Financial Accounting

Module 1 The Accounting Equation

• Accounting allows us to understand what's going on within a business.
• The Accounting Equation is the fundamental building block of accounting.
o Assets = Liabilities + Owners’ Equity
• All transactions impact the accounting equation. The accounting equation, like
any mathematical equation, must always balance.
• A transaction is really just an event that occurs during the course of starting a
business or running a business. Some examples of these events are making an
equity investment, taking a loan, purchasing inventory, selling goods, performing
services, and ordering office supplies.
• When any transaction takes place, we can see its impact on the accounting
equation as it increases or decreases assets, liabilities, and/or owners’ equity.
• Most companies use the accrual method of accounting, which means that
transactions are recorded in the period to which they relate, regardless of when
cash is exchanged.
• Accounting is governed by principles and rules. Some of the guiding principles
are conservatism, relevance vs.reliability, historical cost, consistency, materiality,
the entity concept, money measurement, and going concern.
• The elements of accounting such as assets, liabilities, owners’ equity, revenue,
and expenses, each have specific definitions outlined in accounting standards.
The basic definitions are:
o Assets are resources owned or controlled by an entity that will produce
benefits in the future.
o Liabilities are obligations to pay a third party for resources provided to an
entity.
o Owners’ equity consists of funds contributed by owners as well as profits
generated by the business.
o Revenue is the money that a business receives from providing goods or
services to a customer.
o Expenses are the costs associated with providing goods or services to a
customer.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved.
Module 2 Recording Transactions
• When businesses are recording transactions in their financial records, they use
smaller groupings called accounts. For example, assets include accounts such
as cash, accounts receivable, inventory, and fixed assets.
• We use an accounting method called double entry accounting, which uses debits
on the left and credits on the right. Debits and credits do not necessarily mean
good and bad, they simply represent increases or decreases, depending on the
account being debited or credited.
• Assets and expenses increase with a debit and decrease with a credit, while
liabilities, equity, and revenue increase with a credit and decrease with a debit.

Credits

Revenues
Debits Credits Credits
Debits
Assets = Liabilities + Owner’s Equity
Debits
Credits Debits Debits

Expenses

Credits

• The total of debits must always be equal to the total of credits. This is why the
fundamental accounting equation holds true and assets equal liabilities plus
owners’ equity.
• All transactions are recorded in journal entries, with debits on the left and credits
on the right. Journal entries can then be summarized in T-accounts, again with
debits on the left and credits on the right.
• Finally, all the T-accounts of a business can be summarized in a trial balance. A
trial balance is simply a list of all of the business’ accounts that have balances at
that date, and the amount in each account.
• The balance in each account is listed in the trial balance, shown in either the
debit or credit column. Asset and expense accounts will typically have debit
balances, while liability, equity, and revenue accounts will show credit balances.
• Since debits always equal credits for each journal entry, and every journal entry
is posted to T-accounts, it follows then that the total of all the debit balance
accounts should equal the total of all the credit balance accounts in the trial
balance.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 2
Module 3 Financial Statements
• The trial balance contains two types of accounts—real accounts and nominal
accounts. Real accounts end up on the balance sheet and reflect the cumulative
balance in each account from the inception of the business. Assets, liabilities,
and equity accounts are real accounts. Nominal accounts end up on the income
statement and their balances represent activity over a certain period of time.
Revenues and expenses are nominal accounts.
• At the end of each accounting period, the balance of all nominal accounts are
transferred to retained earnings (part of owners’ equity, a real account), so their
balances start back at zero at the beginning of each accounting period. This
allows for isolating the operating activity associated with each accounting period.
Accounts on the trial balance typically are combined into condensed accounts for
presentation on the balance sheet and income statement.
• The balance sheet provides a snapshot of the business at a specific point in time.
The balance sheet shows all of the asset, liability, and owners’ equity accounts
as of that specific date.
• Under US GAAP, the balance sheet presents accounts in the following order:
current assets, non-current assets, current liabilities, non-current liabilities, and
owners’ equity. Within each asset and liability group, items are presented in order
of liquidity, with the most liquid (those that can be most easily and quickly
converted to cash) first. Under IFRS, the balance sheet is generally presented
with the least liquid items first, and in the following order: non-current assets,
current assets, owners’ equity, non-current liabilities, and current liabilities.
• The income statement shows all revenue and expense accounts for a given
period of time. Using trial balances from any two points in time, a business can
create an income statement that will tell the financial story of the activities for that
period.
• The income statement can show the following measures of income: gross profit
(sales less cost of goods sold), operating income (gross profit less operating
expenses), income before taxes (operating income less nonoperating expenses),
and finally, net income (income before taxes less taxes).
• Together, the balance sheet and income statement are two important financial
statements that show the company’s financial position.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 3
Module 4 Takeaway Document
• Transactions that enter the accounting systems can be considered either explicit
transactions or implicit transactions. Explicit transactions are those that are
triggered by a specific event, often an exchange of resources between two
parties. Implicit transactions, on the other hand, do not have a specific trigger,
but instead, often involve some degree of judgment in determining the timing and
amount of the journal entries.
• Implicit transactions often lead to what is known as adjusting entries, which are
journal entries made at the of a given accounting period (month, quarter, or year)
to record necessary adjustments. The goal is generally to conform to the revenue
recognition and matching principles.
• Adjusting journal entries typically relate to either accruals or deferrals. Accruals
are transactions where cash changes hands after revenue or expense is
recognized and deferrals are transactions where cash changes hands before
revenue or expense is recorded. Accruals and deferrals always involve revenues
or expenses and are the essence of two important concepts we have already
covered—revenue recognition and the matching principle. At the end of the
period, a company will want to ensure that all appropriate accrual and deferral
entries have been made to accurately reflect the activities related to that period.
• Inventory is another asset that needs to be analyzed at the end of each period.
While some businesses use the perpetual inventory system and record the
expense for inventory at the time it is sold, other businesses use the periodic
inventory system. Under this system, the business only periodically records cost
of goods sold by physically counting the actual inventory on hand and backing
into the amount that must have been sold. This is another example of an
adjusting journal entry.
• Inventory systems can use any of several costing methods, including First In First
Out (FIFO), Last In First Out (LIFO), weighted average, or specific identification.
• For a manufacturing business, inventory costs are a bit more complicated. Most
businesses will have two types of costs: Product Costs and Period Costs.
Product costs are those that a business incurs to buy, manufacture, and deliver a
good or service to a customer. The product costs will include the raw materials
and parts that are purchased from suppliers as well as direct labor and
supervision and overhead costs such as rent on the plant building and
depreciation of plant equipment. Period costs, on the other hand, are all of the
other costs a company incurs while doing business, such as executive salaries or
office rent. A manufacturing business will track its inventory in three stages: raw
materials, work in process (WIP), and finished goods.

