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Corporate Finance
University of Kansas School of Law
Harper Ho, Virginia

Corporate Finance

Ho

Spring 2014

Three Primary Bodies of Law

1. Accounting regs (FASB)

2. Security Regs (SEC) = Enforcement authority

3. State Corp law

Accounting = Primary role is recording and accounting for the receipt and disbursement of a limited set of money-denominated assets

1. GAAP (Generally Accepted Accounting Principles) = Set by US Fin. Acct Standards Board (FASB)

2. IFRS (International Financial Reporting Standards) = (set by international accounting standards board)

3. PCAOB = Non-profit Corp established by Congress to oversee the audits of public companies and broker-dealer compliance (no role in rule-making)

Four Basic Financial Accounting Reports

1. The balance sheet – Assets = Liabilities + Equity

2. The income statement = Connection in time between balance sheet A and balance sheet B

3. The cash flow statement

4. The statement of changes in stockholders equity

Cost-principle = Assets are reported on a company’s books at historical cost and not at higher market values (book value)

Consolidated Returns = When a Corp owns 50% or more of the voting power of another Corp, the parent Corp will prepare consolidated financial statements

1. When a Corp owns less than 50% but more than 20% the returns are not consolidated; but instead use the Equity Method of accounting and enters its original investment in the subsidiary as an investment

Accounting Periods = Are typically yearly (but can be quarterly or monthly)

1. Cash Method = Revenues are only recognized when received

2. Accrual Method = All expenses incurred to generate reported income for the period must be matched (Corps must use)

3. Forms of Financial Reporting

a. Publicly traded companies are governed by the periodic reporting requirements under the SEA

Capital Expenditure Decisions (CAPEX) = Capital budget listing the major projects approved for investment. Today’s capital investments generate future returns

1. Investment decisions = Decisions on what to invest IOT generate future income

a. Real asset (acquisitions)

b. Firm (keeps cash)

c. shareholders (dividends)

d. Financial Assets (

2. Financing decisions = Choice between debt (loans) and equity (shareholders) financing

a. Equity financing = Either by issuing new shares or taking present cash flow and reinvesting the cash in new assets

b. Debt Financing = loans, debentures, bonds

Liabilities = This can include all kinds of obligations, like money borrowed from a bank to launch a new product, rent for use of a building, money owed to suppliers for materials, payroll a company owes to its employees, environmental cleanup costs, or taxes owed to the government. Liabilities also include obligations to provide goods or services to customers in the future

1. Unconditional Purchase Obligation = Mfg. sells inventory to a 3rd party for current cash with an agreement to repurchase inventory in the future

2. Product warranty claims, liability claims,

3. contingent liabilities = (uncertain and not disclosed on the balance sheet)

a. If it is probable and the amount of the charge can be reasonably estimated, the company must take a charge against earnings in the current period

4. Capital Leases = Leases that are disguised credit purchase (lease for useful life of the asset at the value of the asset). If one of the following is true, the lessee must capitalize the lease and record the NPV of the payments as both an asset and an offsetting liability

a. The lease contains a bargain purchase option, defined as a price so low that exercise of the option is almost certain

b. The lease automatically passes title at the end of the lease to the lessee without further payment

c. The lease term is equal to at least 75% of the estimated useful life of the asset; or

d. The NPV of the lessee’s minimum payments under the lease equals 90% or more of the fair market value of the asset at the beginning of the lease

5. Current Liabilities = Liabilities due within the current 12mo. accounting cycle (accounts payable, taxes

6. Non-Current Liabilities = Liabilities due outside of the current 12mo. accounting cycle

Shareholders’ equity = is sometimes called capital or net worth. It’s the money that would be left if a company sold all of its assets and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners, of the company

1. SH Equity = Assets – Liabilities

2. SH Equity Rank = Preferred stock, Common Stock

3. If shares sold for more than their par value (i.e. no-par shares), or for more than the amount assigned to capital, the balance will be assigned to additional paid in capital

4. Value of the common stock will fluctuate

a. Retained Earnings = If a profit is earned and no dividends are paid, the common stock will increase by the amount of that profit

b. Accumulated Deficit = If losses, the capital accounts will be diminished by the amount of the losses

Income Statement = A report that shows how much revenue a company earned over a specific time period (usually for a year or some portion of a year). An income statement also shows the costs and expenses associated with earning that revenue. The literal “bottom line” of the statement usually shows the company’s net earnings or losses. This tells you how much the company earned or lost over the period

Basic Accounting Principles

1. Historical costs = Assets are always reported on BS (transaction cost)

2. Reliability =

3. Materiality = Record and take account of transactions that would matter to the individual shareholder (i.e. rounding numbers)

4. Economic Entity = If owned by parent Corp (50%), consolidation of reporting

5. (Matching) Accrual Accounting = Matching principle that income and expenses are accounted for at the time they occur (revenue and expenses recorded when legally payable and know its value)

f profitability before government and financier expenses

4. (Sales, general, administrative)

5. R&D

6. Stock Compensation

7. Operating Profit [income; synonymous with earnings before income and taxes EBIT)

Debt

1. (interest expenses)

2. Pre-tax Profit

3. (tax expense)

Equity

1. Net-profit [or loss] = Residual income claimed by equity holders after all expenses are paid to other claimants

a. Can be distributed as a dividend; or

b. Retained earnings (marked on the balance sheet as an asset and increase in retained earnings)

EBITDA = EBIT + depreciation + amortization (non-cash expense items) is a rough approximation of cash flow

Management’s Discussion Analysis = material changes in the income statement in the balance sheet and income statement since the last statement and material changes to future statements

Earnings Per Share (EPS)

1. Basic = The average # of shares issued and outstanding during the year

2. Diluted = Basic # of shares + shares that would have been outstanding if all stock options were exercised and all convertible securities were converted into common stock

Accounting Options

Inventory Accounting

Cost of Goods Sold = Cost of materials that went into producing goods

1. FIFO = One effect of this method is to provide more realistic reflection of the current value of inventory

a. Matches how inventory is actually handled

b. Gives a better idea of actual cost of inventory

2. LIFO = Treats the most recently purchased inventory as that which is 1st used to mfg. or sell goods

a. Matches current costs with current sales prices

b. If inventory is never depleted to zero, the stated value of inventory will get more and more out of alignment with current costs under conditions of inflation

3. Weighted Average Method = Since a business cannot identify exactly which units are sold, it can use an average cost

Depreciation Accounting [matching principle]

Replacement Cycle = The useful life of an asset may not be the entire physical life of the asset

1. When businesses purchase assets, they must make an estimate of how long the useful life will be

Straight Line Depreciation = Most common method. Assume an asset has X years of life, an original cost of Y, and no salvage value, then take Y/X and it gives you the depreciation per year