Corporate EC316 Finance & Investments Scott E. Pardee Fall 2000 Week 2: September 18-22 The Balance Sheet, Fraser & Ormiston. Read Ch. 2, study review questions, prepare to discuss case studies at end of chapter. Class 3. The Balance Sheet Tuesday, September 19. The Balance Sheet shows the financial condition of a company as of a specific date. Is the company solvent? What is the company's liquidity position? How does this company match up with others? How has this company evolved over time? It is a snapshot as against a moving picture. Or better a series of snapshots: December 31 March31 June 30 September 30 December 31 Let's talk about double-entry bookkeeping for a while. Assets = Liabilities + Stockholder's Equity T-Charts, are immensely helpful in resolving issues. For every plus there is a minus, whether on the same side of the balance sheet or on the other. Usually, it is easy to figure out. You sell a bond, that raises liabilities directly; the cash proceeds add to cash balances. Assets are plus, Liabilities are plus; the totals on both sides of the balance sheet increase. Then as you use the cash to buy machinery, the assets under cash are reduced, and the machinery assets are increased. The two transactions are plus and minus on the same side
of the balance sheet, and so there is no increase in the totals. This is still fairly easy to understand. The Accounting Cycle 1. The Economic Event. A transaction takes place. 2. Interpretation. The accountant decides how this affects the company's positions, and where it should be entered. 3. JOURNAL: The Transaction is entered into the journal, among daily entries. 4. LEDGER: The transaction is posted to the general ledger of the firm, and to subsidiary ledger accounts. 5. WORKSHEET: END OF PERIOD A. Unadjusted trial balance B. Adjusting entries May require reverting to Journal and Ledger C. Adjusted Trial Balance D. Closing Entries E. Final Trial Balance 6. FINANCIAL STATEMENTS 7. Income Statement 8. Statement of Retained Earnings 9. Balance Sheet 10. Statement of Cash Flows. The General Ledger and Journal Entries Two tables: the listing of the transactions, and their adjustments, and then the T-accounts for each item, and from the T-accounts to the financial statements. If you were accounting students, I would put you through your paces to put one of these together. But, for our purposes, it is sufficient to know that someone is doing this, both in the department you are in and for the firm as a whole. You can bet that computerization has made a big difference here, but the point #2, Interpretation, remains crucial. If a transaction is misposted, whether by accident or by misinterpretation of accounting procedures, it can cost many hours of work, with or without computers. Issue 1 .The Balance Sheet Equation. The principle of double entry book keeping. Taking the R.E.C., INC Balance Sheet, trace through some transactions. 1. Sale of stock, raising $5,000,000. Add to paid-in capital and to cash. 2. Use $4mm to invest rest in inventories. 3. Pays down $1 mm in Long-term debt.
4. 5.
Borrows $2 mm from banks (notes Payable) to reduce accounts payable. We can go all day long. You'll get the hang of it.
