue and expenses, to obtain a proper net income the
revenues must be matched with the expenses they incurred
– When revenues are recognized in one year and expenses in another, neither year is accurately representative of
the business’s operations and fails to assist in perpetuity-like financial valuation
– Matching is employed in circumstance when a business provides a service or good in one year and is paid by
the customer in another year, otherwise the business would look like a complete loser in the first year and a
complete winner in the next year
– Income is a small number that represents the difference between two large numbers (revenue and expense),
relatively small changes to these large numbers can cause relatively large changes to net income
1. Exploration of matching, focusing on the most important matching rules: inventory
accounting
B. THE SALE OF GOODS

– Historically the most important type of transaction affecting the income statement was the sale of goods, it is
therefore very important to have good accounting rules for sale-of-goods transactions
– Generally revenue for the sale of a good is recognized when delivery occurs
– Inventory: A business’s stock of goods held for sale to customers
– Opening Inventory: Goods left over from prior periods
– Closing Inventory: Goods left over at the end of a period, determined by physically counting the number of
goods on hand
– Closing inventory necessarily equals the opening inventory
– There are two approaches to the cost of goods sold problem:
1. Perpetual Inventory: Keep track of the actual costs of specific goods and expense these actual
costs when the associated goods are sold and revenue is recognized, requiring the business to
keep track of the cost of each inventory item in perpetuity
a. Problem is that it is difficult to keep track of each individual item
b. Used primarily by businesses, like yacht dealers, whose inventory only
includes a few items at any given time
2. Periodic Inventory: Takes advantage of the two facts that (i) the cost of goods sold only needs
to be determined once per period and (ii) since sales revenue is booked when goods are
delivered to customers only costs related to goods delivered during the period are relevant;
therefore at any given time a previously acquired item is either still on hand (not delivered) or
has been sold (delivered)
a. GOODS ACQUIRED = GOODS ON HAND + GOODS SOLD
b. GOODS SOLD = GOODS ACQUIRED – GOODS ON HAND
c. When this formula is adjusted to account for multiple accounting periods
the result is: GOODS SOLD IN PERIOD = GOODS AVAILABLE TO
SELL IN PERIOD – GOODS ON HAND AT END OF PERIOD (“goods
available to sell in period” includes goods left over from prior periods and
goods acquired during the period)
d. COST OF GOODS SOLD = OPENING INVENTORY + PERIOD
PURCHASES – CLOSING INVENTORY
e. All that is necessary to determine the cost of goods sold is to (i) remember
last period’s closing inventory, (ii) keep a running total of all inventory
purchases during the period, and (iii) take a closing inventory
– The simplicity and accuracy of periodic inventory confirms the wisdom of determining profit or loss
periodically rather than on a transactional basis because it achieves an elegant matching, assuring acceptable
profit and loss numbers, while being relatively simple
– Financial accounting works the least well with regard to service businesses, high-tech firms, and financial
services, where the sale of goods rules do not answer the bulk of profit and loss questions
C. CLOSING PERIODIC INVENTORY

– The problem we now have to deal with is the valuation of the closing inventory, of which there are two
common methods:
1. First-in-first-out (“FIFO”): FIFO is the older method and the most obvious, goods are sold in
the order that they are acquired, the first items acquired are the first items sold (the natural
flow of a seller of perishable goods who wants to get rid of older goods before they go bad),
the balance sheet reflects the most recently purchased inventory
3
2. Last-in-first-out (“LIFO”): LIFO is the newer method, goods removed for sale are taken out
from the newer goods first, this can result in a stale inventory on the balance sheet nearly
forever
3. Other methods include an average cost method that falls between FIFO and LIFO, and a retail
method that determines cost by reversing an average mark-up from wholesale to retail
– The most important practical difference between FIFO and LIFO are that when prices are rising, which is the
general case, LIFO results in a larger cost of goods sold and a smaller closing inventory
– Since FIFO usually results in bigger profits, one would expect managements to prefer FIFO, nevertheless
companies use a mix of FIFO, LIFO, and other methods
– LIFO does a better job of showing how the business operations are currently doing, and more perpetuity like
profit numbers for analysts to use in valuating the business
– FIFO can result in booking large profits as a result of purchasing items for a comparatively small amount years
back and selling them at a general price rise, which can have little bearing on how the company is currently
doing
– Current rules require that the inventory be valued by comparing cost and market value and using the lower of
the two
– Market Value: The wholesale cost to replace the inventory
D. PROBLEMS: LIFO VS. FIFO

An wholesaler, at the beginning of the current year, had an opening inventory that contained 100 widgets at $50 each.
During the current year, it sold 50 widgets. No items in inventory were stolen, destroyed, or damaged.
(1) If the wholesaler purchased 50 widgets at $60 each during the year, what is its cost of goods sold expense for the year
under FIFO and LIFO, respectively?
Open + Purchase – Close = COGS
Open = 5000 ($50 x 100 widgets)
Purchase = 3000 ($60 x 50 widgets)
Close = Amount left in inventory
COGS: FIFO 50 x 50 = 2500; LIFO 50 x 60 = 3000
Under FIFO it is assumed the new widgets were sold
5000 + 3000 – 5500 = 2500
Under LIFO it is assumed the old widgets were sold
5000 + 3000 – 5000 = 3000
(2) If the wholesaler purchased no widgets during the year, what is its cost of goods sold expense for the year under FIFO
and LIFO, respectively?
Open = 5000 ($50 x 100 widgets)
Purchase = 0
COGS: FIFO and LIFO 50 x 50 = 2500
Under FIFO and LIFO the same widgets are sold
5000 + 0 – 2500 = 2500
In LIFO if you do not purchase new goods you can manipulate your COGS because you know what you are
selling, and if you wait to buy expense items until Jan. 2 to keep your COGS down.
(3) If the wholesaler purchased 25 widgets at $60 each during the year, what is its cost of goods sold expense for the year
under FIFO and LIFO, respectively?
Open = 5000 ($50 x 100 widgets)
Purchase = 1500 ($60 x 25 widgets)
COGS: FIFO 50 x 50 = 2500; LIFO 25 x 60 + 25 x 50 = 2750
Under FIFO it is assumed the new widgets were sold
5000 + 1500 – 4000 = 2500
Under LIFO it is assumed the old widgets were sold
5000 + 1500 – 3750 = 2750
In FIFO purchases do not matter to the COGS, under LIFO you can manipulate figures with the amount of
purchases you make
E. THE BOLT COMPANY INVENTORY

Reconsider you analysis of Problem V.E assuming that The Bolt Company uses LIFO.
F. COSTS INCLUDED IN INVENTORY

– Inventorying an amount treats it as asset-related, which defers the expense until the associated goods are sold,
this deferral matches the expense with the revenue
1
– Inventory Costs: The applicable expenditures and charges directly or indirectly incurred in bringing an article to
its existing condition and location
– A broad range of costs are inventoried, this advances matching by driving numerous expenditures through
GAAP’s best matching mechanism: inventory accounting
– Ideally financial statement results should not differ based on whether a company manufactures or buys
inventory, by including a broad range of inventory-related costs GAAP provides more comparable books for
those businesses that manufacture their inventory and those that buy their inventory
– For manufacturers the inventory is subdivided into three categories that represent the three stages of the
manufacturing process:
1. Raw materials:
2. Goods in progress: Raw materials are a cost of goods in progress
3. Finished goods: Only category treated as sold and charged to cost of goods sold, goods in
progress are a cost of finished goods
– A decision to book an item does not require that the item have an immediate income statement, when cash is
received prior to being earned, the cash and offsetting liability are shown on the balance sheet
– Revenue only appears on the income statement once it is earned
– Inventory costs are increased by accrued-but-unpaid wages, the manufacturer is in effect borrowing the
workers’ services in the last pay period
CASES
Revenue Ruling 2005-42 “Realization of Environmental Cleanup Costs”
Environmental clean-up costs are allocable to the inventory produced during the taxable year the costs were incurred
When a business contaminates land through its manufacturing process there are cleanup costs that must be booked,
but when is the appropriate time to realize them? The cost of cleanup is more along the line of repairs than improvements
since the land value does not increase by the cleanup. Therefore they must be included in inventory costs. Whether or not the
costs are incurred before, during, or after manufacture they are incurred as a result of the manufacturing process and must be
accounted for. Repair costs are allocable to the property produced during the taxable year in which the costs are incurred,
even though the repairs may have been necessitated by use of the equipment (land) in prior taxable years. There are five
different situations to consider with individual solutions.
Situation 1: N manufactured its product at Site X and discharges hazardous waste as a result of that activity. N now incurs
costs in 2005 to remediate the contaminated soil and groundwater at Site X from its previous manufacturing. During and after
the remediation, N continues to manufacture at Site X.
Solution 1: Because the environmental remediation costs to clean up Site X are incurred in 2005, they are properly
allocable to the inventory produced by N in 2005. Therefore environmental remediation costs are allocable to the
products manufactured in 2005 by N.
Situation 2: Same as Situation 1 but N manufactures a different product now then when the ground was contaminated.
Solution 2: Because the environmental remediation costs to clean up Site X are incurred in 2005, they are properly
allocable to the inventory produced by N in 2005. Therefore environmental remediation costs are allocable to the
products manufactured in 2005 by N regardless of the fact that they are manufacturing different products.
Situation 3: Same as Situation 1, except that N temporarily ceases its manufacturing activities at Site X during a part of 2005
while it remediates the contaminated soil and groundwater.
Solution 3: Even though during part of the year Site X is idle the costs are still incurred due to the production
activities of X during the rest of the year.
Situation 4: Same as Situation 1, except that N has permanently ceased its manufacturing activities at Site X and
manufactures at another site.
Solution 4: Even thought Site X is no longer used costs are incurred in 2005 due to the continuance of
manufacturing at another site.
Situation 5: Same as Situation 1, except that N buried the waste on site Y, that they did not own or otherwise use in the
manufacturing activities, during and after the remediation N continues to manufacture at Site X but has permanently stopped
using Site Y.
Solution 5: The cost of cleaning up Site Y is still incurred as a result of their manufacturing process and the
remediation is allocable to the products manufactured in 2005.
Environmental remediation costs that are incurred to clean up land that a taxpayer contaminated with hazardous
waste by the operation of the taxpayer’s manufacturing activities are incurred by reason of the taxpayer’s production
activities and are properly allocable to the inventory produced during the taxable year the costs are incurred.
1
G. PROBLEMS: INVENTORY COSTING

(1) The management of a company engaged in manufacturing wants to book profit as quickly as possible. Does this
management prefer to charge a cost to inventory rather than expense the cost?
Inventory, so that costs can be pushed into the future (as long as the sale of inventory does not occur
rapidly).
(2) Which of the following costs are charged to inventory:

(a) Insurance on raw materials.
Yes, cost of insuring the item is incurred during production and increases the value because it is less risky
to build and transport
(b) Storage costs of finished goods.

No, do not want to include storage because it decreases the value of the good by adding to its cost
(c) A holiday bonus paid to the chief financial officer.

No
(d) Attorneys fees related to a dispute over the cost of supplies used in manufacturing.
Yes, lawyer expenses arose because of the manufacturing, the problem whether or not manufacturing was
taking place during the trial and the cost is probably related to inventory that is no longer around because
law suits take a long time and inventory doesn’t last that long
A business may include in inventory their costs of building and transporting goods. As per the rule on
pages 95 and 96, inventory includes costs directly or indirectly incurred in bringing an article to its existing
condition and location.
H. CONSERVATISM
– Conservatism: Requires accountants to prepare conservative financial statements, which means that the
statements err on the side of caution by understating assets and overstating liabilities
– Inventories are written down when prices go down but are written up when prices go up
– Conservatism protects investors and protects accounts from being sued by those investors
– Hurts stock if it sells at a low price caused by the market respecting over-conservative financial statements
I. LIFO AND THE FINANCIAL MARKETS

– Most evidence says that the market values a company the same regardless of if it uses LIFO or FIFO
– This fact that capital markets look through the details of LIFO and FIFO is important support for the efficient
capital markets hypothesis
J. MATCHING IS IN THE EYE OF THE BEHOLDER

(Not Required)
CASES
Thor Power Tool Company v. Commissioner of Internal Revenue
(Not Required)
K. NOTES AND PROBLEMS: THOR POWER

(Not Required)
L. CLASS NOTES
– Ideal income statements are perpetuity like and would show things that the company can do again and again
1. Transactions that are spread over years can create lumps in the balance sheet, to avoid this
you must recognize parts of the sale over the years not all at once
2. Revenue and expense must be in the same period, otherwise one period would show the time
you expensed the product and the next would show the revenue from it
– Companies that sell goods are most concerned with the cost of making those goods
– It is difficult to know when to book expenses as well as revenues
– There is a desire to match revenue with the expense that each project creates
– Perpetual Inventory: Keep track of each cost of item (airplane, yacht) and then when you sell them book the
gain or loss
– Periodic Inventory: Take inventory at the end of the period rather than keeping track of every item, you group
them all together
1. GOODS SOLD = GOODS AVAILABLE – GOODS ON HAND AT END
2. COST OF GOODS SOLD = OPENING INV. + PURCHASES – CLOSING INV.
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3. You only have to keep track of two things: (i) the inventory taken at the end of the year and
(ii) the cost of your inventory
– Over the life of a business (this is not useful for our purpose, which is why we inventory periodically):
1. GOODS AQUIRED = GOODS SOLD + GOODS ON HAND
2. GOODS SOLD = GOODS AQUIRED – GOODS ON HAND
– When you have a mass of bolts how do you know which ones are left (the new, old, cheap, expensive), two
methods are used to figure this out, FIFO and LIFO
– FIFO: First In, First Out (the first items you put in are the first you pull out)
1. Advantages: When prices rise the new items are the stuff that is closest to the current value so
your closing inventory will be closest to the fair market value
2. Disadvantages:
– LIFO: Last In, First Out (the first items you put in are the last you pull out)
1. Advantages:
2. Disadvantages: When prices go way up the pre-fluctuation cost is what is on the balance sheet
so the true value is not as closely represented as in FIFO
– Inflation: It takes more money this year than last year to buy the same basket of goods (a dollar this year has a
different value than a dollar this year)
– When prices are rising LIFO understates inventory and FIFO understates revenue
– Inventory includes the cost of bringing the item to its existing condition and location (shipping, wages, etc.)
– GE Inventory (pg. 342)
1. Raw Materials and Work in Process: Items used to make the goods and goods in production
2. Finished Goods: Goods that have been processed and completed
3. Unbilled Shipments: Items shipped but have not been paid for
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- CHAPTER VIII: NON-INVENTORY ASSETS -

