DECISION-­MAKING AND  

SCENARIOS
MODULE  3.2  – Expressing  Business  
Strategies  In  Financial  Terms
Balance  Sheets  and  Income  Statements
Professor  Robert  Holthausen
Professor  Richard  Lambert

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Agenda

• 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  Income  Statement  first
• Then  do  the  Cash  Flow  Statement  and  how  it  relates  back  to  the  
other  two

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What  Makes  Balance  Sheet  Accounts  Change  Over  Time?
Beginning Business  Activities,  Transactions Ending   Balance
Balance and   Events  During  the   Period
CashBeg +   Receipts   -­‐ Payments = CashEnd
Accts  RecBeg +   Sales  -­‐ Collection = Accts  RecEnd
InventoryBeg +   Purchases  – Cost  of  Goods  Sold = InventoryEnd
PPEBeg +   Purchases  – Deprec -­‐ Disposals = PPEEnd
Accts PayBeg +   Purchases  – Payments to   Suppliers = Accts  PayEnd
Wages PayBeg +   Wage Expense   – Wages  Paid = Wages  PayEnd
Contributed   +   Stock Issuance  – Stock   = Contributed
CapitalBeg Repurchases CapitalEnd
Retained   EarnBeg +   Net Income   -­‐ Dividends = Retained   EarnEnd

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We  Could  Analyze  Each  Account  Independently,  But

• We  can  learn  even  more  if  we  understand  how  the  changes  in  
accounts  are  related  to  each  other
• This  is  governed  by  the  Balance  Sheet  Equation
§ Assets  =  Liabilities  +  Owners’  Equity
• This  equation  is  going  to  impose  a  discipline  and  consistency  
across  accounts  that  is  going  to  
§ Help  us  make  fewer  mistakes  and
§ Help  us  Identify  the  Relation  between  the  Cash  Flow  
Statement  and  the  other  two  statements

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Implications  of  Balance  Sheet  Equation

• Assets  =  Liabilities  +  Owners’  Equity

• Any  transaction  or  event  that  is  recorded  in  the  financial  statements  
must  preserve  the  balance  sheet  equation
• This  means  each  transaction  itself  must  balance
• If  one  account  is  impacted,  at  least  one  other  must  be  as  well  
• Example:    Suppose  an  asset  account  goes  UP,  then  at  least  one  of  
the  following  also  happens
– Another  asset  account  has  to  go  DOWN,  or
– A  liability  account  goes  UP,  or
– An  owners’  equity  account  goes  UP

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Financial  Statement  Impact  of  Transactions  and  Events

• For  each  transaction  or  event,  we  will

• Determine  which  “accounts”  (if  any)  are  affected
• Make  sure  that  the  balance  sheet  still  balances
Assets  =  Liabilities  +  Owners’  Equity

• Most  of  these  transactions  and  events  are  part  of  the  New  Product  
Venture  example  we  will  be  analyzing  in  Module  4.
• Any  transaction  or  event  that  impacts  the  Income  Statement  will  flow  
into  Retained  Earnings
– A  real  accounting  system  would  keep  a  more  detailed  record  of  the  
types  of  revenues  and  expense

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Issue  Shares  (A  Financing  Transaction)

a) Raise  $240,000  of  cash  in  exchange  for  shares  of  common  stock.  

ASSETS            =        LIABILITIES    +  OWNERS’  EQUITY

Cash Contributed
Capital
Issue  Shares +$240,000 +$240,000

Cash  Goes  Up,  but  there  is  no  Impact  on  Income
We  want  to  distinguish  between  Owners’  Equity  going  up  because  of  profits  and  Owners’  
Equity  going  up  because  of  new  contributions.
This  is  a  financing  transaction;;  It  is  not  a  measure  of  how  well  the  project  is  performing

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Long  Term  Assets  -­ PPE

a) Purchase  PPE  for  $70,000  Cash

b) PPE  expected  to  last  7  years  and  be  worth  $0  at  that  time

ASSETS        =        LIABILITIES  +    OWNERS’   EQUITY

Cash PPE Retained  

Earnings
Purchase -­‐$70,000 +$70,000
Depreciation -­‐$10,000 -­‐$10,000
Expense   (each  year)

PPE     is  not  charged  entirely  to  income  immediately  because  it  will  benefit  many  periods.

