Hi, I'm Rick Lambert, Professor of Accounting at the Wharton school, and in this module we're going to be continuing our discussion of decision making and scenarios. In particular, we're going to be focusing on balance sheets and income statements. So in this module we're going to look at a series of common transactions and events and see how they impact the financial statements. We'll focus on the balance sheet and the income statement first, and then do the cash flow statement and how it relates back to the other two. So, if we look at balance sheets, here's a group of common items on balance sheets, some assets, liabilities, and owner's equity accounts and how they evolve over time. We can talk about the things that make them go up or make them go down. Feel free to pause this chart, take a look at it, I'm not going to go into a lot of depth on it right now, but we're going to come back and talk about each of these parts and you might want to refer back to this one later on. So we could analyze each of those accounts independently but we can learn even more if we understand how the changes are related to each other. This is governed by the balance sheet equation, assets equals liabilities plus owners' equity. This equation is going to impose a discipline and consistency across the accounts that is going to help us make fewer mistakes, and also help us identify what the relationship between cash flow, which is again what we're trying to ultimately forecast to do our present value calculations, and the other two statements, which are usually easier to forecast. So implications of the balance sheet equation, assets equals liabilities plus owner's equity has to balance. This means any transaction or event that is recorded in the financial statements has to preserve that balance sheet equation. That means that transaction has to balance as well. If one account is impacted at least one other account has to be impacted to keep things in balance. So, for example, if an asset account goes up, at least one of the following also has to happen. Some other asset account goes down or a liability account goes up or an owner's equity account goes up. So we're going to take a look at a series of transactions and help try to cement in how each of those work. When we look at these transactions or events, we're going to determine which accounts, if any, are impacted, and make sure that the balance sheet stays in balance. Now, most of the transactions and events that we're going to be talking about are ones we're going to be explicitly using in our next module, where we're analyzing a new product venture. So this will have some carry over to that. Any transactions or events that impact the income statement, remember, go into the balance sheet and the retained earnings account. Now, a real accounting system would actually keep separate track of specific revenues and expenses so that we could put together a more detailed income statement. So our first transaction is a financing transaction. The company raises $240,000 in cash in exchange for shares of common stock. So we need to keep the balance sheet equation in balance. We've got assets to the left of this red line and liabilities and owners' equity accounts on the right of the red line. What's on the left has to be balanced with what's on the right. So how would we record this transaction? Well, clearly cash goes up by $240,000, so that's on the asset side. No other assets are impacted so the rest of the transaction would have to be on the other side of the equation. There's no liability here, so it's an owners' equity account. In particular, contributed capital goes up by $240,000. So even though cash goes up, there's no impact on income. Cash and income aren't the same thing. And even though owners' equity goes up, there's again, no impact on income. An important thing that an accounting system needs to do is keep separate owners' equity going up because of new investment, and owners' equity going up because of profitability. This is a financing transaction. It's not a measure of how well our projects are performing. Now, let's take some of that cash and buy something with it. Let's buy some long term assets. Property, plant, and equipment for $70,000. So cash goes down $70,000 but we don't charge that to income. Income doesn't go down $70,000 because long term assets, by definition, are going to be benefitting multiple periods. So instead of reducing income by $70,000 this period, we're going to say we have a different asset than cash. Property, plant and equipment. So, one asset goes down and another asset goes up. Long-term assets are ones that are going to benefit many periods. We keep them on the balance sheet as long as they're going to continue to provide some benefits. On the other hand, if we had rented or leased property, plant, and equipment, when we pay for that year's rent, that benefit's used up. So we would actually expense those. With a long term asset you typically have one big cash out flow, whereas with leasing or renting you would have a recurring series of cash flows. By seeing that you've got an asset on the balance sheet you can tell the difference between those two. Now overtime we're going to use that asset. Suppose it's expected to last seven years. Then we're going to divide our $70,000 asset over the seven years and we call that depreciation expense. $10,000 a year. We're going to charge off $10,000 of the depreciation each year for the seven years. So during those years, the asset itself goes down, property, plant and equipment and now, over on the other side of the balance sheet, owners' equity is going to go down, retained earnings is going to go down. This is going to be an expense that's part of our income in those years, we're going to match that with the other expenses in the revenues, hopefully we are going to be getting benefits in those future years that more than offset this expense. So this is an example of something called straight line depreciation. So the depreciation expense in each year is level over time. Ultimately, at the end of the asset life, we're going to dispose of it, or perhaps sell it, and if that happens, we'll record a cash in flow, or an outflow, at that point. Now, let's look at some inventory transactions. Let's start out by buying $99,000 of inventory, but on credit. So no cash is used up and nothing hits the income statement yet, either. We've got an asset inventory that's worth $99,000 but cash didn't go down. Instead we've got a liability that goes up. So the asset goes up, liability goes up. The liability we would call accounts payable. When we make a payment to the suppliers, that's when the cash goes down and the liability goes down as well, so if we made a payment for $94,000, cash would go down by 94 and the liability would go down by 94 