But we have to careful about several kinds of transactions. 1. Securities transactions. You sell a US Treasury bill to raise cash. The Securities account on the asset side is decreased; cash is increased. You might as well have sold a machine or a piece of land. Now watch what happens when you use the securities to buy the machine. First, securities go down, cash goes up; then cash goes down and machinery goes up. The cash account gets a real workout. Remember, cash itself is an asset; raising cash is a plus; lowering cash is a minus. Selling other assets to raise cash give offsetting. 2. There are a number of items that earmark funds in specific businesses. For example: Wachovia Bank, Allowance for Credit Losses, is a negative item on the asset side of the balance sheet. It is just under loans, and belongs there. To the extent that banks have big loan losses, they should show up in such accounts. Banks may use this account to manage their earnings. Raising their reserves against losses at times when it suits them (since this is a charge against income), and lowering them when they want to have bigger profits. Another example: RennaisanceRe's Reserves for claims and claim expenses, and reserves for unearned premiums, plus the Note. This is on the liability side for an insurance company, which is appropriate, because it is money that has to be paid out. Note from the note the rather elaborate language explaining how the reserves are calculated. This is an account that insurance companies can also use to manage earnings. Issue 2: The Operations Cycle Introduce here Higgins Figure 1-1, The Cash Flow-Production Cycle Issue 3. The Current accounts Keep the one-year limit clearly in mind, for assets and liabilities. These are measures of the relative liquidity of the firm. They are also measures of unfolding events, a pickup or decline in business. Often, when a firm fails, the first signs can be traced back to these accounts. Again, the relationships over time, and the relationships compared with other companies. When we get to ratios, many apply here. Accounts Receivable. You are dealing with credit sales. Watch this like a hawk, because the company may be changing the terms of its sales. This shows up in allowance for doubtful accounts. Past experience, knowledge of customer quality, state of the economy, collection policy. Keep good records, keep allowance low, if possible, but realistic. 4. Inventories:
Inventories are important. Issues to be covered: 1. General accounting rules. 2. FIFO: Profits and Taxes 3. Average Cost: Profits and Taxes 4. LIFO: Profits and Taxes 5. Year 1 vs. Year 2 6. Accounting for lost inventory. 7. Perpetual Approach. 8. Periodic Approach. 9. Lower of Cost or Market. 10. Inflation and inventory valuation. They are the raw materials and component parts you buy to make products, and the ones you hold on hand. They include imbedded costs, such as labor, rent, and capital costs to the firm that sold the goods to you. They are the goods in process that you are working on. You are adding value to these goods through your own labor and use of facilities, and your own technology. They are the finished goods waiting to be sold, whether in your own warehouse or in transit or on consignment with a firm that is selling it for you. Whenever the finished goods are sold, you want to match the revenues to the cost of goods sold, to determine gross profit. Inventory management is one of the most important tasks of the firm, whether in retailing, wholesaling, manufacturing, or in the production of raw materials, such as iron ore. Refer to F&O Exhibit 2.3 Inventories are assets that you have acquired or produced at a cost. To the extent that you have lots of inventories on hand, you have a sunk cost on your hand. Also, you have the carrying costs, in terms of interest on capital, as well as storage and insurance.
You aim to have rapid turnover of inventories. Japanese firms, such as Toyota, gained a foothold in international markets, partly through producing better quality products, partly through the support of their government, and partly through inventory management -- the Kamban system -- just in time delivery. They sent their sales people out to the homes of customers. They received orders, and filled them quickly (cutting inventories of finished goods). They made sure the production line moved quickly, and with few errors -- if you make an error, the whole production line stops and everyone glares at you. Parts are delivered to the factory just as they are needed -- a reason why Japanese cities have so many small trucks running about, adding to the traffic snarl. Your suppliers, who are independent companies, are just as maniacal about delivery times, both ways. US firms have now caught up and gone ahead -- bar coding means that retailers have a real time knowledge of their inventories, and can order directly from factories as they need additional goods to sell. Only the companies that can meet delivery schedules succeed. The accounting for inventories is also important -- and complex. Stock and flow. The stock of inventories is what shows up on your balance sheet. The flow of goods through your inventories is what shows up on your income statement. General Rule 1: Items should be included in inventories if they are being held for sale and the company has unrestricted ownership of them. For the most part that is easy, but consider items under consignment. Look at Intel's accounts, the item deferred income of shipments to distributors. "Certain of the Company's sales are made to distributors under agreements allowing price protection and/or right of return on merchandise unsold by the distributors. Because of frequent sales price reductions and rapid technological obsolescence in the industry, Intel defers recognition of such sales until the merchandise is sold by the distributors." This is entered in the balance sheet as a liability.