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Purchasing  PPE

• Even  though  it  uses  up  cash,  it’s  not  all  charged  to  that  period’s  
income  statement
• This  is  because  we  can  use  it  for  many  periods
• PPE  is  an  asset  because  it  has  future  benefits
• If  instead  PPE  was  leased  or  rented,  no  asset  would  be  recorded.    
Instead  there  would  be  a  (smaller)  recurring  cash  outflow  that  
was  charged  to  that  period’s  income  statement.

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Long  Term  Assets  -­ PPE

a) Purchase  PPE  for  $70,000  Cash

b) PPE  expected  to  last  7  years  and  be  worth  $0  at  that  time

ASSETS        =        LIABILITIES  +    OWNERS’   EQUITY

Cash PPE Retained  

Earnings
Purchase -­‐$70,000 +$70,000
Depreciation -­‐$10,000 -­‐$10,000
Expense  (each   year)

Depreciation  Expense  =  $70,000  /  7  years  =  $10,000  per  year.    This  reduces  our  income  in  
those  years.    Hopefully  the  benefits  from  using  the  asset  outweigh  this  expense.

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Depreciation  of  PPE

• Straight  line  Depreciation  – a  common  way  to  spread  the  

purchase  price  over  the  useful  life
• Depreciation  per  Year  =  
(Purchase  Price  – Expected  Salvage  Value)
Expected  Useful  Life
• The  book  value  of  the  PPE  generally  does  not  match  what  you  
could  sell  it  for
• At  the  end  of  the  asset’s  life,  we  sell  it  (or  dispose  of  it)  and  
record  that  cash  inflow  or  outflow  in  that  period.

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Inventory  Transactions

a) Buy  $99,000  of  inventory  on  credit

b) Make  a  payment  of  $94,000  to  the  supplier
c) Sell  Inventory  that  Cost  $90,000  
ASSETS          =          LIABILITIES      +  OWNERS’   EQUITY
Cash Inventory Accounts   Retained  
Payable Earnings
Purchase +$99,000 +$99,000
Payment -­‐$94,000 -­‐$94,000
Sale -­‐$90,000 -­‐$90,000
If  we  purchase  more  inventory  than  we  sell,  Inventory  goes  up
If  we  purchase  more  inventory  than  we  pay  for,  Accounts  Payable  goes  up

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Inventory  Transactions

a) Buy  $99,000  of  inventory  on  credit

b) Make  a  payment  of  $94,000  to  the  supplier
c) Sell  Inventory  that  Cost  $90,000  
ASSETS          =          LIABILITIES      +  OWNERS’   EQUITY
Cash Inventory Accounts   Retained  
Payable Earnings
Purchase +$99,000 +$99,000
Payment -­‐$94,000 -­‐$94,000
Sale -­‐$90,000 -­‐$90,000
If  we  purchase  more  inventory  than  we  sell,  Inventory  goes  up
If  we  purchase  more  inventory  than  we  pay  for,  Accounts  Payable  goes  up

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Inventory  Transactions

a) Buy  $99,000  of  inventory  on  credit

b) Make  a  payment  of  $94,000  to  the  supplier
c) Sell  Inventory  that  Cost  $90,000
ASSETS          =          LIABILITIES      +  OWNERS’   EQUITY
Cash Inventory Accounts   Retained  
Payable Earnings
Purchase +$99,000 +$99,000
Payment -­‐$94,000 -­‐$94,000
Sale -­‐$90,000 -­‐$90,000
If  we  purchase  more  inventory  than  we  sell,  Inventory  goes  up
If  we  purchase  more  inventory  than  we  pay  for,  Accounts  Payable  goes  up

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Inventory

• Inventory  is  carried  on  the  books  at  what  you  paid  for  it,  not  what  
you  expect  to  sell  it  for
• When  you  sell  inventory,  you  take  the  inventory  off  the  books  (at  
cost)  and  replace  it  on  the  books  with  the  cash  (or  receivable)  
you  get  when  you  sell  it
• The  difference  is  the  profit  on  the  sale

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Sales  and  Collection

a) Sell  $200,000  of  products  on  credit

b) Collect  $180,000  from  Customers

ASSETS                =           LIABILITIES  +    OWNERS’  EQUITY

Cash Accounts Retained  

Receivable Earnings
Sale +$200,000 +$200,000
Collection +$180,000 -­‐$180,000

Sales  make  Income  go  up;;  Collections  make  Cash  go  up
If  Sales  exceed  Collections,  then  Receivables  have  a  net  increase