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved. 4
 • Every time a business makes a purchase, which is an explicit transaction, it must
determine when the corresponding benefit from that purchase will come. Long-
lived physical assets, such as machinery and buildings, will often help produce
revenues for many years to come. To reflect this, we record adjusting journal
entries to recognize depreciation expense related to the assets over multiple
periods, which is an implicit transaction.
• Straight-line depreciation is calculated by dividing the gross book value by the
estimated useful life of the asset. Any salvage value should be subtracted from
the gross book value and any disposal costs should be added to the gross book
value before calculating depreciation. The original cost of the asset less
accumulated depreciation (a contra-asset account) is the net book value of the
asset. Remember that land is an exception to the rule. We do not depreciate land
because it is not “used up” by the business, and its value is typically not reduced
or consumed.
• Note that there are depreciation methods other than straight-line, such as the
double declining balance method. This is an accelerated method, which causes
more depreciation expense to be recognized in the early years and less in the
later years. The choice of depreciation method can have a large impact on net
income for the period. Over the life of the asset, the same amount of depreciation
will be calculated, but a company using double declining balance depreciation
will report lower net income in the early years, and higher in the later years,
compared to a company using straight-line depreciation.
• When an asset is sold, the journal entry to record the sale eliminates net book
value by writing off the asset and the accumulated depreciation on the asset and
then recognizes any gain or loss based on whether the asset sold for higher or
lower than its net book value at the time of the sale.
• Non-physical long-lived assets such as intangible assets are treated in a similar
manner, except the expense is called amortization, rather than depreciation. In
some cases, the journal entry will directly reduce the asset account, while in
other cases, the journal entry will use a contra-asset account called accumulated
amortization.
• Another example of contra-asset accounts is the allowance for credit losses,
which is commonly used by credit providers to recognize potential credit risks.
• In a balance sheet, the allowance for credit losses, otherwise known as the
allowance for bad debts or allowance for doubtful accounts, records the
estimated amount of receivables that a creditor considers uncollectible. Netting
off the bad debt allowance against the gross amount of receivables, the creditor
can calculate the value the company expects to receive from credit customers.
• In an income statement, a bad debt expenses account is used to record any
increase to the allowance. This account records losses from expected defaults in
the same accounting period that the credits are extended.
• Then, when specific receivables fall past due beyond a given period (e.g., 120
days), they are written off from the balance sheet. To do so, the creditor would
credit the receivables account and debit the allowance account.

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved. 5
 • Another example of adjusting journal entries is deferred tax assets and deferred
tax liabilities. These arise because temporary timing differences can cause the
calculation of taxable income to be deferent from how a business calculates its
income before taxes for financial reporting purposes.
• A deferred tax liability arises when there is an amount of tax that is going to be
due in the future, related to income that is reported in the current period. A
deferred tax asset reflects a prepayment of some amount of tax on an amount
that has not yet been reported as income on the income statement.
• Adjusting journal entries are part of the closing process. The closing process is
really just an opportunity for a company to evaluate its trial balance and ensure
that the proper accruals and other adjusting entries have been made so that the
financial statements will accurately reflect the results of all transactions that
occurred during the period.

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved. 6
Module 5 The Statement of Cash Flows
• In addition to the balance sheet and the income statement, the statement of cash
flows is the third and final of the financial statements.
• The purpose of the statement of cash flows is to provide a more detailed picture
of what happened to a business’ cash during an accounting period. It shows the
different areas in which a business used or received cash, and reconciles the
beginning and ending cash balances.
• Cash flows are important for valuing a business and managing liquidity and are
essential to understand where actual cash is being generated and used. The
statement of cash flows gives more detail about the sources of cash inflows and
the uses of cash outflows.
• The sections of a statement of cash flows are: Operating Activities, Investing
Activities, and Financing Activities. The format of this statement is slightly
different between US GAAP and IFRS.
• The Cash Flows from Operating Activities section includes information on
cash used or received in the process of preparing and providing goods or
services to customers. This section is closely tied to net income; it essentially
shows what net income would be under the cash accounting method. It does this
by taking away the components of the income statement that don’t have an
impact on the cash account and those that do not pertain to the operations of the
company.
• There are two methods for preparing the operating section: the direct method
and the indirect method. Both methods result in the same number: net cash
flow from operating activities. Calculating the operating section of the statement
of cash flows using the direct method is straightforward; simply take all of the
cash collections from operating activities and subtract all of the cash
disbursements from operating activities. This method uses transactional
information that impacted cash during the period. Rather than organizing
transactional data as we did under the direct method, when using the indirect
method, we start with net income from the income statement and make
adjustments to undo the impact of the accruals that were made during the period.
• The Cash Flows from Investing Activities section of the statement of cash
flows contains cash flows relating to longlived assets, such as property, plant,
and equipment. Additional inflows and outflows that would be included in this
section relate to loans made to another entity, called loans receivable, and
certain investment securities.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 7
 • The Cash Flows from Financing Activities includes cash flows associated with
raising and paying back money to investors and creditors. Dividends paid are
included in this section under US GAAP, but under IFRS dividends paid may be
included in the operating rather than the financing section. While interest paid is
included in the operating section under US GAAP, it can sometimes be included
here under IFRS. Another useful way to get a feel for how a business is
managing its cash is to create a statement of sources and uses of funds.
• As with all financial statements, we should interpret the information on the
statement of cash flows with the context of the business in mind. One thing to
consider and an area where the statement of cash flows gives us a lot of insight
is what phase the business is in: fast-growing startup, profitable/growing, mature
company, or a company in state of decline. Our expectations for the business’
statement of cash flows changes based on the business’ phase.

