Entrepreneurship for

Computer Science
CS 15-390
Financial Accounting- Part III
Lecture 19, April 1, 2018

Mohammad Hammoud
 Today…
• Last Session:
• A lecture on communications by Kit Needham- Part II

• Today’s Session:
• Financial Accounting- Part III

• Announcements:
• CP3 is due on April 14. All teams will present their works in the last week of
classes (i.e., in April 15 and April 17)
• Quiz II will be held next Sunday, April 8 (all the materials covered after the
midterm are included)
 Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Assets that areInventory
easily converted $100,000
Short-term obligations
Taxes Payable
that have $2,000
into cash withinTotal
theCurrent
next Assets
operating $115,000 to be paid
Totalwithin 1 year
Current Liabilities $87,000
period (typically within 1 year)
Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)
Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000
Assets that CANNOT be easily converted Long-term obligations that will be
into cash within the next operating paid OWNER’S
off overEQUITY
a period of years
period (typically within 1 year) Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets
Cash
Accounts Receivable
-
$5,000
$10,000
Current Liabilities
Accounts Payable
Wages Payable
= Net Working Capital
$80,000
$5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000
A measure of solvency
Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)
Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

 Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000
Listed in the
order of liquidity OWNER’S EQUITY
(i.e., the ability Common Stock $15,000
of an asset to Retained Earnings $30,000
be converted Total Owner’s Equity $45,000

into cash)
Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000
Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000
Listed in the
OWNER’S EQUITY order that they
Common Stock are due
$15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000

Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000

Interpreting Balance Sheets: An Example
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $5,000 Accounts Payable $80,000
Accounts Receivable $10,000 Wages Payable $5,000
Inventory $100,000 Taxes Payable $2,000
Total Current Assets $115,000 Total Current Liabilities $87,000

Long-Term (Noncurrent) Assets Long-Term (Noncurrent Debts)

Equipment $30,000 Bank Debt $10,000
Accumulated Depreciation ($3,000)
Net Long-Term Assets $27,000 Total Liabilities $97,000

OWNER’S EQUITY
Common Stock $15,000
Retained Earnings $30,000
Total Owner’s Equity $45,000 Let us elaborate
a little bit on
Total Assets $142,000 Total Liabilities & Owner’s Equity $142,000 this section
 Stocks: Few Basics
• A stock is a piece of ownership in a company

• A holder of stocks (i.e., a shareholder) has a claim to a part of the company's

assets and earnings

• The ownership of a shareholder is determined by the number of shares they

own relative to the number of outstanding shares
• E.g., If a company has 1,000 outstanding shares and one person owns 100 shares,
that person would own and have claim to 10% of the company's assets and earnings

• Outstanding shares include shares held by institutional investors as well as

restricted shares held by insiders and company officers
 Stocks: Few Basics
• There are two types of stocks:
1. Common Stocks:
• They entitle the owners to vote at meetings of board of directors
• The owners may or may not receive dividends (i.e., a distribution of a portion of a
company’s earnings), decided by the board of directors

2. Preferred Stocks:
• They do not entitle the owners to vote at meetings of board of directors
• The owners receive fixed periodic dividends
• They are cumulative; that is, if a payment to an owner is skipped due to insufficient
earnings, it should be paid when earnings allow
• They have a higher claim on assets and earnings than common stocks
• E.g., Owners of preferred stocks receive dividends before common shareholders and
are given priority in the events of bankruptcy and liquidation
 Stocks: Few Basics
• On many balance sheets, common stock is divided into 2 components:
1. Common Stock at Par Value
• Par value is an arbitrary value that represents the cost of a share; it is set when the
company originally issues shares before there is a market
• Most companies set a par value for their stocks to a minimal amount
• E.g., The par value for shares of Apple is $0.00001 and the par value for
Amazon stock is $0.01
• Shares cannot be sold below par value upon Initial Public Offering (IPO)- this way,
investors are confident that no one will receive a favorable price treatment (more
on IPOs next week)