A. INTORDUCTION
– The law can have difficulty determining what constitutes property and accounting has similar problems but
accounting’s basic idea is clear: An asset is an expenditure incurred that is not expensed currently, but, is
deferred (a pool of future, or deferred, expenses)
– An expenditure to purchase a machine is not expensed but is treated as the cost of an asset, conversely an
expenditure for current insurance is an expense and is not added to an asset account
– The definition of assets as deferred expenses leads to a prominent feature of accounting: An asset’s book value
is its historic cost(the cost deferred), not the asset’s current fair market value
– An asset is only revalued from its historic cost if a gain or loss is recognized as a consequence of a sale or other
event
– A given expense is “capitalized” or expensed so as to be deferred, thus assetness for accounting purposes
depends upon a determination of the connection between an expenditure and future revenues
– Traditional legal notions of property have limited relevance to the accounting issue
– Finance is in tandem with accountings approach to assetness, the present value hinges on future cash flow and
makes perfect sense to relate assetness to future events, as GAAP do
1. Accounting for other types of assets, aside from inventory, used in accounting
B. REPAIR OR IMPROVEMENT
– When an expenditure is incurred to make an asset more useful or valuable it can be difficult to decide whether
to expense or capitalize the expenditure
– Expenditures that are labeled “repairs” are expensed, while those labeled “improvements” are capitalized (the
basic issue again being whether to defer or not defer)
– Repair or improvement decisions come down to a judgment call as to which treatment measures profit best and
is first made by management then reviewed by auditors (auditors give management substantial leeway)
– A federal income tax regulation explanation of the difference between repair and improvement states: “The cost
of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life,
but keep it in an ordinarily efficient operating condition [is expensed]. ... Repairs in the nature of replacements,
to the extent that they arrest deterioration and appreciably prolong the life of the property, shall ... be
capitalized.”
– One cannot distinguish between repairs and improvement based solely on the basis of their contribution to
value, the distinction rests on expectations: A repair is required to keep a property’s value in line with
expectations, an improvement goes beyond those expectations and increases future expectations
– Financial accounting values assets at their historic cost, which reflects the expectations at the time of
acquisition, expenditures that are consistent with these historic expectations do not require an adjustment, and
are expensed, expenditures that are inconsistent with these historic expectations and relate to new value are
capitalized
C. WORLDCOM
– Costs that should be treated as asset-related are not just academic concerns, the single largest accounting
restatement in history involved WorldCom whose biggest error was improperly capitalizing (and therefore
deferring) rather than immediately expensing $3.5 billion during five quarters
– The “Report of Investigation by the Special Investigative Committee of the Board of Directors of WorldCom,
Inc. 89-101 (2003)” made the following findings:
1. WorldCom improperly capitalized approximately $3.5 billion of operating line costs in
violation of well-established accounting standards and WorldCom’s own capitalization
policy, which were made in large, round-dollar amounts after the close of the quarter and on
ly a few days before the company’s earnings announcement
2. By capitalizing these line costs WorldCom avoided recognizing standard operating expenses
when they were incurred and instead postponed them into the future, accounting rules
required WorldCom to recognize their operating expenses immediately
3. Capitalizing line costs exaggerated WorldCom’s pre-tax income (pre-tax income is calculated
by subtracting period expenses from revenues and is reflected on the company’s income
statement), capital expenditures do not appear on the income statement and do not
immediately reduce pre-tax income, they instead appear as assets on the balance sheet and by
capitalizing certain operating expenses WorldCom improperly shifted expenditures from the
income statement to the balance sheet, increasing current income and postponing the time
when these costs would offset revenue
4. WorldCom CFO Scott Sullivan was given the opportunity to justify the capitalized expenses
but his explanation lacked any substantive accounting basis for the capitalization
D. PROBLEM: WORLDCOM
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The WorldCom Special Committee, which, after all was created to assign blame, easily discards Sullivan’s argument.
Actually, the argument is quite interesting. Consider a simple example: A company knows that it will run out of warehouse
space in six months. The perfect supplemental warehouse is available for rent right now. To assure the availability of the
warehouse in six months, the company signs a five-year lease today that is effective immediately. The company is not going
to move into the newly rented warehouse for six months, however. How should the first six months’ rent be accounted for? In
the company’s mind, and economically, this rent relates to the future when the newly-rented warehouse is to be used in the
business. Under matching, therefore, the first six months’ rent should be deferred. Is this wrong? Is WorldCom
distinguishable?
Should treat the first six months as acquiring the warehouse for when you are going to use it, and you
spread out the cost over the years that you actually do use the warehouse.
E. INTEREST CAPITALIZATION
– Capitalization issues are presented when a business borrows money in order to construct a new plant or other
property
EXAMPLE
A business borrows $1 million to build a factory whose construction will takes 1 year, over which time the business incurs
$100,000 of interest on the $1 million debt. Matching principles suggest that the $100,000 of interest should be deferred. This
deferral is effected by capitalizing the interest as an additional $100,000 construction cost similar to other more obvious
construction costs like materials and labor.
– Another reason to capitalize construction-period interest is that it helps to equalize the accounting for self-
constructed and purchased assets (if a business buys a new plant, the seller’s price should be no less than its cost
plus interest), the initial book value (cost) of a purchased plant should at least equal construction cost plus
interest
– Self constructed plants also include costs plus interest, with self construction they are included directly, rather
than being included indirectly through the price paid, as with a purchase
– FASB adopted this it-must-be-worth-what-it-cost-to-build approach: “At the time of the decision to acquire an
asset the enterprise believes that the present value of its cash flow service potential is at least as great as the sum
of the costs that will have to be incurred to acquire it... the enterprise’s commitment of cash or other resources
to acquire the asset provides the best available objective evidence of an asset’s cash flow service potential at the
time of acquisition”
– Current GAAP only capitalize interest, not lost revenue, accounting for the cost of equity capital tied up in
construction is considered in Section VIII.P, but two details of GAAP construction period interest of particular
note:
1. The underlying land is treated as part of the period (the land is as much tied up in
construction, and not earning revenue, as are the bricks and mortar
2. Only construction period interest is capitalized (interest related to the periods prior to and
after construction is expensed, only costs incurred during construction would have been
recovered by a seller if the project had been purchased
– The amount of interest treated as construction period interest equal (i) all interest on any debt specifically
connected with the project plus (ii) a portion of the interest on the general debt of the business
– Current construction-period interest rules also prohibit inventorying interest, any interest accrued later is not
construction-period interest, it should be treated as an indirect cost of the goods manufactured in the factory and
expensed
– Construction-period interest rules are perhaps the least conservative feature of GAAP, management is allowed
to defer interest including interest on borrowings with no direct connection to construction, because it is
expected that there will be related value in the constructed project
F. DEPRECIATION BASICS
– The cost of assets are deferred in order to be matched with future revenues
– Inventory matching is achieved by booking the associated cost when the revenue is booked (as the goods are
delivered to the customer), many assets used in business generate revenue by being used rather than by being
sold
– Depreciation: The collection of accounting rules that provide how the costs of assets consumed in business are
matched with revenues (not all assets are depreciated but most must be, i.e. real estate, improvements,
buildings, machinery, equipment, etc.)
EXAMPLE
A business purchases a machine for $100 and starts using it on Jan. 1. The machine will work for exactly five years, at the
end of which it will die and have no value. The $100 that the machine cost relates directly to the revenues that will be earned
over the five years of its use. Using straight line depreciation there is a $20 depreciation expense each year for the five years
of the machines usefulness.
Cost 100-Useful Life: 5 Years

Salvage Value: 0
1
Placed in Service: 1st Day of Year 1

Straight-Line Depreciation
– Pro-rata depreciation graphs as a straight line, which is why it is often referred to as “straight-line depreciation”
– Businesses often use an averaging convention when figuring depreciation to help avoid determining
depreciation on a daily or other burdensome basis
– Bookkeeping for depreciation is archaic: Using the example above, the $20 of depreciation is an estimate, while
the $100 cost is a hard number, therefore the accountants do not write down the machine’s assets account down
to $80, instead the $20 of accumulated depreciation is added to a separate “contra” asset account that functions
like a negative asset account (most businesses omit this detail from the balance sheet, instead showing the “net
asset” amount equal to the asset’s historic cost reduced by accumulated depreciation)
– Most businesses use straight-line depreciation but is not the only type of depreciation, others include, declining
balance, sum-of-the-years-digits, and double declining balance
– The non-straight line methods are just fancier mathematical formulae for allocating the $100 cost of the
machine among the five years of its useful life
– When a depreciation method allocates more depreciation to the earlier years of an asset’s life (and less to the
later years) than a second depreciation method, the first method is referred to as “accelerated” of “faster” and
the second as “slower,” when using the word “accelerated” it is being compared to the straight-line method
because they are faster than straight-line depreciation
– Salvage Value: Value left over at the end of the machine’s life
– Accounting depreciation takes salvage value into account, which can be illustrated by modifying the example
by assuming that the machine will be worth $5 as junk after five years of use
– GAAP depreciation is based on management’s expectations at the time that an asset is acquired, making
opportunities for management to manipulate depreciation limited, although there are three variables at
management’s discretion (although choice has not resulted in much controversy)
1. Life (can cause difficulties)
2. Salvage Value (can cause difficulties)
3. Method
G. DEPRECIATION: AVERAGING
– For many businesses, the method used in determining depreciation has little net effect on profit or loss
EXAMPLE
By modifying the no salvage value example so that the business buys and starts using one of the $100 machines at the
beginning of each year, we can create a table that will show the effect three different depreciation methods would have
Year Machine Purchased Cost 5-Yr. S/L Dep. 10-Yr. S/L Dep. 2X Decl. Balance Dep.
This 100 20 10 40
Last 100 20 10 24
1
2 100 20 10 14.40
3 100 20 10 10.80
4 100 20 10 10.80
5 100 0 10 0
6 100 0 10 0
7 100 0 10 0
8 100 0 10 0
9 100 0 10 0
Total Effect 100 100 100
No matter how the machines are depreciated, the total depreciation expense each year is eventually $100
– With level purchases, when one depreciation method is accelerated compared to a second, the accelerated
method provides a greater expense with respect to recently purchased assets, but this greater expense is
averaged away by less expense with respect to older assets, so that both depreciation methods result in the same
total expense (taking all assets whenever acquired into account)
– So long as the same accounting method is applied constantly there is little effect on net profits, depreciation
methods have the most effect on businesses whose expenditures on depreciable property vary from year to year
because depreciation from earlier purchases cannot perfectly average with depreciation from later purchases
– Depreciation is important to GAAP because there are numerous businesses for which depreciation methods
matter
H. ACCOUNTING CONSISTENCY
– Averaging effect illustrates why GAAP has strict rules on temporal consistency, accounting rules must be
applied the same from year to year otherwise inaccuracies could compound rather than average and there would
be considerable opportunities for management to manipulate their books (Halliburton was able to double
revenues one year by changing their accounting method, which it did so without disclosing the change)
– Accounting rules generally prevent changes and require companies to disclose any allowable changes they
make
I. VIEWS OF DEPRECIATION
– Under GAAP depreciation is a reasonable method for allocating costs among years so as to achieve an
acceptable method of matching
– Economic Depreciation: Exact actual decline in assets’ value (usually faster than GAAP straight-line
depreciation)
– Historically depreciation looked at depreciation with the understanding that businesses should set aside
resources to replace depreciating assets, and such amounts should not be viewed as profit even if they are not
specifically ear-marked for replacement of deteriorating property
– Reserve or Sinking Fund View: Depreciation is the amount set aside (held in reserve) to replace deteriorating
assets (technically a “sinking fund” is a separate cash account that is funded over time in order to assure that a
business will have enough money to retire long-term debt that requires a large payment of principle maturity)
– Understanding depreciation is useful in distinguishing repairs from improvements: Normally one would assume
lower depreciation based on regular maintenance, thus an improvement is an expenditure that is not consistent
with the assumptions and expectation underlying the depreciation method
– Depreciation can also be used to think about the leasing transactions from Chapter III: Rent in a net lease
depends solely on (i) the cost of the leased asset, (ii) the lease term, (iii) the asset’s residual value, and (iv) the
discount rate , in other words rent pays the lessor solely for (a) the use of money over the lease term and (b) for
the decline in value of the leased asset over the lease term (from cost to residual value), therefore rent should
equal depreciation plus interest
J. PROBLEMS: DEPRECIATION
A manufacturer builds a plant with a total capitalized cost of $500 million. Calculate the straight-line depreciation each year
under the following alternative assumptions:
(1) 50-year life, no salvage value.

$10 million per year.

$12.5 million per year.

(4) 50-year life, $20 million salvage value.

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(10) Which seems more important, useful life or salvage value?

Useful Life (Years)
Salvage 40 50 60 Avg.
Value $0 12.5 10 8.33 10.27
(Millions) $20 12 9.6 8 9.87
$50 11.25 9 7.5 9.25
Avg. 11.91 9.53 7.94
Useful life is more important because the more years the machine is useful the greater difference there is
between the per year depreciation value, when compared to the same amount of useful life with higher
salvage values. A little change on useful life has more effect than a little change on salvage value.
K. INVENTORIED DEPRECIATION
– The single most important fact about depreciation is that much of depreciation in America is not expensed, it is
inventoried, since most depreciable property is used in manufacturing and all direct and indirect cost of
producing inventory (except interest) are capitalized
– The path that depreciable property takes from the time it is incurred to the income statement is winding and
once again inventory accounting affects matching
1. The cost rests in the asset account for a depreciable asset
2. As the asset is depreciated the cost is moved to an inventory account
3. The cost is removed from inventory and expensed on the income statement as part of cost of
goods sold expense
– When depreciation is inventoried it hits the income statement only when the associated goods are treated as sold
under the manufacturer’s accounting method, soon under LIFO and later under FIFO
L. GAINS AND LOSSES

– The gross sale price is revenue, the book value of the sold item is an expense, as to the disposition or retirement
of non-inventory assets the accounting is different but has the same effect: Gain or loss is determined on an
asset-by-asset basis and only the net gain (revenue) or loss (expense) of each item hits the income statement
EXAMPLE
A business that purchases land for $75,000 and sells it for $100,000: If the land is in perpetual inventory the $100,000 would
be revenue and the $75,000 an expense, but if the land is used in business (but not inventoried) only the $25,000 profit would
be revenue, with no effect on expenses
– Bookkeeping for gain or loss with respect to depreciable assets is a bit tricky because of archaic bookkeeping
for depreciation
EXAMPLE
A business that retires (discards as worthless) an asset with no salvage value and has depreciated the entire cost: The only
bookkeeping required upon the retirement is the elimination of the asset account for the asset, which held the asset’s
historical cost, and a reduction in the accumulated depreciation account by the same amount
– Bookkeeping for the retirement of worthless machines is accomplished by eliminating offsetting balances, no
adjustment to any other account is necessary, the same goes for when an asset has salvage value but is sold for
that exact amount, since there is still no gain or loss
– Matters become involved when the sale price differs from net book value: When the sale price does not equal
the net book value, cash increases or decreases and a gain or loss must be booked
– Gains and losses are usually small and amount from changes in economic conditions that differ from those that
were expected when the asset was placed in service
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– Bookkeeping for gain or loss on non-inventory assets highlights one very significant feature of financial
accounting: The amount of gain or loss booked in a given year can relate economically to a number of years
(when land that has been in use for years is sold, the profit from it which has accumulated over time is booked
all at once), because financial accounting does not recognize profit until it is objectified by a transaction, which
means that book profit for a year can vary considerably from economic profit for that year
M. PROBLEMS: SALE OF DEPRECIATED PROPERTY

As to the plant considered in Problems VIII.J, above, describe the effects on the income statement and the balance sheet
under each of the nine depreciation methods described there of each of the following:
(1) The plant is abandoned as worthless at the end of the 50th year.
(2) The plant is sold at the end of the 20th year for $308 million.
N. UTILITY RATEMAKING
– In ratemaking accounting rules determine the rates paid by consumers and businesses for electricity, telephone
services, water, and other goods and services provided by regulated for-profit utilities
– Medicare reimbursement is similar to ratemaking except that the money is paid by the government rather than
customers (a hospital that had 100% Medicare usage would receive all its funds from the government, in a cost
plus profit format)
– Public policy problem underlying utility ratemaking is that some goods and services are provided best by a
monopoly, because the public interest is served, by preventing the monopoly from exploiting the market,
accomplished by regulating the monopoly’s profits so that they do not exceed a reasonable return on (net
equity) capital
– The way that the utility measures profit directly determines rates and utilities commissions provide elaborate
accounting rules for ratemaking purposes, which generally start with GAAP, but supplement accountancy’s
rules in order to achieve more clarity and detail
– Since rates are set to limit profits both revenues and expenses affect the rate charged (revenue is relatively easy
compared to expenses) and while the depreciation method will affect ratepayers there is no obvious correct
choice
EXAMPLE
An electric company issues $250 million worth of new stock and buys a plant: (1) Under a 15- year, straight-line, no salvage,
depreciation the result would be an increase in rates of $16.7 million per year (plus interest), for 15 years, (2) Under a 25-
year, straight-line, no salvage, depreciation the result would be an increase in rates of $10 million per year (plus interest), for
25 years
– Customers pay the interest through higher rates on any capital that the utility shareholders have not recovered
by billing its customers, therefore a customer that expects to pay for electricity for a short period of time would
prefer a slower depreciation method (so that future customers pay for more of the plant), while a customer that
expects to pay for electricity for a long period of time with increasing usage would prefer a faster depreciation
method (so that more of the plant is paid for in the earlier years)
– Shareholders should be indifferent to the depreciation method since they will get their capital back one way or
another
– In financial accounting, matching in generally done by booking revenue and then the expenses are matched (on
occasion, such as when payment is received, revenue is differed in order to match it with associated expenses),
however, in ratemaking charging expenses to a year automatically generates matching revenues (it is perfect)
O. PROBLEM: NUCLEAR DECOMMISSIONING

Under federal law, when an electric utility retires a nuclear power plant from service, which is referred to as
“decommissioning” the plant, the utility must clean up the nuclear mess. This clean-up becomes necessary the moment the
reactor is first run, regardless of how long, or even whether, the plant is actually used to generate power for consumers.
Assume that a utility fires up a new nuclear plant for the first time today. The utility expects to pay $200 million to
decommission the plant in 35 years (after one year of testing and 34 years of use). How should the relevant public utilities
commission account for the $200 million for making purposes? (Hint: this context gives poignance to the notion of a sinking
fund, discussed in Section VIII.I.)
Based on the sinking fund theory and using straight line depreciation, the utility should decrease revenue by
$5.9 million a year to compensate for the clean up costs that will be incurred per year over the 34 years of
revenue that the plant will generate.
Time value issues that need to take into account the present value of the liability is increasing. On the day
they open the plant the present value of the cost of the clean up is a liability and the liability grows each
year as the current value increases. The business puts the money in a trust fund so it is there when the
cleanup needs to take place. In exchange for cleaning up the mess the company is allowed to run a nuclear
plant, the asset is their license from the government.
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P. RATEMAKING FOR EQUITY-FINANCED CONSTRUCTION

– Ratemaking helps to advance the analysis of equity-financed construction
– Assuming a utility could finance the construction of a plant out of equity capital, the utility could have kept that
money in the bank and generated revenues that would count toward the return on capital provided to the
shareholders and the ratepayers would not have to pay a return on that capital through higher rates
– Ratepayers should not pay higher rates solely to provide shareholders a current return on capital tied up in
building the new plant because it is not currently being used to generate electricity it is being used to construct a
plant, but at the same time the shareholders should not lose money because that would discourage growth and
construction
– “Lost” earnings on money tied up in construction should be paid for by the future consumers who will actually
benefit from the new plant, this complex goal is achieved by two accounting adjustments:
1. The utility is treated as if it earned a fair return on capital tied up in the construction (the same
as if the capital had been in the bank)
2. The utility is treated as reinvesting the imputed earnings in the plant and capital is increased,
this assures that the lost current revenues are repaid (plus interest) by future ratepayers
– For financial accounting, matching is less important than in ratemaking, so that to GAAP the burden of
imputation outweighs matching benefits, particularly in light of accounting’s conservatism
EXAMPLE
A company finances a $10 million project by taking the money out of the bank: (1) A GAAP analysis would consider the cost
of the construction as $10 million (2) Under ratemaking the cost would be the $10 million plus the annual interest yield, 8%
in this example or $1.66 million, the value the capital would have increased by had it been left in the bank, therefore
ratemaking would consider the cost of the project cost $11.66 million, so that current customers pay the same rates as if the
money had stayed in the bank
Q. BY-PASSING, EXTRAORDINARY ITEMS, AND PRO-FORMA STATEMENTS

– Certain gains or losses, due to extraordinary events booked, in a given year may say little about how the
business actually did in that year (a car dealership falls into a sink hole)
– A loss could by-pass the income statement by being booked as a direct reduction of equity, but it would remove
an important event in the life of the business from the income statement
– GAAP try to balance concerns that the income statement should reflect only how things are going for the
business’s operations against concerns that omitting non-operating events can tell an incomplete story
– The number of items that by-pass the income statement is small, nonetheless FASB remains concerned and as a
consequence businesses are required to present “other comprehensive income” that reflects these extraordinary
items
– An extraordinary item is both unusual in nature and infrequent in occurrence (losses that are so rare it would be
unreasonable to insure against them)
– Pro-forma: Non-GAAP financial statements released in addition to GAAP statements that do not include certain
expense items that do not qualify as extraordinary under GAAP (limited in that management must explain: (1)
the difference between their pro-forma and GAAP, and (2) why the pro-forma version is preferable)
R. DISCUSSION PROBLEM: EBITDA