A start-up will typically have negative or very low cash flow from operating activities,
negative cash flow from investing activities, and large fluctuations in cash flow from
financing activities. A profitable/growing business will usually have positive cash flow
from operating activities, negative cash flow from investing activities, and positive,
negative, or neutral cash flow from financing activities. A mature company will generally
have positive cash flow from operating activities, slightly negative cash flow from
investing activities, and negative cash flow from financing activities. A business in
decline will typically have negative cash flow from operating activities, positive cash flow
from investing activities, and cash flow from financing activities that could be either
positive or negative.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 8
Module 6 Analyzing Financial Statements
• Analyzing financial statements is critical in order to understand the performance
of a business. To do so, we can use different types of ratios that uncover
important relationships between financial statement items.
• Ratios are typically most useful when making comparisons to other companies or
to the past performance of the company itself. Therefore, it’s important to first get
an overall understanding of the company and the industry in which it operates.
• One of the most commonly evaluated ratios is a firm’s return on equity or ROE,
which shows the return that a business generated during a period on the equity
invested in the business by the owners of the business. It is calculated by
dividing net income by owners’ equity.
• The DuPont Framework expands the ROE formula to consist of three factors:

The Dupont Framework

Return on Equity (ROE) = Profitability × Efficiency × Leverage

Profit Margin Asset Turnover Leverage

Net Income Sales Assets

Sales Assets Equity

• The DuPont Framework measures profitability using Profit Margin, efficiency

using Asset Turnover, and leverage using the Leverage Ratio (or Equity
Multiplier), as shown above. Although they are not used in the DuPont
Framework, there are many other ratios that measure profitability, efficiency, and
leverage, which can provide useful insights in financial statement analysis.
• PROFITABILITY RATIOS:
o Profitability reveals how much profit is left from each dollar of sales after
all expenses have been subtracted. Profit margin is calculated by dividing
net income by the total sales for the period.
o The gross profit margin ratio is calculated by dividing gross profit by total
sales for the period and tells us what percentage of our revenue is left to
cover other expenses after the cost of goods sold is subtracted. Recall
that gross profit is equal to sales minus cost of goods sold.
o Earnings before interest after taxes or EBIAT, is a measure of how much
income the business has generated while ignoring the effect of financing
and capital structure, or the proportion of debt that the business has.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 9
 • EFFICIENCY RATIOS:
o To measure Operating Efficiency, asset turnover (calculated as sales
divided by average assets) tells us how well a business is using its assets
to produce sales. A business that can create more revenue with fewer
assets is more efficient. This ratio uses both the income statement and the
balance sheet; we typically use the average of the beginning and ending
balance sheet amounts to estimate the average level of assets during the
period.
o Inventory turnover (calculated as COGS divided by average inventory)
helps understand how efficiently a business is managing its inventory
levels. A higher inventory turnover represents more efficient inventory
management.
o Days Inventory (calculated as 365 divided by inventory turnover) relates to
inventory turnover. The only difference is that it is expressed as the
average number of days the inventory is held before it is sold rather than
how many times the inventory turned over during the period. At times it
may be more intuitive to consider and discuss ratios and changes to these
ratios when the terms are expressed in days.
o The accounts receivable turnover or AR turnover (calculated as sales
divided by average accounts receivable) indicates a business’ efficiency in
collecting receivables from customers. A higher AR turnover represents
more efficient cash collections.
o The average collection period, sometimes referred to as Days Sales
Outstanding or Days Sales in Receivables (calculated as 365 divided by
AR turnover), is the average number of days it took for a business to
collect payment from a customer.
o To measure Accounts payable turnover, or AP turnover (calculated as
COGS divided by average accounts payable), we look at how long it takes
us to pay our vendors. Vendors include suppliers of inventory and also
suppliers of services or other non-inventory items.
o Another way to gauge our accounts payable is to look at days purchases
outstanding (calculated as 365 divided by AP turnover). Again this simply
shows the AP turnover measured in average days outstanding.
o The days purchases outstanding, days inventory, and average collection
period combine into what is called a cash conversion cycle. This metric, is
a measure of how long it takes a business from the time it has to pay for
inventory from its suppliers until it collects cash from its customers.

Days Average Collection Days Purchases Cash Conversion

Inventory + Period − Outstanding = Cycle

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 10
 • LEVERAGE RATIOS:
o Financial Leverage, also known as the Equity Multiplier, is calculated
as average total assets divided by average total equity and measures the
impact of all non-equity financing, or debt of all sorts, on the firm’s ROE. If
all of the assets are financed by equity, the multiplier is 1. As liabilities,
which are forms of debt, increase, the multiplier increases from 1
demonstrating the leverage impact of the debt.
o Another very common indicator of leverage is the debt to equity ratio,
which is calculated as average total liabilities divided by average total
equity.
• OTHER RATIOS:
o The current ratio (calculated as current assets divided by current liabilities)
helps us understand the business’ ability to pay its short term obligations.
It focuses on the business’ more liquid assets and liabilities, or those that
are convertible to cash or coming due, within a year.
o The quick ratio is similar to the current ratio except only highly liquid
current assets can be used in the numerator. It is typically calculated as
current assets less inventory, all divided by current liabilities. It’s also
sometimes called an acid test ratio
o The interest coverage ratio, also known as the times interest earned, is
calculated as EBIT divided by interest expense and is a good way to
gauge how capable a business is of making the interest payments on its
debt. For this, we use a common income number called EBIT (Earnings
Before Interest and Taxes).
o Ratios can be very useful when comparing one company to another
because they allow you to eliminate to a large extent the impact of size
differences that exists among companies. Most ratios, however, are in
some ways influenced by managerial judgment in recording transactions
that have a great impact on the financial statement. As a financial analyst,
in some cases you will need to make adjustments to the financial
statements to account for the differences before they can be used for
comparisons. Considerations such as seasonality and the impact of policy
differences may need to be taken into account when analyzing financial
information.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 11
Module 7 Takeaway Document
• Forecasting financials is an important part of accounting skills and is used by
managers, financial analysts, and investors to predict future potential revenue
streams, expenses, and cash flow. While creating financial reports for future
periods involves a great deal of uncertainty, it is still very useful for businesses to
make their best predictions based on the information they have. Forecasts can
be used at a project level, for example, to help make a decision as to whether to
undertake a particular project or at a company level, for example, to decide
whether to invest in a certain company or whether financing is needed.
• Pro-forma financial statements are one of the most common types of financial
forecasts. The percent of sales forecasting method is used when creating pro-
formas internally; it involves determining future expected sales and finding trends
among various accounts in the financial statements. Businesses also use other
assumptions and methodologies when the percent of sales method is not ideal.
For example, some line items, such as cost of goods sold, can often be
forecasted by assuming that they will continue to grow proportionally with sales.
Other line items may be more accurately forecasted using assumptions based on
information other than sales, such as other information in the annual report or in
industry reports. For example, in forecasting PPE and depreciation, while longer-
term planned capital expenses may roughly mirror sales, we will often use more
detailed descriptions about planned purchases in the notes sections of financial
statements as the basis of our forecast. Another account that typically does not
vary directly with sales is income tax expense. Instead, if the business is stable,
income tax expense generally can be estimated as a certain percentage of
income before taxes.
• To forecast liabilities and equity, the current portion of long-term debt is
determined based on the part of a long-term loan that becomes current or is to
be repaid within one year. Since they are linked, interest expense and
borrowings can be tricky to forecast and may take some trial and error. For
example, a company that may need additional funding, meaning an increase in
borrowings, will have increased interest expense. In some cases, borrowings will
be a plug to make the balance sheet balance. In other cases, another account
such as cash or equity may be used as a plug to make the balance sheet
balance. Retained earnings are calculated by adding net income to the retained
earnings account balance of the prior year. Any dividends to be paid need to be
subtracted from retained earnings.

