1. 1 ACCOUNTING: G604 Eric Rasmusen, erasmuse@Indiana.edu 20 January 2006

2. 2 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? TWO BRANCHES OF ACCOUNTING

3. 3 BIG IDEAS IN ACCOUNTING 1. Summarize a companys 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.

4. 4 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?

5. 5 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 ACCOUNTING INDUSTRY TERMS

6. 6 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)

7. 7 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.

8. 8 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?

9. 9 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.

10. 10 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.

11. 11 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 firms operations are steady over time, how it accounts for costs over time matters less.

12. 12 Allocating Overhead Microsoft produces Office and Windows. The headquarters helps with both. To which products budget should the HQ cost be allocated? There is no real theoretical answer to this. It depends on the decision being made.

13. 13 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 more goods are sold.)

14. 14 SOLVENCY RATIOS 1. The Current Ratio 3. The Debt-Equity Ratio Can the firm pay its longterm debts? Can the firm pay its short-term debts?

15. 15 PROFITABILITY RATIOS Return on Equity: Earnings Per Share: Fully diluted--how many shares are there?

16. 16 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

17. 17 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.

18. 18 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. Good will and Writedowns

19. 19 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 buildings 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 acquisitions falling in value, as an "extraordinary charge".

20. 20 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.

21. 21 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)

22. 22 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 )

23. 23 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.