4
CHAPTER
Analyzing Financing
Activities
Current (short-
term) Assets
Noncurrent
(Long-Term)
Assets
Resources or claims to
resources that are
expected to be sold,
collected,or used
within one year or the
operating cycle,
whichever is longer,
Resources or claims
to resources that are
expected to yield
benefits that extend
beyond one year or
the operating cycle,
whichever is longer,
Current Asset Introduction
Classification
Current Asset Introduction
Operating Cycle
Services sold to
customers
Cash on hand
1
2
Cash
pai
d to
em
plo
yees
3
4
Cu
sto
m
er
s p
ay
fo
r
ser
vices
Products sold
to customers
Cash on hand
1
2
Cash
pai
d fo
r
pr
od
uc
ts 4
Cu
sto
m
er
s p
ay
fo
r
pr
od
uc
ts
3
Cash
Currency,coins and amounts on deposit
in bank accounts,checking accounts,and
some savings accounts,
Current Asset Introduction
Cash,Cash Equivalents and Liquidity
Cash Equivalents
Short-term,highly liquid investments that are,
? Readily convertible to a known cash
amount,
? Close to maturity date and not
sensitive to interest rate changes,
Current Asset Introduction
Cash,Cash Equivalents and Liquidity
? Does not present serious valuation problems because of its
liquidity
? Requires special precautions against theft and defalcation
? Examine for restrictions on disposition
— remove restricted balances from current assets since they are not
available for paying current obligations
— in assessing liquidity,
consider repercussions
of violating these
agreements
— exposure often measured
by the ratio of restricted
balances to the total
Current Asset Introduction
Analysis of Cash and Cash Equivalents
C a s h a n d C a s h Eq u i v a l e n ts a s Pe r c e n t o f T o ta l
A s s e ts
0, 0 0 %
5, 0 0 %
1 0, 0 0 %
1 5, 0 0 %
2 0, 0 0 %
2 5, 0 0 %
K
o
d
a
k
T
e
x
a
s
In
s
tr
u
m
e
n
ts
C
o
c
a
-C
o
la
S
e
a
rs
D
e
lt
a
C
h
ir
o
n
S e r i e s 1
Receivables are amounts due from others
that arise from the sale of goods or services,
or the loaning of money
Accounts receivable refer to oral promises of
indebtedness due from customers
Notes receivable refer to formal written
promises of indebtedness due from others
Current Asset Introduction
Receivables
Receivables are reported at their net realizable
value —total amount of receivables less an
allowance for uncollectible accounts
Management estimates the allowance for
uncollectibles based on experience,customer
fortunes,economy and industry expectations,
and collection policies
Current Asset Introduction
Valuation of Receivables
Assessment of earnings quality is often affected by an analysis of receivables and their
collectibility
Analysis must be alert to changes in the allowance—computed relative to sales,
receivables,or industry and market conditions,
Two special analysis questions,
(1) Authenticity of Receivables
Review credit policy for changes
Review return policies for changes
Review any contingencies on receivables
(2) Collection Risk
Review allowance for uncollectibles in light of industry conditions
Apply special tools for analyzing collectibility,
? Determining competitors’ receivables as a percent of sales—vis-à-vis the
company under analysis
? Examining customer concentration—risk increases when receivables are
concentrated in one or a few customers
? Investigating the age pattern of receivables—overdue and for how long
? Determining portion of receivables that is a renewal of prior receivables
? Analyzing adequacy of allowances for discounts,returns,and other credits
Current Asset Introduction
Analyzing Receivables
Securitization (or factoring) is when a company
sells all or a portion of its receivables to a third party
Receivables can be sold with or without recourse to a
seller (recourse refers to guarantee of collectibility)
Sale of receivables with recourse
does not effectively transfer risk of
ownership
Sale of receivables without
recourse does not always transfer
risk of ownership
Current Asset Introduction
Securitization of Receivables
For securitizations with any type of recourse,the seller
must record both an asset and a compensating liability
for the amount factored
For securitizations without any recourse,the seller
removes the receivables from the balance sheet
Note disclosure of securitizations
are not required—this means an
analyst will be unaware of these
transactions unless information
about them arises from other
sources such as press releases
Current Asset Introduction
Analysis of Securitization
Prepaid expenses are advance payments for services or
goods not yet received that extend beyond the current
accounting period—examples are advance payments for
rent,insurance,utilities,and property taxes
Current Asset Introduction
Prepaid Expenses
Two analysis issues,
(1) For reasons of expediency,noncurrent prepaids
sometimes are included among prepaid expenses
classified as current--when their magnitude is large,
they warrant scrutiny
(2) Any substantial changes in prepaid expenses
warrant scrutiny
Analysis of Prepaids
Inventories
Definitions
Inventories are goods held for sale,or
goods acquired (or in process of being
readied) for sale,as part of a company’s
normal operations
Expensing treats inventory costs like period
costs—costs are reported in the period
when incurred
Capitalizing treats inventory costs like
product costs—costs are capitalized
as an asset and subsequently
charged against future
period(s) revenues
benefiting from their sale
Merchandise
Available
for Sale
Net Cost
of Purchases
Cost of
Goods Sold
Beginning
Inventory
Ending
Inventory
Inventories