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved. 12
 • Another important component in planning and evaluating the future of a business
is to look at the expected cash flows that the company will generate. These
provide an indication of how much actual cash is generated, and hence available,
to be paid out to investors in the business or invest in new projects. The
equation is:

FCF = (1−t) × EBIT + DEP − CAPX − Δ NWC

FCF = Free Cash Flows

t = Tax Rate
EBIT = Earnings Before Interest and Taxes
Dep = Depreciation and Amortization
Capx = Capital Expenditures
Δ NWC = Change in Net Working Capital

*Formula from HBS case “Calculating Free Cash Flows”, Rob in Greenwood, David Scharfstein

• With free cash flows determined, stakeholders consider the valuation of various
projects. In order to fully consider the valuation of a project, however,
stakeholders must consider the concept time value of money because a dollar
received today is worth more than one that would be received a year from now
due to opportunity costs of how else the dollar could be spent, inflation, and the
certainty of payments. In order to fairly compare different projects, the value of
the cash flows has to be considered at the same time period. For simplicity, we
often translate all cash flows to the value that they would be worth today, the
“present value.” In order to make the calculation, you need a discount rate, which
is the rate that would otherwise be available in the market or the rate that best
captures the risk inherent in the project being evaluated.
• In evaluating potential projects, we also have to have an idea of how long the
cash flows will continue. In some cases, cash flows will be finite. In others, they
will be assumed to continue indefinitely. In the latter case, we use this model to
determine the terminal value of the cash flows.

GORDON GROWTH MODEL

Present Value of Cash Flows in the Final Year of Our Projection

Infinite Cash Flows
=
Discount Rate − Growth Rate

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved. 13
 • With all cash flows determined, the value of the project can be calculated by
using the net present value, or NPV, of the cash flows. The NPV nets out the
present values of all the cash inflows and outflows of the project. The result is a
single number that gives a good indication of what a business or a particular
investment is worth today. It is important that the NPV uses only relevant cash
flows in the analysis.
• If the business has already paid for something that will be used at no additional
cost by the new project, those costs are omitted because they are sunk costs
and shouldn’t factor into the decision of whether or not the project should be
undertaken. Likewise, costs that will be incurred whether we go ahead with the
project or not are also irrelevant to this decision. The valuation of a project will
change as the assumptions that go into the NPV model, such as the cash flows
and discount rate, change. This sensitivity analysis is an important part of the
overall analysis.
• Other valuation measures introduced in the module include the internal rate of
return, or IRR, and the Payback Period. The IRR is the discount rate that sets the
NPV of a project equal to zero. The IRR allows us to see the percentage rate that
would be earned for a given set of cash flows. This method incorporates the time
value of money as the NPV does. This metric is often used when there is a lack
of clarity or a lack of consensus within the company as to what discount rate
should be used in an NPV calculation. The payback period tells us how fast the
investors can expect to have their money returned. This metric is more useful for
someone who is concerned about limiting the downside potential rather than
evaluating the whole project. It ignores the time value of money and the cash
flows that occur after the payback period.
• Lease accounting is the process by which an organization records the financial
impacts of their leasing activities in their accounting calculations and reports.
According to the latest lease accounting standards, lessees are required to
recognize ROU assets and lease liabilities for all leases with terms longer than
12 months. Under US GAAP, two types of long-term leases are operating leases
and finance (previously capital) leases. In contrast, under IFRS, all long-term
leases are treated as finance leases.

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved. 14
Financial Accounting
Module 1 The Accounting Equation
• Accounting allows us to understand what's going on within a business.
• The Accounting Equation is the fundamental building block of accounting.
o Assets = Liabilities + Owners’ Equity
• All transactions impact the accounting equation. The accounting equation, like
any mathematical equation, must always balance.
• A transaction is really just an event that occurs during the course of starting a
business or running a business. Some examples of these events are making an
equity investment, taking a loan, purchasing inventory, selling goods, performing
services, and ordering office supplies.
• When any transaction takes place, we can see its impact on the accounting
equation as it increases or decreases assets, liabilities, and/or owners’ equity.
• Most companies use the accrual method of accounting, which means that
transactions are recorded in the period to which they relate, regardless of when
cash is exchanged.
• Accounting is governed by principles and rules. Some of the guiding principles
are conservatism, relevance vs.reliability, historical cost, consistency, materiality,
the entity concept, money measurement, and going concern.
• The elements of accounting such as assets, liabilities, owners’ equity, revenue,
and expenses, each have specific definitions outlined in accounting standards.
The basic definitions are:
o Assets are resources owned or controlled by an entity that will produce
benefits in the future.
o Liabilities are obligations to pay a third party for resources provided to
an entity.
o Owners’ equity consists of funds contributed by owners as well as profits
generated by the business.
o Revenue is the money that a business receives from providing goods or
services to a customer.
o Expenses are the costs associated with providing goods or services to
a customer.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved.
Financial Accounting
Module 2 Recording Transactions
THE RECORDING PROCESS

• When businesses are recording transactions in their financial records, they use
smaller groupings called accounts. For example, assets include accounts such
as cash, accounts receivable, inventory, and fixed assets.
• We use an accounting method called double entry accounting, which uses debits
on the left and credits on the right. Debits and credits do not necessarily mean
good and bad, they simply represent increases or decreases, depending on the
account being debited or credited.