One fad in the 1990s was to measure firms’ performance using, rather than profit, Earnings Before Interest, Taxes,
Depreciation, and Amortization (EBITDA); particularly growth in EBITDA over time. The idea is that EBITDA is a better
predictor of the future, since interest, taxes, depreciation, and amortization (basically, depreciation of intangible assets, see
Section XI.C) do not relate to the to the day-to-day of the business and are not cash-like.
A nice Illustration of the power of EBITDA in the 1990’s comes from Kurt Eichenwald’s book about Enron, Conspiracy of
Fools. He recreates the following 1997 board meeting discussed between Rebecca Mark, then the head of Enron’s
international operations, and Jeffrey Skilling, then the President:
Mark [noted:] “We need to keep investigating to grow as fast as possible. Merrill Lynch says out valuation is all
about EBITDA, not earnings”
This is ludicrous! “So the more money you lose, the more valuable you are?” Skilling said. “That’s nuts!”
Mark didn’t give an inch. “Our bankers tell us we have to grow EBITDA. That’s what our investors are looking
for.”
What do you think of EBITDA?
S. MARK-TO-MARKET ACCOUNTING
– Mark-To-Market Accounting: An alternative to GAAP’s historical cost (recognition-based) accounting, at the
end of the year assets are treated, first, as having been sold for their fair market values, and second, as having
1
been repurchased at these new values (liabilities are adjusted to reflect any change in their economic burden,
resulting in gain or loss)
– At the end of the year a balance sheet is prepared and lists assets and liabilities at their fair market value, the
difference between the two is the equity and any increase or decrease in equity between consecutive years is the
profit or loss
– Similar balance-sheet-driven accounting is used in high inflation countries because it is easier to adjust for
inflation under this accounting than under a transactional method
– Securities and commodities brokers have long used mark-to-market accounting for assets, because the values of
most assets (readily-valuable stocks, bonds, options, commodities futures, etc.) are easily determinable
– Savings and Loan scandals in the 1980’s made mark-to-market fashionable because its use would have helped
many of the S&Ls from going broke
– Enron slowed the movement towards mark-to-market, Enron booked profit on its long term energy contracts
with increased value, but the problem was there was no real market for the contracts so the “values” were based
on Enron’s own questionable valuation methodology (when the market learned Enron was a house of cards the
company lost their ability to borrow an pushed it into bankruptcy)
– Despite the Enron debacle the SEC has recommended all financial instruments be accounted for using mark-to-
market accounting
– FASB’s most authoritative pronouncements are its Statements of Financial Accounting Standards (SFASs),
which require businesses to provide considerable detail in the footnotes to the financial statements of the current
values of financial assets and liabilities
1. SFAS 115: Applies mark-to-market accounting to some of a regular business’s investments,
still it reflects considerable skepticism about the desirability of mark-to-market accounting
because changes in the fair market value of investments are beyond the control of businesses
and thus do not resemble ordinary business profits, and the fluctuation of market values from
year to year means full mark-to-market accounting can have erratic effects on the income
statement
2. SFAS 121: A business that makes tremendously optimistic assumptions in determining
depreciation must catch up with special write-down when facts make clear that those
assumptions were wrong
T. CLASS NOTES
– Tangible Assets: Assets such as buildings, land, machines, etc., assets that are valuable to a business by being
used, not by being sold (depreciation is needed to account for their use, a way of matching use)
– All tangible assets other than land depreciates, they value the business by being consumed over time and we
need to match the revenues from the machine with the expenditure of the use of the machine
– Straight line depreciation: Start with the original value and a junk or scrap value (what it will be worth at the
end of its life), then draw a straight line over the life of the item to figure out how much it will be worth (how
much it will depreciate) every year
– Accelerated (curved line) depreciation: Takes into account the fact that most machines depreciate quicker in the
earlier years of their life
– Microsoft uses straight-line depreciation (pg. 380)
– What is at stake with depreciation:
1. A company that buys the same amount of equipment each year not a lot, with an accelerated
method new machines will go faster and older ones slower so they will balance out
2. Depreciation matters most for growing and shrinking businesses: A company that is growing
and uses an accelerated method is going to have less income (money is spent buying assets
that are depreciating quickly), a shrinking company is going to have more income (they will
have already expensed most of their depreciation)
– If we did not account for machine depreciation over time it would not be perpetuity-like because over time you
would be liquidating
– Inventoried depreciation: A depreciating factory or machine is considered a cost of production (all expenses
incurred either directly or indirectly in bringing an article to its existing state and location), as to non-inventory
assets (the sale of which is not the core of the business) you account for transactions on a net basis
– Gains and losses (the residual value of a machine is $5):
1. The business sells the machine for $5 in cash: Cash goes up $5, depreciation is $95, and the
machine total is $100
2. The business abandons the machine for $0 in cash: Depreciation is $95 and the business has
to take a $5 loss (expense)
3. The business sells the machine for $10 in cash: Depreciation is $95 and the business takes a
$5 gain (revenue), economically they only lost $90 but since $95 loss was already booked
they book $5 profit instead of $90 depreciation
– Utility ratemaking (regulated monopolies):
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1. One provider of electricity is much more effective and efficient than having multiple
providers all running lines across town
2. State regulates these monopolies so that they can be efficient while not overcharging, so that
they do not earn a monopoly profit
3. State sets electric rates so that the companies get their costs back plus a reasonable profit,
there is no market price because there is no competition
4. Reverse engineer a market price by saying it is a cost plus a profit
5. If rates are too low the business will not be able to raise capital and will go out of business
6. The hardest part is figuring out what a reasonable return is, enough so that they can provide
power but not so much they are making an unreasonable profit
7. With long depreciation they must wait longer to get their money back
– Guide to the chart in footnote 23 on pg. 127:
1. “Interest on unrecovered cost” is the 8% of “unrecovered costs”
2. “Total rate effect” is “depreciation” plus the interest on “unrecovered cost”
– There are some items that bypass the income statement
1. GE’s foreign currency beat the U.S. dollar so they made a billion dollar income, but it is not
shown on the income statement
2. Microsoft’s other comprehensive income of $587 million went down 4 million from 2001 to
2002 (pg. 375)
– Extraordinary Items: Items that are booked in a special area of the income statement that are infrequent and
unusual in occurrence (a car dealership falling into a sinkhole), natural disasters in areas they are expected to
occur (hurricanes in the Gulf of Mexico, tornadoes in the mid-west) are not sufficiently infrequent and unusual
– Extraordinary items are so rare that none of our example companies have any extraordinary items other than
accounting changes
– EBITDA: Principle focus is on amortization, the market recognizes that EBITDA is not earnings and allow it
because it is so well established
– Savings and Loans: Banks were borrowing at 12% but their loans were at 5%, interest rates went up so the
value of their loans went down and accounting statements did not reflect this, so investors could not tell that the
banks were in trouble (as interest rates rise the value of a bank goes down and as interest rates go down the
value goes up, but this is not perpetuity like, it has nothing to do with management)
– Mark-to-Market: Solution to the Savings and Loan problem was mark-to-market accounting, which focuses on
current market values at the end of each period rather than waiting for a transaction to book the value
1. Critics say that this method is only reflective of how well the market is doing since a company
can fluctuate with the current value of their assets
2. Securities traders’ (or a bank that sells securities on the side) business is managing stocks and
bonds, so their business is mark-to-market
– Enron: Convinced the FCC and Arthur Anderson that their contracts were like stocks and bonds and valued
their contracts subjectively, when there was really no market at all for them
– FSAF 115: Not responsible for knowing
– FSAF 121: If there is an asset that is clearly not worth what they paid for it, they have to take a write-down (i.e.
if a casino you own is underwater in Louisiana you have to take a write-down even if there has not been an
event, such as demolition, that would technically create a reason to book it)
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- CHAPTER IX: -
- THE CASH FLOWS STATEMENT -
A. INTRODUCTION
– The cash flows statement is the last of the three basic financial statements to be discussed, it is also the newest
and most primitive (it was introduced in 1978 as a hoped-for solution to the problems with the income
statement, but companies have figured out how to manipulate it just as they do the income statement)
1. Basics of the cash flow statement
2. Utility and significance of the cash flows statement
3. Comparison between the cash flows statement and the income statement
4. Discussion of the non-GAAP form of income accounting called the “cash method” that is
different from the cash flows statement
B. WHAT THE CASH FLOWS STATEMENT SAYS

– Cash Flows: Cash (or the equivalent) received by the business less cash (or the equivalent) paid out (a checking
account statement is a simple cash flows statement)
– Cash flows accounting does not match by accruing and deferring, there are no assets or liabilities
1. All cash taken in is a receipt
2. All cash expended is a payment
– There are two forms of cash flows statements that differ only in how the determine “operating cash flow”
1. Direct: Presents the operating cash flow explicitly, showing separately cash in and cash out,
this is the preferred method but rare
2. Indirect: Reverse-engineers net operating cash flow from net income without identifying
receipts and payments, most businesses use indirect because internal records are set up with
accrual in mind and do not have direct operating cash flows information readily available
– Cash flows are divided among three activities that are distinct enough that classifying cash flows with reference
to them provides useful information
1. Operating (distinguishes direct from indirect cash flows statements): Resembles income
without accrual or deferral, consists of cash in less cash out from ordinary business activities
2. Investing: Ownership of any type of asset other than inventory (not just things commonly
viewed as investments, like stocks and bonds), amounts paid for assets reduce net cash flow,
while amounts received increase cash flow
3. Financing: Dealings with the business’s lenders and equity, borrowing or issuing stock
generates cash flow, while paying debts and distributions to equity (such as dividends)
consumes cash
– There are numerous problems with cash flow especially its three-part presentation (a business can borrow to
buy inventory, which is then sold at a loss and still generate large amounts of operating cash)
– It is useful to contrast the income statement and cash flows statement:
Income Cash Flows
Receivables Revenue Nothing
Payables Expense Nothing
Prepaid Revenue Deferred Immed. Receipt
Prepaid Expense Deferred Immed. Charge
Non-Business Asset Cost Depreciated Immed. Charge
Inventory Cost Deferred Immed. Charge
Non-Business asset Sale Gain Only Entire Sale Price
Borrowing (Principal) Nothing Immed. Receipt
Repaying Debt Nothing Immed. Charge
Issuing Stock (Equity) Nothing Immed, Receipt
Dividends (and the Like) Nothing Immed. Charge
C. BACK TO THE FUTURE

– Almost from the outset, accountancy believed that accrued net income was a better measure of the economic
performance of a business than cash flow and so it focused on the income statement with little concern for cash
flow
– Under a finance analysis the value of a business should be the present value of all expected future distributions
of cash to the equity owners, cash flows show on the cash flows statement bear little resemblance to these future
distributions (borrowing generates cash but must be repaid, so it is not available for the owners to consume
outside the business)
– The general trend in financial accounting is to provide more types of information, looking at only income can
cause investors to miss valuable information about a business
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– Financial flexibility is the key to business and income does not reflect a business’s ability to generate income
over medium periods of time (over long periods income and cash flow are much more useful), the greater a
business’s financial flexibility the better able it is to deal with change and unforeseen circumstances
– Difficulties with cash flow can indicate problems, failing businesses frequently get into cash flow trouble before
income starts to plummet (income statements are more misleading about failing businesses since they assume
an indefinitely ongoing business)
– For a healthy business the cash flows statement is best viewed as a presentation of useful information, and not
measuring anything (compared to the balance sheet which measures equity, and the income statement which
measures profit or loss)
D. PROBLEM: INCOME V. CASH FLOW

The MIDDLE Company is a wholesaler. It buys goods from manufacturers and sells them to retailers. MIDDLE has no
obligations other than accounts payable. All material property, other than inventory, is leased. No dividends are paid.
MIDDLE issues no stock. MIDDLE does not buy its stock back from shareholders. Which of (i) GAAP income statements, (ii)
GAAP cash flow statements, and (iii) cash basis income statements best describe the success of MIDDLE’s business
operations and why?
E. THE CASH METHOD

– Cash Method or Cash Basis: A type of income accounting most used in preparing income tax returns, more
closely resembles the accounting on the GAAO income statement than that on the cash flows statement
(basically GAAP that ignores receivables and payables)
1. Books revenue only when cash is received: Receivables (for revenue) are viewed as
unrealized and not booked
2. Books expenses only when paid: Payables (for expenses) do not appear on cash method
F. PROBLEM: VALUING A SERVICE BUSINESS

Betty is a very successful orthodontist who operates as a corporation. The corporation pays her for her services as cash is
available.
Betty personally invested in an otherwise unrelated gene splicing firm. The firm got in financial trouble. At one point in the
past, in order to get one of the firm’s creditors to delay foreclosing on a loan in default, the firm’s investors, including Betty,
granted (non-recourse) security interests in some of their personal assets. One of the assets that Betty pledged was all of her
stock in the orthodontia corporation.
You represent the creditor of the gene splicing firm that has a lien on Betty’s orthodontia stock. The gene splicing firm has
gone out of business. All of its assets have been picked over by its creditors. Your client still is owed a considerable sum. You
informed Betty’s attorney that you want the orthodontia stock. He sends you the most recent audited financial statements of
the orthodontia corporation. The balance sheet looks as follows:
Assets Liabilities
Cash 10,000 Bank 35,000

Supplies 30,000
Prepaid Rent 5,000 Equity
45,000
Common Stock 10,000
The CPA’s opinion letter, which is typical for small service businesses, provides as follows:
We have examined the statements of assets and equity of Betty’s Orthodontia Corporation and the related
statements of revenues and expenses and changes in shareholders’ equity. Our examinations were made in
accordance with generally accepted auditing standards and, accordingly, included such tests of the accounting
records and such other auditing procedures as we considered necessary in the circumstances.
As described in the notes to the financial statements, the aforementioned statements have been prepared on the cash
receipts and disbursements method of accounting, and do not purport to present the company’s financial position or
results of operations in conformity with generally accepted accounting principles.
In our opinion, the aforementioned statements present fairly the assets, liabilities, and shareholders’ equity of the
company and its revenues and expenses and changes in its equity on the basis of the accounting described in the
notes mentioned in the preceding paragraph.
Betty’s lawyer says that these financial statements show that Betty’s stock is worth $10,000. He offers you $10,000 in
exchange for you client relinquishing its security interest. What do you say to him?
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G. ENRON’S OPERATING CASH FLOW

– The Enron mess gave a nice example of potential problems in the cash flow statement, particularly the operating
portion: Enron used mark-to-market accounting for many of its activities and its aggressive valuations enabled
it to book paper profits without any cash to back them up (Enron borrowed to but assets that were sold to
generate operating cash flow, using a device called “prepay”)
– Based on testimony of Robert Roach the Chief Investigator for the Subcommittee on Investigations:
1. Prepay: Paying in advance for a service or product to be delivered at a later date, used to
receive money up-front for services to be rendered in the future (used in a complex form by
Enron as a source of financing to mislead investors)
2. Enron had two major reasons to reduce its balance sheet debt and increase cash flow from
operations: (i) to improve Enron’s credit rating, and (ii) to support and even boost Enron’s
share price
3. Cash flow was seen as the most reliable measure of a company’s performance, because it was
believed this number could not be as easily manipulated as earnings, and was the best
indication of a company’s ability to meet its obligations
4. Enron placed heavy emphasis on generating operating cash flow, and gave management cash
flow numbers they were expected to meet, using the following options: (i) Sell its hard assets,
such as power plants and pipelines, (ii) sell the value (and risks) of specific trades in its
trading book to collect cash proceeds, and (iii) borrow money from a bank, using their trades
and their promise of delivering cash a few years down the road as collateral (this third option
is the focus of Roach’s testimony)
5. By borrowing cash against Enron’s trades they would have to record the amount as debt,
which it was unwilling to do, instead it used a complex prepay system to hide its debt: Enron
booked the advance of cash as a trading activity rather than as a loan and proceeds from the
loan as cash from operations rather than cash from financing, and by doing so was able to
raise $8 billion worth of funds
6. By using this method Enron was able to keep a better credit rating allowing it to borrow more
money, making it a more attractive trading partner, holding off trading partners contractual
rights to close out existing claims and demanding payment, cost of borrowing remained
lower, and kept debt holders from demanding payment
7. This method also drove Enron’s stock price, having a direct impact on the value equity
analysis assigned to Enron, had investors known that Enron was not $12 billion in debt but
rather closer to $17 billion they would have sold off stock until the price was consistent with
that level of indebtedness
8. Enterprise Value: A measure of what the market believes a company’s ongoing operations are
worth (assumes that the market has a knowledge of the company’s indebtedness and preferred
equity obligations)
9. By using prepay transaction s to generate cash flow from operations, Enron was able to
maintain its investment grade ratings, which allowed Enron to build a trading business that
was the engine behind Enron’s income growth, as earnings grew, so did Enron’s share price
10. To legally structure the prepays in order to be treated as contracts there must be parties
(Enron, the lending bank, and a third-party) and none of the individual agreements could be
linked commercially, or make any reference to each other, they all had to stand alone: This
would be accomplished by transferring the price risk from the gas supplier to the purchaser,
who must have an ordinary business reason for purchasing the gas
11. Enron blatantly contradicted this criteria by having the bank send their money to a third-party
in exchange for a commodity to be paid in the future, the third-party would then enter into the
same deal with Enron, then Enron would negate any risk to the parties of the commodity’s
price changing by exchanging with the bank the floating price of the commodity for the fixed
price of the commodity
12. The banks and third-parties were all aware of the entire structure and its accounting purposes
H. PROBLEM: MORE BOLT DIVORCE

Reconsider your analysis of Problem V.E in light of The Bolt Company cash flows statement above.
I. PROBLEM: MICROSOFT CASH FLOWS STATEMENT