Inventory Cost Flows
FI FO
42%
O t h e r
4%
W e i g h t e d
A v e r a g e
19%
L I FO
35%
Use of Inventory Methods in Practice
Inventories
Inventory Costing Method
Costs of
Goods Sold
Ending
Inventory
Oldest
Costs
Recent
Costs
Inventories
First-In,First-Out (FIFO)
When a unit is sold,the
average cost of
each unit in
inventory is assigned
to cost of goods sold,
Cost of
Goods
Available for
Sale
Units
available on
the date of
sale
÷
Inventories
Average Cost
?Most companies take a
physical count of
inventory at least once
each year,
?When the physical count
does not match the
Merchandise Inventory
account,an adjustment
must be made,
Inventories
Advantages of Each Costing Method
Inventory on January 1,Year 2 10 @ $400 $ 4,000
First purchase in Year 2 20 @ $500 10,000
Second purchase in Year 2 10 @ $500 5,000
Third purchase in Year 2 20 @ $600 12,000
Total available for sale 60 desks $31,000
Note,55 desks are sold in Year 2
Inventories
Illustration of Costing Methods
Beginning Net Cost of Ending
Inventory + Purchases = Goods Sold + Inventory
FIFO $4,000 + $27,000 = $28,000 + $3,000
LIFO $4,000 + $27,000 = $29,000 + $2,000
Average $4,000 + $27,000 = $28,416.5 + $2,583.5
Assume sales of $35,000 for the period—then gross profit under each method
is,
Sales – Cost of Goods Sold = Gross Profit
FIFO $35,000 -- 28,000 = $7000
LIFO $35,000 -- 29,000 = $6,000
Average $35,000 -- 28,416.5 = $6,583.5
Inventories
Illustration of Costing Methods
?A company is
required to use the
same accounting
methods from period
to period,
?A change is only
acceptable when it
improves financial
reporting,
Inventories
Inventory must be reported at market value
when market is lower than cost,
Defined as current
replacement cost
(not sales price),
Can be applied three ways,
(1) separately to each
individual item,
(2) to major categories of
assets,
(3) to the whole inventory,Dictated by the conservatism
principle,
Inventories
Compute LCM for individual items,inventory
groups,and overall inventory,
I nv e nt or y I t e m s
U ni t s on
H a nd Tot a l C os t
Tot a l
M a r k e t I t e m s C a t e g o r i e s W h o l e
C y c l e s,
R o a d s t e r 20 $ 1 6 0,0 0 0 $ 1 4 0,0 0 0 1 4 0,0 0 0$
S p r i n t 10 5 0,0 0 0 6 0,0 0 0 5 0,0 0 0
C a t e g o r y s u b t o t a l $ 2 1 0,0 0 0 $ 2 0 0,0 0 0 2 0 0,0 0 0$
O f f - R oa d
T r a x - 4 8 $ 4 0,0 0 0 $ 5 2,0 0 0 4 0,0 0 0
B l a z 'm 5 4 5,0 0 0 3 5,0 0 0 3 5,0 0 0
C a t e g o r y s u b t o t a l $ 8 5,0 0 0 $ 8 7,0 0 0 8 5,0 0 0
T o t a l $ 2 9 5,0 0 0 $ 2 8 7,0 0 0 2 6 5,0 0 0$ 2 8 5,0 0 0$ 2 8 7,0 0 0$
L C M A p p l i e d t o
Inventories
Purchase Commitments are contracts with other
entities to purchase inventory several months or
years in advance
Accounting does not reflect these commitments
since title to the goods has not passed to the
buyer
Disclosure exists
for certain noncancelable
purchase commitments
Inventories
Inventory Purchase Commitments
Inventory includes accumulation of costs under
long-term contracts—reduced by billings
Two common methods of accounting for these
inventory costs
? Completed-contract method
? Percentage-of-completion method
Inventories
Inventory under Long-Term Contracts
4th Q 1st Q 2nd Q 3rd Q 4th Q 1st Q
Per Unit Year 2 Year 3 Year 3 Year 3 Year 3 Year 4
Selling price $1,300 $1,400 $1,500 $1,600 $1,600 $1,500
Replacement cost 1,100 1,200 1,300 1,400 1,400 1,300
Inventories
Illustration of Changing Prices
Purchases
4th Q 1st Q 2nd Q 3rd Q 4th Q 1st Q Balance Sheet
Beginning of Year 2 Year 3 Year 3 Year 3 Year 3 Year 4 Inventory Figure
2nd Q Year 4 $1,100 $1,200 $1,300 = $3,600
3rd Q Year 4 1,200 1,300 $1,400 = 3,900
4th Q Year 4 1,300 1,400 $1,400 = 4,100
1st Q Year 4 1,400 1,400 $1,300 = 4,100
2nd Q 3rd Q 4th Q 1st Q
Year 3 Year 3 Year 3 Year 4
Sales $1,500 $1,600 $1,600 $1,500
Cost (when purchased) 1,100 1,200 1,300 1,400
(4thQ-Y2) (1stQ-Y3) (2ndQ-Y3) (3rdQ-Y3)
Gross profit $ 400 $ 400 $ 300 $ 100
Inventories
Illustration of Changing Prices -- FIFO
Purchases
4th Q 1st Q 2nd Q 3rd Q 4th Q 1st Q Balance Sheet
Beginning of Year 2 Year 3 Year 3 Year 3 Year 3 Year 4 Inventory Figure
2nd Q Year 4 $1,100 $1,200 $1,300 = $3,600
3rd Q Year 4 1,100 1,200 $1,400 = 3,700
4th Q Year 4 1,100 1,200 $1,400 = 3,700
1st Q Year 4 1,100 1,200 $1,300 = 3,600
2nd Q 3rd Q 4th Q 1st Q
Year 3 Year 3 Year 3 Year 4
Sales $1,500 $1,600 $1,600 $1,500
Cost (when purchased) 1,300 1,400 1,400 1,300
(2ndQ-Y3) (3rdQ-Y3) (4thQ-Y3) (1stQ-Y4)
Gross profit $ 200 $ 200 $ 200 $ 200
Inventories
Illustration of Changing Prices -- LIFO
Purchases
Operating
Average 4th Q 1st Q 2nd Q 3rd Q 4th Q 1st Q Balance Sheet
Beginning of Costa Year 2 Year 3 Year 3 Year 3 Year 3 Year 4 Inventory Figure
2nd Q Year 3 ----- $1,100 $1,200 $1,300 = $3,600.00
3rd Q Year 3 $2,400b $1,400 = 3,800.00
4th Q Year 3 2,533.3c $1,400 = 3,933.3
1st Q Year 3 2,622.2d $1,300 = 3,922.2
(a) Balance sheet value of inventory – Average cost of goods sold (Prior balance sheet figure divided
by 3),
(b) $3,600 – ($3,600/3) = $3,600 – $1,200 = $2,400,
(c) $3,800 – ($3,800/3) = $3,800 – $1,266.7 = $2,533.3,
(d) $3,933.3 – ($3,933.3/3) = $3,933.3 – $1,311.1 = $2,622.2,
2nd Q 3rd Q 4th Q 1st Q
Year 3 Year 3 Year 3 Year 4
Sales $1,500 $1,600 $1,600 $1,500
Cost (Average) 1,200 1,266.7 1,311.1 1,307.4 *
Gross profit $ 300 $ 333.3 $ 288.9 $ 192.6
*Balance sheet value of inventory divided by 3 = $3,922.2/3 = $1,307.4,
Inventories
Illustration of Changing Prices – Average Cost
Question 1,Does Inventory Physically Exist and Is It Fairly Valued?