Credits

Revenues
Debits Credits Credits
Debits
Assets = Liabilities + Owner’s Equity
Debits
Credits Debits Debits

Expenses

Credits

• Assets and expenses increase with a debit and decrease with a credit, while
liabilities, equity, and revenue increase with a credit and decrease with a debit.

Debits Credits

Assets Liabilities

Expenses Equity

Credits Revenues

Debits

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved.
 • The total of debits must always be equal to the total of credits. This is why the
fundamental accounting equation holds true and assets equal liabilities plus
owners’ equity.
• All transactions are recorded in journal entries, with debits on the left and credits
on the right. Journal entries can then be summarized in T-accounts, again with
debits on the left and credits on the right. Finally, all the T-accounts of a business
can be summarized in a trial balance. A trial balance is simply a list of all of the
business’ accounts that have balances at that date, and the amount in each
account.
• The balance in each account is listed in the trial balance, shown in either the
debit or credit column. Asset and expense accounts will typically have debit
balances, while liability, equity, and revenue accounts will show credit balances.
• Since debits always equal credits for each journal entry, and every journal entry
is posted to T-accounts, it follows then that the total of all the debit balance
accounts should equal the total of all the credit balance accounts in the trial
balance.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 2
Financial Accounting
Module 3 Financial Statements
• The trial balance contains two types of accounts—real accounts and nominal
accounts. Real accounts end up on the balance sheet and reflect the cumulative
balance in each account from the inception of the business. Assets, liabilities, and
equity accounts are real accounts. Nominal accounts end up on the income
statement and their balances represent activity over a certain period of time.
Revenues and expenses are nominal accounts.
• At the end of each accounting period, the balance of all nominal accounts are
transferred to retained earnings (part of owners’ equity, a real account), so their
balances start back at zero at the beginning of each accounting period. This
allows for isolating the operating activity associated with each accounting period.
Accounts on the trial balance typically are combined into condensed accounts for
presentation on the balance sheet and income statement.
• The balance sheet shows a company’s financial position as of a specific
date. It provides a snapshot of the business at a specific point in time, such as
December 31. The balance sheet shows all of the asset, liability, and owners’
equity accounts as of that specific date.
• Under US GAAP, the balance sheet presents accounts in the following order:
current assets, non-current assets, current liabilities, non-current liabilities, and
owners’ equity. Within each asset and liability group, items are presented in
order of liquidity, with the most liquid (those that can be most easily and quickly
converted to cash) first.
• Under IFRS, the balance sheet is generally presented with the least liquid items
first, and in the following order: non-current assets, current assets, owners’
equity, non-current liabilities, and current liabilities.
• The income statement shows a company’s financial performance over a
period of time. It shows all revenue and expense accounts for a given period of
time, such as for the year ending December 31. 2014. Using trial balances from
any two points in time, a business can create an income statement that will tell
the financial story of the activities for that period.
• The income statement can show the following measures of income: gross profit
(sales less cost of goods sold), operating income (gross profit less operating
expenses), income before taxes (operating income less nonoperating expenses),
and finally, net income (income before taxes less taxes).
• Together, the balance sheet and income statement are two important financial
statements that show the company’s financial position and performance,
respectively. Later on, in Module 5, we will learn about the third and final financial
statement, the statement of cash flows.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved.
Financial Accounting
Module 4 Takeaway Document
• Transactions that enter the accounting systems can be considered either explicit
transactions or implicit transactions. Explicit transactions are those that are
triggered by a specific event, often an exchange of resources between two
parties. Implicit transactions, on the other hand, do not have a specific trigger,
but instead, often involve some degree of judgment in determining the timing and
amount of the journal entries.
• Implicit transactions often lead to what is known as adjusting entries, which are
journal entries made at the of a given accounting period (month, quarter, or year)
to record necessary adjustments. The goal is generally to conform to the revenue
recognition and matching principles.
• Adjusting journal entries typically relate to either accruals or deferrals. Accruals
are transactions where cash changes hands after revenue or expense is
recognized and deferrals are transactions where cash changes hands before
revenue or expense is recorded. Accruals and deferrals always involve revenues
or expenses and are the essence of two important concepts we have already
covered—revenue recognition and the matching principle. At the end of the
period, a company will want to ensure that all appropriate accrual and deferral
entries have been made to accurately reflect the activities related to that period.
• Inventory is another asset that needs to be analyzed at the end of each period.
While some businesses use the perpetual inventory system and record the
expense for inventory at the time it is sold, other businesses use the periodic
inventory system. Under this system, the business only periodically records cost
of goods sold by physically counting the actual inventory on hand and backing
into the amount that must have been sold. This is another example of an
adjusting journal entry.
• Inventory systems can use any of several costing methods, including First In First
Out (FIFO), Last In First Out (LIFO), weighted average, or specific identification.
• For a manufacturing business, inventory costs are a bit more complicated. Most
businesses will have two types of costs: Product Costs and Period Costs.
Product costs are those that a business incurs to buy, manufacture, and deliver a
good or service to a customer. The product costs will include the raw materials
and parts that are purchased from suppliers as well as direct labor and
supervision and overhead costs such as rent on the plant building and
depreciation of plant equipment. Period costs, on the other hand, are all of the
other costs a company incurs while doing business, such as executive salaries or
office rent. A manufacturing business will track its inventory in three stages: raw
materials, work in process (WIP), and finished goods.

