Module 1: The Accounting Equation

Net Effect is Zero | Two parts, Balance Sheet Must Balance

When the net effect is 0, why record it at all?

Let’s say your company purchases some inventory for $500 and pays cash. Assets would increase by $500 (you now have the inventory) and at the same time, assets would decrease by $500 (you no longer have the cash). While the recording of this transaction may seem trivial, since it ultimately nets to 0, it is, in fact, a vital part of the overall financial reporting for a company.

What would happen if we ignored this transaction and simply left it off the books? It would appear that we were missing $500 cash since there would be no record of the $500 being used to pay for the inventory! Additionally, we wouldn’t know that there was an additional $500 worth of inventory on hand for sale. You can’t sell what you don’t know you have!

Two Parts!

When a company sells its inventory to a customer, they will record the transaction on their books. This transaction will always have two parts—one part to recognize revenue and another part to account for the inventory and related cost of the inventory.

As an example, let’s say that clothing retailer, Threads, sells four shirts and three pairs of pants to a customer for $200. The customer pays cash. Let’s also assume that Threads originally paid $100 to acquire the clothing.

How would Threads record this transaction on their books? Let’s start with the easiest piece of this transaction—the cash! Threads received $200 in cash, which means that assets will increase by $200. That $200 is also revenue for the company, so owners’ equity (which holds revenues and expenses) will also increase by $200.

Remember that the balance sheet must always balance!

Now that we have accounted for the revenue portion of the transaction, we can shift our focus to the second part, the inventory and cost of goods sold.

Threads originally paid $100 for the clothing that they sold to the customer, which means that $100 worth of inventory (an asset) was placed on their books at the time of purchase.

Now that the inventory has been sold, that inventory needs to come off of the books. Assets will decrease by $100 to show that the inventory is no longer available.

The inventory cost Threads $100, so they will need to reflect that on the balance sheet. Cost of goods sold (COGS) is the expense corresponding to the cost of inventory that is sold to customers.

Since COGS is an expense account, it will decrease owners’ equity by $100. Here is what the final journal entry would look like:

Cash     200

    Sales revenue    200

COGS    100

     Inventory     100

You can think of it like this:

Increase in assets 200

     Increase in owners’ equity (revenue) 200

Decrease in owners’ equity (expense) 100

     Decrease in assets 100

Module 2: Recording Transactions

Deferred Revenue, Prepaid Expenses

Accounting is a challenging process of measuring, validating and reporting financial information for an entity. Most would say that accounting is the language of business, and without it, you can’t talk the talk. Just like any language, there are words that cause great confusion for those learning it for the first time. Here are a couple of accounting terms that usually trip people up:

Deferred Revenue

You see the word revenue and automatically think, ‘REVENUE, REVENUE, REVENUE! Credit revenue.’ Put on the breaks there, pal. What if I told you that Deferred Revenue is actually a liability, an obligation to pay? You saw the word revenue, but did you happen to see that word in front of it—DEFERRED? This means that you can’t claim any revenue just yet. Some people find it helpful to use the word ‘unearned’ as opposed to ‘deferred’ to make it clear that the revenue isn’t yet realizable.

Unearned/Deferred Revenue is a liability account that represents the obligation to provide goods or services to a customer in the future. Unearned/Deferred Revenue is recorded when a business receives a payment in advance from a customer, but the business has not yet delivered the goods or provided the service. Once the business fulfills its obligation to provide goods or services, the liability is reduced and the revenue is recognized. Say it with me, ‘Unearned/Deferred Revenue is not a revenue account!'

Let’s look at an example.

Suppose a catering company received $10,000 cash from a client on January 1, 2019 to provide catering services on March 1, 2019.

When the cash is received on January 1, the catering company should debit cash and credit deferred revenue to show that they have received money for a service that they have not provided yet.

Cash 10,000

     Deferred Revenue 10,000

On March 1, once the service has been provided, the catering company can now recognize the associated revenue. They will debit deferred revenue to show that they no longer have the obligation to provide the service and they will credit revenue to show that the revenue has now been earned and can be recognized.

Deferred Revenue  10,000

     Revenue 10,000

Prepaid Expense

You see the word expense and automatically think, ‘EXPENSE, EXPENSE, EXPENSE! Wait, wait, is this similar to Deferred Revenue? Where the word ‘prepaid’ makes the word ‘expense’ behave differently?’ Yes, you got it! Prepaid Expense is in fact NOT an expense account, but rather an asset account.

A Prepaid Expense is an asset that represents the right to receive goods or services in the future. Some common examples are prepaid rent or prepaid insurance, where a company pays for rent or insurance in advance of the coming month or year. At the time of the payment, the transaction is recorded as an asset, and as time passes, the asset is reduced and the expense is recognized. Say it with me, ‘Prepaid Expense is not an expense account!’

Let’s look at an example.