Also, consider goods in transit -- when does the transfer of ownership actually take place. Today we look at Free on Board (FOB) shipping point vs. Free on Board (FOB) destination. One or the other party must shoulder the responsibility for freight, insurance, and interest costs. If you are the receiver of goods, you want to stick that to the supplier. If you are the sender, you want to stick that to the buyer. General Rule 2. All costs associated with the manufacture, acquisition, storage, or preparation of inventory items should be capitalized and included in the inventory account. Again, two issues. One is accounting for discounts, particularly relating to the timing of payments embedded in the terms of sale -- these are accounting complexities that are outside scope the of this course. The other is the COGS, cost of goods sold, which in the case of a manufacturer includes the many costs of bringing the inventory into saleable condition -- especially the direct costs of production plus overheads. These are discussed at length in the packet, and we will revert to some of the case studies. Now let's work with the little example provided in the text: Item #1 #2 #3 #4 #5 Total 5 items Purchase Price $ 5 $ 7 $ 8 $ 9 $11 $40
Now suppose you are a used car dealer, and these are 1994 Ford Tauruses, in thousands of dollars. They're all pretty much in the
same shape, and you are offering them all at the same price -- $15. A customer looks at them all and says he will take whichever one you choose. Which one do you sell him? #1 has the biggest mark-up, and thus the biggest profit and tax liability. The markup $10, the gross profit $10, the tax liability (at 30%) of $3, and the net profit of $7. Also, it leaves you remaining inventory at the highest level, $35. THIS IS THE FIFO APPROACH #3 are the one with the average cost, average markup, profit, and tax liability. The markup is $7, the gross profit is $7, the tax is $2.10, and the net profit is $4.90. Also it leaves your remaining inventory at $32. THIS IS THE AVERAGE COST APPROACH #5 has the smallest markup, the smallest profit, and the smallest tax liability. The markup is $4, the gross profit is $4, the tax liability is $1.20, and the net profit if $2.80. Also, it leaves your remaining inventory at the lowest level $29. THIS IS THE LIFO APPROACH Remember these three pairs of points as you remember your name. Selling the lowest cost item maximizes gross and net profits in the current year. Selling the lowest cost item maximizes current taxes. Selling the lowest cost item leaves the biggest inventory value on hand. And visa versa, that is. Selling the highest cost item minimizes gross and net profits in the current year. Selling the highest cost item minimizes taxes for the current year. Selling the hand. cost item leaves the smallest inventory value on
This makes a new table: TABLE 1 Item sold Cost Revenue #1 #2 #3 #4 #5 Total 5 items $ 5 $ 7 $ 8 $ 9 $11 $40 $15 15 15 15 15 75
Gross Profit $10 8 7 6 4 35
Tax $3.00 2.40 2.10 1.80 1.20 10.50
Net Profit $7.00 5.60 4.90 4.20 2.80 24.50
Inventory Remaining $35 33 32 31 29 0
This is the full matrix of what can be done. Now let's follow what the text does TABLE 2 FIFO Whatever three you sell, you book the sale as if it is the first three items which you took into inventory. Item sold #1 #2 #3 #4 #5 Total TABLE 3 LIFO Cost $ 5 $ 7 $ 8 $ 9 $11 $20 45 25 7.50 17.50 Revenue $15 15 15 Gross Profit $10 8 7 Tax $3.00 2.40 2.10 Net Profit $7.00 5.60 4.90 $9 11 20 Inventory Remaining
