Transcript No Slide Title

ACCOUNTING: G604
Eric Rasmusen, [email protected]
20 January 2006
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TWO BRANCHES
OF ACCOUNTING
1. Cost Accounting.
Information for the company's managers.
• How much does it cost to run
the company?
• Is anything missing because
of employee theft?
• Which products are selling
best?
2. Financial Accounting.
Information for shareholders and
other outsiders as well as managers.
•Is the company profitable this year?
• What is the trend in sales?
• How valuable are the company's assets?
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BIG IDEAS IN
ACCOUNTING
1. Summarize a company’s situation into as
few numbers as possible. Earnings per share.
2. Count costs and benefits when the company
acquires the rights or obligations, not when the
money changes hands. Accounts receivable.
3. Annualize flows of cost and benefit.
Depreciation.
4. Put assets and liabilities (stocks)
into current value. Cost of pension benefits.
5. Double entry bookkeeping. Think of all
stocks as assets, liabilities, or equity.
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DOUBLE ENTRY BOOKKEEPING
ASSETS = LIABILITIES + OWNER'S EQUITY
Investors begin with $50,000 in cash.
The equity is then $50,000.
They buy a building for $40,000.
Now the assets are a $40,000 building and
$10,000 in cash, and equity is still $50,000.
They borrow $10,000. Now the assets are
the $40,000 building and $20,000 in cash.
Liabilities are $10,000, and equity is still
$50,000.
What if they sell the building for $70,000?
What if they issue $10,000 in dividends?
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ACCOUNTING INDUSTRY TERMS
CPA. Certified Public Accountant.
An accountant who has passed the
CPA exam and works for an
accounting firm.
CPA's perform AUDITS of
businesses to see if their financial
statements are accurate. (The
government audits someone's taxes to see if they
have reported everything correctly.)
PRIVATE ACCOUNTANT: An
accountant who works for a business
directly rather than for an accounting
firm.
GAAP: Generally Accepted
Accounting Principles. The standard
rules of accounting.
FASB: The private board which
makes accounting rules in the USA
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FINANCIALSTATEMENTS
BALANCE SHEETS describe a
firm's assets and liabilities.
(Wealth)
(value of stock market)
INCOME STATEMENTS
describe a firm's flow of profits
and loss. (Income) (GDP)
CASH FLOW STATEMENTS
describe a firm's flow of profits
and losses in terms of cash
flows during the year. (Income)
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DEPRECIATION
Suppose the company buys equipment for
$70,000 and expects it to last 10 years.
One accounting method would be to list the
equipment as a $70,000 asset for 10 years,
and then to drop it to $0 suddenly.
GAAP say that the asset value should
decline more steadily. An easy way is to
estimate that the value falls $7,000 each year.
That decline is called DEPRECIATION.
After 3 years, the accumulated depreciation
would be $21,000 and the net asset value
would be $49,000. Also, on the income
statement there is a cost of $7,000 each year.
Depreciation is not a cash flow, so it is a
major difference between the income
statement and the cash flow statement.
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EXAMPLE:
AVERAGE COST
Suppose a new drug costs 10 million
dollars to find, and then a 5 million
dollars building to produce. Then, any
number of pills can be produced each
year for 1 dollar of labor each. The pills
will be sold for P dollars each, where
Qd(P) = 1 million, for 10 years. The
discount rate is 5 percent.
What is the cost per pill?
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COST MEASURES
.
(a) The marginal cost is 1 dollar. If the firm looks
at this as the only cost, though it is likely to do
too much research. This would happen if the
firm had two separate budgets, a capital and
research budget and an operations budget, and
did not try to link the two.
(b) In deciding whether the investment is a good
idea, the firm should compute the present value.
That is
((P-1)/.05)* (1- (1/1.05)^10) - 10 - 5
= (20) (P-1) (1-.61) – 15 = 7.8 (P-1) - 15
which equals zero if P= 2.92, which is the
break-even price, and a good number to use for
average cost.
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COST MEASURES (2)
.
(c) What companies do in the real world is to
`expense` research, accounting for it as a cost in
the current year, and to depreciate capital
spending, pretending that it is spread across
several years. Suppose the company does this,
and only invests in this one drug. It chooses to
depreciate the building by the straight-line
method over 10 years. Then the average cost
will be
(10+.5+1) = 11.5 in the first year
.5+1 = 1.5 in the next 9 years,
1 for all later years (zero demand
then)
Expensing research violates the usual principle,
which is to try to spread costs over the time in
which they yield benefits. Research and
advertising are both expensed, even though in
theory they should be depreciated, because it is
hard to figure out the proper lifetime.
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COST MEASURES (3)
If the company followed the accounting system
just described but had a constant flow of new
drugs, then in steady state its accounting total
cost would be
1(10) + 10(.5) + 10(1)= 25 million
Its cash flow would also be an outflow of 25
million per year.
Selling 10 million pills, its unit cost would be 2.5.
If the firm’s operations are steady over time, how
it accounts for costs over time matters less.
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Allocating Overhead
• Microsoft produces Office and
Windows. The headquarters helps
with both.
• To which product’s budget should
the HQ cost be allocated?
• There is no real theoretical answer
to this. It depends on the decision
being made.
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The Income Statement
COSTS OF GOODS SOLD includes
• Materials
• Wages of production workers
• Depreciation on production equipment
(Costs that increase as more goods
are sold.)
OPERATING EXPENSES include
• Selling expenses:
• Salesman wages
• Advertising
• Administrative expenses:
• Office supplies
• Executive salaries
• Office heating
(Costs that do not increase much as
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more goods are sold.)
SOLVENCY RATIOS
Can the firm pay its short-term debts?
1. The Current Ratio
current assets
$57,210

