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Introduction toAccounting and Finance

________ ________

ClassBook

Anthony Webster

5th Edition

Introduction to Accounting and Finance

5th Edition

Anthony Webster

Columbia University

Copyright © 2012, Applied Finance, LLC.ISBN 978-1-4507-4872-8

Contents

How to Use This Book – Read this first!

Part I: Accounting1. Introduction – Why Accounting and Finance are so Great2. Balance Sheet2a. Case Study – Fannie Mae3. Recording Accounting Events4. Income, Owners’ Equity and Cash Flow Statements5. Inventory and Cost of Goods Sold5a. SGA, Depreciation Revisited, Taxes5b. Case Study -- Taxing Hedge Fund Managers5c. Cash Accounting6. Comprehensive Accounting Example6a. Case Study – Q4-2008: Financial Freeze and Causes

Part II: Finance7. Ratio Analysis7a. Equity Ratios8. Cash Analysis9. Time Value of Money10. Evaluating Investments with Discounted Cash Flow (DCF) Methods11. DCF Valuation under Rationing or Mutual Exclusivity12. Introduction to Random Variables12a. Risk12b. Case Study – Sovereign Risk13. Case Study -- Q4 2008 – Economic Impacts of Securitizations14. Financial Projections – I15. Financial Projections – II16. Entity Valuation17. Case Study – Balance Sheet Valuation of an EDP CompanyAbout the Author

How to Use this Book

Introduction to Accounting and Finance Page 4

This book is the primary required textfor the "Introduction to Accountingand Finance" class taught atColumbia University’s EngineeringSchool and at Barnard College.(Class listing: SEAS IEOR 2261).The book covers all of the topicsaddressed in the course, and providesa comprehensive set of exampleproblems discussed during classsessions.

This text may also serve as astandalone, terse introduction to thesubjects of accounting and finance, asa review source for those needing afast-paced refresher course, or as aquick-reference for businessprofessionals that apply accountingand finance in their day-to-day work.

The book is designed to be enjoyed ineither eBook or printed form.


To Print this Book:

The purchaser of this book may print some or all of it at any time, subject tocopyright restrictions 1. The author suggests printing from Adobe Reader withthe following settings:· Page Scaling : “Multiple pages per sheet.”· Pages per Sheet : “2” or “Custom, 1 by 2.” (Choices vary by version).· Orientation “Vertical.”

or Page Order: (Options vary by version).· Auto-Rotate : Selected.

These settings will print two eBook pages per sheet of portrait-oriented paper,looking something like this:

1. You may print this book for your own personal use, but you may not distribute any portion of the text,in either printed or electronic forms, without the author’s prior permission.



To use this Text as an eBook:

To get maximum enjoyment from this text as an eBook, the author suggests:

1) For use on Tablet PCs

Add the AutoInk plugin (available atwww.evermap.com) to your AdobeAcrobat software, then view this bookin Adobe Acrobat. AutoInk providesAcrobat with pen-based annotationcapabilities that are far superior toAdobe’s pen-annotation tool.Unfortunately, the plugin requires thefull version of Acrobat, and will notwork with Adobe Reader.

2) For standard Windows PCs

Download the free version ofPDFxchange Viewer (available atwww.tracker-software.com), andview this book from within thePDFxchange program. PDFxchangeoffers a wonderful set of pdfannotation tools, which are quick andsimple enough to use for in-class notetaking, and are robust enough fordetailed annotating at home.


3) For Macs

Try opening the PDF text with MacPreview (right click on the text icon,then choose “Open With, Preview”).Annotate the book by choosing (fromwithin Mac Preview) “Tools,Annotate, Add Note,” or by simplytyping “CNTRL+Command+N.”Then click where you’d like tocomment and start typing.

Apparently Mac Preview viewer doesnot properly handle the ClassBook onsome Macs. However, the freeapplication Skim seems to workperfectly on virtually all Macs.

If you have any trouble with MacPreview, you can get Skim here:http://skim-app.sourceforge.net/

Like PDFxchange for Windows, MacPreview’s and Skim’s annotation toolsare quick and simple enough to usein-class, and are robust enough fordetailed note-taking at home.


Introduction to Accounting and FinanceAnthony Webster

Chapter 1Why Accounting and Finance are so Great


Why Accounting and Finance are so GreatHealthcare Properties (HCP) Example


Healthcare Properties (HCP):

• Health Care Real Estate Investment Trust(a REIT).– Acquires, develops, leases, sells and

manages healthcare real estate.– Provides mortgage financing to healthcare providers.

