Sunday, November 9, 2008

Financial Accounting - 2





















Net Income







No Account



Journal Entry:

  • Accrued Revenue                    ∙ Accrued Expense

    Debit: Accrued Receivable……..XXX                Debit: Accrued Expense ……..XXX

    Credit: Accrued Revenue …….. XXX                Credit: Accrued Payable …….. XXX

  • Revenue                        ∙ Expense

    Debit: Accounts Receivable (or Cash)…….. XXX            Debit: COGS ……..XXX

    Credit: Revenue …….. XXX                    Credit: Inventory …….. XXX

  • Interest Revenue                    ∙ Interest Expense

    Debit: Interest Receivable……..XXX                Debit: Interest Expense……..XXX

    Credit: Interest Revenue …….. XXX                Credit: Interest Payable …….. XXX

  • Prepaid Operating Costs

    Debit: Prepaid Insurance……..XXX                Debit: Insurance Expense……..XXX

    Credit: Cash …….. XXX                    Credit: Prepaid Insurance …….. XXX

  • Sale of Long Term Asset                    ∙ Depreciation (Contra Account)

    Debit: Cash……..XXX à Add to NI for Cash flow            Debit: Depreciation Expense……..XXX

    Debit: Accumulated Depreciation…..XXX            Credit: Accumulated Depreciation …….. XXX

    Credit: Asset …….. XXX

    Credit: Gain …….. XXX à Subtract from NI for Cash flow

  • Bad Debt Expense (adjusting entry)            ∙ Write-Offs

    Debit: Bad Debt Expense……. XXX                Debit: Allowance for Uncollectible Accounts… XXX

    Credit: Allowance for Uncollectible Accounts… XXX        Credit: Account Receivable… XXX

  • Bad Debt Recovery (First undo write-off)            ∙ Bad Debt Recovery (Second collect cash)

    Debit: Account Receivable… XXX                Debit: Cash… XXX

    Credit: Allowance for Uncollectible Account… XXX        Credit: Account Receivable… XXX

  • Raw Materials                        ∙ Work in Progress

    Debit: Raw Material…XXX (100)                Debit: Work in Progress… XXX (80)

    Credit: Cash… XXX (100)                    Credit: Raw Material… XXX (80)

  • Finished Goods                        Debit: WIP – Direct Labor… XXX (30)

    Debit: Finished Goods…XXX (160)                Debit: WIP – Electricity… XXX (50) (not expensed)

    Credit: WIP… (160)                        Credit: Cash… XXX (80)

  • Reducing Inventory (lower of cost or market value)        ∙ Income Tax            Deferred tax can either be Dr or Cr

    Debit: COGS…XXX (160) – determined by LIFO, FIFO etc        Debit: Tax Expense…XXX If DràAssetàPaid to IRS > Owed to IRS

    Credit: Inventory… (160)                    Credit: Tax Payable…XXX If CràLiabilityàPaid to IRS < Owed to IRS

  • Interest Expense = Bond Value X Yield (or, historical market Interest rate at the time of issuing the bond)
    • Issued at premium        Interest Expense                Interest Payment

    Dr: Cash 108,111        Dr: Interest Expense 4,324 (=4% X 108,111)    Dr: Interest Payable 5,000

    Cr: Bonds Payable 108,111    Dr: Bonds Payable 676 (=5000-4324)    Cr: Cash 5,000

                    Cr: Interest Payable 5,000

    • Issue at discount        Interest Expense                Interest Payment

    Dr: Cash 108,111        Dr: Interest Expense 5000+XXX        Dr: Interest Payable 5,000

    Cr: Bonds Payable 108,111    Cr: Bonds Payable XXX            Cr: Cash 5,000

                    Cr: Interest Payable 5,000

Financial Statement Analysis:

  • Profitability Analysis
    • Return on Assets (ROA): how well the firm uses its assets to generate income; independent of the source of financing (does not consider leverage)
      • ROA = (Net Income + Interest Expense net of income tax) / Average Total Assets
      • ROA = (Profit Margin for ROA) * (Total Asset Turnover)
      • Average Total Assets = (Total Assets_Begin + Total Assets_End) / 2
      • Profit Margin for ROA = (Net Income + Interest Expense net of income tax) / Sales
      • Total Asset Turnover = Sales / Average Total Assets; ability to generate sales from a given level of assets; Higher ratio is preferred to a lower one
      • A/R Turnover = Sales / Average A/R; Measures how quickly a firm collects cash; Higher ratio is preferred to a lower one
      • Inventory Turnover = COGS / Average Inventory; How fast firms sell merchandise; higher ratio is preferred
    • Return on Common Equity (ROCE): residual return left for the common shareholders. Since it may be low in poor years but high in good years, it has a risk, that is, the residual return is not known
      • ROCE = (Net Income – preferred dividends) / Average common shareholders' equity
      • ROCE = (Profit Margin for ROCE) * (Total Assets Turnover) * (Leverage Ratio)
      • Profit Margin for ROCE = (Net Income – preferred dividends) / Sales
      • Leverage Ratio = Average Total Assets / Average Common Shareholders' Equity; high leverage indicates firm has a lot of assets and shareholders have less of their own investments at risk; good in good years because the common shareholders capture all profits over what is needed to service the debt; Bad in poor years because the debt has to be serviced
    • Earnings per Share (EPS): Diluted includes certain securities that may be converted to a common share e.g. Options, convertible bonds, vendor agreements that involve stock payouts
      • EPS = (Net Income – preferred dividends) / Weighted average of common equity
      • P/E = market share price / EPS; lower is preferred; also called earnings multiple
  • Risk Analysis
    • Short Term Risk
      • Current Ratio = Current Assets / Current Liabilities; Measures ability to pay short-term liabilities
      • Quick Ratio = Current liquid assets / Current Liabilities; includes bank a/c but NOT inventories
      • CFO / Current Liabilities; ability of the firm to pay current liabilities without borrowing
      • Working Capital = Current Assets - Current Liabilities
    • Long Term Risk
      • Debt to Equity Ratio = Total Liabilities / Shareholder's Equity; indicates the financing provided by debtors or creditors; firm is said to be highly leveraged when this ratio is large
      • CFO / Total Liabilities; ability to pay all liabilities from cash without new debt or investment
      • Interest Coverage Ratio= EBIT / Interest Exp; protection operating profit provides to debtors
  • Pro Forma Financial Statements: projection of what the financial statements might look like if certain future conditions prevail; only as good as the forecast of the future conditions
  • Valuation
    • Comparison to similar transaction    - Adjusted book Value    - Valuation Multiples    - DCF
  • Basic Objectives
    • Useful to present and potential investors, creditors, and other users
    • In assessing the amount, timing, and uncertainty of future cash flows (SFAC 1)
    • Provides information about 1) economic resources, 2) the claims to those resources, and 3) the changes in them
  • Fundamental Qualities: To be useful, financial information must be
    • Relevant
    • Reliable (i.e., verifiable, neutral, faithfully represented)
    • Comparable – cross sectional
    • Consistent – time series
  • Assumptions
    • Going Concern
    • Monetary Unit
    • Economic Entity
    • Periodic Reporting (assumes that business operations can be recorded and separated into different periods)
  • Key Principles
    • The Historical Cost Principle
    • Revenue Recognition Principle
    • Matching Principle
  • Key Constraints
    • Materiality (whether an item affects the decision of a reasonable individual)
    • Conservatism

Balance Sheet: Snapshot in time of investing and financing activities

  • Assets – resource that has a potential future economic benefit (inventory, A/R, cash, building, prepaid rent)
  • Liabilities – arises when a firm receives benefits or services and in exchange promises to pay for these at a definite future time (A/P, notes, bonds, salaries, taxes, mortgage payable)
  • Equity – Assets – Liability (original contribution + retained earnings)
    • Contributed Capital
      – original investment by owners
      • Common Stock: A Par/face/Stated value of the shares which has a legal definition
      • Additional Paid-In Capital (APIC): A measure of the of cash or other assets received in the issuance of common or preferred stock in excess of par or stated value
    • Retained Earnings
      – amount of earnings left in the firm after the payment of dividends to the owners
      • Cumulative sum of profits earned from the inception of a business – Cumulative sum of all dividends distributed to the owners from the inception of a business
    • Treasury Stock – stock that the company buys back and keeps in its treasury. It is a reduction to shareholders' equity
  • Assets = Liabilities + Shareholders' Equity
    • Investing (A) = Financing (L + E)
    • Resources (A) = Sources of Resources (L + E)
  • RetainedEarnings_End = RetainedEarnings_Begin + Net Income - Dividends