Suppose a company paid $12,000 cash on January 1, 2019 for a year’s worth of rent. When the cash is paid on January 1, the company should credit cash and debit prepaid rent to show that they have the right to receive something (the rental) that they have already paid for.

Prepaid Rent 12,000

     Cash 12,000

As each month passes, the company has to reduce (or expense) the amount of prepaid rent on their books to show that they are ‘using’ up the asset with the passage of time.

Rent Expense 1,000

     Prepaid Expense 1,000

*Once this entry has been made 12 times, for every month, the amount in the prepaid rent account will be zero.

Module 3: Financial Statements

COGS, Current Assets, Prepaid Expenses

Cost of Goods Sold is an EXPENSE account, which means that it increases with a debit and decreases with a credit. It is closely related to inventory, which we will cover in greater detail in Module 4.

Current assets include things like cash or any other assets (checks, short-term investment, and receivables) that can be converted to cash within a year or within a company’s operating cycle, whichever is longer. Similarly, current liabilities represent obligations that will have to be paid within a year or within a company’s operating cycle, whichever is longer (accounts payable, salaries payable, interest payable).

Prepaid expenses (prepaid insurance, prepaid rent, etc.) are assets because they represent the right to receive goods or services in the future. As time passes, and the goods or services are received, the asset is reduced or expensed. Prepaid expenses are considered current assets because they are typically expensed (partially or completely) within a year or within a company’s operating cycle.

Similarly, deferred (unearned) revenues are considered liabilities because they represent the obligation to provide goods or services to a customer at some point in the future. As times passes, and the goods or services are provided, the liability is reduced and revenue can be recognized. Deferred revenues are considered current liabilities because they are typically turned into revenue (partially or completely) within a year or within a company’s operating cycle.

Module 4: Adjusting Journal Entries

Accrual Accounting, Accumulated Depreciation

Accrual accounting stipulates that revenue should be recognized in the period in which it is earned and realizable, not necessarily when cash is received. Similarly, expenses should be recognized in the period in which they are incurred, not necessarily when cash is paid out. Here are a couple of simple examples:

Suppose you own an athletic apparel company. A customer buys $500 worth of clothing from you on credit and agrees to pay in 30 days. To record this transaction on your books, you would debit accounts receivable for $500 and credit revenue for $500. You are crediting revenue even though you haven’t actually received the $500 cash. Why? By providing the athletic apparel to the customer, the revenue has been earned. And, you have every reason to believe that the customer will follow through and pay in 30 days, which means that the revenue is realizable—you are going to get the money.
Again suppose you own an athletic apparel company. You have taken out a $20,000 loan from a bank to purchase several cash registers for your store. The terms of the loan stipulate an annual interest rate of 5% for 5 years, with interest and principal due at the end of the 5 years. At the end of year 1, you record a debit to interest expense for $1,000 and a credit to interest payable for $1,000. You are debiting interest expense even though you haven’t actually paid the $1,000 cash. Why? By ‘using’ the borrowed money for that first year, you have effectively incurred a $1,000 expense that you are obligated to pay at a later date.

That’s essentially what interest is—a fee for having access to a sum of money that isn’t yours. In this case, you aren’t going to pay the fee until the end of year 5, but you have to record it in the period in which the fee is incurred.

Accumulated Depreciation is a contra-asset account, but what does that really mean? We know what an asset is, but what makes something a CONTRA-asset? The prefix ‘contra’ means opposite, and in accounting a contra-asset account is an account that behaves in a manner opposite to a regular asset account.

For example, machinery is an asset account that increases with a debit and decreases with a credit. We depreciate machinery over time using the contra-asset account, accumulated depreciation, to show the cumulative total of all depreciation taken on the machinery. Accumulated depreciation decreases with a debit and increases with a credit (opposite of an asset account!), so that at any given time, the total amount in the machinery account minus the total amount in the accumulated depreciation account, will give us the book value of the machinery.

Module 5: The Statement of Cash Flows

Analyzing a Firm's Cash Inflows and Outflows

The Statement of Cash Flows (SCF) is a financial statement used to track a company’s cash activities over a period of time. It shows cash inflows and outflows related to a firm’s operating, financing, and investment activities, and can be a helpful tool for determining if a company has sufficient cash to pay for things.

Companies can use either the direct or indirect method when generating the SCF, although the only section affected by this choice is the operating section. The direct method simply adds operating cash inflows and subtracts operating cash outflows, to get the cash flows from operating activities for the year. Most companies choose the indirect method. This method starts with net income and then adjusts that number to reflect actual cash flows by undoing the impact of accruals and removing non-operating items impacting net income.

Why would we want to do this? Think about why we have accruals in accounting in the first place. You might recall that revenue in accrual accounting is recorded when it is earned/realizable, not necessarily when cash is received. This is why we credit revenue when we book an accounts receivable. We haven’t actually received the cash from that receivable, but we have every reason to believe that we will, so we go ahead and book the revenue, which ends up in our net income. In order to strip net income down to reflect only cash related activities, we have to get rid of such "accrual" transactions.