• Well diversified– Geography: CA, IL, TN. HQ in San Francisco.– Segments: Medical office, hospital, senior housing,

life science.

HCP Example


Bond of HCP’s is for sale in marketplace (3/16/2009):

§ Market price = $94.50/bond

§ Bond “matures” 9/15/2009.(HCP must pay holders $100/bond,plus interest of $2.80/bond)

Should we buy HCP’s bond?

Buy the Bond?


Compare to US Treasury Bond maturing same day:§ Market price today = $100/bond§ Treasury will pay holders $100 + $0.42 per bond on 9/15/09

Comparison Table:§ Bond What we get / What we pay

HCP $102.80 / $94.5 = 1.0878T-bond $100.42 / $100.0 = 1.0042

HCP looks much better (8.8% return in ~ 6 months)§ What’s the catch?

The World is Coming to an End


Recall March 2009:

• S&P 500 down 19% year-to-date, after falling 39% in 2008.

The World is Coming to an End


• “Retailers expected to begin a wave of bankruptcy filings,altering the landscape at malls and on main streets across thecountry.” WSJ. (REITS ↓)

• General Growth Properties DeathWatch. (REITS ↓) S-Street Seaport

• “The next shoe to drop will be the implosion of the commercialreal estate market.” Atlanta Jrnl. Consititution. (REITS ↓)

• ‘Our largest banks are insolvent and need to be nationalized’Paul. Krugman

Buy HCP’s Bond?


Let’s make our own independent assessment:

A. Qualitative prospects for HCP’s business:Even in terrible economy, is demand for– medical office,– hospital,– senior housing

going to collapse?

Buy HCP’s Bond?


B. Quantitative Analysis: Look at HCP’s Financial Statements (Yahoo Finance)

1. Check Balance Sheet:Reports HCP’s assets (cash and cash-generators)and liabilities (obligations to pay cash in future),at a particular point in time (snapshot).

Buy HCP’s Bond?


HCP Balance Sheet As of Dec 31 2008

ASSETS $MM UONCash And Equivalents 57.6Accounts Receivable 794.5Notes Receivable 1,076.4Other Current Assets 50.5 Total Current Assets 1,978.9

Property, Plant & Equipment, net 8,710.1Other Long-Term Assets 1,160.8Total Assets 11,849.8

LIABILITIESAccounts Payable 308.1Other Current Liabilities 356.2Bond maturing 9/15/2009 102.8 Total Current Liabilities 767.1

Long-Term Debt 5,382.0Other Non-Current Liabilities 499.5Total Liabilities 6,648.6

“Current assets” (CA)= cash and assets that can beconverted to cash within a year.

“Current Liabilities” (CL)= obligations that must bepaid within a year

HCP has CA >> CL

Looks like HCP may be ableto meet bond obligation.

Buy HCP’s Bond?


What if HCP is “burning thru” cash at terrific rate?

2. Check Cash Flow Statement (CF Statement)§ Reports HCP’s cash inflows and outflows, measured over a

period of time (12 months in this case)

§ CF Operations ~ net flow of cash from day-to-day business

§ CF Investing ~ net flow of cash from purchases/salesof plant and equipment (long term maintenance andupgrades)

§ CF Finance ~ net cash flow from HCP’s stakeholders:Issue stock for $, issue bonds, repay bond principal, etc.

Buy HCP’s Bond?


Cash flows from (used in)3 months

Q1Mar-31-2008

3 monthsQ2

Jun-30-2008

3 monthsQ3

Sep-30-2008

3 monthsQ4

Dec-31-2008Totals

Operating Activities 131.7 141.0 182.7 113.3 568.7 0

Investing Activities (21.3) 450.6 27.4 (29.3) 427.3 0

Financing Activities (52.6) 0 (30.9) (143.5) (227.0)

Net Change in Cash 57.7 591.6 179.2 (59.5) 769.0

§ Operations are generating cash.§ Investments in (maintenance of)

plant etc. probably require less cash.§ Paying off bonds and/or paying big dividends.

à No evidence of big cash burn (outflow)

Buy HCP’s Bond?


1. Balance Sheet shows:HCP currently has capacity to meet bond obligation(and all its near-term $ obligations).

2. Cash Flow Statement shows:HCP will almost certainly not lose capacity to meet bondobligation before it is due.

è Price of HCP’s bond was probably driven down bygeneralized panic of the moment.

è Probably want to Buy the Bond.

Buy HCP’s Bond?