Income Statement: Measures the "performance" of a company over a period of time

  • Revenues: measure economic benefits generated by sale of products or providing services over a period of time
  • Expenses: measure economic sacrifices incurred to "earn" the revenues for a given period of time
  • Gains or Positive Other Income: increases in equity from peripheral or incidentaltransactions of an entity
  • Losses or Negative Other Income: decreases in equity from peripheral or incidentaltransactions of an entity
    • Net Income (Profit) = Revenues – Expenses + Gains – Losses
  • EPS: net income divided by the average number of common shares outstanding
    • Basic: True EPS
    • Diluted: Pretends that "stock equivalents" are converted into stock

Cash Flow Statement:

  • Operations: cash from customers less cash paid in carrying out the firm's operating activities
  • Investing: cash paid to acquire noncurrent assets less amounts from any sale of noncurrent assets
  • Financing: cash from issues of long -term debt or new capital, less dividends

Opinion Letter:

  • 1st paragraph: indicates the financial statements covered by the opinion and that the responsibility for the statements rests with management
  • 2nd paragraph: affirms that the auditor followed Generally Accepted Auditing Standards (GAAS), accepted by the accounting profession (unless otherwise noted and described)
  • 3rd paragraph: actual auditor's opinion – unqualified or qualified
    • F/S presents fairly, in all materials respects, the financial position, the results of operations, etc.
    • F/S are in conformity with GAAP
    • Assessment of the effectiveness of the internal control
    • Qualified opinions are either a disclaimer of opinion or an adverse opinion

Asset: To recognize an asset, TWO conditions must be met:

  • An exchange must take place: This precludes all promises and future contracts as being assets unless some payment has been made
  • The future benefit must be quantifiable: This precludes, for example, R&D expenses

Asset Valuation: assignment of a monetary amount to an asset

  • Historical Cost
    • Prepaid Costs
    • Land
  • Depreciated/Amortized Historical Cost
    • Buildings and Equipment
    • Patents
  • Market Value
    • Marketable Securities

Liability: To recognize a liability, TWO conditions must be met

  • The firm has received benefits, and in exchange, promised to pay the provider: This precludes all promises and future contracts as liabilities unless the firm has received some service or asset in the past
  • The amount to be sacrificed is quantifiable and will occur at a definite future time: This precludes unsettled lawsuits since the firm does not know if it will win or lose the suit

Liability Valuation: assignment of a monetary amount to a liability

  • Liabilities due within one year past B/S date are generally valued at amount of the cash payment (e.g., Accounts Payable, Interest Payable)
  • Liabilities due after one year from B/S date are generally valued at the net present value of the future cash payments (Bonds, Capital Leases, Mortgages)

Accrual Accounting: amount and the timing of the recognition of revenues and expenses

  • Revenue Recognition: when BOTH of the following are met:
    • EARNED: Delivery has occurred or services have been rendered
    • REALIZED: Cash collection is 'reasonably assured' and measurable
  • Revenue Amount:
    • Revenues
      are measured by the cash or equivalent that it expects to receive
    • Uncollectible Accounts
      have no value by definition and are not included in revenue
    • Sales Discounts and Allowances
      are reductions in price and not included in revenue
    • Sales Returns
      are a reversal of the sale and are not included in revenue
  • Expense Amount = Cost of the Asset Consumed
  • Expense Recognition: The MATCHING PRINCIPLE – Expenses are recorded in the same time period as the related revenues are recognized
    • Product Costs can be directly matched to the sale:
    • Period Costs
      cannot be directly matched to the sale e.g. depreciation expense, interest expense
  • Closing:
    At the end of the accounting period, revenues and expenses are cleared (reset to zero) for the new accounting period. Their balances flow into Retained Earnings

Cash Flow:

  • Change in Cash = Change in Liabilities + Change in Shareholder's Equity – Change in Non-cash Assets
  • Operating cash flows (CFO): Result from events or transactions that affect net income; i.e., the cash-based revenues and expenses of a company – generally changes current assets
    • Operating (Current) Assets ↑ (e.g. A/R) OR Operating (Current) Liabilities ↓ (e.g. A/P) à Subtract from NI
    • Operating (Current) Assets ↓ (e.g. A/R) OR Operating (Current) Liabilities ↑ (e.g. A/P) à Add to NI
    • Depreciation à Add to NI        ∙ Gains à Subtract from NI        ∙ Loss à Add to NI
  • Investing cash flows (CFI): Result from the purchase or sale of productive assets like PP&E, marketable securities, and from acquisitions and divestitures – generally changes in non-current assets
    • PP&E        ∙ Marketable Securities        ∙ Businesses
  • Financing cash flows (CFF): Result from stocks/bonds issuance, dividend payment, repurchases, or borrowing/repayment of debts – generally changes in equity and non-current liabilities
    • Borrowing and Paying Back Debt    ∙ Issuing and Buying Back Own Equity Securities     ∙ Pay Dividends
  • Dividends: Paid à CFF            ∙ Received à CFO
  • Loans: Principal à CFF            ∙ Interest à CFO
  • Non-Operating (non-current): Assets à CFI    ∙ Liabilities à CFF
  • Red Flags
    • Large increase in Inventories    ∙ Large increases over time in A/P        ∙ Large increase in A/R








+ (equity)




- (dividend)



+ (sell off)

+ (debt)


  • Estimating Bad Debt:
    • %age of sales            ∙ %age of A/R                    ∙ Aging of accounts
  • Aging of accounts:

    Assume firm has $115,000 A/R

    • 1-30 days            ∙ 31-60 days            ∙ 61-90 days            ∙ Over 90 days

      100,000             5,000             5,000             5,000

% write-off: 0.1%             1%                 5%                 90%

Allowance: 100             50                 250                 4,500

  • Ending balance in Allowance for Uncollected is 4,900 (credit)
  • If existing balance is 2,500 (credit), Bad Debt Expense is 2,400
  • Estimated bad debt expense for the period is $2,300 using the allowance method

    Debit: Bad Debt Expense………. 2,300

    Credit: Allowance for Uncollectible Accounts …….. 2,300

  • A firm writes-off specific customers' accounts totaling $450 as uncollectible under the allowance method

    Debit: Allowance for Uncollectible Accounts ……….450

    Credit: A/R …….. 450

  • A firm writes-off specific customers' accounts totaling $495 as uncollectible under the direct write-off method

    Debit: Allowance for Uncollectible Accounts ……….495

    Credit: A/R …….. 495



Allowance for Uncollectible A/C


Bad Debt Expense





































Inventories: Dollar amount of goods the firm has available for sale

  • Costs such as freight, facility, and handling should be expensed and no longer can be capitalized as inventories
  • Merchandising Firms: Purchase Inventories; One account
  • Manufacturing Firms: Produce Inventories; Several accounts
    • Raw material    ∙ Work in progress (process)        ∙ Finished goods
  • Cash Flow Assumptions: In a few industries, it is possible to identify which particular units have been sold (e.g., jewelry, automobile). These firms use specific identification inventory costing. Most firms use cost flow assumption
    • COGS = Inventory_Begin + Purchases – Inventory_End
    • Specific Identification        ∙ FIFO            ∙ LIFO        ∙ Weighted Average
    • LIFO Liquidation - Old LIFO layers are liquidated and "matched" against sales
    • Lower of Cost or Market Value (replacement cost) - Cost is value for ending inventory using FIFO, LIFO etc
    • Beginning inventory        100 units @ 2.00    200

      Purchase #1        300 units @ 2.10    630

      Purchase #2        400 units @ 2.25    900

      Goods available for sale 800             1,730

      300 units sold. 500 units left


      • 300 units sold. COGS: 100*2 + 200*2.10 = $620
      • 500 units left. Ending Inventory: 100*2.10 + 400*2.25 = $1,110


      • 300 units sold. COGS: 300*2.25 = $675
      • 500 units left. Ending Inventory: 100*2+300*2.1+100*2.25= $1,055

      Weighted Average:

      • Cost per unit = $1,730/800 = $2.1625
      • 300 units sold. COGS: 300*2.1625 = $648.75
      • 500 units left. Ending Inventory: 500*2.1625 = $1081.25

Long Lived Tangible and Intangible Assets: Assets the company expects to keep for more than one year