Go through Microsoft’s cash flows statement in the Appendix and explain the import of each line. (Assume that “other
current assets” means inventory. Do not analyze the lines “Stock option income tax benefits” and “Sales/(repurchases) of
put warrants.”)
J. PROBLEM: CASH FLOW V. EBITDA

Review Section VIII.R, regarding EBITDA. Is EBITDA more useful in valuing a business than the cash flows statement?
K. INCOME: WHY BOTHER?
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– If one believes the efficient capital market hypothesis to be correct, one can conclude that the accountants were
wrong and should have saved the effort spent developing the income statement and have been satisfied with the cash
flows statement, but there are a few contrary arguments
1. If all users of a business’s financial information are just going to measure income, it makes
sense to do it once for everybody
2. Income measurements by management may provide important information not discernable
from cash flows
3. The value assed by accountants is in accruing cash receipts and disbursements so as to attain a
more useful measure of firm performance over short intervals
– Even true believers in the efficient capital markets hypothesis can find utility in accrual accounting
L. CONCLUSION: INTO THE FRAY

– This is the end of the introduction to the basic financial statements
– The next section looks at situations where GAAP has difficulties (both practical and theoretical)
M. CLASS NOTES
– Cash flows statement is most important in measuring cash or liquidity (a business can have lots of assets but no
cash and not be able to pay its employees)
– Enron had cash flow problems
– Cash is the lubricant of business, if you are not getting cash it is an early sign of trouble
– When cash problems start a business can continue selling but to lousier buyers and for longer contract (they can
book the revenue from the sale and still look alright when in truth they are not receiving cash as consistently or
quickly)
– Cash flows is anti-mark-to-market, there are no assets, liabilities, accrual or deferral
– Cash flows statement consists of three sections:
1. Operating: Any purchase of assets other than inventory, proceeds from sales of assets
2. Investing: Money spent to buy back stock, commissioning of stock, borrowing
3. Indirect: start with net income, add depreciation because it does not reduce cash, subtract
increase in inventory, decrease less increase in receivables, increase less decrease in payables
– Most companies do not keep cash flow records
– Enron could borrow and generate cash flow but had to manufacture operating cash flow
1. They would “sell” power to other businesses (Chase, Citibank) for future delivery, but the
banks did not want power they wanted money
2. Enron was really borrowing money, the cash that came in should have been in finance, but
they were operating as if they had sold power
3. The banks had the option to sell back the power at a certain price at a later point in time
4. All the operating cash flow was based on these prepay borrowing transactions
– Method of the cash flow statement is different from the cash method, which says you earn revenue and gain
expense when you write the check (i.e. you get taxed when you get paid, not when you work and earn the
money, so your last paycheck of the year could be taxed in the following year)
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PART D: DIFFICULT ACCOUNTING

- CHAPTER X: REVENUE RECOGNITION -
A. INTRODUCTION: HARD NUMBERS IN A VIRTUAL ECONOMY
– Risk (uncertainty) presents the most challenging problem in finance, and is the central concern of accounting
– Revenue recognition, particularly for businesses that earn money other than by selling goods, is the most
important context where uncertainty troubles accounting
– Most of the recent accounting problems in the telecommunication industry involved the booking of revenue that
had not been earned, and that most likely was not going to be earned
1. Exploration of revenue recognition
2. Problems that can be presented even with a simple sale of goods
3. General concerns regarding revenue recognition
4. Analysis of in-kind property exchanges
5. Accounting for revenues from personal services
B. SALE OF GOODS
– Revenue earned by the sale of goods is relatively straight forward yet it still provides some difficult theoretical
problems, but accountancy has developed a practical solution: Book revenue when the good is delivered
– Recognition (timing) is do central to accounting that many use the word “accounting” to refer to timing
– In most sales the key point is when the order is received, consider the timeline of a simple sale of a good, an
argument can be made that revenue is earned at any points in time:
1. Idea for the product
2. Development of product
3. Marketing of product
4. Manufacturing begins
5. Specific good is made
6. Order is solicited
7. Order is received
8. Good is shipped
9. Good is delivered
10. Invoice is sent to customer
11. Customer mails payment
12. Payment is received
13. Check clears
14. Return period for full refund expires
15. Warranty period lapses
16. Period in which seller can be sued with respect to the product lapses
– GAAP uses the delivery rule for two reasons: (i) It is easy and clear to apply, and (ii) it facilitates matching
sales revenues with cost of goods sold expense (determined using a periodic inventory accounting method that
is based on counting a physical inventory)
C. GENERAL REVENUE RECOGNITION PRINCIPLES

– GAAP’s recognition rule reflects a compromise between measuring economic activity and just reporting cash
flows, accountants need an event that is clearly defined and verifiable on audit to demonstrate both that
economic activity has occurred and that there is a clear value associated with that activity
– Delivery demonstrates that most of the earning underlying the sale has been completed and that a third person
has put a price on that activity
– The terms under which a business sells and acquires goods and services can be quite manipulable, accounting
rules that put endue emphasis on when cash changes hands would allow businesses considerable flexibility and
would result in books differing between firms solely as a consequence of payment terms
– In 1999, the SEC put out a rare substantive accounting pronouncement called Staff Accounting Bulletin 101
(SAB 101) which provided the following rules for recognition (all conditions must be met):
1. Persuasive evidence of an arrangement exists (assures that the transaction is sufficiently real
to support revenue recognition
2. Delivery has occurred or services have been rendered (the work horse of the four, practical
considerations have demonstrated that it is the right rule here)
3. The seller’s price to the buyer is fixed or determinable (functions similar to those served by
the first rule, recognition is to occur when there is evidence of value from a transaction with a
third party, only when a third party where its mouth is does a transaction support booking
revenue)
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4. Collectibility is reasonably assured (assures that the value in the transaction is real, Herzfeld
illustrates the problems when there is a reasonable possibility that the buyer might not pay)
– Channel Surfing: A manufacturer or wholesaler stuffs its distribution channel by delivering more goods to its
customers than it knows that the customers can sell in order to book the revenue (the extra goods probably will
be returned so the revenue is not really earned, but the practice is hard to police)
D. PROBLEMS: RECOGNITION
(1) Company A has a product available to ship to customers prior to the end of its current fiscal year. Customer Beta places
an order for the product, and Company A delivers the product prior to the end of its current year. Company A’s normal and
customary business practice for this class of customer is to enter into a written sales agreement that requires the signatures
of the authorized representatives of the Company and its customer to be binding. Company A prepares a written sales
agreement, and its authorized representative signs the agreement before the end of the year. However, Customer Beta does
not sign the agreement because Customer Beta’s purchasing department has orally agreed to the sale and states that it is
highly likely that the contract will be approved the first week of Company A’s next fiscal year. May Company A recognize the
revenue in the current year for the sale of the product to Customer Beta when (1) the product is delivered by the end of its
current fiscal year and (2) the final written sales agreement is executed by Customer Beta’s authorized representative within
a few days after the end of the current year?
(2) Company Z enters into an arrangement with Customer A to deliver Company Z’s products to Customer A on a
consignment basis. Pursuant to the term of the arrangement, Customer A is a consignee, and title to the products does not
pass from Company Z to Customer A until Customer A consumes the products in its operations. Company Z delivers product
to Customer A under the terms of their arrangement. May Company Z recognize revenue upon delivery of its product to
Customer A?
(3) Company A receives purchase orders for the products it manufactures. At the end of a given year, customers may not yet
be ready to take delivery of the products for various reasons. These reasons may include, but are not limited to, a lack of
available space for inventory, having more than sufficient inventory in their distribution channel, or delays in customers’
production schedules. May Company A recognize revenue for the sale of its products once it has completed manufacturing if
it segregates the inventory of the products in its own warehouse from its own products?
(4) Company R is a retailer what offers “layaway” sales to its customers. Company T retains the merchandise, sets it aside
in its inventory, and collects cash deposit from the customer. Although Company R may set a time period within which the
customer must finalize the purchase, Company R does not require the customer to enter into an installment note or other
fixed payment commitment or agreement when the initial deposit is received. The merchandise generally is not released to
the customer until the customer pays the full purchase price. In the event that the customer fails to pay the remaining
purchase price, the customer forfeits its cash deposit. In the event the merchandise is lost, damaged, or destroyed, Company
R either must refund the cash deposit to the customer or provide replacement merchandise. When may Company R recognize
revenue f r merchandise sold under its layaway program?
(5) Company M is a discount retailer. It generates revenue from annual membership fees it charges customers to shop at its
stores and from the sale of products at a discount price to those customers. The membership arrangements with retail
customers require the customer to pay the entire membership fee (e.g., $35) at the outset of the arrangement. However, the
customer has the unilateral right to cancel the arrangement at any time during its term and receive a full refund of the initial
fee. Based on historical data collected over time for a large number of homogeneous transactions, Company M estimates
that approximately 40% of the customers will request a refund before the end of the membership contract term. Company
M’s data for the past five years indicates that significant variations between actual and estimated cancellations have not
occurred, and Company M does not expect significant variations to occur in the foreseeable future. May Company M
recognize in earnings the revenue for the membership fees and accrue the costs to provide membership services at the outset
of the arrangement?
(6) The preceding five questions came from SAB 101. What does it say about FASB, and private standard-setting in general,
that these questions were unanswered in 1999?
(7) Section VIII.G discussed Halliburton’s accounting for cost overruns covered by government contracts. Was the method
that Halliburton changed to proper?
E. ACCOUNTING AS NATURAL LAW

– GAAP require that a transaction with a third party demonstrate that earning really has occurred before the
revenue can be booked
CASES
Tooey v. C.L. Percival Co. “Dispute Over Definition of ‘Net Profits’ in Employment Contract”
The term “net profits” only applies to profits from recognized earned income during the year
The plaintiff Tooey (“Tooey”) was hired as the manager of the paper and woodenware department at the defendant’s
company at which time they entered a contract that would pay a weekly salary plus 25% of the net profits of his department.
One of Tooey’s duties included purchasing merchandise. After the defendant quit, his contract was terminated on Dec. 31 st
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1916, and the company stopped paying both his salary and the 25% net profits. Tooey contends that the term “net profits”
requires him to be paid two additional sums: (1) an extra 25% of $8,788.69 (the cost of the merchandise purchased during his
last year of employment but not delivered until the year later) and (2) 25% of $18,781.16 the difference between the cost
price and the market value of merchandise on hand in the department.
These contentions are not consistent with practical bookkeeping. For the last year of Tooey’s employment, neither of these
values would appear on nor be a factor in the company’s balance sheet. Tooey is claiming that he is entitled to a percentage
of net profits that might be expected to appear in the next year’s financial statements, and this was certainly not within the
contemplation of the parties or the terms of the contract.
The term “net profits” as used by the parties was never defined or discussed by them. In the science of bookkeeping net
profits of a business are reduced to actual possession, in the form of cash or completed sales. Undelivered goods and
differences between purchase price and market values of merchandise are not considered profit except in a speculative sense.
To think otherwise would be to confuse profits with property, when an asset is sold for above cost profit is accrued; profit is
not accrued because an asset could be sold for above cost. The word “income” means what has come in, it must have been
received. “Net profit” means the difference between income and outgo, which must be calculated by consummated sales.
In addition, when terms of a contract are in dispute the court should enforce the practical construction that the parties placed
upon those terms during execution of the contract. During other periods of Tooey’s employment the 25% was figured without
these additional figures. Therefore the court finds no justification for either the inventory or balance sheet taking a different
form for the year of the plaintiff’s termination.
F. NOTES AND PROBLEMS: TOOEY AND INCENTIVE COMPENSATION

(1) As a matter of contract law, is Tooey properly decided?
(2) Although it is not likely, assume that Tooey had counsel. Do you think Tooey’s counsel thought that she was getting
anything but GAAP earnings? If so, how could she have made the intent more clear? Would competent counsel have let
Tooey sign the contract?
(3) As a business matter, is the Tooey contract, as interpreted by the court, the contract that you would draft to give Mr.
Tooey a piece of his economic contribution to the C.L. Percival Co.? If not, what would you do differently? Think through the
incentives for Tooey (the company) to modify behavior in order to increase (decrease) Tooey’s compensation under various
contract provisions. Remember to be practical.
(4) Designing incentive compensation for key employees of businesses is a difficult art. Reflect on how using GAAP in such
contracts—and, generally, on how using GAAP to evaluate management—effects management’s behavior. These contractual
incentives are not reflected in the efficient capital markets hypothesis. Note that if the hypothesis is wrong and the market
relies heavily on book earnings (regardless of their content) in valuing corporate stick, shareholders would want
management to focus on book earning, so that incenting senior management (those in a position to have a material impact on
book earnings) to increase GAAP earnings would make perfect sense.
G. INCENTIVE COMPENSATION: STOCK OPTIONS AND RESTRICTED STOCK

– Stock Options: An employer awards an employee an option to buy stock of the employer at some price above
that at which the stock was trading on the grant date, avoid the need to draft complicated provisions to measure
an employee’s effectiveness
– In the last economic boom the most popular form of incentive compensation was stock options, employees were
rewarded for the general performance of the employer
– The smaller the role of an employee in the total corporate business, the more remote is the connection between
the employee’s performance and the employer’s stock value and the less incentive the stock option provides for
the employee to do their job better
– Stock options cost the employer no cash and there are tax and accounting advantages to using them: for
financial accounting purposes, no expense is ever required when stock compensation is used (Microsoft’s 2002
income was 45% higher than it would be with expensing of all stock-based compensation)
– In 2004, FASB adopted mandatory expensing of compensatory options, but the SEC delayed the effective date
of the rule, and may do so indefinitely
– Stock options have been blamed for some recent economic ills, managers are viewed as being more concerned
with protecting the value of their options than with managing the company (options also give managers reason
to manipulate the books and mislead investors), options also encourage risk taking since if managers win the
stock value goes up, but bear no loss once the stock value goes below the exercise price specified in their option
– There are also problems with trying to evaluate employee performing by using stock options, notwithstanding
hard-working and effective employees many companies’ stock plummeted in the recent recession, and to avoid
alienating the employees the companies had to reduce the exercise price on the options,
– Some companies have solved this problem, most prominently Microsoft, by switching to restricted stock plans
which issue employees shares that need to be returned if the employee quits within a certain time period, this
means that the employee gains even if the stock goes down but benefits more if the stock goes up
2
– Under GAAP the value of the stock at the time that the option was granted is treated as an expense pro-rated
over the restriction period (if an employee is granted $100 of stock, for which he must stay five years, there is a
$20 compensation amount (usually an expense) each year
H. PROBLEM: INCENTIVE COMPENSATION TODAY

Assume that you are in charge of CALPERS (the California Public Employees Retirement System). It provides pensions for
all employees of the State of California and is one of the largest institutional investors. CALPERS has so much clout that it
can influence the policies of public corporations. How would you want companies that you invest in to compensate key
employees?
I. IN-KIND EXCHANGES OF PRODUCTIVE ASSETS

– Cash is not the only thing that goods can be sold for such as in-kind trades where on good is traded for another
for another (common in the entertainment and dot-com industries, trading one advertisement for another)
– The most important accounting issue is what dollar amount is to be placed on the transaction, since no cash is
involved the businesses are probably giving each other a discount, but the current accounting practice is to value
the exchange as if one party paid cash market price to the other, who then paid the same amount right back in a
market transaction
– This may seem worthless since the revenue would have an offsetting expense and the transaction could
basically be ignored but there are reasons for it
1. Revenues are an important number for some businesses
2. The two parts of the exchange may not offset (a radio station that trades an ad for a new roof
from a construction company may gain an improvement rather than a repair and the offsetting
expense would be deferred)
– Another problem with associated exchanges is illustrated by the bad accounting that got many
telecommunications companies in trouble (including Enron and WorldCom): Huge amounts of fiber optic cable
capacity were acquires and the demand was never realized, the companies entered into contracts in which one
would allow the other to use its excess capacity in one region in exchange for the same use in another and
booked large valuations as revenue even though nothing was sold to a customer and probably never would be
– The exchange does not complete the earnings process and revenue was being booked that had not been earned,
the following two nonmonetary exchange transaction do not culminate an earnings process (these operate in
addition to the general rules of SAB 101, they provide that exchanges of nonmonetary assets that do not
culminate the earning process have no book effect so that the asset receives is treated as a substitute for the asset
surrendered):
1. An exchange of a product or property held for sale in the ordinary course of business for a
product or property to be sold in the same line of business to facilitate sales to customers other
than parties to the exchange
2. An exchange of a productive asset not held for sale in the ordinary course of business for a
similar productive asset
J. PROBLEMS: EXCHANGES
(Not Required)
(1) Did the accounting for exchanges of excess capacity in the telecommunications industry prior to SAB 101, discussed
above, comply with the APB pronouncement quoted above?
(2) Car dealers regularly swap cars when one has a car that the other has a customer for. What is the accounting treatment?
(3) An airline trades in 60 valuable, but fully depreciated (zero net book value), airplanes in partial payment for 60 new
planes. What is the accounting treatment?
(4) A real estate development corporation exchanges some vacant land that it has held as an investment for land that it
intends to build an office building on. What is the accounting treatment?
K. MULTIPLE ROLE TRANSACTIONS

(Not Required)
– In an exchange both parties are a seller and a buyer, whenever parties play both roles in a transaction they are
related for purposes of accounting for a given piece of the transaction and it may not really demonstrate that
earning has occurred
– Background for Lincoln Savings and Loan v. Wall:
1. The U.S. government charters banks and Savings and Loan institutions (S&Ls), and to protect
depositors the federal government provides insurance
2. Institutions are required to have adequate capital (net worth) determined on a balance sheet
(assets minus liabilities) basis
3. Historically S&Ls were small and specialized in making home loans to the local community,
S&Ls took money (deposits) from the community and relent it as home loans
1
4. Prior to 1989, the regulation of S&Ls was separate from and less rigorous than bank
regulation
CASES
Lincoln Savings and Loan Association v. Wall “”
L. NOTES AND PROBLEMS: LINCOLN SAVINGS