Fairly valuing inventories depends not only on proper accounting for physical
quantities but also on proper inclusion and costing of items
Notes can reveal unusual accounting policies regarding inventory carrying costs
Composition of inventory among raw materials,work-in-process,and finished goods
can provide clues of future performance
Analysis of the level of both inventories and accounts receivable,over time and in
relation to sales,can gives clues into inventory quality (e.g.,existence,worth) and the
effects of factors like demand and returns
Additional analyses of inventory,if possible,include,
? How are LIFO inventories computed—on an item-by-item basis or by use of
pools?
? Is income affected by changes in inventory pools and,if so,by how much?
? Is inventory affected by year-end purchasing decisions?
? Are additional expenses or losses recorded to offset income arising from
involuntary liquidation of LIFO inventories?
? What assumptions concerning LIFO inventories underlie quarterly reports?
Inventories
Analyzing Inventories - Reliability
Question 2,Is Accounting for Inventories Consistent?
Analysis must be alert to changes in principles of inventory
accounting (e.g.,from LIFO to FIFO)
Analysis must also be aware of accounting changes affecting
comparability of financial statements that do not necessarily
require disclosure in either the financial statements or auditor’s
report (e.g.,number of LIFO pools)
Inventories
Analyzing Inventories -- Reliability
Question 3,Can Effects of Different Inventory Methods Be
Measured?
Analysis must be alert to increased management’s latitude in
managing earnings from use of LIFO
Management can also manage earnings by dipping into LIFO
inventory pools—yielding LIFO liquidations
Any LIFO liquidation gain can be considered separately as an
unusual nonrecurring item by removing it from cost of goods sold
in a recast income statement
Interim financial statements require forecasts
of costs of inventory items as well as projections
of future changes in inventory quantities and mix
—often impairing reliability
Inventories
Analyzing Inventories -- Reliability
Three step process,
(1) Inventory + LIFO reserve
(2) Deferred tax payable + [LIFO reserve x Tax rate]
(3) Retained earnings + [LIFO reserve x (1-Tax rate)]
LIFO reserve is the amount by which current cost
exceeds reported cost of LIFO
inventories
Inventories
Analyzing Inventories—Restatement of LIFO to FIFO
Campbell Soup Balance Sheet Adjustment— using an analytical
entry,
Inventories 89.6
Deferred Tax Payable 30.5
Retained Earnings 59.1
Campbell Soup Income Statement Adjustment,
Year 11
Under LIFO Difference Under FIFO
Beginning Inventory $ 819.8 $ 84.6 $ 904.4
+ Purchases (P)c P ---- P
-- Ending inventory (706.7) (89.6) (796.3)
= Cost of goods sold $P + 113.1 $ (5.0) $P + 108.1
Inventories
Analyzing Inventories—Restatement of LIFO to FIFO
Investment securities (also called marketable
securities) are of two types,
Debt Securities
? Government or corporate debt obligations
Equity Securities
? Corporate stock that is readily marketable,
Investment Securities
Composition
Held-to-Maturity
Controlling Interest (above
50% holding)
Classification
Investment Securities
Investment Securities
Debt Securities Equity Securities
Available-for-Sale
Trading
Significant Influence
(between 20% and
50% holding)
No Influence (below 20%
holding)
- Trading
- Available-for-Sale
Investment Securities
Accounting for Debt Securities
Accounting
Balance Sheet Income Statement
Category Description Unrealized
Gains/Losses
Other
Trading Securities
acquired mainly
for short-term or
trading gains
(usually less than
three months)
Fair Value
Recognize in net
income
Recognize realized
gains/losses and
interest income in
net income
Available-for-Sale Securities neither
held for trading
nor held-to-
maturity
Fair Value Not recognized in
net income,but
recognized in
comprehensive
income
Recognize realized
gains/losses and
interest income in
net income
Held-to-Maturity Securities
acquired with both
the intent and
ability to hold to
maturity
Amortized
Cost
Not recognized in
either net income
or comprehensive
income
Recognize realized
gains/losses and
interest income in
net income
Investment Securities
Accounting for Transfers between Security Classes
Transfer Accounting
Effect on Asset Value in
Balance Sheet
Effect on Income
Statement From To
Trading Available-for-Sale No effect Unrealized gain or loss on
date of transfer included
in net income
Available-for-Sale Trading No effect Unrealized gain or loss on
date of transfer included
in net income
Available-for-Sale Held-to-Maturity No effect at transfer;
however,asset reported
at (amortized) cost
instead of fair value at
future dates
Unrealized gain or loss on
date of transfer included
in comprehensive income
Held-to-Maturity Available-for-Sale Asset reported at fair
value instead of
(amortized) cost
Unrealized gain or loss on
date of transfer included
in comprehensive income
Investment Securities
Classification and Accounting for Equity Securities
Category No Influence Significant Influence Controlling
Interest Available-for-Sale Trading
Ownership Less than 20% Less than 20% Between 20% and 50% About 50%
Purpose Long- or
intermediate-term
investment
Short-term
investment or
trading
Degree of business
control
Full business
control
Valuation Basis Fair value Fair value Equity method Consolidation
Balance Sheet
Asset Value
Fair value Fair value Acquisition cost adjusted
for proportionate share of
investee’s retained
earnings and appropriate
amortization
Consolidated
balance sheet
Income Statement,
Unrealized Gains
In comprehensive
income
In income Not recognized Not recognized
Income Statement,
Other Income
Effects
Recognize
dividends and
realized gains and
losses in income
Recognize
dividends and
realized gains
and losses in
income
Recognize proportionate
share of investee’s net
income less appropriate
amortization in income
Consolidated
income
statement
At least three main objectives,
(1) to separate operating from investing (and
financing) performance
(2) to evaluate investment performance and
risk
(3) to analyze accounting distortions due to
accounting rules and
/or earnings management