Book the three sales as if they are the last three items taken into inventory. Item sold #1 #2 #3 #4 #5 Total Cost $ 5 $ 7 $ 8 $ 9 $11 28 15 15 15 45 7 6 4 17 2.10 1.80 1.20 5.10 4.90 4.20 2.80 11.90 12 Revenue Gross Profit Tax Net Profit Inventory Remaining $5 7
TABLE 4 AVERAGE COST, book the sales as if you are choosing the middle items taken into inventory. Item sold #1 #2 #3 #4 #5 Total TABLE 5 SUMMARY FIFO LIFO $20 28 45 45 25 17 7.50 5.10 17.50 11.90 20 12 Cost $ 5 $ 7 $ 8 $ 9 $11 $24 45 21 6.30 14.70 $15 15 15 $8 7 6 $2.40 2.10 1.80 $5.60 4.90 4.20 11 16 Revenue Gross Profit Tax Net Profit Inventory Remaining $ 5
AVG
$24
45
21
6.30
14.70
16
Under inflation: LIFO is preferred. Under deflation: FIFO is preferred. Now let's add two more items: TABLE 6 #1 #2 #3 #4 #5 #6 #7 Total 7 items $ 5 $ 7 $ 8 $ 9 $11 $12 $14 $66
Now we sell those, plus the remaining items from the first year. This makes a new table: TABLE 7 Item sold #1 #2 #3 #4 #5 #6 #7 Total 7 items Cost $ 5 $ 7 $ 8 $ 9 $11 $12 $14 $66 Revenue $15 15 15 15 15 15 15 105 Gross Profit $10 8 7 6 4 3 1 55 Tax $3.00 2.40 2.10 1.80 1.20 0.90 0.30 31.50 Net Profit $7.00 5.60 4.90 4.20 2.80 2.10 0.70 73.50 Inventory Remaining $61 54 46 37 26 14 0 0
This is the full matrix of what can be done.
TABLE 8 FIF0 -- WHAT IS LEFT IN THE SECOND YEAR IS #4 AND #5, YOU SELL THOSE PLUS #6 AND #7. Item sold #4 #5 #6 #7 Total 4 items Cost $ 9 $11 $12 $14 $46 Revenue 15 15 15 15 60 Gross Profit 6 4 3 1 14 Tax 1.80 1.20 0.90 0.30 4.20 Net Profit 4.20 2.80 2.10 0.70 9.80 Inventory Remaining 37 26 14 0 0
TABLE 9 LIFO -- WHAT IS LEFT IN THE SECOND YEAR IS #1 AND #2, YOU SELL THOSE PLUS #6 AND #7. Item sold #1 #2 #6 #7 Total 4 items Cost $ 5 $ 7 $12 $14 $38 Revenue $15 15 15 15 60 Gross Profit $10 8 3 1 22 Tax $3.00 2.40 0.90 0.30 6.60 Net Profit $7.00 5.60 2.10 0.70 15.40 Inventory Remaining $61 54 14 0 0
Note that the profit is bigger this time, since you are reaching back into the lower cost inventory; this also raises your taxes. TABLE 10 AVERAGE COST -- YOU HAVE LEFT ITEMS #1 AND #5, WHICH YOU SELL ALONG WITH ITEMS #6 AND #7. Item sold #1 Cost $ 5 Revenue $15 Gross Profit $10 Tax $3.00 Net Profit $7.00 Inventory Remaining $61
#5 #6 #7 Total 4 items
$11 $12 $14 $42
15 15 15 60
4 3 1 18
1.20 0.90 0.30 5.40
2.89 2.10 0.70 12.60
26 14 0 0
This is in the middle. SUMMARY TABLE YEAR 2. TABLE 11 Total FIFO LIFO AVERAGE
$46 $38 $42
60 60 60
14 22 18
4.20 6.60 5.40
9.80 15.40 12.60
0 0 0
This time FIFO gives the lowest profit and taxes. This time LIFO gives the highest profit and taxes. Companies that loaded up profits with FIFO in year 1 have to pay the piper later on. Companies that deferred profits with LIFO, now have a chance to catch up on profits -- at a time when they are reducing inventory. But this means selling FISH -- FIRST IN STILL HERE. Two additional issues. 1. Loss of inventory. Suppose during the year, item #2 is stolen or becomes unsellable for any other reason. TABLE 12 #2 $ 7 15 8 2.40 5.60 33
Two approaches to valuing inventories now become important. Perpetual -- Whenever you discover the loss, you can mark down your inventory to take account of it. You will take a final inventory chec...