(Not Required)
(1) Before going on the bench, Judge Sporkin was a very tough head of enforcement for the SEC. In this role, he was
outspoken in advocating that lawyers and accountants involved in regulatory matters have a duty to protect the public good
that can override the professionals; duty to pursue the best interest of their clients. This view is evident in the Lincoln
Savings opinion. Stanley Sporkin was widely criticized as trying to convert the bar and accountancy into police. How do you
think that he would have dealt with Herzfeld in Section V.M? (The death penalty is not available for violations of the federal
securities law.)
(2) The Lincoln Savings opinion only scratches the surface of the exploits of Charles Keating. He is most well known for his
improper involvement with five senators (referred to by the media as the “Keating Five”) in order to get them to interfere
with the investigation of Lincoln Savings. One consequence of this involvement was the Washington interference with the San
Francisco FHLBB investigation, referred to in the opinion. Another deed of Keating was arranging for Lincoln Savings to
sell ACC junk bonds in a way that investors thought that the bonds were federally-insured certificates of deposit. Many
people lost lots of money when ACC went broke. In short, Charles Keating running into Stanley Sporkin was a King Kong vs.
Godzilla matchup for ‘80s.
(3) A tax sharing agreement is required whenever a group of corporations file a consolidated federal income tax return. With
a consolidated return, the tax owing is determined by the group and not separately for each corporation. A tax sharing
agreement allocates the group’s tax liability among the group’s members. The Lincoln Savings tax sharing agreement’s
allocation of federal income tax liability to Lincoln Savings based on its GAAP income would not have been respected under
relevant federal income tax law. Any good corporate lawyer, and Judge Sporkin is a very good corporate lawyer, would
know this. The Lincoln Savings agreement’s inconsistency with tax standards alone would have made Judge Sporkin’s
argument that the agreement demonstrated that Lincoln Savings’ management was operating the S&L inappropriately.
Judge Sporkin took a different tack, however, and trashed the actual application of GAAP by Lincoln Savings and its
auditors. In light of the relationship between GAAP and the federal securities laws (as discussed in Sections VI.M and VI.N),
why do you think that the former SEC enforcer wanted to make a point about GAAP in action?
(4) Were the four basic transactions (Wescon, Philip Gordon, Memorex, and GOSLP) booked improperly under GAAP?
M. SERVICE BUSINESSES
(Not Required)
– Despite the fact that service businesses have been around forever the applicable accounting rules are not
completely settled and accounting for services under GAAP can be quite challenging, for example firms
providing medical care, transportation, architecture, entertainment, accounting, legal services, consulting, etc.
(this does not include financial services like lending money, taking risks, and net leasing)
– Accounting has not been forced to fully confront services accounting, financial accounting arose so that capital
users could account to capital providers (accountancy only entered the big time when big corporations and
public capital markets emerged and grew)
– Services businesses were different from big business, they were traditionally small and used little capital, but
recently they have needed more capital for computers, software, and other investments
– Few service businesses have publicly traded stock but there is even talk of law firms going public, as they go
public they will begin to require certified financial statements and GAAP will not be able to be ignored for
much longer
– SAB 101 only requires that services be rendered, which makes accounting for services difficult because there is
no nice event that mark the recognition of services revenue
EXAMPLE
At a law firm economic earnings occur as the firm’s lawyers put in time, which suggests that the firm should accrue revenue
as lawyers put in time, but there are problems: (i) The firm may not bill all of the time expended on a clients behalf (in which
case it would be better to wait and book revenue when bills are sent out), (ii) at the time services are provided there may not e
a “fixed price” (in which case it would be best to wait and book revenue when payment is received), and (iii) at the time a
trial is won there may still be the possibility of appeals (in which case it would be best to wait to book revenue until all
appeals are exhausted)
– The lack of guidance on GAAP for services is widely acknowledged, the language in SAB 101 does provide general
guidelines but does not answer the hard questions in service transactions of when services are performed and when
the price is fixed or determinable
– SAB has one example of when service should be rendered:
1
1. Services revenue should be recognized on a straight-line basis, unless evidence suggests that
the revenue is earned or obligations are fulfilled in a different pattern, over the contractual
term of the arrangement or the expected period during which those specified services will be
performed, which ever is longer
2. Should recognize revenue on a straight-line basis unless evidence suggest that the revenue is
earned or obligations are fulfilled in a different pattern
– Standard accounting texts gloss over services
– Most service firms do not even try to apply GAAP , since they do not usually need certified financial statements
and are not required to use GAAP accrual accounting, frequently they will use the cash method discussed in the
preceding chapter
N. PROBLEM: ACCOUNTING FOR A CONSULTING BUSINESS

(Not Required)
The CONSULTING Corporation consults for various customers on a variety of matters, including health care. It enters into
one long-term contract on January 2, 2005 with HUGE, Inc. CONSULTING is paid $1 million upon entering the contract.
The contract requires CONSULTING, by the end of 2005, to come up with a plan that will save HUGE at least $30 million in
health care costs in 2006. If the plan is submitted to HUGE in a timely fashion and is successful, CONSULTING is to receive
an additional $5 million in 2007. CONSULTING must refund $500,000 if the plan is not timely. How should CONSULTING
account for revenue from this contract and related expenses?
O. CLASS NOTES
– At what point does a business earn money, so that they can book revenue, there are many options but the
general rule is upon delivery
– When you actually get something done (deliver the good, build the plant) things can still go wrong (lawsuit,
return) but by delivering you have done enough to book the revenue
– Channel stuffing allowed businesses to manipulate the delivery rule
– In 1999, the SEC put out SAB 101, which finally guided accounting as to when revenue can be recognized:
1. There is a real transaction
2. For real money
3. You are probably going to get paid
– Microsoft sells a product license (the software) but they also sell the tech support and the updates
1. Defer the revenue that is for customer service and updates
2. Achieves matching because the revenue is booked with the expense of the employees who are
providing the customer support
– When revenue recognition criteria is not met revenue is recognized as payments are received
– TOOEY: Percival Company hires a guy to be their buyer, want to make money by based on buying cheaply not
selling expensively, Tooey was realized as an important driver of profit because he was the man buying and the
company wanted to give him incentive to do his job well
1. They cut a deal that they are going to pay him 25% of the net profits
2. Based on GAAP they pay him the 25% based on the stuff sold while he was there
3. He wants to be paid the profits of the future for the items he purchased, because while he was
there the company was selling the products from his predecessor at a high price, which were
not bought at the cheap prices that he bought the stuff at
4. What are net profits in a legal sense, the contract never defined net profits
5. The principles of the science of the bookkeeping restrict the profits of any business to such
profits that have been reduced to actual possession in the form of cash or its equivalent by
completed sales
6. When accountants talk about net profits it is reasonable to assume the are using standards
from GAAP
7. The reason it was never defined was because everyone knew what it meant, the only problem
was that no one expected him to quit so soon (over 20 years the difference would be minimal,
but since it was only a few months it became problematic)
8. If LIFO had been used it would not have been a big deal either, but FIFO was the standard
and was what everyone used back then
9. Lesson is to not leave any term definition to anyone other than yourself when drafting
contracts
– Stock options and incentive compensations is when businesses give their management options to buy stock at
today’s price at some point in the future (if stock goes up they can make money, if it goes down they do not lose
anything)
1
– The problem occurs when the stock goes down even though the management is doing a good job, which can
frustrate the employees: One solution has been to give the employees free stock, that has to be returned if they
leave within a certain time period
– Management manipulated this by backdating options
– Instead of paying employees cash, companies gave out stock options which made executives want to manipulate the
stock
– Tax rule was that expense was booked at exercise but the theory of accounting was that it was capital
– Accounting rules are so bad for high tech markets that it is impossible to tell what companies are making money and
what are losing money
1
- CHAPTER XI: INTANGIBLES -

A. VALUE IS GETTING HARDER TO SEE
– Financial accounting developed to report on low-tech (by contemporary standards) businesses that sell goods
– Businesses in the new economy present tough accounting issues
– Modern day businesses make money in new ways, known as “intangibles”:
1. Marketing and branding
2. Intellectual property
3. Human capital, know-how, and training
4. Technology, patents, and copyrights
B. DISCUSSION PROBLEM: A LOAN OFFICER MEETS INTANGIBLES

You are a loan officer at a bank. Under applicable rules of your bank, you can make one more $1 million loan this year.
There are two prospective borrowers: The first is The Bolt Company, whose balance sheet is set out above in Section V.B.
The second is a high-tech firm that has no material assets other than a patent that it developed for a tool that radically
simplifies genetic engineering, It plans to license the technology to an established manufacturer of similar tools so as to
collect large royalties. Prospects are quite good. Assume that both firms will pay the same rate of interest. Your job is to
make the loan that the bank is most likely to collect on. To evaluate the likelihood that the borrower will have cash available
and make required loan payments, but also the saleability and value of the borrower’s assets should the borrower default
and a foreclosure sale be necessary. How do you decide which of the two businesses to lend to?
C. THE CURRENT REGIME

– Usually lawyers think of intangibles as stocks, bonds, mutual funds, receivables, etc. but these are not called
intangibles by accountants, to accountants there are two types of intangibles:
1. Identifiable (patents, copyrights, and trademarks)
2. Non-Identifiable (goodwill and going concern value, which is the value from having the
business up and running), which are not represented by anything and cannot be sold
separately from the company
– Under a finance valuation the value of a business is the present value of the expected future cash flow, therefore
per se assets are irrelevant because two companies with the same assets can have two very different values
depending on their earning potential
– A good reputation, well-trained employees, non-patentable technology, and other intangibles can make one
business more profitable than another with similar assets
– An asset appears on the books when an expenditure is deferred rather than immediately expensed, intangibles
are not so simple
– With intangibles the easy answer is to treat them like repairs and improvements by capitalizing those
expenditures that are associated with value that will be realized in future years, although it may turn out to be
more difficult than expected
– Research and development (“R&D”) expenditures present problems similar to those presented by advertising,
successful advertising can be a gold mine, but most either fails or has limited success (GAAP expenses all
R&D)
– GAAP does book intangibles in one important situation: When a business is acquired at a purchase price that
exceeds the total fair market value of identifiable assets (tangible and intangible), where the excess debit is
accounted for by using “goodwill”
– Goodwill: A bookkeeping entry that is required so that the debits equal the credits
EXAMPLE
The Bolt Company is sold, at which time its assets’ fair market value is as such:
Cash 100,000
Receivables 300,000
Inventory 800,000
Property, Plant and Equipment 1,700,000
2,900,000
If the company is sold for $5.65 million, to make things balance there must be $2.75 million accounted for, those
unidentifiable assets are considered goodwill.
– Under SFAS 141 the basic principles of SFAS 121 discussed in Section VIII.S, apply: The intangibles must be
reviewed yearly for impairment, which exists when the acquired business is not generating the excess earnings
for which the buyer paid a premium (if there is an impairment, the intangibles must be written down
accordingly, with an associated expense)
– In the case of intangibles depreciation is normally known as “amortization” (technically, amortization is just a
cost allocation, while depreciation is an allowance for an anticipated loss in value)
– Intangibles generally are riskier and less fungible (marketable) than tangible assets
1. Intangible value can seem less real and much less connected with related expenditures
3
2. Matching is more difficult with intangibles (when matching is unclear, expensing is the
default rule)
– The U.S. rules for intangibles are more conservative than international rules for competitors, for example IASB
allows capitalization and amortization, over five years or so, of development (but not research)
– Tougher U.S. rules burden U.S. companies in competing for capital in the increasingly international capital
markets
D. ACCOUNTING DIFFICULTIES FROM INTANGIBLES; TO WIT, THE TECH BUBBLE

– In hindsight, the tech bubble and its demise all seem obvious because highs-tech companies invest in their
businesses, not by buying machinery, but by building intangibles like technology, know-how, and human
capital
– The costs of intangibles are expensed so a high-tech company that is doing well economically shows as little
profit on its financial statements as a business that is doing poorly
– Financial accounting for income does not help investors
– During the tech bubble investors gave up on financial accounting and SEC-required disclosures and instead bet
on a company’s management team or product, until it was realized the companies were never going to throw off
cash as to have real value
– FASB is doing little about self-developed intangibles (accountants lack the expertise to deal with them and
companies do not want to release information that is not required out of fear of losing a competitive advantage)
E. PROBLEM: ACCOUNTING AND THE REALITY OF INTANGIBLES

Review Section XI.B. Under current GAAP, the high-tech firm’s financial statements show little net income (because of the
expensing of all of the R&D associated with developing the patent) and report few assets and little net worth. Does this
change your analysis as a loan officer? Would it if you knew little about the value of the high-tech firm’s patent? Do you
think that the efficient capital markets hypothesis applies to loan officers?
F. PROBLEM: R&D
An automobile company undertakes the development of a new hybrid car that can use either electric batteries or fossil fuel.
The project ultimately succeeds and an hybrid car is produced. Expenditures are incurred as follows:
(1) Doing basic laboratory work on electromagnetism.
(2) Doing basic laboratory work on integrating the two power units.
(3) Designing a prototype.
(4) Building a prototype.
(5) Testing a prototype.
(6) Designing the production model.
(7) Engineering the production process.
(8) Testing the production model.
(9) Doing further testing required by government agencies to be permitted to sell car in U.S.
Which of these expenditures should be expensed? Which are expensed under SPAS 5 (as described in Note 5)?
G. PROBLEM: THE INTANGIBLES OF THE BOLT DIVORCE

Reconsider the Bolt divorce described in Problem V.E. Do you want the other lawyer to understand the economics of
intangibles?
H. GOODWILL FOR AMERICA’S SWEETHEART

– Intangibles are of interest whenever one is trying to value businesses and interests therein
CASES
Piedmont Publishing Company v. Rogers “Television Station Buyout Option”
Piedmont Publishing Co. (“Piedmont”) and Mary Pickford Rogers (“Pickford”) were rival applicants for a license from the
Federal Communications Commission for a television station in Winston-Salem, NC. The two decided to pool their interests
and organized a corporation, Triangle Broadcasting Corporation (“Triangle”) under NC law in order to apply for the license
together. Triangle was awarded the license and an exclusive local contract with the National Broadcasting Company
(“NBC”).
1
Piedmont owned 1,000 shares of stock, valued at $100,000 and Pickford owned 500 shares valued at $50,000 (in fraction
form Piedmont owned 2/3 stake and Pickford 1/3 stake in Triangle). The agreement gave Piedmont an option to buyout
Pickford, which Piedmont exercised.
The controversy in this case is over enforcement of Piedmont’s option and the formula to determine the purchase price to be
paid by Piedmont:
An amount per share of stock equal to the sum of the two following items, divided by the number of outstanding
shares of the corporation:
(1) An amount equal to the total book value at the beginning of any such period adjusted to reflect an annual
depreciation and obsolescence charge of not over 10% against such tangible assets as having been depreciated on the
books at a higher rate; and
(2) An amount determined by multiplying the average net annual profits of Triangle by five.
Pickford alleged the purchase price computed by Triangle’s accountants was inadequate and unfair and the formula was
inappropriately applied. Harry Borthwick (“Borthwick”) an accountant, and partner at Ernst & Ernst, computed the option
price. The trial court found:
(1) Triangle’s accountants correctly interpreted the option, and properly applied the formula
Pickford contended that it was error in connection to:

(1) The true market value of Triangle’s television station when the option was exercised was $1,270,548.23, which
would make the Pickford’s option price around $400,000 not the $86,000 calculated by Borthwick
(2) In computing the option price neither the accountants nor the trial court included goodwill in the total book value
(3) The components of goodwill should include (i) the fair market value of the telecasting license, (ii) the fair market
value of the television station, and (iii) the fair market value of Triangle’s contract with NBC
The question presented is whether goodwill should be included in the book value of Triangle. Past decision appear to be in
conflict about the answer, however in contract law the parties’ intent controls the meaning of the contract terms. The contract
uses the words “total book value” in the formula. By adding the word “total” the parties meant to include the value of
Triangle’s intangible assets.
The court feels that Piedmont intended to pay Pickford a fair price for her involvement in securing the license and making the
station a success, which means everyone intended to include goodwill. Since Borthwick gave no consideration to goodwill in
his computation it must be reconfigured.
This case does not hold that goodwill must be included in all buyout options, only that the parties involved intended for it to
be when they created the contract when the used the term “total book value.”
I. THE ECONOMIS OF PICKFORD

– Since 1955 there have only been three major television networks: ABC, CBS, and NBC
– In markets where a greater number of stations exist each national network enters into an exclusive affiliation
contract with one station in that market, which is advantageous because:
1. The network provides programming
2. The network promises the station to offer it first call for all programs broadcast in that
community
3. The network pays the station a percentage of the national advertisement revenue
– Commercial television is dependant on advertising revenue
– Network programming has substantially exceeded local programming in attracting viewers
– Network affiliation has an intangible value associated with both attracting viewers and advertisers
J. NOTES AND PROBLEMS: PICKFORD

(1) Note that Judge Drapeau, unlike the Iowa Supreme in Tooey in Section X.E, ignores GAAP when accounting is involved
in interpreting a contract. Is it relevant that Pickford involved valuation, while Tooey involved a more technical concept, net
profits? Is it relevant that Pickford presumably knew little accounting (although presumably her advisors did), while Tooey
was knowledgeable in accounting?
(2) Why was Pickford involved in the television station in the first place?
(3) In this light, why do you think that the option contract price was the sum of book value plus capitalized earnings?
(4) Did matters play out as was expected at the time that the contract was drafted, particularly given the early exercise of the
option?
(5) If the parties had intended to use fair market value option prices, how would the contract have been drafted? Could Ernst
& Ernst have determined fair market value? Would either party have trusted a formula or one person to determine market
value? As a lawyer interested in a clear and workable contract, would you prefer a book or market value option price?
3
(6) Piedmont’s lawyers could not have been much clearer in saying that they wanted GAAP value. Pickford presumably had
very competent counsel. Thus, is Judge Drapeau right as a matter of contract law?
(7) Pickford’s lawyers probably did not understand what a bad contract she was signing. Judge Drapeau saved them, but
they were lucky. There is a message here: A lawyer cannot rely on others to understand a transaction and its accounting and
explain it to the lawyer. Without knowing accounting and finance, the lawyer cannot ask the right questions or be guaranteed
of grasping the answers.
K. ACCOUNTING IS POWER
(Not Required)
L. NOTES AND PROBLEMS: WINSTAR