involving investment
securities
Analyzing Investment Securities
Investment Securities
Determine whether investment securities (and related income
streams) are investing or operating in nature—based on an
assessment of whether each investment is strategic or made
purely for the purpose of investment
Remove all gains (losses) relating to investing activities—
including dividends,interest income,and realized and
unrealized gains and losses—when evaluating the operating
performance of a company
Separate operating and non-operating
assets when determining operating
return on investment
Separating Operating from Investing Assets and Performance
Investment Securities
ROI
= Investment income
(Beginning fair value of investment + Ending fair value of investment)/2
Evaluating Investment
Performance and Risk
Investment Securities
Investment income consists of three parts,Interest
(and dividend) income + Realized gains and losses +
Unrealized gains and losses
Held-to-Maturity Available-for-Sale Total
Investment income (1998),
Interest and dividend 219 219
Realized gains and losses
Unrealized gains and losses (70) (70)
Total before tax 219 (70) 149
Tax adjustment (33%) (72) 23 (49)
Total after tax 147 (47) 100
Average investment base (1998),
1997 Fair value 1,591 526 2,117
1998 Fair value 1,431 422 1,853
Average 1,511 474 1,985
Return on investment (ROI)
Before tax 14.5% -14.8% 7.5%
After tax 9.7% -9.9% 5.0%
Investment Securities
Evaluating Investment Performance and Risk—Coca-Cola Case
Analyzing Accounting Distortions from
Investment Securities
Investment Securities
Potential accounting distortions an analyst
must be alert to,
? Classification based on intent
? Opportunities for gains trading
? Liabilities recognized at cost
? Inconsistent definition of equity
securities
Auditors
Derivative Securities
commodity price risk
foreign currency risk
interest rate risk
Background
Market risks
Derivative Securities
Hedges are contracts that seek to insulate companies from
market risks—securities such as futures,options,and swaps are
commonly used as hedges
Derivative securities,or simply derivatives,are contracts whose
value is derived from the value of another asset or economic item
such as a stock,bond,commodity price,
interest rate,or currency exchange rate
— they can expose companies to considerable
risk because it can be difficult to find a
derivative that entirely hedges the risks or
because the parties to the derivative contract
fail to understand the risk exposures
Background
Derivative Securities
Derivative is a contract possessing each of the following characteristics,
? One or more underlying indexes and one or more notional amounts
(and/or payments)—the underlying indexes and the notional amounts
determine the settlement amount,if any,
? No initial net investment or an initial net investment less than that
required for a normal transaction yielding similar responses to
market risk changes,
? Permits a net settlement,
Underlying index,or simply underlying (also called a primitive),is the
main driver of derivative value--it can be any economic variable such as a
commodity price,security price,index,interest rate,or exchange rate
Notional amount is the number of units—expressed in figures,weight,
volume,dollars,or other unit measure—as specified in the contract
Net settlement is a cash resolution for the contracting parties in lieu of
settling up in full amounts (or quantities)
Definitions
Derivative Securities
Classification of Derivatives
Derivatives
Hedge Speculative
Fair Value
Hedge
Cash Flow
Hedge
Foreign
Currency
Hedge
Fair Value
Hedge
Hedge of Net
Investment in
Foreign
Operation
Cash Flow
Hedge
Derivative Securities
Accounting for Derivatives
Derivative
Balance Sheet
Income Statement
Speculative
Derivative recorded at fair
value
Unrealized gains and losses included in
income
Fair value hedge Both derivative and hedged asset and/or liability
recorded at fair value
Unrealized gains and losses on both
derivative and hedged asset and/or liability
included in income
Cash flow hedge Derivative recorded at fair value (offset by accumulated
comprehensive income)
Unrealized gains and losses on effective
portion of derivative are recorded in other
comprehensive income until settlement date,
afterwhich transferred to income; unrealized
gains and losses on the ineffective portion of
derivative are included in income
Foreign currency
fair value hedge
Same as fair value hedge
Same as fair value hedge
Foreign currency
cash flow hedge
Same as cash flow hedge
Same as cash flow hedge
Foreign currency
hedge of net
investment in
foreign operation
Derivative (and cumulative
unrealized gain or loss)
recorded at fair value (part of
cumulative translation
adjustment in accumulated
comprehensive income)
Unrealized gains and losses reported in other
comprehensive income as part of translation
adjustment
Derivative Securities
Tabular Presentation—group derivatives with common characteristics,but
separately report information for each type of risk category (for example,interest rate
risk or foreign currency risk) and by maturity dates; disclosures must be sufficient to
evaluate the cash flow impacts of derivatives under alternative scenarios for the
underlying economic variable
Sensitivity Analysis—report the effects of hypothetical changes in the underlying
market risk (for example,interest rate,foreign currency exchange rate or commodity
price) on future earnings,cash flows,or fair values (as appropriate) over a period of
time; disclosures can be separately reported for each risk class
Value-at-risk—reports the potential loss in earnings,
cash flows,or fair values from a company’s derivatives
based on market movements with a given likelihood
(probability) of occurrence,usually expressed as a percent,
over some holding period (method often is viewed as a
measure of maximum normal loss from derivatives)
Disclosures for Derivatives
Derivative Securities
Value-at-Risk for a Hypothetical Derivative
-4 0 0 -3 0 0 -2 0 0 -1 0 0 0 100 200 300 400
V a l u e o f D e r i v a t i v e i n $ M i l l i o n
L
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Value-at-Risk at 95%
confidence level
$ 125 million
Derivative Securities