2. Additional Paid-in Capital (or Capital Surplus)

• This represents the excess paid by an investor over and above the share’s par value
 Example: X Inc.
X Inc.
• $10,000,000 of common stock at $0.50 Equity Section of Balance Sheet
For the Year Ending December 31, 2017
per share entails 10,000,000/0.5 = Common Stock ($0.50 par value) $10,000,000
20,000,000 shares of stock outstanding Additional paid-in capital $44,000,000
Retained Earnings $32,000,000
Total Shareholders Equity $86,000,000

• The total amount of money raised by

X Inc. from the sale of all of its stock through time has been:
• Common stock at par + Additional paid-in capital
= $10,000,000 + $44,000,000
= $54,000,000
• This amount represents an average value of $2.70 per share
 Retained Earnings
• Retained earnings on a balance sheet are equal to the prior year’s retained
earnings plus this year’s addition to retained earnings
X Inc.
Equity Section of Balance Sheet
• Assume for X Inc.: For the Year Ending December 31, 2017
• Net income = $12,000,000 Common Stock ($0.50 par value) $10,000,000
Additional paid-in capital $44,000,000
• Common stock dividends paid = $3,000,000 Retained Earnings $32,000,000
• Thus, the addition to retained earnings = Total Shareholders Equity $86,000,000
$12,000,000 - $3,000,000 = $9,000,000

• What was the retained earnings on the balance sheet of X Inc. for the year
ending December 31, 2016? 32,000,000 - $9,000,000 = $23,000,000
 Retained Earnings: A Common Error
• A common error concerning retained earnings is that the amount
listed on a balance sheet for a given year can be used by the
respective company to cover future losses or pay off debt

• Retained earnings are NOT cash!

• Rather, retained earnings are money that have been used over years
to purchase assets
• They cannot be “re-spent” unless the company wants to liquidate assets
previously purchased
 Book Value vs. Market Value
• The sum of common stock at par value, additional paid-in capital, and
retained earnings of a company signifies its book value
X Inc.
Equity Section of Balance Sheet
• What is the book value of X Inc.? For the Year Ending December 31, 2017
• $86,000,000 Common Stock ($0.50 par value) $10,000,000
Additional paid-in capital $44,000,000
Retained Earnings $32,000,000
• If X Inc. trades in the stock market at a Total Shareholders Equity $86,000,000

current price per share of $6.00, then its

equity would be:
• 20,000,000 shares × $6.00 per share = $120,000,000
• This is referred to as the market value of X Inc.
 Valuating Post-Revenue Companies
• There is nearly always a disparity between the book value and the
market value of a company (or of an asset in a company)
• The book value is a recorded historical cost (or original acquisition cost)
• The market value is based on the perceived supply and demand, which can
vary constantly

• This disparity shall be recognized at the point of sale

• Prior to sale, there is no reason to account for any differences!

• A company’s valuation can be specified at its market value, but if the

difference between book and market values is considerable, an
appraisal process must be used to reconcile them
 Valuating Pre-Revenue Companies
• How can you valuate your pre-revenue startup?
• Use your business model to develop a corresponding mathematical model
• Select your beachhead market using the process we learned earlier in the term
• Use your mathematical model to do projections for your beachhead market
over 5 or 7 years (assume very conservative parameter values)
• Compute the net present value of your projections
• The riskier and earlier your startup, the higher the discount rate should be
(a discount rate between 40% and 70% is not uncommon)
• What are the factors that can play roles in reducing the discount rate (and
accordingly, increase the valuation of your startup)?
 Valuating Pre-Revenue Companies
• Some factors that can play roles in reducing the discount rate:
• “Who is the team?”
• “How solid are your market research and business model?”
• “Do you have a strong IP or patent”?
• “At which development stage is your product currently”?
• “Do you have any letters-of-intent and/or binding contracts”?
• “Have you started experimenting & have you collected any promising
statistics that can verify your value and growth hypotheses”?
• “Do you have a clear plan and a solid strategy to cross the chasm”?
 Next Class
• Financial Accounting- Part IV