Here are some helpful rules to help you remember how to de-accrue (undo accruals) and make adjustments to net income under the indirect method:

+ increases in operating current liabilities

+ decreases in operating current assets

- decreases in operating current liabilities

- increases in operating current assets

Cash flows from operating activities are cash flows that involve the daily operations of a business. Activities such as purchasing inventory (cash outflow), paying employees (cash outflow), and collecting from customers (cash inflow) are all reoccurring things that a business must do in order to operate.

Cash flows from investing activities are cash flows associated with long-term investments in property, plant, & equipment, securities, patents etc. Think of investing in this sense as an investment in things that a company will use long-term. Activities such as purchasing land (cash outflow), purchasing new equipment (cash outflow), and selling a property (cash inflow) are all long-term transactions.

Cash flows from financing activities are cash flows associated with getting funds for a business. Taking out a loan or issuing stock are the two most common ways to finance a business. Complementary to this is paying back the loan or paying dividends to your shareholders, and thus, these activities are also included in the financing section.

As with most concepts in financial accounting, there are a few things to remember related to differences between GAAP and IFRS, which report some cash flow activities in different ways. Here are some helpful rules to help you remember the differences:

Transaction	GAAP Classifcation	IFRS Classification
Interest Received	Operating	Operating or Investing
Dividends Received	Operating	Operating or Investing
Interest Paid	Operating	Operating or Financing
Dividends Paid	Financing	Operating or Financing

Module 6: Analyzing Financial Statements

Inventory Turnover

What does inventory turnover actually mean?

We all know by now how to calculate inventory turnover (COGS divided by average inventory), but what does it actually mean? Well, as the name suggests, inventory turnover is a measure of how quickly a company’s inventory is turned over or replenished. Why would a company need to measure this?

Inventory that is highly perishable, such as bread and produce at a grocery store, must be carefully monitored not only to avoid waste or contamination but also to drive sales (Who wants to buy stale groceries?). Let’s assume that the industry average for inventory turnover in grocery stores is 24. This means that inventory turns over or is replenished 24 times in a year or about every 15 days. A grocery store operating with an inventory turnover of 12 (meaning their inventory is replenished only 12 times per year or about every 30 days) could compare themselves to the industry average and implement some changes in the way they handle their inventory. If the number comparison didn’t work, surely the smell of rotting fruits and vegetables would! Higher inventory turnover also means that the business has to deploy less capital in inventory. Holding sales constant, a business with an inventory turnover of 12 has twice the inventory of a business with an inventory turnover of 24. Thus, higher inventory turnover signals higher levels of efficiency.

Module 7: Accounting for the Future

Forecasting Financial Statement

Forecasting financial statements is an important endeavor for all types of companies. Internally it helps the company create goals and make decisions. For external purposes, companies generally use some of the information derived from forecasted financial statements to give projections to analysts and investors. It’s important to remember that these numbers are just forecasts, and they are not certain. Additionally, companies make a lot of assumptions in calculating forecasts, so it’s important to do a sensitivity analysis. Sometimes called a scenario analysis, sensitivity analysis allows companies to evaluate their assumptions, and perform worst-case and best-case scenarios.

Microsoft Excel has a neat tool where you can see how changes in one or two assumptions would change a specific value in a projection. For example, you could see how assumptions about sales growth percent and assumptions about interest percent would affect net income. Review this great resource that shows how to use that tool, using the example of a sales projection.

This is an advanced Excel function, and it will take some time to master it, but it’s very useful. Once you have mastered this data table version of scenario analysis, you can also explore some of Excel’s other functions, including scenario analysis, which allows you to compare multiple scenarios, and goal seek, which will change one assumption in an analysis to reach a desired final outcome. Excel skills are important and practical skills for all business professionals.

Change in Net Working Capital

In determining Free Cash Flow (FCF), many learners struggle and make mistakes with calculating changes in Net Working Capital (NWC). Net Working Capital represents all the amounts that companies need for daily operations, which represents the difference between current assets and current liabilities.

In calculating FCF, you subtract the change in Net Working Capital. An easy mistake to make is to forget to determine the change in NWC. This is a two-step process. First, calculate the NWC for each year by subtracting current liabilities from current assets. Then, determine the change in NWC from each year by subtracting the previous year’s NWC from the current year’s NWC.

If Net Working Capital increases, it is subtracted in calculating FCF, but if NWC decreases, it is added in calculating FCF, because you are subtracting a negative value. It’s also helpful to think about why this makes sense conceptually. If NWC increases from one year to another, it means that the company needs to invest more in its current assets. Thus, the company will have less cash left over at the end of the year. Alternatively, if NWC decreases from one year to another, it means that the company has either decreased its investments in current assets or it has increased its reliance on liabilities. In either case, the company is freeing up cash that in the previous year it had used to invest in current assets or pay back current liabilities.

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