Identify Objectives for Using Derivatives—risk associated with derivatives is
much higher for speculation than for hedging; many companies implicitly speculate
with derivatives
Risk Exposure and Effectiveness of Hedging Strategies—evaluate the
underlying risks,the risk management strategy,the activities to hedge its risks,and
the effectiveness of hedging operations; also consider counterparty risk
Transaction Specific versus Companywide Risk Exposure—evaluate
companywide effects of derivatives; hedging specific risk exposures to transactions,
commitments,assets,and/or liabilities does not necessarily ensure hedging of
companywide risk
Inclusion in Operating or Nonoperating Income—to the
extent derivatives are hedges,then unrealized and realized
gains and losses should be excluded from operating income
and their fair values should be excluded from operating assets
Analysis of Derivatives
Long-Lived Asset Introduction
Long-lived assets—resources or claims to resources are used to
generate revenues (or reduce costs) in the long run
Definitions
Tangible fixed assets such as
property,plant,and equipment
Deferred charges such as
research and development
(R&D) expenditures,and natural
resources
Intangible assets such as
patents,trademarks,
copyrights,and goodwill
Long-Lived Asset Introduction
Capitalization—process of deferring a cost that is incurred in the
current period and whose benefits are expected to extend to one or
more future periods
For a cost to be capitalized,it must meet each of the following
criteria,
? It must arise from a
past transaction or event
? It must yield identifiable and
reasonably probable future benefits
? It must allow owner (restrictive)
control over future benefits
Capitalization
Long-Lived Asset Introduction
Allocation—process of periodically expensing a
deferred cost (asset) to one or more future expected
benefit periods; determined by benefit period,salvage
value,and allocation method
Terminology
? Depreciation for tangible fixed
assets
? Amortization for intangible assets
? Depletion for natural resources
Allocation
Long-Lived Asset Introduction
Impairment—process of writing down asset value
when its value-in-use falls below its carrying (book)
value
Two distortions arise from impairment,
? Conservative biases distort
long-lived asset valuation
because assets are written
down but not written up
? Earnings management
opportunities increase in a
trade-off for more useful
balance sheets
Impairment
Long-Lived Asset Introduction
Capitalizing versus Expensing,An Illustration
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Assets and Capacities
Assets (units),
Acquisitions 1 – 1 – 1 – – – – –
Replacement – – – – 1 – 1 – 2 –
Total 1 0 1 0 2 0 1 0 2 0
Productive Capacity 1 1 2 2 3 3 3 3 3 3
Cash Flows ($)
Revenues $ 500 $ 500 $1,000 $1,000 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500
Capital 1,000 0 1,000 0 2,000 0 1,000 0 2,000 0
Expenditure
Interest expense 100 100 100 100 100 100 100 100 100 100
Long-Lived Asset Introduction
Capitalizing versus Expensing,An Illustration
Capitalizing versus Expensing Example,Income and Ratios with and without Capitalization
I n c o m e w i t h a n d w i t h o u t C a p i t a l i z a t i o n
- 1 0 0 0
- 5 0 0
0
500
1000
1500
1 2 3 4 5 6 7 8 9 10
Y e a r
In
c
o
m
e
(
$
)
W it h o u t
W it h
R e t u r n o n A s s e t s w i t h a n d w i t h o u t C a p i t a l i z a t i o n
- 0, 6
- 0, 4
- 0, 2
0
0, 2
0, 4
0, 6
1 2 3 4 5 6 7 8 9 10
Y e a r
R
a
t
io W it h o u t
W it h
D e b t - t o - E q u i t y w i t h a n d w i t h o u t C a p i t a l i z a t i o n
0
0, 5
1
1, 5
2
2, 5
3
1 2 3 4 5 6 7 8 9 10
Y e a r
R
a
t
io W it h o u t
W it h
R e t u r n o n E q u i t y w i t h a n d w i t h o u t C a p i t a l i z a t i o n
-2
- 1, 5
-1
- 0, 5
0
0, 5
1
1 2 3 4 5 6 7 8 9 10
Y e a r
R
a
t
io W it h o u t
W it h
Tangible
Expected to Benefit Future Periods
Actively Used in Operations
Property,Plant and Equipment
Plant Assets & Natural Resources
Plant Assets
Plant Assets & Natural Resources
Plant Assets
Historical cost principle is used for valuation—
justification includes,
? Conservatism—in not anticipating
subsequent replacement costs
? Accountability—in dollar amounts for
management
? Objectivity—in cost
determination
Acquisition
cost
Acquisition cost excludes
financing charges and
cash discounts,
All
expenditures
needed to
prepare the
asset for its
intended use
Purchase
price
Plant Assets & Natural Resources
Plant Assets Costing Rule
Total cost,
including
exploration and
development,
is charged to
depletion expense
over periods
benefited,
Extracted from
the natural
environment
and reported
at cost less
accumulated
depletion,
Examples,oil,coal,gold
Plant Assets & Natural Resources
Natural Resources
Natural resources (wasting assets)—rights to extract or consume natural resources
Valuation emphasizes objectivity of historical cost,the
conservatism principle,and accounting for the monies
invested; represent a company’s capacity to produce
goods and services
Limitations of historical costs,
? Balance sheets do not purport to reflect market values
? Not especially relevant in assessing replacement values
? Not comparable across companies
? Not particularly useful in measuring opportunity costs
? Collection of expenditures reflecting different
purchasing power
Plant Assets & Natural Resources
Valuation Analysis
Depreciation is the process of allocating
the cost of a plant asset to expense in the
accounting periods benefiting from its
use,
Cost
Allocation
Acquisition
Cost
(Unused)
Balance Sheet
(Used)
Income Statement
Expense
Depreciation
Plant Assets & Natural Resources
The calculation of depreciation requires
three amounts for each asset,
? Cost,
? Salvage Value,
? Useful Life,
? Depreciation Method
Plant Assets & Natural Resources
Factors in Computing Depreciation
80%
9%
4%
7%
Str a i g h t- l i n e
A c c e l e r a te d &
O th e r
D e c l i n i n g -
b a l a n c e
U n i ts -o f-
p r o d u c ti o n
The majority of companies use the straight-line
method,
Plant Assets & Natural Resources
Comparing Depreciation Methods
Cost - Salvage Value
Useful life in periods
Depreciation
Expense per Year
=
SL
Plant Assets & Natural Resources
Comparing Depreciation Methods