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Sales  and  Collection

a) Sell  $200,000  of  products  on  credit

b) Collect  $180,000  from  Customers

ASSETS                =           LIABILITIES  +    OWNERS’  EQUITY

Cash Accounts Retained  

Receivable Earnings
Sale +$200,000 +$200,000
Collection +$180,000 -­‐$180,000

Sales  make  Income  go  up;;  Collections  make  Cash  go  up
If  Sales  exceed  Collections,  then  Receivables  have  a  net  increase

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Wages  and  Benefits

a) Employees  Earn  $55,000  of  Wages  and  Benefits

b) Of  this,  $46,000  is  paid  and  the  rest  is  deferred  

ASSETS                  =      LIABILITIES     +   OWNERS’  EQUITY

Cash Wages Retained  

Payable Earnings
Wages Earned +55,000 -­‐$55,000
Wages Paid -­‐$45,000 -­‐$45,000

Earning  the  benefits  lowers  income,  paying  the  benefits  lowers  cash
If  more  benefits  are  earned  than  paid,  the  Wages  Payable  account  goes  up

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Wages  and  Benefits

a) Employees  Earn  $55,000  of  Wages  and  Benefits

b) Of  this,  $46,000  is  paid  and  the  rest  is  deferred  

ASSETS                  =      LIABILITIES     +   OWNERS’  EQUITY

Cash Wages Retained  

Payable Earnings
Wages Earned +55,000 -­‐$55,000
Wages Paid -­‐$46,000 -­‐$46,000

Earning  the  benefits  reduces  income,  paying  the  benefits  reduces  cash
If  more  benefits  are  earned  than  paid,  the  Wages  Payable  account  goes  up

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Pay  Dividend  – A  Financing  Transaction

a) Pay  Cash  Dividend  of  $5000

ASSETS              =     LIABILITIES  +  OWNERS’   EQUITY

Cash Retained  
Earnings
Dividend Paid -­‐$5,000 -­‐$5,000

Retained  Earnings  Go  Down,  because  some  of  our  earnings  are  no  longer  retained!
But  Dividends  are  not  an  expense;;  they’re  not  a  cost  needed  to  generate  revenues.    
We  want  to  distinguish  between  how  much  the  project  generates  in  profits  and  what  the  firm  
does  with  those  profits  (pay  out  a  dividend  or  re-­invest  them  in  the  firm)

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Summary  of  All  Transactions  (so  far)
Assets Liabilities Owners'  Equity
Accounts   Accounts   Wages   Contributed   Retained  
Transaction  or  Event Cash Receivable Inventory PPE Payable Payable Capital Earnings

Beginning  Balance $0 $0 $0 $0 $0 $0 $0 $0

Investment    By  Owners $240,000 $240,000

Purchase  of  PPE -­‐$70,000 $70,000
Depreciation  of  PPE -­‐$10,000 -­‐$10,000
Purchase  Of  Inventory  on  Credit $99,000 $99,000
Payment  for  Inventory  Purchases -­‐$94,000 -­‐$94,000
Sale  of  Inventory -­‐$90,000 -­‐$90,000
Sales  Revenue $200,000 $200,000
Collects  from  Customers $180,000 -­‐$180,000
Wages  and  Benefits  Expense $55,000 -­‐$55,000
Payment  for  Wages  and  Benefits -­‐$46,000 -­‐$46,000
Payment  of  Dividend -­‐$5,000 -­‐$5,000
Payment  of  Taxes  (see  Below)
Ending  Balance $205,000 $20,000 $9,000 $60,000 $5,000 $9,000 $240,000 $40,000

Owners'  
Totals  for Assets $294,000 Liabilities $14,000 Equity $280,000

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Income  Statement  (so  far)

Sales Revenue $200,000

Cost  of  Goods  Sold ($90,000)
Gross   Profit $110,000
Depreciation Expense ($10,000)
Wage Expense ($55,000)
Pre-­‐tax   Income $45,000

Now   we  need  to  calculated   Income   Tax  Expense!