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved.
 • Every time a business makes a purchase, which is an explicit transaction, it must
determine when the corresponding benefit from that purchase will come. Long-
lived physical assets, such as machinery and buildings, will often help produce
revenues for many years to come. To reflect this, we record adjusting journal
entries to recognize depreciation expense related to the assets over multiple
periods, which is an implicit transaction.
• Straight-line depreciation is calculated by dividing the gross book value by the
estimated useful life of the asset. Any salvage value should be subtracted from
the gross book value and any disposal costs should be added to the gross book
value before calculating depreciation. The original cost of the asset less
accumulated depreciation (a contra-asset account) is the net book value of the
asset. Remember that land is an exception to the rule. We do not depreciate land
because it is not “used up” by the business, and its value is typically not reduced
or consumed.
• Note that there are depreciation methods other than straight-line, such as the
double declining balance method. This is an accelerated method, which causes
more depreciation expense to be recognized in the early years and less in the
later years. The choice of depreciation method can have a large impact on net
income for the period. Over the life of the asset, the same amount of depreciation
will be calculated, but a company using double declining balance depreciation
will report lower net income in the early years, and higher in the later years,
compared to a company using straight-line depreciation.
• When an asset is sold, the journal entry to record the sale eliminates net book
value by writing off the asset and the accumulated depreciation on the asset and
then recognizes any gain or loss based on whether the asset sold for higher or
lower than its net book value at the time of the sale.
• Non-physical long-lived assets such as intangible assets are treated in a similar
manner, except the expense is called amortization, rather than depreciation. In
some cases, the journal entry will directly reduce the asset account, while in
other cases, the journal entry will use a contra-asset account called accumulated
amortization.
• Another example of contra-asset accounts is the allowance for credit losses,
which is commonly used by credit providers to recognize potential credit risks.
• In a balance sheet, the allowance for credit losses, otherwise known as the
allowance for bad debts or allowance for doubtful accounts, records the
estimated amount of receivables that a creditor considers uncollectible. Netting
off the bad debt allowance against the gross amount of receivables, the creditor
can calculate the value the company expects to receive from credit customers.
• In an income statement, a bad debt expenses account is used to record any
increase to the allowance. This account records losses from expected defaults in
the same accounting period that the credits are extended.
• Then, when specific receivables fall past due beyond a given period (e.g., 120
days), they are written off from the balance sheet. To do so, the creditor would
credit the receivables account and debit the allowance account.

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved. 2
 • Another example of adjusting journal entries is deferred tax assets and deferred
tax liabilities. These arise because temporary timing differences can cause the
calculation of taxable income to be deferent from how a business calculates its
income before taxes for financial reporting purposes.
• A deferred tax liability arises when there is an amount of tax that is going to be
due in the future, related to income that is reported in the current period. A
deferred tax asset reflects a prepayment of some amount of tax on an amount
that has not yet been reported as income on the income statement.
• Adjusting journal entries are part of the closing process. The closing process is
really just an opportunity for a company to evaluate its trial balance and ensure
that the proper accruals and other adjusting entries have been made so that the
financial statements will accurately reflect the results of all transactions that
occurred during the period.

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved. 3
Financial Accounting
Module 5 The Statement of Cash Flows
• In addition to the balance sheet and the income statement, the statement of cash
flows is the third and final of the financial statements.
• The purpose of the statement of cash flows is to provide a more detailed picture
of what happened to a business’ cash during an accounting period. It shows the
different areas in which a business used or received cash, and reconciles the
beginning and ending cash balances.
• Cash flows are important for valuing a business and managing liquidity and are
essential to understand where actual cash is being generated and used. The
statement of cash flows gives more detail about the sources of cash inflows and
the uses of cash outflows.
• The sections of a statement of cash flows are: Operating Activities, Investing
Activities, and Financing Activities. The format of this statement is slightly
different between US GAAP and IFRS.
• The Cash Flows from Operating Activities section includes information on
cash used or received in the process of preparing and providing goods or
services to customers. This section is closely tied to net income; it essentially
shows what net income would be under the cash accounting method. It does this
by taking away the components of the income statement that don’t have an
impact on the cash account and those that do not pertain to the operations of
the company.
• There are two methods for preparing the operating section: the direct method,
and the indirect method. Both methods result in the same number: net cash
flow from operating activities. Calculating the operating section of the statement
of cash flows using the direct method is straightforward; simply take all of the
cash collections from operating activities and subtract all of the cash
disbursements from operating activities. This method uses transactional
information that impacted cash during the period. Rather than organizing
transactional data as we did under the direct method, when using the indirect
method, we start with net income from the income statement and make
adjustments to undo the impact of the accruals that were made during the period.
• The Cash Flows from Investing Activities section of the statement of cash
flows contains cash flows relating to long-lived assets, such as property, plant,
and equipment. Additional inflows and outflows that would be included in this
section relate to loans made to another entity, called loans receivable, and
certain investment securities.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved.
 • The Cash Flows from Financing Activities includes cash flows associated with
raising and paying back money to investors and creditors. Dividends paid are
included in this section under US GAAP, but under IFRS dividends paid may be
included in the operating rather than the financing section. While interest paid is
included in the operating section under US GAAP, it can sometimes be included
here under IFRS.
• Another useful way to get a feel for how a business is managing its cash is to
create a statement of sources and uses of funds.
• As with all financial statements, we should interpret the information on the
statement of cash flows with the context of the business in mind. One thing to
consider and an area where the statement of cash flows gives us a lot of insight
is what phase the business is in: fast-growing startup, profitable/growing, mature
company, or a company in state of decline. Our expectations for the business’
statement of cash flows changes based on the business’ phase.
o A start-up will typically have negative or very low cash flow from operating
activities, negative cash flow from investing activities, and large
fluctuations in cash flow from financing activities.
o A profitable/growing business will usually have positive cash flow from
operating activities, negative cash flow from investing activities, and
positive, negative, or neutral cash flow from financing activities.
o A mature company will generally have positive cash flow from operating
activities, slightly negative cash flow from investing activities, and negative
cash flow from financing activities.
o A business in decline will typically have negative cash flow from operating
activities, positive cash flow from investing activities, and cash flow from
financing activities that could be either positive or negative.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 2
Financial Accounting
Module 6 Analyzing Financial Statements
Note: This summary is longer and more comprehensive than most Module Summaries,
as it will be helpful for you to have a list of all the ratios we covered in this module in
one place.