Facts,Asset cost=$110,000; Useful life=10 years;
Salvage value=$10,000
End of Accumulated Book
Year Depreciation Depreciation Value
$110,000
1 $ 10,000 $ 10,000 100,000
2 10,000 20,000 90,000
,
,
9 10,000 90,000 20,000
10 10,000 100,000 10,000
Plant Assets & Natural Resources
Straight-Line Depreciation Illustration
Step 1,
Step 2,
Double-declining-
balance rate = 2 ×
Straight-line
depreciation rate
Step 3,
Depreciation
expense =
Double-declining-
balance rate ×
Beginning period
book value
Ignores salvage value
Straight-line
depreciation rate =
100 %
Useful life
Plant Assets & Natural Resources
Double-Declining-Balance Method
Plant Assets & Natural Resources
Double-Declining-Balance (and SYD) Depreciation
Illustration
Depreciation Cumulative Amount
Double- Sum-of-the Double- Sum-of-the
Year Declining Years’-Digits Declining Years’-Digits
1 $22,000 $18,182 $22,000 $18,182
2 17,600 16,364 39,600 34,546
3 14,080 14,545 53,680 49,091
4 11,264 12,727 64,944 61,818
5 9,011 10,909 73,955 72,727
6 7,209 9,091 81,164 81,818
7 5,767 7,273 86,931 89,091
8 4,614 5,455 91,545 94,546
9 3,691 3,636 95,236 98,182
10 2,953 1,818 98,189 100,000
Depreciation
Per Unit =
Cost - Salvage Value
Total Units of Production
Step 1,
Step 2,
Depreciation
Expense =
Depreciation
Per Unit ×
Units Produced
in Period
Activity (Units-of-Production) Method
Plant Assets & Natural Resources
Total cost,
including
exploration and
development,
is charged to
depletion expense
over periods
benefited,
Extracted from
the natural
environment
and reported
at cost less
accumulated
depletion,
Examples,oil,coal,gold
Plant Assets & Natural Resources
Depletion is calculated using the
units-of-production method,
Unit depletion rate is calculated as follows,
Total Units of Capacity
Cost – Salvage Value
Plant Assets & Natural Resources
Depletion of Natural Resources
Total depletion cost for a period is,
Unit Depletion
Rate
Number of Units
Extracted in Period ×
Total
depletion
cost Unsold
Inventory
Cost of
goods sold
Plant Assets & Natural Resources
Depletion of Natural Resources
Plant Assets & Natural Resources
Analyzing Depreciation and Depletion
? Assess reasonableness of depreciable base,useful life,and
allocation method
? Review any revisions of useful lives
? Evaluate adequacy of depreciation—ratio of depreciation to total
assets or to another size-related factors
? Analyze plant asset age—measures include
Average total life span = Gross plant and equipment assets /
Current year depreciation expense,
Average age = Accumulated depreciation / Current
year depreciation expense,
Average remaining life = Net plant and equipment assets /
Current year depreciation expense,
Average total life span = Average age + Average remaining life
(these measures also reflect on profit margins and financing requirements)
Noncurrent assets
without physical
substance,
Useful life is
often difficult
to determine,
Usually acquired
for operational
use,
Intangible
Assets
Often provide
exclusive rights
or privileges,
Intangible Assets
? Patents
? Copyrights
? Leaseholds
? Leasehold
Improvements
? Goodwill
? Trademarks and
Trade Names
Record at
cost,including
purchase
price,legal
fees,and
filing fees,
Intangible Assets
Accounting for Intangible Assets
?Amortize over shorter of economic
life or legal life,subject to a maximum
of 40 years,
?Use straight-line method,
?Research and development costs are
normally expensed as incurred,
Intangible Assets
Accounting for Intangible Assets
Intangible Assets
Accounting for Intangible Assets
Manner of Acquisition
Purchased Developed Internally
Identifiable Capitalize Expense (with some
intangible and amortize exceptions)
Unidentifiable Capitalize Expense
intangible and amortize
Intangible Assets
Goodwill
Goodwill is the value assigned
to a rate of earnings above the
norm-it translates into excess
earnings called superearnings
Goodwill (1) can be a sizable asset,(2) is
recorded only upon purchase of another entity
or segment,and (3) varies considerably in
composition
Occurs when one
company buys
another company,
Only purchased
goodwill is an
intangible asset,
The amount by which the
purchase price exceeds the fair
market value of net assets acquired,
Intangible Assets
Goodwill
39%
22%
10%4%
6%
19%
4 0 y e a r s
O t h e r
L e g a l / E s t i m a t e d
l i f e
1 0 - 1 5 y e a r s
2 0 - 3 0 y e a r s
N o t e x c e e d i n g
4 0 y e a r s
Intangible Assets
Goodwill Amortization Period
Intangible Assets
Analyzing Intangibles and Goodwill
? Search for unrecorded intangibles and
goodwill—often misvalued and
most likely exist off-balance-sheet
? Examine for superearnings as
evidence of goodwill
? Review amortization periods—any bias likely is in the
direction of less amortization and can call for
adjustments
? Recognize goodwill has a limited useful life--whatever
the advantages of location,market dominance,
competitive stance,sales skill,or product
acceptance,they are affected by changes in business
CHAPTER
Analyzing Financing
Activities
Current (short-
term) Assets
Noncurrent
(Long-Term)
Assets
Resources or claims to
resources that are
expected to be sold,
collected,or used
within one year or the
operating cycle,
whichever is longer,
Resources or claims
to resources that are
expected to yield
benefits that extend
beyond one year or
the operating cycle,
whichever is longer,
Current Asset Introduction
Classification
Current Asset Introduction
Operating Cycle
Services sold to
customers
Cash on hand
1
2
Cash
pai
d to
em
plo
yees
3
4
Cu
sto
m
er
s p
ay
fo
r
ser
vices
Products sold
to customers
Cash on hand
1
2
Cash
pai
d fo
r
pr
od
uc
ts 4
Cu
sto
m
er
s p
ay
fo
r
pr
od
uc
ts
3
Cash
Currency,coins and amounts on deposit
in bank accounts,checking accounts,and
some savings accounts,
Current Asset Introduction
Cash,Cash Equivalents and Liquidity
Cash Equivalents
Short-term,highly liquid investments that are,
? Readily convertible to a known cash
amount,
? Close to maturity date and not
sensitive to interest rate changes,
Current Asset Introduction
Cash,Cash Equivalents and Liquidity
? Does not present serious valuation problems because of its
liquidity
? Requires special precautions against theft and defalcation
? Examine for restrictions on disposition