Other Real-world Considerations:

§ Check news on HCPFuture event will cause massive cash bleed this year?

§ Check notes to financial statements(www.sec.gov)

§ Etc.

Buy HCP’s Bond?


Epilogue 9/15/2009:

Bond ‘matures’§ HCP meets obligations associated with this bond.

§ Buyers on 3/15/2009 realized 8.8% return over 6 months(~ 18% annualized return).

What Accounting Is


The language of business.

Universally accepted method of:

§ Identifying

§ Measuring

§ Reporting

an entity’s financial information

What Accounting Does


Provides financial information on entities:

§ Amounts of financial resources

§ How resources were financed (paid for)

§ Financial results achieved by using resources

Who Uses Accounting Info


Anyone who needs to evaluate an entity’s financial state.

Parties inside or outside an entity:

§ Branch manager, CFO, CEO

§ Stockholders (owners)

§ Potential investors and lenders

Accrual vs. Cash Accounting


Cash accounting:

§ Record changes to entity’s cash

§ Keep track of total cash

§ Report on these two things

§ Done

Accrual vs. Cash Accounting


Accrual accounting:

§ Measures financial events as accrued, regardless of whencash transactions happen.

§ Recognizes revenue when earned (accrued)and expenses when incurred (accrued),rather than when payment is made or received.

Provides much more info:

§ More useful to managers and investors.

§ We will primarily use accrual accounting.

Accrued Definition


Webster’s Online Dictionary:

§ To come into existence

§ To accumulate or be periodically incremented(“interest accrues on a daily basis”)

Verb form:§ “Accrue vacation time…”

Accrual vs Cash Accounting Example


Accounting For Apple

Date Actions Taken by Apple Accrual Accounting Cash AccountingImpact on Apple Impact on Apple

6/15/2008 Ship 1,000 3G Iphones to AT&T;send AT&T invoice for $100,000

Record "revenue" or "sales" of$100,000

? 2

6/18/2008 Order 1,000 3G Iphone chipsets ? 3 ? 4from Infineon for $50 each.

7/21/2008 Pay $25,000 cash for heating oil. ? 5 ? 6ordered on same day.

Concepts Governing Accounting


1. Accrual2. Money measurement3. Duality4. Entity5. Going concern6. Cost7. Accounting period8. Conservatism9. Realization10.Matching11.Consistency12. Materiality

Accrual Concept


Measure financial events when accrued(when experienced or as accumulated),regardless of when cash transactions happen

Examples (Apple):§ Record revenue when products/services delivered§ Record expense as soon as obligation is created

(NOT necessarily when payments are made or received)

Money Measurement Concept


Consider only items and transactions that can be convenientlyreported in $ or other currency.

Apple should measure and report:§ Cost in $ of buying 1,000 chipsets§ Cost of paying Steve Jobs’ salary

Skip:§ Steve Job’s value to Apple§ Fact that FoxConn’s assembly workers just went on strike§ Value of the apple logo

Money Measurement Concept


What if Lenovo bought Apple?(Lenovo bought IBM’s Thinkpad laptop business)

Would Lenovo then report the value of the Apple logo?

Important Accounting Quantities


§ Assets

§ Liabilities

§ Owners’ Equity



Assets: Valuables owned or controlled by entity§ Cash,§ Things to be converted to cash,§ Things used to generate cash.

For Apple:§ Functioning iPhones in warehouse§ Unpaid invoices to AT&T§ Land and buildings

Not:§ 200 Macs in parking lot, completely destroyed by rain.§ Head of R&D department.

For HCP:§ Cash, property plant and equip, etc.



Note:

Assets usually measured at cost (or cost minus wear):§ Functioning iPhones in inventory

(at cost paid to Foxconn)§ Land (price paid)

Exceptions§ Cash and other currencies (current value)§ Stock options, commodity futures (current value)



Liabilities:§ Financial obligations of an entity§ Items representing future cash outlays

For Apple:§ Unpaid invoices from Foxconn (supplier)§ Outstanding mortgage balance on HQ building§ Salaries earned but not yet paid.

For HCP:§ “Accounts payable” (amounts owed to suppliers)§ Bond principal and interest owed§ Etc.



Owners’ Equity(or “Book Equity” or “Book Value”)

Two ways to understand Equity (must know both)

1. Owners’ Equity == Assets – Liabilities

2. Owners’ Equity = Σ Cash infusions by owners + Σ Net Income - Σ Dividends paid to owners

(Σ means sum over life of entity)

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