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

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.

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.

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.

Advanced Topics in Accounting

Accounting for Intangible Assets

Intangible assets are literally assets that you cannot touch. These are non-monetary assets without physical substance that provide future benefits to a business.

By 2020, intangible assets as a percentage of total market value of S&P 500 companies had grown to 90%. Examples of intangible assets include patents, trademarks, and artistic work such as books, plays, music, art, and other works.

In accounting, intangible assets created in-house generally have no book value as the cost of creating those assets are expensed as incurred rather than capitalized. So how it is that they came to make up over 90% of many companies’ book value? The primary way to acquire intangible assets is through purchase or acquisition and not through creation in-house. Intangible assets represent a wide variety of productive human activities.

When Heinz acquired Kraft in 2015, out of roughly 53 billion dollars in assets acquired, 49.7 billion dollars was made up of intangible assets and included trademarks and customer relationships. Most large companies have completed a great many acquisitions in their lifetime.

Once an intangible asset has been acquired, the company will record the asset on its balance sheet. There are two kinds of intangible assets – ‘finite life’ intangible assets and ‘indefinite life’ intangible assets. Finite life intangible assets are those whose useful economic life in terms of months or years can be estimated with reasonable certainty. A good example is a drug patent whose useful life in the US is limited to twenty years by patent regulation.

Other intangible assets have ‘indefinite lives’ – useful lives that extend beyond a foreseeable horizon. An example might be a communication broadcast license that can be renewed at little cost and effort. For both US GAAP and IFRS, goodwill and intangible assets with indefinite useful lives are tested for impairment at least annually. If it is determined that the asset has been impaired, the company will need to record an impairment loss to reduce the value of the asset – a debit to impairment loss and a credit to the intangible asset.

Equity Investments represent one company’s investment in another firm or financial entity. One of the key questions to consider when purchasing an equity investment is the level of control or influence likely to be obtained. A ‘significant’ stake provides greater control, but with greater stake comes greater risk. Equity investments are accounted for differently depending upon the level of investment/risk:

Fair Value Method: Is used for investments representing less than a 20% ownership stake, in which the investor is presumed not to have significant influence. Is generally recorded as “marketable securities” or “investments”.

Equity Method using the VIE (variable interest entity) Model: Is used in cases where both share ownership and other aspects of the relationship are taken into account to determine the level of interest or control one company has over another.

Equity Method using VOE (voting interest entity) Model: Is used in cases when voting share ownership alone can determine the level of interest and control one company has over another company.

Consider this situation – Company A invests in Start-up X and owns 51% of the outstanding shares of the company. Company B invests in Start-up Z and owns 25% of the outstanding shares of the company as well as having a long-term agreement to purchase 80% of the company’s output at a fixed price, plus a margin.

Which company – A or B – can be said to have a controlling interest in these start-ups?

Potentially both! While Company A has a controlling interest through its share ownership, Company B has a controlling interest because, in addition to its share ownership, it is absorbing a significant amount of Start-up Z’s risk through its cost-plus purchase agreement and thereby transferring equity risk to itself. The power relationship between the two companies may also be altered by the agreement. Company B, as a major client of Start-up Z, can exert considerable decision-making influence on the firm.

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

Analyzing Financial Statements

DuPont Framework

Why is ROE (return on equity) such an important metric of company success? Return on equity is calculated by dividing net income by total owner’s equity:

Return on Equity (ROE) = Net Income / Owner's Equity

The DuPont Framework helps us understand how we can expand ROE to gain insight into three key aspects of a company’s operations: profitability, efficiency, and leverage, all captured by the ROE metric. Click here to view the DuPont Framework broken down into the three ratios that reflect the three key aspects of the company’s operations. Those ratios can be broken down even further to gain additional understanding on specific aspects of the company’s financial performance. Ratios can be very useful when comparing one company to another because they allow analysts to eliminate, to a large extent, the impact of size differences that exist among companies. Most ratios, however, are in some ways influenced by managerial judgment in recording transactions that have a great impact on the financial statement.

While accounting standards attempt to minimize the differences between companies, situations exist where two companies will reasonably elect different ways of accounting for items that appear very similar. Understanding these differences is essential to analyzing companies using ratio analysis.

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.

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