— remove restricted balances from current assets since they are not
available for paying current obligations
— in assessing liquidity,
consider repercussions
of violating these
agreements
— exposure often measured
by the ratio of restricted
balances to the total
Current Asset Introduction
Analysis of Cash and Cash Equivalents
C a s h a n d C a s h Eq u i v a l e n ts a s Pe r c e n t o f T o ta l
A s s e ts
0, 0 0 %
5, 0 0 %
1 0, 0 0 %
1 5, 0 0 %
2 0, 0 0 %
2 5, 0 0 %
K
o
d
a
k
T
e
x
a
s
In
s
tr
u
m
e
n
ts
C
o
c
a
-C
o
la
S
e
a
rs
D
e
lt
a
C
h
ir
o
n
S e r i e s 1
Receivables are amounts due from others
that arise from the sale of goods or services,
or the loaning of money
Accounts receivable refer to oral promises of
indebtedness due from customers
Notes receivable refer to formal written
promises of indebtedness due from others
Current Asset Introduction
Receivables
Receivables are reported at their net realizable
value —total amount of receivables less an
allowance for uncollectible accounts
Management estimates the allowance for
uncollectibles based on experience,customer
fortunes,economy and industry expectations,
and collection policies
Current Asset Introduction
Valuation of Receivables
Assessment of earnings quality is often affected by an analysis of receivables and their
collectibility
Analysis must be alert to changes in the allowance—computed relative to sales,
receivables,or industry and market conditions,
Two special analysis questions,
(1) Authenticity of Receivables
Review credit policy for changes
Review return policies for changes
Review any contingencies on receivables
(2) Collection Risk
Review allowance for uncollectibles in light of industry conditions
Apply special tools for analyzing collectibility,
? Determining competitors’ receivables as a percent of sales—vis-à-vis the
company under analysis
? Examining customer concentration—risk increases when receivables are
concentrated in one or a few customers
? Investigating the age pattern of receivables—overdue and for how long
? Determining portion of receivables that is a renewal of prior receivables
? Analyzing adequacy of allowances for discounts,returns,and other credits
Current Asset Introduction
Analyzing Receivables
Securitization (or factoring) is when a company
sells all or a portion of its receivables to a third party
Receivables can be sold with or without recourse to a
seller (recourse refers to guarantee of collectibility)
Sale of receivables with recourse
does not effectively transfer risk of
ownership
Sale of receivables without
recourse does not always transfer
risk of ownership
Current Asset Introduction
Securitization of Receivables
For securitizations with any type of recourse,the seller
must record both an asset and a compensating liability
for the amount factored
For securitizations without any recourse,the seller
removes the receivables from the balance sheet
Note disclosure of securitizations
are not required—this means an
analyst will be unaware of these
transactions unless information
about them arises from other
sources such as press releases
Current Asset Introduction
Analysis of Securitization
Prepaid expenses are advance payments for services or
goods not yet received that extend beyond the current
accounting period—examples are advance payments for
rent,insurance,utilities,and property taxes
Current Asset Introduction
Prepaid Expenses
Two analysis issues,
(1) For reasons of expediency,noncurrent prepaids
sometimes are included among prepaid expenses
classified as current--when their magnitude is large,
they warrant scrutiny
(2) Any substantial changes in prepaid expenses
warrant scrutiny
Analysis of Prepaids
Inventories
Definitions
Inventories are goods held for sale,or
goods acquired (or in process of being
readied) for sale,as part of a company’s
normal operations
Expensing treats inventory costs like period
costs—costs are reported in the period
when incurred
Capitalizing treats inventory costs like
product costs—costs are capitalized
as an asset and subsequently
charged against future
period(s) revenues
benefiting from their sale
Merchandise
Available
for Sale
Net Cost
of Purchases
Cost of
Goods Sold
Beginning
Inventory
Ending
Inventory
Inventories
Inventory Cost Flows
FI FO
42%
O t h e r
4%
W e i g h t e d
A v e r a g e
19%
L I FO
35%
Use of Inventory Methods in Practice
Inventories
Inventory Costing Method
Costs of
Goods Sold
Ending
Inventory
Oldest
Costs
Recent
Costs
Inventories
First-In,First-Out (FIFO)
When a unit is sold,the
average cost of
each unit in
inventory is assigned
to cost of goods sold,
Cost of
Goods
Available for
Sale
Units
available on
the date of
sale
÷
Inventories
Average Cost
?Most companies take a
physical count of
inventory at least once
each year,
?When the physical count
does not match the
Merchandise Inventory
account,an adjustment
must be made,
Inventories
Advantages of Each Costing Method
Inventory on January 1,Year 2 10 @ $400 $ 4,000
First purchase in Year 2 20 @ $500 10,000
Second purchase in Year 2 10 @ $500 5,000
Third purchase in Year 2 20 @ $600 12,000
Total available for sale 60 desks $31,000
Note,55 desks are sold in Year 2
Inventories
Illustration of Costing Methods
Beginning Net Cost of Ending
Inventory + Purchases = Goods Sold + Inventory
FIFO $4,000 + $27,000 = $28,000 + $3,000
LIFO $4,000 + $27,000 = $29,000 + $2,000
Average $4,000 + $27,000 = $28,416.5 + $2,583.5
Assume sales of $35,000 for the period—then gross profit under each method
is,
Sales – Cost of Goods Sold = Gross Profit
FIFO $35,000 -- 28,000 = $7000
LIFO $35,000 -- 29,000 = $6,000
Average $35,000 -- 28,416.5 = $6,583.5
Inventories
Illustration of Costing Methods
?A company is
required to use the
same accounting
methods from period
to period,
?A change is only
acceptable when it
improves financial
reporting,
Inventories
Inventory must be reported at market value
when market is lower than cost,
Defined as current
replacement cost
(not sales price),
Can be applied three ways,
(1) separately to each
individual item,
(2) to major categories of
assets,
(3) to the whole inventory,Dictated by the conservatism
principle,
Inventories
Compute LCM for individual items,inventory