 2.61
current liabilities $21,935
Can the firm pay its longterm debts?
3. The Debt-Equity Ratio
debt
$61,935

 0.56
owner's equity $111,155
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PROFITABILITY
RATIOS
Return on Equity:
net income $12,585

 11.3%
equity
$111,155
Earnings Per Share:
net income
$12,585

 $1.57 / share
number of shares
8,000
“Fully diluted”--how many shares are there?
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SOLVENCY RATIO
COMBINATIONS
• High current ratio, high debt-equity
• High current ratio, low debt-equity
• Low current ratio, high debt-equity
• Low current ratio, low debt-equity
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Double Taxation of
Profit
1. In the US, corporations pay corporate
income tax.
2. When dividends are paid, the shareholders
pay individual income tax.
The result: firms have an incentive not to pay
dividends (instead, they repurchase shares). And
capital is expensive for corporations.
(there is really triple taxation, in that the
money invested in corporations probably is
what is left over from labor income after
income tax)
Why do firms pay dividends at all? A puzzle.
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Good will and
Writedowns
A firm is formed by partners who put up $7 million of their
own money and borrow $3 million from a bank. They use the
$10 million to buy a second company which had spent $3
million to buy a building that is now worth $6 million on the
open market.
Assets: A 6 million dollar building and 4 million in goodwill
Liabilities plus equity: 3 million in debt plus 7 million in equity
The “goodwill” is supposed to represent value of the
assets of an acquired company above and beyond the market
value of its component assets.
A year later, everyone realizes that the purchase was a mistake,
and the building is really only worth $4 million, both on the
market and to our company.
What happens in the accounting?
Nothing.
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Good will and
Writedowns, ctd.
Assets: a $6 million building and 4 million in goodwill
Liabilities plus equity: 3 million in debt plus 7 million in
equity
The building’s market value falls to $4 million.
The company can (and should), "write down" the assets
which are “impaired”. It declares that the building has lost
value, and that the company now estimates its value to be
$4 million.
Assets: a $4 million building and 0 million in goodwill
Liabilities plus equity: 3 million in debt plus 1 million in
equity
Equity is the residual category, that changes to make
assets equal liabilities plus equity.
On the income statement, the company will declare a $6
million loss from the acquisition’s falling in value, as an
"extraordinary charge".
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•
•
• BIG PROBLEM 5: ACCOUNTING
• Profit rates vary across industries because of the
accounting rules and the types of expenses. The
problem arises because costs and revenues arrive at
different times. Suppose two firms each have 100
in capital.
•
• Firm 1 pays 50 for labor and raw materials and
gets 80 in revenue each year. Profit is 30, and the
return on capital is 30%.
• Over two years, total profit is 60.
•
• Firm 2 pays 50 for labor and 60 for raw materials
inventory in the first year, and gets revenue of 110.
Profit is 0 and the return on capital is 0%.
• Firm 2 pays 50 for labor and 0 for raw materials in
the second year, and gets revenue of 110. Profit is
60 and the return on capital is 60%.
• Over two years, total profit is 60.
•
• Growing industries will look less profitable.
•
• How this plays out depends on the particular
accounting rules. But what is general is that
differetn industries will be affected differently.
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•
Lilly Solvency Ratios, 2004
Current Ratio =
Current assets/Current liabilities
= 12835/7593 = 1.69
(2003: 7943/5560 = 1.42 )
Debt/Equity =
Total Liabilities/Equity
= (7593+6353)/10919 =
(2003: (5560+6362)/9869 = )
OR
Debt/Equity =
(LT Debt+ ST Debt)/Equity
= (4491+2020)/10919= 0.59
(2003: (4687+196)/9869 = .49)
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Profitability Ratios- 2004
Return on Equity = Net Income/Equity
= 1810/ 10919 = 0.16
(2003: 2560/9869 = 0.25 )
Return on Assets = Net Income/Assets
= 1810/24867 = .07
(2003: 2560/ 21688 = 0.11 )
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Earnings per Share, 2004
Earnings per Share =
Net Income/Number of Shares
= 1810/1088= 1.66
(2003: 2560/1082 = 2.36)
A perpetuity paying 2.36 annually
would, if r=.05, be worth 47.20.
A recent price (Jan 2006) was 57.95.
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