  • Tangible Assets
    • Property, Plant and Equipment        ∙    Leased Buildings and Equipment
  • Intangible Assets: to be recognized as an asset, the intangible asset must be purchased from a third party
    • Patents        ∙    Franchises     ∙    Copyrights    ∙    Brand names     ∙     Goodwill
  • Expensing Long Term Assets over Time
    • Balance Sheet                    Income Statement

      Building and Equipment                Depreciation

      Natural Resources                    Depletion

      Intangibles                        Amortization

      Land                        Not expensed

      Goodwill                         Not expensed (Impairment test)

  • Issues in depreciation:
    • Measuring the depreciable basis of the asset
      • Acquisition Cost – Salvage (Residual) Value
      • Acquisition Cost includes all costs of acquiring and putting the asset in use
        • the fair value of what was given up in exchange for the asset (such as cash), or
        • the fair value of what was received; whichever is more easily determined
      • Salvage Value estimates market price in the future. Rarely, it may be –ve if disposal costs are very high
    • Estimating its useful life (economic life or service life): Most difficult task as obsolescence typically results from forces outside the firm. Accountants reconsider assets' estimated service lives every few years
    • Deciding on the pattern of depreciation
      • accelerated depreciation (A)    -    straight-line depreciation (S)
      • decelerated depreciation (D)     -    expense immediately (E)
      • no depreciation (N)
    • Acceptable methods (GAAP):
      • straight line        - Units of Production (use)    - Accelerated (Declining bal; Sum of years' digits)
    • Acceptable methods (Tax): MACRS = Modified Accelerated Cost Recovery System (similar to declining balance)
    • Straight line (time) depreciation: most common method
      • Basis = (cost – salvage value)    &     Rate = 1/ service life in years
      • Annual depreciation = Basis * Rate = (cost – salvage value) / (service life in years)
    • Units of Production depreciation: Sometimes the exhaustion of assets can be better measured by units of output or production e.g. a delivery truck may be good for 200,000 miles before wear and tear make it uneconomically useful. It may matter little whether the miles are driven in a few years or many
      • Depreciation Cost per Unit = (cost - salvage Value) / Estimated Number of Units
      • Annual depreciation = (Depreciation Cost per Unit) * (Number of Units Produced that period)
    • Accelerated (sum of years' digits method):
      • Sum of years' digits = n*(n+1) / 2 e.g. 5 years = 1+2+3+4+5 = 5*6/2 = 15
      • Basis = (cost – salvage value)    &    Rate = (remaining years) / (sum of years' digits)
      • Annual depreciation = Basis * Rate
    • Repairs generally restore usefulness. As such, repairs are expensed in the period they occur
    • Improvements increase usefulness and thus they are usually added to the cost of the asset and a new depreciation may have to be determined
    • Patents expire after 20 years in the U.S.; R&D and advertising should be expensed immediately
    • Impairment Test: Goodwill and Other Intangibles tested for impairment
      • Calculate undiscounted cash flows from an asset àUCF
      • Check whether book value > UCF. If yes
        • Reduce asset book value to fair value, or, Discounted Cash Flows (DCF)
        • New book value on Balance sheet = PV of DCF
        • Impairment loss on Income Statement = Old book value – New book value

Liabilities: Some (e.g. mortgage) may be noncurrent but have a current portion (payments due within the operating cycle)

  • Mortgage or Notes for borrowing small amounts    •    Bonds to raise larger amounts
  • Bond indenture (agreement)    •    Can issue at par, discount, premium     •    Coupon / No Coupon    
  • Types: Debenture bond – no collateral (most common) & Convertible bond
    • Coupon Payment = Face Value X Coupon Rate
    • Coupon Rate > Market Rate à Bond Price > Face Value à Issued at Premium
  • Off-Balance Sheet Financing: any means that secures the use of assets for the firm without having to recognize an offsetting liability
    • Can make key financial ratios look more favorable
    • It lowers the cost of borrowing if lenders are not aware of the unrecorded liabilities
      • It avoids violating some debt covenants (Examples: structured investment vehicles (SIV))
  • Leases: Firms may lease assets instead of purchasing them. Some leases are so inflexible that they are tantamount to a purchase
    • Capital Lease: recognizes lease as if it were a purchase
      • Both the leased asset (leasehold) and the lease liability (PV of the lease obligations) are recognized
      • The leased asset may be depreciated over time and the lease liability is amortized as payments are made
      • Signing the lease        Payments