(Not Required)
M. PRE-OPENING AND START-UP “EXPENSES”

(Not Required)
N. PROBLEM: ADVERTISING EXPENDITURES

(Not Required)
O. CLASS NOTES
– Intangibles: Assets that aren’t represented by anything normally thought of as an asset
1. Identifiable: Trademarks, patents, copyrights
2. Unidentifiable: Goodwill
– A company with incompetent employees and bad management is going to make less money than a business that
has the exact same assets but well trained employees and good management
– Real technology is patents, copyrights, trademarks, covenants not to compete
– How do we account for intangibles, there is no real cash value since you can not sell a trained work force, they
are also hard to value and once you do value it, it is very risky because if something happens and the company’s
name is tarnished the value can drop excessively
– Non-identifiable: Goodwill, you cannot sell it or get rid of it the only way to sell it is to sell the entire business
(can sell technology or knowledge but some stuff cannot be sold and that is goodwill)
– Problems include different accounting rules for tangibles and intangibles (if a business puts up a sign it has an
asset, but the money spent on what to put on the sign is an expense)
– US rules are different that foreign rules (R&D must be expensed in the US)
– When you build inventory or a facility you capitalize all building costs
– When you build a patent you cannot capitalize R&D costs
– Businesses that grow by buying assets go up on the books while companies that build by advertising appear stagnant
or go down
– When you buy a business there is a transaction and the accountants allow goodwill to be put on the books
– Under the 2002 rules you test the goodwill for impairments periodically
– Microsoft goodwill (pg. 375)
– Tobacco companies won their legal battle that accountings rules should apply and book value should be the value of
the company, since goodwill is not included in the value they won arguments that they could not be held liable for
judgments that were for more than the company was worth
– PICKFORD: Piedmont and Pickford enter a deal for 2/3 and 1/3 respectively and a buyout option
– Tooey and Pickford were both problems that occurred in a short period of time
– GAAP is not good in the short term
– Had the contracts in these cases lasted over a long period of time there would be less of an issue
– GAAP assumes long term, that businesses are going to continue, it is hard to come up with short term solutions
using GAAP
3
- CHAPTER XII: CONTINGENCIES -

A. INTRODUCTION
– Conservatism, a key financial accounting principle, is an approach to uncertainty, which plays an important role
in GAAP (uncertainties as to when revenue is earned cause considerable accounting indeterminacy)
– Contingencies: Uncertainties arising out of events that have occurred already, which when resolved in the future
may result in either (i) legal liability or (ii) damage to or loss of an asset
1. Accounting rules for certain specified contingencies (two most important contingencies: (i)
Pension and retirement benefits and (ii) health care for retirees)
2. Basic approaches to SAFS 5 (SFAS 5’s two most common items: (i) Bad debts and (ii)
lawsuits)
3. How GAAP’s rules for contingencies facilitated the troubling management of earnings by
various companies
B. SFAS 5
– The current rules for contingencies are contained in the very important SFAS 5
– Consistent with accounting conservatism, gain contingencies—uncertain future gains—are not booked until
recognized
– Loss contingencies are events that (i) occurred prior to the end of the reporting year and (ii) may result in a cash
loss or an asset’s value being impaired at a future time
– The key rule of SFAS 5 is an estimated loss from a loss contingency shall be accrued by a charge to income if
both of the following conditions are met:
1. Information available prior to issuance of the financial statements indicates that it is probable
that an asset had been impaired or a liability had been incurred at the date of the financial
statements
2. The amount of loss can be reasonably estimated
– A statistician might want to book liability discounted by the risk, but FASB books (i) the entire liability, if
probable, or (ii) nothing, if not probable
– Accountants interpret “probable” as 75% likely (a very high degree of certainty)
– Disclosure is not necessary if the matter is less than 20% likely
– If the probability is between 20% and 75% likely it must be discussed in the notes
– The right-or-zero approach to measurement leads to troubling outcomes: If a liability is huge and highly likely,
but cannot be reasonably estimated, zero is automatically the right estimate (why this is right is not obvious)
– Some of Enron’s games involved SFAS 5
C. PROBLEMS: SFAS 5
(1) How should possible warranty claims be accounted for? (In this light, reconsider the analysis in Section VII.K(1))
(2) How should the possibility that goods will be returned be accounted for? What does this say about channel stuffing,
which was discussed in Section X.C. Dreamworks stock value recently fell 14% in one day after the company announced
unexpectedly high returns of the DVDs of Shark Tales and Shrek 2.
(3) SFAS 5 can apply to the same assets as SFAS 121, discussed above in Chapters VIII and X. What is the relationship
between the two pronouncements?
(4) What does SFAS 5 say about the accounting for an announcement by the reporting business’s sole supplier of some
crucial commodity that the supplier will raise prices substantially next year?
(5) If a company commits a tort and carries partial insurance with regard to any potential liability, what is the accounting?
D. BAD DEBTS
– The most important role of SFAS 5 is as a backstop to the basic revenue recognition rules discussed above in
Chapter X (under SAB 101, discussed in Chapter X, revenue cannot be booked at all unless “collectibility is
reasonably assured”)
– When goods are delivered prior to cash being received accounting treats the associated receivable as a receipt
(under SAB 101 questionable receivables and associated revenues cannot be booked)
– Statistically even the best debtors sometimes do not pay their debts and SFAS 5 accommodates accrual
accounting to this reality by reducing the total receivables, and thereby reducing profits to reflect the estimated
portion of the receivables that will not be collected (known as “allowance for estimated uncollectible amounts,”
“allowance for estimated losses,” “allowance for doubtful accounts,” and most commonly “bad debit reserve”)
– If it is not possible to estimate future losses, revenue cannot be booked until cash or other property is received
EXAMPLE
3
A wholesaler’s experience may be as such:

It will collect 97% of non-overdue amounts, 85% of amounts overdue by two months or less, and 15% of amounts overdue
by more than two months. At the end of the year the wholesaler examines its receivables and breaks them down by whether
they are overdue and by how long.
$1,000,000 non-overdue (3% estimated uncollectible) $30,000
$200,000 overdue two months or less (15% estimated uncollectible) $30,000
$100,000 overdue by more than two months (85% estimated uncollectible) $85,000
(total estimated uncollectible) $145,000
– The wholesaler must fully account for its receivables with further adjustments for the books at the beginning of
the current year that already reflected a write-down for the preceding year’s estimated amount of collectible
amounts (during the current year, actual, specific receivables became wholly or partially worthless)
– Realized losses are charged against the allowance for estimated uncollectible amounts, reducing the allowance,
rather than expensed, as if the losses were payments on the allowance quasi-liability (at the end of the year the
allowance is likely to have been nearly or completely exhausted by losses realized during the year)
– If the cumulative amount of bad debt losses realized during a year exceeds the beginning-of-year balance of the
allowance for estimated uncollectible amounts, the excess losses are expensed when realized, which causes a
smaller current-year profit (conversely, if the business collects more than expected less will have to be added to
the allowance at year end and profits will be bigger for the current year)
– To an accountant the allowance for estimated uncollectible amounts is analogous to depreciation:
1. A business asset is worth less than its historical cost
2. An estimate based on past experience is made
3. A special write-down is made to reflect expectations
4. Adjustments are made as matters play themselves out
– The allowance for uncollectible amounts serves two functions:
1. It effects matching (the portion of the allowance for a year that relates to sales made during
the year thus matched the current year’s sales made during the year thus matches the current
year’s sales revenues with the losses expected to be realized in the future as a consequence of
the current sales)
2. Allowance serves conservatism (it is overtly optimistic to book all current sales revenue when
it is known that all will not be collected)
– Financial statements do not present an overly optimistic picture of the business
E. PROBLEM: ALLOWANCE FOR ESTIMATES UNCOLLECTABLE AMOUNTS

A firm’s allowance for estimated uncollectible amounts at the beginning of the year is $30,000. During the year, it’s actual
losses are $29,000. The firm’s relevant collection experience is as follows:
Age % Collected
Under 1 Month 99%

Between 1 & 2 Months 90
Over 6 Months 35
Its year-end receivables are as follows:
Age Amount
Under 1 Month $1 Million

Between 1 & 2 Months 150,000
Over 6 Months 1,000
$1,176,000
What is the firm’s total expense related to bad debts for the year?
99% of $1,000,000 = $10,000
90% of $150,000 = $15,000
85% of $20,000 = $3,000
60% of $5,000 = $2,000
35% of $1,000 = $650
Total = $30,650
F. LITIGATION
1
– Lawyers run into accountants frequently when the accountants must reflect threatened or pending litigation on
the financial statements
– SFAS 5 reflects a careful, if questionable, balancing of (i) the concerns of the affected professions and (ii) of the
public interest in meaningful financial statements, Paragraph 10 provides: Disclosure is not required of a loss
contingency involving an unasserted claim or assessment when there has been no manifestation by a potential
claimant of an awareness of a possible claim or assessment unless it is considered probable that a claim will be
asserted and there is a reasonable possibility that the outcome will be unfavorable
– An unasserted claim need not be booked or even disclosed as long as it is not “probable” that the potential
claimant will assert the claim (a business could have a huge potential liability suit over a toxic waste spill, but
so long as it is not probable the information will get out no accrual or disclosure is required)
– As to an asserted claim SFAS 5 provides that the claim is booked only if (i) it is probable that the business will
lose the case and (ii) the amount of the judgment can be reasonably estimated
– Defense lawyers usually either think (i) they are going to win or (ii) they cannot guess what a judge or jury will
award if they lose
– Very few reserves are established for litigation losses (if a pending lawsuit is not a joke a footnote is to the
financial statement is required)
– The American Bar Association and the AICPA negotiated a 1976 “treaty” controlling the professions’
respective procedural responsibilities, the key to which is the “audit letter” sent by management to lawyers
– Audit Letter: List of all material asserted claims and unasserted claims (with descriptions and evaluations),
management has decided must be disclosed under SFAF 5, presented to the auditor during an audit (the auditor
assumes management has consulted with its attorneys in connection with the list)
– Management sends an audit letter to the attorneys, based on matters to which the attorney gave substantive
attention, and asks for (i) either the attorney’s comments on the management-prepared list of asserted claims or
the attorney’s own list of asserted claims and (ii) the attorney’s confirmation of the completeness of
management’s list of asserted claims
– If the attorney does not reply or refuses to confirm the auditor will not certify the financial statements
– The ABA encourages attorneys to reply that they cannot evaluate a claim, unless it is extraordinarily clear (if
the attorney so declines to comment managements treatment is usually adopted)
– For unasserted claims the attorney must communicate to management, but not the auditor, if they believe that
the evaluation is incomplete
– If management does not disclose to the auditors facts involving matters to which the attorney gave substantive
attention and believes must be disclosed, the attorney should resign (which usually gives notice to auditors)
– Attorneys never have to deal directly with auditors and so the attorney-client relationship is protected
– The limited disclosure requirements in Paragraph 10 of SFAF 5 means that accountants do not find out about
remote unasserted claims
G. PROBLEM: AN ATTORNEY AND AN AUDIT

The EMERGING company is about to try to sell its stock to the public for the first time (an Initial Public Offering).
EMERGING has used a small accounting firm thus far. Now, in order to facilitate SEC clearance of the IPO, EMERGING
has retained a Big 4 accounting firm. Because EMERGING is small, the Big 4 firm has assigned its most junior manager,
just out of school, to the firm’s first audit of EMERGING.
You represent EMERGING in defending high-profile product liability litigation. The rookie manager wants to review your
entire file and demands a letter from you that provides your evaluation of the case, including dollar amounts and
probabilities. He threatens that, if you do not comply, he will block certification of EMERGING’s financial statements and
will report EMERGING to the SEC. EMERGING’s management really wants the IPO and, thus, wants to make the new
auditors happy in order to get them to certify EMERGING’s financial statements. What do you tell your client about how you
and it should deal with the new auditor?
Tell the auditor: Read your own rules and the treaty, which says the company does not need to disclose the
information.
Tell the client: They should call the manger’s boss and make noise about him trying to implicate them in
problems that they do not legally need to disclose
H. EARNINGS MANAGEMENT
– SFAS 5 reflects conservatism since loss contingencies are booked while gain contingencies are not, however
this conservatism also makes it much easier for management to engage in troubling earnings management
– Earnings Management: Management makes an early year look worse in order to make a later year or years look
better by accelerating expenses into (of deferring revenues out of) the current year, thereby taking expenses out
of (or pushing revenues into) future years
– Many mangers believe that the market prefers companies whose earnings increase smoothly, to smooth out the
results of two or three years revenue can be deferred or expenses can be accelerated
– SFAS 5 is a perfect tool for overestimating the allowance for estimated uncollectible amounts, the excess is an
expense in the year booked and in later years the losses realized can be charged against the excess allowance,
which increases profits in the later years
1
– A reserve, while technically a liability or an offset to an asset account, is similar to a bank account that does not
appear on the financial statements, and managed earnings are therefore sometimes referred to as “cookie jar”
accounting
– Big Bath Accounting: A company sets up a large reserve in an initial year (the big bath), just to be able to
charge future costs to the reserve (the bath year is usually a year in which the market is already expecting bad
news, because more bad news till not hurt the stock price much)
– The most famous abuse of reserves occurred at WorldCom: WorldCom reduced accrued expenses, reserves, so
as to artificially increase earnings $3.3 billion over two years
– The Report of Investigation by the Special Investigative Committee of the Board of Directors of World Com,
Inc. tells the story of WorldCom’s reserve manipulation:
1. Line Costs: the costs of carrying a voice call or data transmission from its starting point to its
ending point
2. Most of WorldCom’s residential and commercial calls outside urban areas must flow through
non-WorldCom networks, and they must therefore pay an outside service provider for carrying
some portion of its calls
3. Line costs are immensely important to WorldCom’s profitability because they are its single
largest expense (from 1999 to 2001 they accounted for approximately half of the Company’s
total expenses)
4. Each month WorldCom had to estimate the cost associated with use of non-WorldCom lines
and facilities, although the relevant bills may not be realized or paid for several months
(WorldCom was forced to recognize the estimated costs immediately and treat them as an
expense for financial statement purposes)
5. In accordance with proper accounting procedures WorldCom set up a liability account known
as an “accrual” on its balance sheet, as bills arrived they WorldCom would pay them and
reduce the accruals accordingly
6. Since accruals are based on estimates they must sometimes later be adjusted, and line costs
accrual estimates are very difficult to make (particularly for foreign telecommunications) and if
payments are running higher than the estimated amounts, the accruals should be increased (if
lower, they should be decreased)
7. WorldCom manipulated this process in three ways: (i) Releasing accruals without any apparent
analysis of whether the Company had actually had excess accruals in its accounts, (ii) not
releasing accruals in the period in which they were identified, when they had excess accruals,
and (iii) reducing reported line costs by reducing accruals that had been established for other
purposes, a violation of the accounting principle that reserve created for one expense type
cannot be used to offset another expense
– WorldCom’s accrued line costs liability fell over $1 billion in 2001
– Other companies managed earnings more systematically, like Freddie Mac for whom the Baker Botts law firm
prepared an Internal Investigation of Certain Accounting Matters:
1. One of Freddie Mac’s principle financial goals was to achieve strong, stable earnings growth,
and they had a long-standing practice of making discretionary accounting judgments to
produce financial statements that closely approximated expert analyst’s estimates (they
believed they were free to do so under GAAP as long as the amounts were not quantitatively
material)
2. The general effect of this practice was to move their stock price to within one or two cents of
the estimates
3. The practice was directed primarily at a series of reserve accounts, especially the SFAS 91
amortization reserve, the legal or general contingency reserve, and the tax reserve
4. Maintenance of SFAS 91 is problematic in two ways: (i) The existence of the reserve was not
permitted under SFAS 91 and (ii) at one point the Company departed from its previous
practice and used a different methodology in calculating the reserve
5. SFAS 91 required that when actual payments differed from estimates a catch-up adjustment
was to be made, so Freddie Mac created a model to estimate the level of anticipated
prepayments and to calculate the amount of the catch-up amortization adjustments
6. The Chief Financial Officer enhanced the amortization model and the Company created a
reserve to absorb the differences between the estimated and actual prepayments and recorded
the catch-up adjustments to the reserve rather than booking them to the income statement as
required by SFAS 91
7. As the size of the reserve grew Arthur Anderson became uncomfortable with the process
– Enron is best known for cutting edge financial engineering but the first criminal indictment of Jeffery Skilling
focused on old-school earnings management:
1. Due to rising energy costs Enron’s profitability quickly increased by over $1 billion during
2000 and 2001, which if disclosed to the public would have made it apparent that Enron
Wholesale’s revenue was closely tied to the market price for energy (this would undermine
Enron’s description and presentation of itself as the dominant “intermediator” in the energy
markets, rather than a speculative trading company whose stock would trade much lower)
1
2. Skilling fraudulently used reserve accounts within Enron Wholesale to (i) mask the extent and
volatility of Enron Wholesale’s windfall trading profits, (ii) avoid reporting large losses in
other areas of business, and (iii) preserve earnings for use in later quarters so Enron could
meet analysts’ expectations
3. This plan was done solely to accomplish the goal of reporting a higher earnings per share
number than expected in order to artificially inflate Enron’s share price
I. DISCUSSION PROBLEMS: SMOOVE