also, no impact on income yet though, because the inventory is still being held, we still have that asset. Later when we sell the asset, that's when the inventory account goes down and income is going to go down as well, retained earnings. No cash is going down at this point, okay, the cash goes down when we pay for the inventory. The income goes down when the inventory is actually sold. Note that if we buy more inventory than we sell, the inventory account goes up during the year. If we buy more inventory than we pay for, the accounts payable account goes up. Inventory on the balance sheet is typically kept at its historical cost, what you paid for it, not what you expect to sell it for. Once you ultimately sell it, you take the inventory off the books and replace it with the sales price, either cash or receivable, and the difference between those two is the profit on the sale. So let's look at an example of a sale. Suppose we sell some products for $200,000, but on credit. Well, the sale means retained earnings goes up, the income statement goes up, but we don't have cash. Instead, what we have is a receivable, okay? A promise to pay us cash. So that's what we're going to record, an asset goes up but this time it's a receivable. Later on, when some of the cash is collected, the cash goes up, but we don't record income at that point, because we already recorded the income back when the sale happened. Instead, we record the receivable going down. So the cash goes up when we collect, the income goes up when the sale happens, in between, we have a receivable. If we sell more, as we have in this case, than we collected, note that the receivable is going up. Some of the sales aren't in the form of cash. They're in the form of the receivable. A receivable is going to be an example of a working capital account, as we'll see. Wages and benefits. Suppose that we have some employees that earn $55,000 of wages and benefits. Well, we record that as an expense on the income statement, just like cost of goods sold, just like depreciation expense, so retained earnings goes down. And let's suppose initially we havent paid it yet, well then cash doesn't go down, but that means a liability to pay the cash goes up. So now we've got a liability going up and an owners' equity account going down to keep the balance sheet in balance. If we ultimately pay $46,000 of it this year and defer the rest, well that's when the cash goes down. So the cash goes down, and the liability goes down, note that in this case, the expense on the income statement was bigger than the cash paid, and so the liability account on the balance sheet is what balances that difference between cash and income, the liability goes up in this case. Our last transaction is going to be a dividend transaction, so this is also an example of a financing transaction. Pay a cash dividend of $5,000. Well, cash goes down and it makes sense that retained earnings goes down because a dividend means the income is no longer retained. But here it's important to note that even though retained earnings is going down this is not part of the income statement. Dividends aren't an expense needed to help generate cash, instead dividends are a return of some of the capital that we have gotten from investors. So it's important to distinguish between how much profits the firm is generating and then what happens to those profits. Are they paid out as a dividend or retained in the form of retained earnings? So if we take a look at all of our transactions so far. Here is a table. All the asset accounts, starting at zero, as liability accounts and the owners' equity accounts are, how they change as a result of each of our transactions, and then our ending balances. Note that the total assets, $294,000, equals the sum of the total liabilities, $14,000, and the total's owners' equity, $280,000. This would allow us to put together an income statement. So we've got sales revenue minus cost of goods sold for a margin of $110,000. Then we've also got depreciation expense and wage expense to bring us down to $45,000. But we didn't do the taxes yet, so let's add that in. Now, taxes can be complicated, so when in doubt consult a tax professional on this. One complicated feature is there's usually a different set of rules for calculating taxable income than there is for calculating the firm's regular accounting income. And so we're going to examine one of those differences, namely depreciation. Depreciation on our regular accounting book says we typically do something called straight line depreciation and just divide the $70,000 evenly over the seven years, $10,000 a year. This lowers our income by $10,000 and if that's how we report it in our tax books, it would lower our taxable income by $10,000. If the tax rate's 40%, that would lower our taxes by $4,000 a year. And $4,000 each year over the next seven years. But for tax purposes, firms are allowed to use something called accelerated depreciation. The purpose of this in the tax code is to help stimulate investment in property, plant, and equipment. Accelerated depreciation means you're going to be allowed to deduct more than $7,000 the first year and less than $7,000 in later years, but that means you get more of your tax deduction early. Given the time value of money, the present value of your tax payments goes down as a result to this, which makes the after tax cost of purchasing the property, plant and equipment go up. So, in our example, suppose, instead of depreciating one seventh of the cost of the asset each year, we're actually allowed to deduct 29% of it in the first year. So that means tax depreciation would be $20,300 which is roughly double what the straight line would have been. If everything else on the two sets of books was the same, we could calculate our pre tax income on the tax return now at $34,700 and our taxes would be $13,880. Let's assume that that's paid in cash. Well, now we can complete our summary of all the transactions, adding in the tax payment, lowering our cash, and lowering our retained earnings. Now we can put together our financial statements. Here's our balance sheet. The assets on the left. We've got the current assets first, then the long term assets. The liability accounts together, the owners' equity accounts last. Again, distinguishing between contributed capital and retained earnings. Note that the change in retained earnings is not the same as the income because there was a dividend paid out from that as well. Our income statement, including the taxes now, is $31,120. Next, we want to put together the cash flow statement. So, our objective is to see what happens with those same transactions on the cash flow statement and then relate that back to what we just did with the income statement and the change in the other balance sheet accounts.