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Taxes  

• Calculation  of  Taxes  can  be  complicated  – when  in  doubt,  consult  a  
tax  professional
• There  is  usually  a  different  set  of  rules  for  calculating  taxable  income  
than  for  calculating  income  on  the  firm’s  “regular”  accounting  books
• We’ll  examine  one  of  those  differences  – Depreciation

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Depreciation  – Book  Purposes

• For  accounting  purposes  (called  BOOK  purposes),  firms  

generally  use  Straight  Line  Depreciation
• For  our  $70,000  purchase  of  PPE  and  a  7  year  useful  life,      Book  
Depreciation  is  $70,000  /  7  =  $10,000  a  year
• If  this  was  also  used  for  tax  purposes,  this  would  lower  taxable  
income  by  $10,000.
– If  the  tax  rate  is  40%,  this  would  lower  our  taxes  by  $4,000

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Depreciation  – Tax  Purposes

• But  for  tax  purposes,  firms  are  often  allowed  to  use  
ACCELERATED  DEPRECIATION
• The  purpose  of  this  feature  of  the  tax  code  is  to  help  stimulate  
investment
• Accelerated  Depreciation  means  that  more  depreciation  than  
$7,000  is  allowed  in  the  early  years  and  less  than  $7,000  in  the  
later  years
• This  means  that  you  get  more  of  your  tax  deduction  early.
• Given  the  time  value  of  money,  the  PV  of  your  tax  payments  is  
lower,  so  this  makes  the  after-­tax  cost  of  purchasing  the  PPE  
lower!

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Back  To  Our  Example
• Suppose   that  for  tax  purposes,  instead  of  depreciating   1/7th of  the  cost  of  
$70,000,   we’re  allowed   to  deduct  29%  of  $70,000   in  the  first  year
• This  means  Tax  Depreciation   =  .29  x  70,000   =  $20,300   (about   double   the  
straight-­line  amount)
• Assuming  everything  else  on  the  tax  return  is  the  same  as  on  our  book  
income  statement,  our  tax  return  would  be  as  follows:
Taxable  Income
Sales  Revenue $200,000
Cost  of  Goods  Sold -­‐$90,000
Depreciation  Expense -­‐$20,300
Wages  and  Benefits -­‐$55,000
         Taxable  Income $34,700
           Tax  at  40% $13,880

• Let’s  assume  that  the  tax  of  $13,800   is  paid  in  cash

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Summary  of  All  Transactions  (including  taxes)
Assets Liabilities Owners'  Equity
Accounts   Accounts   Wages   Contributed   Retained  
Transaction  or  Event Cash Receivable Inventory PPE Payable Payable Capital Earnings

Beginning  Balance $0 $0 $0 $0 $0 $0 $0 $0

Investment    By  Owners $240,000 $240,000

Purchase  of  PPE -­‐$70,000 $70,000
Depreciation  of  PPE -­‐$10,000 -­‐$10,000
Purchase  Of  Inventory  on  Credit $99,000 $99,000
Payment  for  Inventory  Purchases -­‐$94,000 -­‐$94,000
Sale  of  Inventory -­‐$90,000 -­‐$90,000
Sales  Revenue $200,000 $200,000
Collects  from  Customers $180,000 -­‐$180,000
Wages  and  Benefits  Expense $55,000 -­‐$55,000
Payment  for  Wages  and  Benefits -­‐$46,000 -­‐$46,000
Payment  of  Dividend -­‐$5,000 -­‐$5,000
Payment  of  Taxes -­‐$13,880 -­‐$13,880
Ending  Balance $191,120 $20,000 $9,000 $60,000 $5,000 $9,000 $240,000 $26,120

Owners'  
Totals  for Assets $280,120 Liabilities $14,000 Equity $266,120

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Balance  Sheet

Assets Liabilities  and  

Owners’  Equity
Cash $191,120 Accounts Payable $5,000
Accounts  Receivable $20,000 Wages  Payable $9,000
Inventory $9,000 Total Liabilities $14,000
Current  Assets $220,120
Property Plant  and   $60,000 Contributed   Capital $240,000
Equipment,   Net
Retained   Earnings $26,120
Total  Owners’  Equity $266,120
Total  Assets $280,120 Total  Liabilities Plus   $280,120
Owners’  Equity

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Income  Statement  (Including  Taxes)

Sales Revenue $200,000

Cost  of  Goods  Sold ($90,000)
Gross   Profit $110,000
Depreciation Expense ($10,000)
Wage Expense ($55,000)
Pre-­‐tax   Income $45,000
Tax Expense $13,880
Net  Income $31,120

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Next  – The  Cash  Flow  Statement

• And  How  it  Relates  to  the  Income  Statement  and  Change  in  
Balance  Sheet  accounts

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KNOW L E DG E FOR ACTI ON
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