• Analyzing financial statements is critical in order to understand the performance

of a business. To do so, we can use different types of ratios that uncover
important relationships between financial statement items.
• Ratios are typically most useful when making comparisons to other companies or
to the past performance of the company itself. Therefore, it’s important to first get
an overall understanding of the company and the industry in which it operates.
• One of the most commonly evaluated ratios is a firm’s return on equity or ROE,
ACCT-remediation-M6Summary-01
which shows the return that a business generated during a period on the equity
invested in the business by the owners of the business.

Net Income
Return on Equity (ROE) =
Owners’ Equity

• The DuPont Framework expands the ROE formula to consist of three factors:

The Dupont Framework

Return on Equity (ROE) = Profitability × Efficiency × Leverage

Profit Margin Asset Turnover Leverage

Net Income Sales Assets

Sales Assets Equity

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved.
 • The DuPont Framework measures profitability using Profit Margin, efficiency
using Asset Turnover, and leverage using the Leverage Ratio (or Equity
Multiplier), as shown above. Although they are not used in the DuPont
Framework, there are many other ratios that measure profitability, efficiency, and
leverage, which can provide useful insights in financial statement analysis.
• PROFITABILITY RATIOS:
o Profitability reveals how much profit is left from each dollar of sales after
all expenses have been subtracted. Profit margin is calculated by dividing
ACCT-remediation-M6Summary-02
net income by the total sales for the period.

Net Income
Profit Margin =
Sales

o The gross profit margin ratio tells us what percentage of our revenue is left
to cover other expenses after the cost of goods sold is subtracted. Recall
that gross profit is equal to sales minus cost of goods sold.

Gross Profit
Gross Profit Margin =
Sales

o Earnings before interest after taxes or EBIAT, is a measure of how much

income the business has generated while ignoring the effect of financing
and capital structure, or the proportion of debt that the business has.
• EFFICIENCY RATIOS:
o To measure Operating Efficiency, asset turnover tells us how well a
business is using its assets to produce sales. A business that can create
more revenue with fewer assets is more efficient. This ratio uses both the
income statement and the balance sheet; we typically use the average of
the beginning and ending balance sheet amounts to estimate the average
level of assets during the period.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 2
 o Inventory turnover helps understand how efficiently a business is
managing its inventory levels. Excess inventory costs money to store and
uses up the firm’s cash that could be used for other investments. A higher
inventory turnover represents more efficient inventory management.

Cogs
Inventory Turnover =
Average Inventory

Here we used average inventory balance instead of the ending balance

displayed on the balance sheet. This is especially significant and provides
better results than using the ending balance, especially for a firm that is
growing quickly, as the level of inventory could have fluctuated during
the year.
o Days Inventory relates to inventory turnover. The only difference is that it
is expressed as the average number of days the inventory is held before it
is sold rather than how many times the inventory turned over during the
period. At times it may be more intuitive to consider and discuss ratios and
changes to these ratios when the terms are expressed in days.

Average Inventory 365

Days Inventory = Days Inventory =
Cogs / 365 Inventory Turnover
or

o The accounts receivable turnover or AR turnover indicates a business’

efficiency in collecting receivables from customers. Uncollected
receivables represent cash that is tied up and can’t be used for other
purposes. A higher AR turnover represents more efficient cash collections.

Credit Sales
Accounts Receivable Turnover =
Average Accounts Receivable

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 3
 o The average collection period, sometimes referred to as Days Sales
Outstanding or Days Sales in Receivables, is the average number of days
it took for a business to collect payment from a customer. This helpful
measure can be compared to the cash collection policy of the firm. If
payment is expected from customers within 30 days, but the average
collection period is 40 days, it may be a sign of concern.

or

o To measure Accounts payable turnover, or AP turnover we look at how

long it takes us to pay our vendors. Vendors include suppliers of inventory
and also suppliers of services or other non-inventory items. One input for
this ratio is credit purchases, which can be estimated by looking at COGS.
We are also assuming that all goods are bought on credit and not paid for
with cash. In both cases other adjustments may have to be made.

(where credit purchases data is available) (where credit purchases data is

NOT available)

o Another way to gauge our accounts payable is to look at days purchases

outstanding. Again this simply shows the AP turnover measured in
average days outstanding.

(where credit purchases data is available) (where credit purchases data is

NOT available)

It can also be calculated by:

365
Days Purchases Outstanding =
Accounts Payable Turnover

• The days purchases outstanding, days inventory, and average collection period
combine into what is called a cash conversion cycle. This metric, is a measure of
how long it takes a business from the time it has to pay for inventory from its
suppliers until it collects cash from its customers.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 4
 Days Average Collection Days Purchases Cash Conversion
Inventory + Period − Outstanding = Cycle

• LEVERAGE RATIOS:
o Financial Leverage, also known as the Equity Multiplier, is calculated
as average total assets divided by average total equity and measures the
impact of all non-equity financing, or debt of all sorts, on the firm’s ROE. If
all of the assets are financed by equity, the multiplier is 1. As liabilities,
ACCT-remediation-M6Summary-03
which are forms of debt, increase, the multiplier increases from 1
demonstrating the leverage impact of the debt.

Average Total Assets

Leverage =
Average Total Equity

o Another very common indicator of leverage is the debt to equity ratio.

Average Total Liabilities

Debt to Equity =
Average Total Equity

• OTHER RATIOS:
o The current ratio helps us understand the business’ ability to pay its
short term obligations. It focuses on the business’ more liquid assets and
liabilities, or those that are convertible to cash or coming due, within
a year.

Current Assets
Current Ratio =
Current Liabilities

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 5
 o The quick ratio is similar to the current ratio except only highly liquid
current assets can be used in the nominator. It’s also sometimes called
an acid test ratio.

Current Assets − Inventory

Quick Ratio =
Current Liabilities

o The interest coverage ratio, also known as the times interest earned, is
a good way to gauge how capable a business is of making the interest
payments on its debt. For this, we use a common income number called
EBIT (Earnings Before Interest and Taxes). This number has to be
calculated from the income statement by adding back interest expense
and tax expense for the period to net income.

