1 G601, IO I Eric Rasmusen, [email protected] 13 September 2006 Accounting and Data I This is for one 75 minute session.

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G601, IO I Eric Rasmusen, [email protected] September 2006

Accounting and Data I

This is for one 75 minute session .

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Readings

2 September, Tuesday. Accounting Data, and Finance I.

   I have constructed a data page that has lots of links. The Wharton WRDS finance data site is at http://wrds.wharton.upenn.edu

   The Eli Lilly Annual Report. Just skim Lilly report, except for the financial tables.

   Eric Rasmusen, ``Aphorisms on Writing, Speaking, and Listening,'' in ascii latex and pdf. I have short versions in ascii latex and pdf. Reader 68.

   Overheads are here in powerpoint.

Due: Problem Set 2: 3.4, 3.5, 3.8. Answers are (or will be) here.

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NEXT TIME

Finance. Read on present value

L:atex assignment .

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Handouts• 2005 Financial Highlights• Problem set 1 first page• Data webpage

Problem Set 2 (due : 3.4, 3.5, 3.8.

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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

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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.)

GAAP (GAP): Generally Accepted Accounting Principles. The standard rules of accounting.

FASB (FAZBEE): The private board which makes accounting rules in the USA

ACCOUNTING INDUSTRY TERMS

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BIG IDEAS IN ACCOUNTING1. Summarize a company’s 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. Accrual, not cash flow. Accounts receivable.

3. Annualize flows of cost and benefit. Depreciation.

4. Allocate all costs to some product or part of the business.

5. Double entry bookkeeping. Equity =Assets - Liabilities.

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ACCRUAL A new company paid its workers and suppliers $10,000 and receives $8,000 in cash from customers by December 31.

Customers have ordered but not paid for $3,000 in goods that have not yet been shipped.

Customers have ordered and paid for $2,000 in goods that have not yet been shipped.

Customers have been shipped but not paid for $1,500 in goods.

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ACCRUAL, continued

On hand, the company has $4,000 in inventory on December 31.

The company must pay $1,000 in taxes on April 15, 2006 for its 2005 activities.

The company has placed orders for $5,000 in materials that it will receive next year.

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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.

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Allocating Overhead

• Microsoft produces Office and Windows. The headquarters helps with both.

• To which product’s budget should the HQ cost be allocated?

• There is no real theoretical answer to this. It depends on the decision being made.

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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?

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FINANCIAL STATEMENTS

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)

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Data to do

• WRDS—log in, do a search on Ford (F)

• Compustat-Exec comp. Use IBM

• Do a CRSP search for excess return

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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 $6 million to buy a building.

Assets: 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, unless the company chooses to do something and write down the assets.

Goodwill and Writedowns

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Goodwill and Writedowns, ctd.

Assets: a $6 million building and 4 million in goodwillLiabilities plus equity: 3 million in debt plus 7 million in equityThe building’s market value has fallen 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 goodwillLiabilities 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 acquisition’s falling in value, as an "extraordinary charge".

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Merger Accounting A company has a chance to play with its accounting after a merger.

PRE-MERGER:Company Apex has assets of $100M and market value of $100M Company Brydox has assets of $50M and market value of $80M

Then Apex pays $90M for Brydox, which is worth $120M to Apex. Apex borrows the $90M to pay for Brydox.

Post-MergerApex has assets of $190M and a market value of $130M.Brydox has assets of $0 and a market value of $0.

Notice how the industry assets have risen and the market value of firms in the industry has fallen.

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COMPARING ACROSS INDUSTRIES 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 different industries will be affected

differently.  

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EXTRA MATERIALS PROBABLY NOT TO BE

USED

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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?

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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.

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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.

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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 firm’s operations are steady over time, how it accounts for costs over time matters less.

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Course Website

A link to the course website

http://www.rasmusen.org/g601/0.g601.htm