Financial Accounting





Kerry Back

Major accounting statments

  • Income statement
    • Revenue - expenses - taxes = net income
  • Balance sheet
    • Assets and liabilities
  • Statement of cash flows

Cash flows

  • Anything run through the income statement that is not a cash item creates a balance sheet item
  • Any cash item that is not run through the income statement also creates a balance sheet item
  • Income minus change in balance sheet = cash

Timing of expenses

  • Match expenses with corresponding sales. Deduct when you record income.
  • Raw materials are inventories, not expenses.
  • Same for labor cost of goods in process.
  • Materials + labor charged against sales when sales occur.
  • Build-up of inventory is an increase in invested capital and a negative cash flow.

Timing of income

  • Record sales when they occur (or on delivery) not when receivable is collected.
  • A sale that is not collected is a build-up of invested capital (accounts receivable).
    • Record sale in income statement.
    • Offset it in cash flows with build-up of invested capital
  • Pre-payment of sales is recorded as a liability.
    • Increase in liability is a reduction in invested capital.
    • Cash from prepayment shows up not in income but as reduction in invested capital.

Property, plant & equipment

  • IRS requires investment in “long-term assets” to be expensed (depreciated) over time.
  • Not expensed against corresponding sales. Timing of sales is irrelevant.
  • Not expensed according to your own beliefs about how long the assets will last.
  • Fixed schedules for different types of assets
  • MACRS = Modified Accelerated Cost Recovery System: Wikipedia

Depreciation and income

  • Depreciation shows up as a cost in the income statement
  • Reduces taxable income, so reduces taxes
  • It is not a cash outflow.
  • Depreciation is a reduction in invested capital, which offsets the cost shown in the income statement.
  • Only effect of depreciation on cash flows is tax shield.

Disposal of PP&E

  • Selling equipment produces a taxable gain or loss
  • Is also a reduction in invested capital
  • Selling price minus book value minus taxes goes in income statement
  • Subtracting reduction in invested capital adds back the book value to cash flow
  • Net effect on cash flow is selling price minus taxes