EBIT EBIT
Interest Coverage Ratio = Times Interest Earned =
Interest Expense Interest Expense
or

o Something to consider is the impact of Seasonality in a business’

performance, as it can cause repeating fluctuations. Comparing financial
statements for a full period to those for several smaller periods throughout
the year can help reveal these performance cycles.
• Ratios can be very useful when comparing one company to another because
they allow you to eliminate to a large extent the impact of size differences that
exists among companies. Most ratios, however, are in some ways influenced by
managerial judgment in recording transactions that have a great impact on the
financial statement. As a financial analyst, in some cases you will need to make
adjustments to the financial statements to account for the differences before they
can be used for comparisons.
• The impact of policy differences is most noticeable on how companies
recognize revenue; whether purchased assets are expensed or capitalized; and
how a long-lived asset will be depreciated.

© Copyright 2020 President and Fellows of Harvard College. All Rights Reserved. 6
Financial Accounting
Module 7 Takeaway Document
• Forecasting financials is an important part of accounting skills and is used by
managers, financial analysts, and investors to predict future potential revenue
streams, expenses, and cash flow. While creating financial reports for future
periods involves a great deal of uncertainty, it is still very useful for businesses to
make their best predictions based on the information they have. Forecasts can
be used at a project level, for example, to help make a decision as to whether to
undertake a particular project or at a company level, for example, to decide
whether to invest in a certain company or whether financing is needed.
• Pro-forma financial statements are one of the most common types of financial
forecasts. The percent of sales forecasting method is used when creating pro-
formas internally; it involves determining future expected sales and finding trends
among various accounts in the financial statements. Businesses also use other
assumptions and methodologies when the percent of sales method is not ideal.
For example, some line items, such as cost of goods sold, can often be
forecasted by assuming that they will continue to grow proportionally with sales.
Other line items may be more accurately forecasted using assumptions based on
information other than sales, such as other information in the annual report or in
industry reports. For example, in forecasting PPE and depreciation, while longer-
term planned capital expenses may roughly mirror sales, we will often use more
detailed descriptions about planned purchases in the notes sections of financial
statements as the basis of our forecast. Another account that typically does not
vary directly with sales is income tax expense. Instead, if the business is stable,
income tax expense generally can be estimated as a certain percentage of
income before taxes.
• To forecast liabilities and equity, the current portion of long-term debt is
determined based on the part of a long-term loan that becomes current or is to
be repaid within one year. Since they are linked, interest expense and
borrowings can be tricky to forecast and may take some trial and error. For
example, a company that may need additional funding, meaning an increase in
borrowings, will have increased interest expense. In some cases, borrowings will
be a plug to make the balance sheet balance. In other cases, another account
such as cash or equity may be used as a plug to make the balance sheet
balance. Retained earnings are calculated by adding net income to the retained
earnings account balance of the prior year. Any dividends to be paid need to be
subtracted from retained earnings.

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved.
 • Another important component in planning and evaluating the future of a business
is to look at the expected cash flows that the company will generate. These
provide an indication of how much actual cash is generated, and hence available,
to be paid out to investors in the business or invest in new projects. The
equation is:

FCF = (1−t) × EBIT + DEP − CAPX − Δ NWC

FCF = Free Cash Flows

t = Tax Rate
EBIT = Earnings Before Interest and Taxes
Dep = Depreciation and Amortization
Capx = Capital Expenditures
Δ NWC = Change in Net Working Capital

*Formula from HBS case “Calculating Free Cash Flows”, Robin Greenwood, David Scharfstein

• With free cash flows determined, stakeholders consider the valuation of various
projects. In order to fully consider the valuation of a project, however,
stakeholders must consider the concept time value of money because a dollar
received today is worth more than one that would be received a year from now
due to opportunity costs of how else the dollar could be spent, inflation, and the
certainty of payments. In order to fairly compare different projects, the value of
the cash flows has to be considered at the same time period. For simplicity, we
often translate all cash flows to the value that they would be worth today, the
“present value.” In order to make the calculation, you need a discount rate, which
is the rate that would otherwise be available in the market or the rate that best
captures the risk inherent in the project being evaluated.
• In evaluating potential projects, we also have to have an idea of how long the
cash flows will continue. In some cases, cash flows will be finite. In others, they
will be assumed to continue indefinitely. In the latter case, we use this model to
determine the terminal value of the cash flows.

GORDON GROWTH MODEL

Present Value of Cash Flows in the Final Year of Our Projection

Infinite Cash Flows
=
Discount Rate − Growth Rate

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved. 2
 • With all cash flows determined, the value of the project can be calculated by
using the net present value, or NPV, of the cash flows. The NPV nets out the
present values of all the cash inflows and outflows of the project. The result is a
single number that gives a good indication of what a business or a particular
investment is worth today. It is important that the NPV uses only relevant cash
flows in the analysis.
• If the business has already paid for something that will be used at no additional
cost by the new project, those costs are omitted because they are sunk costs
and shouldn’t factor into the decision of whether or not the project should be
undertaken. Likewise, costs that will be incurred whether we go ahead with the
project or not are also irrelevant to this decision. The valuation of a project will
change as the assumptions that go into the NPV model, such as the cash flows
and discount rate, change. This sensitivity analysis is an important part of the
overall analysis.
• Other valuation measures introduced in the module include the internal rate of
return, or IRR, and the Payback Period. The IRR is the discount rate that sets the
NPV of a project equal to zero. The IRR allows us to see the percentage rate that
would be earned for a given set of cash flows. This method incorporates the time
value of money as the NPV does. This metric is often used when there is a lack
of clarity or a lack of consensus within the company as to what discount rate
should be used in an NPV calculation. The payback period tells us how fast the
investors can expect to have their money returned. This metric is more useful for
someone who is concerned about limiting the downside potential rather than
evaluating the whole project. It ignores the time value of money and the cash
flows that occur after the payback period.
• Lease accounting is the process by which an organization records the financial
impacts of their leasing activities in their accounting calculations and reports.
According to the latest lease accounting standards, lessees are required to
recognize ROU assets and lease liabilities for all leases with terms longer than
12 months. Under US GAAP, two types of long-term leases are operating leases
and finance (previously capital) leases. In contrast, under IFRS, all long-term
leases are treated as finance leases.

© Copyright 2021 President and Fellows of Harvard College. All Rights Reserved. 3