      Dr: Leased Assets…XXX    Dr: Interest Expense…YYY        &    Dr: Lease Liability…ZZZ

      Cr: Lease Liability…XXX    Cr: Cash…YYY+ZZZ

    • Operating lease: recognizes the lease as rent
      • A lease expense is recognized as payments are made or adjusted entries are required
      • NO asset or long-term liability are recognized
    • Conditions to recognize as Capital Lease:
      • Transfers ownership to lessee at end of lease    -    Contains a bargain purchase option
      • Lease term = 75% of the asset's useful life    -    PV of lease payments = 90% of asset's fair market value
    • B/S Impact: Capital leases result in higher assets and higher liabilities
    • I/S impact: Capital leases result in higher costs in earlier years; Operating leases result in higher costs in later years; over the life same

Contingencies, Income Taxes, Pension Obligations

  • Contingencies: an existing situation involving uncertainty as to possible gain or loss to a company that will ultimately be resolved when one or more future events occur or fail to occur example: litigation
    • Probable: the future event(s) is likely to occur: Accrue it
    • Reasonably possible: the chance of the future event(s) occurring is more than remote but less than likely: Disclose it
    • Remote: the chance of the future event(s) occurring is slight: No accrual/Disclosure
    • Accrue loss contingencies if both of the following conditions are met:
      • Information indicates that it is probable what an asset has been impaired.
      • The amount of the loss can be reasonably estimated.
  • Income taxes are expenses and should be matched like other expenses, regardless of the cash tax payments
  • Defined Benefit (Pension) Plans
    • Promise to disburse a stream of payments to a retiree after they cease to be employed
    • Cost recognized over estimated career        ∙    Payments disbursed over estimated retirement period
  • Defined Contribution Plans (401k)
    • Employer agrees to make a fixed payment, each year on employee's behalf
    • Cost recognized each year as the payment is made    ∙    Typically a "Match" of the employee contribution
  • Other Post-Employment Benefits e.g. Health care coverage; Same accounting recognition as pension plan

Marketable securities: are bonds/stocks for which there is a reliable, liquid mkt; initially recorded at acquisition cost; later can be adjusted to the mkt value

  • Classified as Marketable Securities when:     ∙ firm can easily convert it to cash    ∙ Intends to do so when it needs cash, i.e., temporary investment
  • Investments are held either for profit (resold at a higher price) or for control purposes
    • If held for profit, the current market value provides useful information on that profit potential. Thus, GAAP provides for certain securities to be valued at market value
    • If held for control, then the profit of the subsidiary firm provides useful information. Both the equity method and consolidations require the parent firm to recognize accrued income of the subordinate
  • Three classes of Marketable Securities for the purposes of valuation after acquisition:
    • Debt Held to Maturity: firm has both intent & ability to hold to maturity; shown on the B/S at the amortized acquisition cost (like bond)
    • Held for Trade (Trading Securities): held for short-term profit; unrealized gains or losses that result from adjustments to mkt value pass through the income st. and increase or reduce net income
    • Securities Available for Sale: acquired for long-term return; unrealized gains or losses that result from adjustments to market value do not pass through the income statement but stay on the balance sheet as an equity account (OCI)
  • Minority, Passive Investments (<20%) - Held for Short Term
  • Minority, Active Investments (20%-50%) - Held for Influence; Requires the Equity Method of accounting:
    • Initial purchase is recorded as an asset at the acquisition cost
    • Each period, the investing firm recognizes revenue = to its proportionate share of the firm
    • Dividends reduce the asset and are not revenue but rather a return of capital
  • Majority, Active Investments (subsidiary, >50%) - Held for Full Control; portion of the subsidiary not owned by the parent is called the Minority Interest
    • Financial statements of legally separate entities be combined under one controlling economic entity
  • (A)OCI: (Accumulated) Other Comprehensive Income
  • Treasury Shares – contra account to shareholder's equity
    • Recorded at cost and kept in a separate acct so that the firm can more easily resell it.
    • TS do not receive cash dividends or vote. They may split or receive dividends in stock.

      Operating Lease Journal Entry (for lessor)

      Dr: Cash…XXX

      Cr: Rent Revenue…XXX

      Dr: Depreciation Expense…XXX

Cr: Acc Dep…XXX

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