(Not required)
J. CLASS NOTES
– Only book gain contingencies when they are recognized
– Loss contingencies are events that occur prior to the end of the reporting year and may have an effect on income
1. If it is probably that the loss has impaired an asset it should be booked (probable means more
then 75% likely)
2. A business is not required to book a liability unless there is both a 75% chance it will occur it
and the loss is estimable
3. When a loss is less than remote but more than likely (over 20% likely) it must at least be
discussed in a footnote
– Likely losses are discussed:
1. Enron: “Enron believes that the ultimate resolution of these matters will not have a material
adverse effect on its financial position or results of operation” (pg. 310-1)
2. GE: We may have to clean up pollution (pg. 532)
3. Microsoft: Anti-trust legislation in Europe, Microsoft denies these allegation and expects that
they will not have an adverse effect on financials (pg. 391)
4. WorldCom: Regulations may increase operating costs (pg. 415)
– Revenue recognition requires:
1. Persuasive evidence of an arrangement exists
2. Delivery has occurred or services have been rendered
3. The seller’s price to the buyer is fixed or determinable
4. Collectibility is reasonably assured
5. Does not count if you sell to a shell corporation or a sale that the buyer has the option to sell it
back
– Even if you sell to the very best customers there is still a chance that you will not get paid (it may be only a
small percentage but you need to take it into account)
1. Enron 3.03 billion with 40 million questionable
2. GE only booked about 97% of receivables
3. WorldCom sells to individuals so their paid-in capital is 53 billion with 3 billion debt reserve
– Microsoft views post-sale activity as a way they earn their money, as opposed to GE who does not
1. GE charges warrant costs to their reserve, they make money because of the warranty, they
consider that a reason why you bought the product and they book at the time of purchase
2. Microsoft sees themselves as making money on updates and they defer revenue they make on
the products (allocate the purchase price to take into account how much of the price the buyer
paid for the product and how much they paid for the updates)
– Lawyers do not want to have to deal with accountants directly so that they do not have to risk any violation of
confidentiality
– ABA and AICPA came to a treaty about how lawyers and accountants would interact with each other during a
companies audit
1. Being a defendant in a lawsuit is a loss contingency (you only have to book if it is probable or
75% likely and you can estimate the cost of losing)
2. Very few lawsuits hit the income statement until after a judgment has been handed down and
appeals have been exhausted (no defense lawyer is going to admit that either they will lose or
that they know the extent of how badly they will lose)
3. Disclosure is not required of a loss contingency involving an unasserted claim when there has
not been a manifestation by a potential claimant unless it is considered probable that someone
will assert a claim and there is a reasonable chance they will be successful (in other words, if
the business does not believe that they are going to be caught, they do not need to disclose it
because otherwise plaintiff’s lawyers could use the financial statements as ads for lawsuits)
4. Lawyers must communicate to management not the auditors about facts and unasserted claims
they believe should be included in the statements
– WorldCom created over $3.3 billion in profits by manipulating their earnings management
– Enron did not want their earnings to go up too much in one year (when they ripped off California) so they
manipulated their earnings to spread it out over future years
1
– Big bath accounting is purposely making a bad year look worse in order to make future years look better
1
- CHAPTER XIII: RELATED PARTIES -

A. THE SEPARATE-ENTITY ASSUMPTION
(Not Required)
B. INTER-BUSINESS EQUITY OWNERSHIP

(Not Required)
C. PROBLEMS: STOCK OWNERSHIP ACCOUNTING

(Not Required)
D. SPECIAL PURPOSE ENTITIES

(Not Required)
E. DISCUSSION PROBLEM “PRINCIPLES” AND FINANCIAL ENGINEERING

(Not Required)
F. CLASS NOTES
3
- CHAPTER XIV: -
- SUMMARY AND CONCLUSION -
A. TAKING STOCK
– Finance and accounting have not turned out to be as clear cut as one would hope
1. Finance is not the science it is supposed to be
2. Accounting is not the mechanical rules it is supposed to be
1. The basics of finance and accounting are reviewed one last time (emphasizing the useful
information they provide)
2. A critique of modern finance and accounting (not to undermine their value but to increase
knowledge of their usefulness to an attorney)
B. THINKING AND TALKING ABOUT BUSINESS

– This text has been about how one thinks and talks about businesses
– Businesses involve individuals pooling resources to produce (or acquire) and sell products or services, in which
complexities lie in:
1. The mix of resources used
2. The arrangements between those providing these resources
3. How these resources are used
– Businesses use a variety of resources:
1. Individuals provide services
2. Property is used, sold and consumed (property can be tangible like buildings and machines or
intangible like stocks and bonds)
3. Value earning capacity (goodwill, know-how, etc.)
– Businesses can acquire these resources in a variety of ways
1. Individuals can be employees or contractors
2. Property can be obtained in infinite ways (purchased, constructed, traded, etc.)
– Two businesses that start off with the same resources can turn out completely different based on the way they
use their resources
– Chapters II through IV focused on finance’s endeavors to value all businesses using rigorous methods (basically
comparing apples to oranges), which incorporates powerful simplifying assumptions:
1. A business is viewed as a generator of cash flow over time
2. Must adjust for the time value of money since a dollar today is worth more than a dollar
tomorrow (done by discounting the future cash flow to the present)
3. Current earnings are perpetuity-like, a business’s (equity) value is determined by simply
dividing those earnings by the appropriate interest (capitalization) rate
– Chapter V focused on accounting’s difficult problem, the numerous aspects of businesses (finance only has to
deal with equity)
1. Accounting starts with the business’s financial books and records
2. Accounting assumes that all transactions involve an even exchange, each transaction is
reflected in two mirroring entries: one for what is received and one for what is given up,
known as “double-entry bookkeeping”
3. Similar accounts are added together as if they are one big account
4. The accounts are presented on a balance sheet to convey the information more efficiently,
with assets on the left and liability and equity on the right
5. The balance sheet deals with the first two questions of complexity: (i) the variety of resources
and (ii) the multiple types of claims thereon (the resources are the assets and the claims to the
resources are the liabilities and equity)
6. Each side of the balance sheet must equal the other
– Chapter VI focused on the income statement, which deals with the third complexity of business, how it uses its
resources
1. The income statement measures how much money the business is making for the owners of its
equity or how equity increased over the course of the business year
2. The most obvious source of new wealth for the equity is the business’s ordinary operations
3. Profit is the increase in equity from one year to the next, or the amount by which the total
amount received for goods or services sold (“revenue”) exceeds the total costs associated with
the sale of those goods and services (“expenses”)
4. Operating profit is shown on the income statement
5. Borrowing has no effect on equity so is not shown on the income statement
6. Businesses differ as to when they actually get paid cash for goods or services sold (in
advance, on deliver, after later billing, etc.), the income statement reflects revenue as the
company earns (“accrues”) it, usually accrual is when the goods are delivered
1
7. Expenses are also booked on the income statement when incurred or accrued (when a
business is paid in advance the charge is deferred until the expense is actually accrued)
– Chapter VII focused on the matching of revenues and expenses that are associated with each other, which the
rules of GAAP take into account
1. GAAP’s most important mechanism for achieving matching is revenues and expenses is
inventory accounting
2. All direct and indirect costs of producing inventory (except interest) are treated as costs of
goods sold
3. Some businesses use the perpetual inventory method to book costs as expenses, under which
the cost of goods sold expense for year is the total cost of the specific goods delivered during
the year
4. More commonly used to time when costs are expensed is the periodic method, under which
the business determines the cost of goods sold expense for the year once a year, the goods
remaining at year end are valued (priced) using various methods like FIFO, LIFO, and
average cost
– Chapter VIII focused on the important accounting problems represented by non-inventory assets and how to
determine their book value
1. One difficulty is distinguishing costs of improvements (capitalized) and repairs (immediately
expensed)
2. Some property used in business is consumed over time and must be depreciated, in which the
cost of such property needs to be matched to the revenues it generates over its useful life
3. The most common method of depreciation is pro-rata or straight-line depreciation
– Chapter IX focused on the third type of useful financial statement known as the cash flows statement, a
comparatively primitive statement that only discloses the cash in less the cash out for the year (similar to a
checking account)
1. There are three parts to a cash flows statement: (i) operating cash flows, (ii) investing cash
flows, and (iii) financing cash flows
2. The cost of non-operating assets are accounted for as negative investing cash flow
3. Interest payments reduce operating, not financing, cash flow
4. A modified form of accrual accounting called “cash basis” or “cash method” resembles
GAAP except that revenue is booked when received in cash and expenses are booked when
paid in cash
– Chapter X focused on the heart of modern financial accounting, its recognition regime (the rules that determine
when revenues and expenses are accounted for as such on the income statement
1. In theory, a given good’s associated revenue is earned throughout its life from conception to
the running of the statute of limitations on its liability for the company
2. In most cases accounting recognizes delivery as the moment that all revenue is earned
3. Matters are more difficult with respect to the service industry
– Chapter XI focused on what an asset is
1. Modern businesses have considerable value that is attributable to resources not traditionally
thought of as assets (goodwill, non-patented technology, know-how, etc.)
– Chapter XII focused on the fact that analysis underlying financial statements must deal with uncertainty
1. GAAP’s rule for dealing with uncertainty is to be conservative, when in doubt resolve
uncertainty in favor of making the business appear less well off
2. There are detailed rules for dealing with uncertain future losses, which are reflected on the
financial statements only if their future occurrence is probable and they are reasonably
estimable
3. Losses that do not have to be shown on the financial statements but are not remote must be
discussed in the notes to the statements
– Chapter XIII focused on the fact that financial accounting statements purport to report on independent
businesses, and when the reporting business is not independent the statements should not be certified
1. Transaction between related parties are accounted for differently than similar transactions with third
parties
2. A corporation (the “parent”) with substantial stock holdings in another corporation (the “subsidiary”)
may have to use special accounting due to the ownership
3. Usually more than 20% ownership requires the use of the “equity method” for accounting for its
relationship to the subsidiary
4. Over 50% of the voting power obliges the statements to reflect the subsidiary on a “consolidated”
basis, where the parent is treated as owning all of the subsidiary’s assets and debts and stock holders of
the subsidiary are treated as stockholders of the parent
C. A CRITIQUE: KNOWLEDGE IS POWER

– There are two fundamental issues this section is directed towards:
1. Whether the information on GAAP financial statements good enough to be the heart of our
disclosure-only (no price regulation) public capitalism
1
2. Whether it make sense for the law to use GAAP numbers in legal contexts, in particular, when
should lawyers rely on GAAP in drafting legislation, regulations, and contracts
– Finance is the rigorous science that values things in money, using assumptions that require it to simplify things
and without a really good source to receive the necessary information from
– As to modern financial accounting there are a variety of difficulties
1. Historic costs: The biggest problem with financial accounting is the mismeasurement of assets
and expenses as a consequence of the books using historic costs rather than current market
values (GAAP financial statements can represent some stale numbers)
2. Recognition: Under GAAP, revenues and expenses are recognized over time, but accounting
gives an artificial significance to a single moment in time, when they are recognized, which
makes it vulnerable to games designed to artificially create an event that would trigger
recognition
3. Formal distinctions: In accounting, like in law, much depends on formal distinctions with
little economic substance
4. Conservatism: Accounting conservatism is admirable but it justifies bad rules (expensing all
research and development) and facilitates abusive earnings management
5. No improbable or hard-to-measure liabilities: GAAP financial statements show nothing for
liabilities or expected losses related to past activities or assets already owned if either (i) the
bad news is not “probable” (less than 70% likely) or (ii) the amount cannot be measured with
reasonable accuracy (with it is ultra-conservative with expensing and unconservative here)
6. Related parties: Accounting assumes that the reporting business is an independent enterprise
as to every aspect of every transaction, and GAAP has not worked well when dealing with
transaction between parties that have common ownership
7. Intangibles: The cost of purchasing an asset is not treated as an immediate expense but as a
deferred expense, this can make GAAP almost irrelevant to businesses whose principle
resources are not traditional assets (businesses that are built on reputation, know-how, human
capital, and technology)
8. Services: The delivery-to-customers rule does not work well for service businesses that do not
have a simple event like delivery to tell them when to book revenue
9. Different books for different owners: When a business changes hands all assets are valued to
reflect their cost at acquisition, this can make a business’s financial statements quite different
in comparison to another similar business that has not changed hands
10. Answers wrong question: Accounting tells us how much the legal entity has recognized in the
past years when it should tell us hoe much unneeded cash flow will the existing business
throw off in perpetuity
D. CONCLUSION: NUMBERS COUNT—SOMETIMES

– The law and lawyers need a way to think and talk about business
– Every lawyer should understand the time value of money and how risk affects value (if only to understand the
economics of home loans and car leases)
– Most lawyers need to understand businesses, where the best source of information about them is their GAAP
– GAAP has well-known limitations that any lawyer using accounting information must understand to avoid
using this information incorrectly
APPENDIX
- CALCULATOR PROGRAMS -
A. INTRODUCTION
– The calculator programs below were created on a Texas Instruments model TI-83, however other similar
models will have the capabilities to perform the same functions
– The following is code that the user must input into their own calculator which will be helpful when calculating
perpetuity and yield for the discussion questions and during testing
– Underscores denote spaces
– Bold denotes calculator functions, everything else must be typed in
B. PERPETUITY
PROGRAMS
PRPTUITY:
PROGRAM:PRPTUITY
:ClrHome
:Disp “_ _WHAT_IS_THE_ _”
:Disp “ANNUAL_PAYMENT?”
1
:Prompt P
:ClrHome
:Disp “_ _ WHAT_IS_THE_ _”
:Disp “_INTEREST_RATE?_”
:Prompt R
:ClrHome
:Disp “THE_VALUE_OF_THE”
:Disp “_PERPETUITY_IS_”
:Disp P / ( R / 100 )
C. YIELD
PROGRAMS
YIELD:
PROGRAM:YIELD
:ClrHome
:Disp “_WHAT_WOULD_YOU_”
:Disp “_LIKE_TO_CONVERT?”
:Disp “ ”
:Disp “_1:_NOM_TO_EFF_”
:Disp “_2:_EFF_TO_NOM_”
:Disp “ ”
:Prompt X
:If X = 1
:Then
:ClrHome
:Disp “NOMINAL_INTEREST”
:Disp “_ _ _ _ _RATE?_ _ _ _ _”
:Disp “ ”
:Prompt I%
:ClrHome
:Disp “_HOW_MANY_TIMES_”
:Disp “_PER_YEAR_WILL_”
:Disp “_ _ _ _ THIS_BE_ _ _ _ _”
:Disp “_ _COMPOUNDED?_ _”
:Disp “ ”
:Prompt C/Y
:ClrHome
:Disp ►Eff( I% , C/Y )
:Disp “ ”
:Else
:If X = 2
:Then
:Disp “_ _ _EFFECTIVE_ _ _”
:Disp “_ INTEREST_RATE?_”
:Disp “ ”
:Prompt I%
:ClrHome
:Disp “_HOW_MANY_TIMES_”
:Disp “_PER_YEAR_WILL_”
:Disp “_ _ _ _ THIS_BE_ _ _ _ _”
:Disp “_ _COMPOUNDED?_ _”
:Disp “ ”
:Prompt C/Y
:ClrHome
:Disp ►Nom( I% , C/Y )
2
2
- GLOSSARY -
A. DEFINITIONS
A
Account: Running record of transactions affecting one item (a bank account, a building, etc.)
Accounting: The process of analyzing and justifying one’s actions to another
Accounts: Basic books and records a business keeps itself
Accrual: Book the transaction before cash changes hands
Accruing: Booking a revenue or expense for the sale of goods before cash changes hands
Adjudication: Act like judiciary and decide the laws meaning
Adjustable-rate or Variable-rate loans: Loans that provide for interest rate adjustments that reflect the current
Amortization: The rate at which you pay down a loan
Amortization Schedule: The terms of a loan that control when principle is to be repaid
Annual Percentage Rate (APR): Computed by multiplying each compounding periodic rate by the number of compounding
periods in a year, an APR of 17.4% means that each month 1/12 of that percentage is owed (1.45% per month) so the
effective rate on 17.4% is 18.86% (APR is an effective rate displayed in its nominal form)market conditions
Asset Account: Record in respect to an asset (with student loans, as you take money out the asset goes up as you pay them
back the asset goes down)
Audit Letter: List of all material asserted claims and unasserted claims (with descriptions and evaluations), management has
decided must be disclosed under SFAF 5, presented to the auditor during an audit (the auditor assumes management has
consulted with its attorneys in connection with the list)
B
Balance: Amount in an account at a given time
Balance Sheet: A useful way of summarizing all the accounts at an instant in time
Big Bath Accounting: A company sets up a large reserve in an initial year (the big bath), just to be able to charge future
costs to the reserve (the bath year is usually a year in which the market is already expecting bad news, because more bad
news till not hurt the stock price much), purposely making a bad year look worse in order to make future years look better
Book Value: Historical cost with some adjustments for things like wear and tear, obsolescence, or depreciation
C
Call: Option to buy (increases profit as value goes up)
Call: Option to buy something at a later date at a set price (you are betting that the stock will go up) no capital is invested in
the property, it is a pure bet
Cash: Amount of cash in the bank
Cash Flows: Cash (or the equivalent) received by the business less cash (or the equivalent) paid out (a checking
Cash Method or Cash Basis: A type of income accounting most used in preparing income tax returns, more closely
resembles the accounting on the GAAO income statement than that on the cash flows statement (basically GAAP that ignores
receivables and payables)
1. Books revenue only when cash is received: Receivables (for revenue) are viewed as unrealized and not
booked
2. Books expenses only when paid: Payables (for expenses) do not appear on cash method financial
statements
Cash Receipts: Cash received
Capitalizing: A stream of future payments reduced to the discounted present value
Capitalization Rate or “Cap Rate”: The interest rate used in capitalizing future payments (VALUE = PMT / CAP RATE,
therefore, CAP RATE = PMT / VALUE)
Channel Surfing: A manufacturer or wholesaler stuffs its distribution channel by delivering more goods to its customers
than it knows that the customers can sell in order to book the revenue (the extra goods probably will be returned so the
revenue is not really earned, but the practice is hard to police)
Closing Inventory: Goods left over at the end of a period, determined by physically counting the number of goods on hand
Company’s Market Value: Determined by multiplying the number of shares outstanding at the end of its most
Compounding: Interest that is reinvested and earns interest (compounding period in the example above is one year)
Conservatism: Requires accountants to prepare conservative financial statements, which means that the statements err
on the side of caution by understating assets and overstating liabilities
Contingencies: Uncertainties arising out of events that have occurred already, which when resolved in the future may result
in either (i) legal liability or (ii) damage to or loss of an asset
Conservatism, a key financial accounting principle, is an approach to uncertainty, which plays an important role in GAAP
(uncertainties as to when revenue is earned cause considerable accounting indeterminacy)
4
Corporate Finance: Examines private businesses and is what is covered in this text
Corporate Finance: Studies how businesses acquire and use money
1. Issuing stock
2. Borrowing goods or services
3. Selling goods or services
4. Buying property
5. Buying services
Cost Accounting: A business’s internal accounting that measures profit on a product or service line
Credit: An adjustment in a pair of entries that increases liabilities or equity or decreases assets
Credit: Increase in a liability (bad thing)
D
Debit: An adjustment in a pair of entries that increases assets or decreases liabilities or equity
Debit: Decrease in a liability (good thing)
Debt Instrument: Proves the holder case payments at one or more specifies future times
Default: The failure of a borrower to fulfill an obligation, at which time the lender may impose the sanctions specified in the
lending contract period)
Defease: Release the original borrower from the debt, usually done when interest rates go up
Deferral: Book the transaction after cash changes hands
Deferral: Cash changes hands prior to the time when revenue or expense is recognized
Deferring: Booking a revenue or expense for the sale of goods after cash changes hands
Depreciation: The collection of accounting rules that provide how the costs of assets consumed in business are matched with
revenues (not all assets are depreciated but most must be, i.e. real estate, improvements, buildings, machinery, equipment,
etc.)
Derivatives: Financial instrument whose value derives from something outside the bargain
Dividends: Money that the company does not need is paid out to its investors in the form of a dividend
Double-Entry Bookkeeping: Assures that the balance sheet balances by providing a limited check on arithmetic and
transcription errors but says nothing about whether the entries are correct
E
Economic Depreciation: Exact actual decline in assets’ value (usually faster than GAAP straight-line depreciation)
Economic Value: The estimated value of the use of the machine
Effective Interest Rate or Yield: The interest rate after the nominal interest rate has been compounded
Equity: What is left over for the shareholders when the creditors are all paid off
Equity: Residual money owed to shareholders
Equity Loan: Buy a house (500,000) and borrow (300,000) with a (200,000) down payment, at the closing the bank gets a
mortgage on your house so that if you sell the house they get paid before you do and if you default on your loans they can
force you to sell your house if you default, if the house goes up to (1,000,000) you can sell the house, pay off the loan, and
keep the extra 700,000
Ex-Dividend Day: Day on which holders of stock are locked in to receive a dividend regardless of if they sell it before the
day the dividend is actually paid, stock usually drops on this day, while retained earnings build up stock value until paid out
Expenditure: Any amount incurred, some are deferred and not currently charged against revenues, expenditures not deferred
are “expenses”
Expense: A cost of earning revenue
Extraordinary Items: Items that are booked in a special area of the income statement that are infrequent and unusual in
occurrence (a car dealership falling into a sinkhole), natural disasters in areas they are expected to occur (hurricanes in the
Gulf of Mexico, tornadoes in the mid-west) are not sufficiently infrequent and unusual
Financial Accounting: Way in which capital users (business managers) report on hoe they are managing investors’ money
Financial Accounting: How managers of for-profit businesses report to shareholders and others about the management of
the business (by preparing and distributing financial statements
Financial Accounting: Way in which capital users (business managers) report on hoe they are managing investors’ money
Financial Accounting Standards Board (FASB): Responsible for setting out what accounting rules are “generally
acceptable,” originally known as the Committee on Accounting Procedure (CAP)
Forward Contract: One party unconditionally agrees to sell to the other party (and the other to buy) a fixed quantity of
some asset at a fixed price at some point in the future (i.e. airlines agreeing to purchase X amount of fuel at Y price over Z
years)
G
Generally Accepted Accounting Principles (GAAP): Rules that control basic financial statements
3
Goodwill: A bookkeeping entry that is required so that the debits equal the credits
H
Hedge Fund: Investors buy shares of the fund, which invests in primarily dividends
I
Inflation: It takes more money this year than last year to buy the same basket of goods (a dollar this year has a different
value than a dollar this year)
Installment Sale: A seller financing, since the price is to be paid in installments over time
Interest: Paid by the borrower to the lender to compensate the lender for borrower’s use of the lender’s funds
International Accounting Standards Board (IASB): The international version of FASB, headquartered in London, pushing
Inventory: A business’s stock of goods held for sale to customers
Inventory Costs: The applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing
condition and location
JKL
Left-Hand Entry: A debit, so named because asset accounts appear on the left-hand side of the balance sheet
Leverage: Borrowing to buy an asset
Leverage: By borrowing to buy you increase the risk of gains and loses, the lender gets interest and commission
Liabilities: Money owed to creditors
Line Costs: the costs of carrying a voice call or data transmission from its starting point to its ending point
M
Mark-to-Market: Solution to the Savings and Loan problem was mark-to-market accounting, which focuses on current
market values at the end of each period rather than waiting for a transaction to book the value
1. Critics say that this method is only reflective of how well the market is doing since a company can
fluctuate with the current value of their assets
2. Securities traders’ (or a bank that sells securities on the side) business is managing stocks and bonds,
so their business is mark-to-market account statement is a simple cash flows statement)
Mark-to-Market Accounting: An alternative to GAAP’s historical cost (recognition-based) accounting, at the end of the
year assets are treated, first, as having been sold for their fair market values, and second, as having been repurchased at these
new values (liabilities are adjusted to reflect any change in their economic burden, resulting in gain or loss)
Market Value: The wholesale cost to replace the inventory
Multiple: Ratio of the capitalized value to the annual future payments
1. MULTIPLE = 1 / CAP RATE
2. A 10% annual yield (1 / .10) has a multiple of 10, a 5% annual yield (1 / .5) has a multiple of 20
N
Negative Amortization: Low payments with a high interest rate which gets added to principle and increases compounding
Net Income, Net Revenue, Income: Other ways of referring to profit
Net Lease: Requires that the lessee provide repairs, maintenance, taxes, etc. in regards to the leased property
Nominal Interest Rate or APR: The annual interest rate before compounding
Nominal or Named Rate: Stated rate dependant upon compounding
O
Opening Inventory: Goods left over from prior periods
Opinion Letter: Certification that the independent auditors have ensured the facts’ legitimacy subject to two conditions
1. Certified statements are not what the auditors would have prepared had they done the management’s
job, just that they are not materially different from GAAP numbers
2. Not tested by one standard set of rules, there are a variety of acceptable ways to account for items
Opinion Letter: Certification that the independent auditors have ensured the facts’ legitimacy subject to two conditions:
1. Certified statements are not what the auditors would have prepared had they done the
management’s job, just that they are not materially different from GAAP numbers
2. Not tested by one standard set of rules, there are a variety of acceptable ways to account for items
Option Contract: The “holder” has the right to buy from or sell to the “writer” certain property at a set price at some point in
the future, however the holder is not required to exercise their right while the writer must comply
3
Payables or Accounts Payable: Amount a business owes for products and services received but not yet paid for
Periodic Inventory: Take inventory at the end of the period rather than keeping track of every item, you group them all
together
1. GOODS SOLD = GOODS AVAILABLE – GOODS ON HAND AT END
2. COST OF GOODS SOLD = OPENING INV. + PURCHASES – CLOSING INV.
3. You only have to keep track of two things: (i) the inventory taken at the end of the year and (ii) the
cost of your inventory
Periodic Inventory: Takes advantage of the two facts that (i) the cost of goods sold only needs to be determined once per
period and (ii) since sales revenue is booked when goods are delivered to customers only costs related to goods delivered
during the period are relevant; therefore at any given time a previously acquired item is either still on hand (not delivered) or
has been sold (delivered)
1. GOODS ACQUIRED = GOODS ON HAND + GOODS SOLD
2. GOODS SOLD = GOODS ACQUIRED – GOODS ON HAND
3. When this formula is adjusted to account for multiple accounting periods the result is: GOODS SOLD
IN PERIOD = GOODS AVAILABLE TO SELL IN PERIOD – GOODS ON HAND AT END OF
PERIOD (“goods available to sell in period” includes goods left over from prior periods and goods
acquired during the period)
4. COST OF GOODS SOLD = OPENING INVENTORY + PERIOD PURCHASES – CLOSING
INVENTORY
5. All that is necessary to determine the cost of goods sold is to (i) remember last period’s closing
inventory, (ii) keep a running total of all inventory purchases during the period, and (iii) take a closing
inventory
Perpetual Inventory: Keep track of each cost of item (airplane, yacht) and then when you sell them book the gain or loss
Perpetual Inventory: Keep track of the actual costs of specific goods and expense these actual costs when the associated
goods are sold and revenue is recognized, requiring the business to keep track of the cost of each inventory item in perpetuity
1. Problem is that it is difficult to keep track of each individual item
2. Used primarily by businesses, like yacht dealers, whose inventory only includes a few items at any
given time
Positive Amortization: Pay some of the principle plus the interest to avoid compounding
Prepaid Interest: To an economist it is just reducing compounding; you can pay the interest before it is due
Principal: The amount originally lent, increased to reflect subsequent additional lendings, and decreased for payments
Pro-forma: Non-GAAP financial statements released in addition to GAAP statements that do not include certain expense
items that do not qualify as extraordinary under GAAP (limited in that management must explain: (1) the difference between
their pro-forma and GAAP, and (2) why the pro-forma version is preferable)
Profit: Measure of how much better off the owners of a business are as a result of that business’s operations over a period of
time (usually a year)
Public Capitalism: Individuals investing directly in stocks and bonds (developed in the American capital markets in the
early 20th Century) for an international convergence of accounting principles
Public Finance: Examines governments
Pure Perpetuity: Promise to pay a periodic sum certain in perpetuity (forever)
Put: Option to sell (increases profit as value goes down)
Put: Option to sell something at a fixed price at a future date (if the underlying stock goes down then the value of the put
goes up), when buying a put you are betting that something will go down, known as a short position
QR
Receivables or Accounts Receivable: Amount a business is owed for products and services delivered but not yet paid for
Regulations: Filing in the gaps in the statute
Reserve or Sinking Fund View: Depreciation is the amount set aside (held in reserve) to replace deteriorating assets
(technically a “sinking fund” is a separate cash account that is funded over time in order to assure that a business will have
enough money to retire long-term debt that requires a large payment of principle maturity)
Residual Value: The value of leased property at the end of the lease period
Revenue: A gross amount earned from the sale of a good or service
Right-Hand Entry: A credit, so named because the liabilities and equities appear on the right-hand side of the balance sheet
S
Salvage Value: Value left over at the end of the machine’s life
Savings and Loans: Banks were borrowing at 12% but their loans were at 5%, interest rates went up so the value of their
loans went down and accounting statements did not reflect this, so investors could not tell that the banks were in trouble (as
interest rates rise the value of a bank goes down and as interest rates go down the value goes up, but this is not perpetuity
like, it has nothing to do with management)
Simple Annuity: Pays a fixed amount per year (or other time period) of r affixed number of years (or other time
3
Short Sale: An investor borrows stock from his broker and sells it, then at a later point the investor must return the same
amount of stock as was originally borrowed (if the stock goes down or their investment goes up the investor will make
money, if the stock goes up or the investment goes down they will lose money)
Short Sales: Borrowing stock from your broker and selling it, X months from now you must return the same amount of
shares, so if it goes down you make money but if it goes up you lose money (usually you cannot go out more than a year)
Stock Options: An employer awards an employee an option to buy stock of the employer at some price above that at which
the stock was trading on the grant date, avoid the need to draft complicated provisions to measure an employee’s
effectiveness
T
Tangible Assets: Assets such as buildings, land, machines, etc., assets that are valuable to a business by being used, not by
being sold (depreciation is needed to account for their use, a way of matching use)
Time Value of Money: You would rather have a dollar today than have a dollar tomorrow because either (i) you can enjoy it
today, or (ii) put it in the bank and earn interest
Trust Accounting: How a trustee explains their actions to the beneficiaries
UVW
Withholding: During WWII the US decided the best way to pay for the war was to tax wages, companies would money from
paychecks under the Federal income tax withholding and send it on your behalf to the federal fund the business, and were
charged with felonies), now many people purposefully withhold extra money so government (small businesses got in trouble
for not sending the money, they would use the money instead to that when they get their refund they get more money
XYZ
Yield: The percentage that you are actually owed (in a 10% nominal interest rate compounded yearly, after 3 years your yield
would be 33.1%)
3
Accrual
Book: Book: Book:
Test: Test: Test: 27
Outline: 21, 24 Outline: 53 Outline:
Accrual (Expenses) Depreciation Management

Book: Book: 114 Book:
Test: 18 Test: 8, 22 Test: 53
Outline: 23, 24 Outline: 32 Outline:
Accrual (Revenue) Disclosure Passage-of-Title

Book: Book: 227 (fn. 3 & 4) Book:
Test: Test: 50 Test: 52
Outline: 22 Outline: 58 Outline:
Annuity Dividends Perpetuity

Book: Book: Book:
Test: Test: 52 Test:
Outline: 8 Outline: Outline: 10
Bonds Employee Wages (See Present and Future Value

Book: 26 Salaries) Book:
Test: 21, 32 Test:
Outline: 8 Extraordinary Items Outline: 5
Book: 131
By-pass Income Statement Test: 20, 49 Profit Sharing
Book: 131 Outlines:38 Book:
Test: 27, 49 Test: 52
Outline: Intangibles Outline:
Book:
Contra Accounts (Negative Test: 20 Repairs and Improvements
Asset Accounts) Outline: Book: 109
Book: 116 Test:
Test: 51 Interest Outline:
Outline: 34 Book:
Test: Salaries
Deferral (What You Can Outline: 4 Book:
Defer / Capitalize) Test: 22, 51
Book: 95 Inventory Outline:
Test: 8, 54 Book: 89
Outline: 28 Test: 9 Stock
Outline: 26 Book:
Deferral (Revenue) Test: 22
Book: Lease Outline:
Test: 19 Book:
Outline: 22 Test: 94 Write Down
Outline: 9, 12 Book: 229
Deferred Revenue For Tech Test: 50
Support Lawsuits Outline: 59

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D. DISCUSSION PROBLEMS: THE NATURE OF ACCOUNTING

E. FINANCE AND ACCOUNTING

F. DISCUSSION PROBLEMS: ACCOUNTING AND FINANCE

PART B: FINANCIAL VALUATION

C. NOMINAL AND EFFECTIVE INTEREST

D. DISCUSSION PROBLEM: THERE’S INTEREST AND THEN THERE’S INTEREST

Estate of Jackson “Compounding Interest”

F. PRESENT AND FUTURE VALUE OF ONE PAYMENT

G. PROBLEMS: TIME VALUE

H. PROBLEMS: PRESENT VALUE OF A SINGLE PAYMENT

- CHAPTER III: ASSET VALUATION -

– The higher the interest rate the less a bond is worth

D. PROBLEM: A LEGAL PRESENT VALUE ISSUE

$521,000 – $62,000 = $459,000

H. FINANCIAL VALUATION OF NONFINANCIAL ASSETS

K. LIMITATIONS (RISK EFFECTS, IN PARTICULAR)

M. DERIVATIVES AND OTHER HYBRID INSTRUMENTS

►Nom(10,12 [ENTER] = 9.57

- CHAPTER IV: BUISNESS VALUATION -

B. THE PERPETUITY APPROACH

C. THE FOUR APPENDIX COMPANIES

E. DISCUSSION PROBLEM: WHAT A SHAREHOLDER BUYS

F. THE MARKET DON’T NEED NO STINKIN’ ACCOUNTING?

PART C: BASIC ACCOUNTING

B. THE BASIC IDEA

C. PROBLEMS: READING BALANCE SHEETS

D. WHAT THE BALANCE SHEET SAYS

E. PROBLEM: BOOK VS. MARKET VALUE

- CHAPTER VI: THE INCOME STATEMENT -

Profit (Loss) 200,000

– This income statement contains considerable information:

C. PROBLEMS: READING INCOME STATEMENTS

Prepare RETAIL’s year-end balance sheet and income statement.

(The business made 20,000)

E. WHAT THE INCOME STATEMENT SAYS

F. PROBLEM: THE BOLT INCOME STATEMENT

I. PROBLEMS: INTEREST ACCRUAL

L. PROBLEM: RECOGNITION AND FINANCE

M. THE LAW MEETS ACCRUAL AND DEFERRAL OF REVENUE

N. NOTES AND PROBLEMS: HERZFELD

O. THE LAW MEETS ACCRUAL OF EXPENSES

P. NOTES AND PROBLEMS: GUERNSEY

- CHAPTER VII: MATCHING AND INVENTORY -

B. THE SALE OF GOODS

C. CLOSING PERIODIC INVENTORY

D. PROBLEMS: LIFO VS. FIFO

E. THE BOLT COMPANY INVENTORY

F. COSTS INCLUDED IN INVENTORY

G. PROBLEMS: INVENTORY COSTING

(2) Which of the following costs are charged to inventory:

(b) Storage costs of finished goods.

(c) A holiday bonus paid to the chief financial officer.

I. LIFO AND THE FINANCIAL MARKETS

J. MATCHING IS IN THE EYE OF THE BEHOLDER

K. NOTES AND PROBLEMS: THOR POWER

- CHAPTER VIII: NON-INVENTORY ASSETS -

Cost 100-Useful Life: 5 Years

Placed in Service: 1st Day of Year 1

(1) 50-year life, no salvage value.

(2) 40-year life, no salvage value.

(3) 60-year life, no salvage value.

(4) 50-year life, $20 million salvage value.