groups,and overall inventory,
I nv e nt or y I t e m s
U ni t s on
H a nd Tot a l C os t
Tot a l
M a r k e t I t e m s C a t e g o r i e s W h o l e
C y c l e s,
R o a d s t e r 20 $ 1 6 0,0 0 0 $ 1 4 0,0 0 0 1 4 0,0 0 0$
S p r i n t 10 5 0,0 0 0 6 0,0 0 0 5 0,0 0 0
C a t e g o r y s u b t o t a l $ 2 1 0,0 0 0 $ 2 0 0,0 0 0 2 0 0,0 0 0$
O f f - R oa d
T r a x - 4 8 $ 4 0,0 0 0 $ 5 2,0 0 0 4 0,0 0 0
B l a z 'm 5 4 5,0 0 0 3 5,0 0 0 3 5,0 0 0
C a t e g o r y s u b t o t a l $ 8 5,0 0 0 $ 8 7,0 0 0 8 5,0 0 0
T o t a l $ 2 9 5,0 0 0 $ 2 8 7,0 0 0 2 6 5,0 0 0$ 2 8 5,0 0 0$ 2 8 7,0 0 0$
L C M A p p l i e d t o
Inventories
Purchase Commitments are contracts with other
entities to purchase inventory several months or
years in advance
Accounting does not reflect these commitments
since title to the goods has not passed to the
buyer
Disclosure exists
for certain noncancelable
purchase commitments
Inventories
Inventory Purchase Commitments
Inventory includes accumulation of costs under
long-term contracts—reduced by billings
Two common methods of accounting for these
inventory costs
? Completed-contract method
? Percentage-of-completion method
Inventories
Inventory under Long-Term Contracts
4th Q 1st Q 2nd Q 3rd Q 4th Q 1st Q
Per Unit Year 2 Year 3 Year 3 Year 3 Year 3 Year 4
Selling price $1,300 $1,400 $1,500 $1,600 $1,600 $1,500
Replacement cost 1,100 1,200 1,300 1,400 1,400 1,300
Inventories
Illustration of Changing Prices
Purchases
4th Q 1st Q 2nd Q 3rd Q 4th Q 1st Q Balance Sheet
Beginning of Year 2 Year 3 Year 3 Year 3 Year 3 Year 4 Inventory Figure
2nd Q Year 4 $1,100 $1,200 $1,300 = $3,600
3rd Q Year 4 1,200 1,300 $1,400 = 3,900
4th Q Year 4 1,300 1,400 $1,400 = 4,100
1st Q Year 4 1,400 1,400 $1,300 = 4,100
2nd Q 3rd Q 4th Q 1st Q
Year 3 Year 3 Year 3 Year 4
Sales $1,500 $1,600 $1,600 $1,500
Cost (when purchased) 1,100 1,200 1,300 1,400
(4thQ-Y2) (1stQ-Y3) (2ndQ-Y3) (3rdQ-Y3)
Gross profit $ 400 $ 400 $ 300 $ 100
Inventories
Illustration of Changing Prices -- FIFO
Purchases
4th Q 1st Q 2nd Q 3rd Q 4th Q 1st Q Balance Sheet
Beginning of Year 2 Year 3 Year 3 Year 3 Year 3 Year 4 Inventory Figure
2nd Q Year 4 $1,100 $1,200 $1,300 = $3,600
3rd Q Year 4 1,100 1,200 $1,400 = 3,700
4th Q Year 4 1,100 1,200 $1,400 = 3,700
1st Q Year 4 1,100 1,200 $1,300 = 3,600
2nd Q 3rd Q 4th Q 1st Q
Year 3 Year 3 Year 3 Year 4
Sales $1,500 $1,600 $1,600 $1,500
Cost (when purchased) 1,300 1,400 1,400 1,300
(2ndQ-Y3) (3rdQ-Y3) (4thQ-Y3) (1stQ-Y4)
Gross profit $ 200 $ 200 $ 200 $ 200
Inventories
Illustration of Changing Prices -- LIFO
Purchases
Operating
Average 4th Q 1st Q 2nd Q 3rd Q 4th Q 1st Q Balance Sheet
Beginning of Costa Year 2 Year 3 Year 3 Year 3 Year 3 Year 4 Inventory Figure
2nd Q Year 3 ----- $1,100 $1,200 $1,300 = $3,600.00
3rd Q Year 3 $2,400b $1,400 = 3,800.00
4th Q Year 3 2,533.3c $1,400 = 3,933.3
1st Q Year 3 2,622.2d $1,300 = 3,922.2
(a) Balance sheet value of inventory – Average cost of goods sold (Prior balance sheet figure divided
by 3),
(b) $3,600 – ($3,600/3) = $3,600 – $1,200 = $2,400,
(c) $3,800 – ($3,800/3) = $3,800 – $1,266.7 = $2,533.3,
(d) $3,933.3 – ($3,933.3/3) = $3,933.3 – $1,311.1 = $2,622.2,
2nd Q 3rd Q 4th Q 1st Q
Year 3 Year 3 Year 3 Year 4
Sales $1,500 $1,600 $1,600 $1,500
Cost (Average) 1,200 1,266.7 1,311.1 1,307.4 *
Gross profit $ 300 $ 333.3 $ 288.9 $ 192.6
*Balance sheet value of inventory divided by 3 = $3,922.2/3 = $1,307.4,
Inventories
Illustration of Changing Prices – Average Cost
Question 1,Does Inventory Physically Exist and Is It Fairly Valued?
Fairly valuing inventories depends not only on proper accounting for physical
quantities but also on proper inclusion and costing of items
Notes can reveal unusual accounting policies regarding inventory carrying costs
Composition of inventory among raw materials,work-in-process,and finished goods
can provide clues of future performance
Analysis of the level of both inventories and accounts receivable,over time and in
relation to sales,can gives clues into inventory quality (e.g.,existence,worth) and the
effects of factors like demand and returns
Additional analyses of inventory,if possible,include,
? How are LIFO inventories computed—on an item-by-item basis or by use of
pools?
? Is income affected by changes in inventory pools and,if so,by how much?
? Is inventory affected by year-end purchasing decisions?
? Are additional expenses or losses recorded to offset income arising from
involuntary liquidation of LIFO inventories?
? What assumptions concerning LIFO inventories underlie quarterly reports?
Inventories
Analyzing Inventories - Reliability
Question 2,Is Accounting for Inventories Consistent?
Analysis must be alert to changes in principles of inventory
accounting (e.g.,from LIFO to FIFO)
Analysis must also be aware of accounting changes affecting
comparability of financial statements that do not necessarily
require disclosure in either the financial statements or auditor’s
report (e.g.,number of LIFO pools)
Inventories
Analyzing Inventories -- Reliability
Question 3,Can Effects of Different Inventory Methods Be
Measured?
Analysis must be alert to increased management’s latitude in
managing earnings from use of LIFO
Management can also manage earnings by dipping into LIFO
inventory pools—yielding LIFO liquidations
Any LIFO liquidation gain can be considered separately as an
unusual nonrecurring item by removing it from cost of goods sold
in a recast income statement
Interim financial statements require forecasts
of costs of inventory items as well as projections
of future changes in inventory quantities and mix
—often impairing reliability
Inventories
Analyzing Inventories -- Reliability
Three step process,
(1) Inventory + LIFO reserve
(2) Deferred tax payable + [LIFO reserve x Tax rate]
(3) Retained earnings + [LIFO reserve x (1-Tax rate)]
LIFO reserve is the amount by which current cost
exceeds reported cost of LIFO
inventories
Inventories
Analyzing Inventories—Restatement of LIFO to FIFO
Campbell Soup Balance Sheet Adjustment— using an analytical
entry,
Inventories 89.6
Deferred Tax Payable 30.5
Retained Earnings 59.1
Campbell Soup Income Statement Adjustment,
Year 11
Under LIFO Difference Under FIFO
Beginning Inventory $ 819.8 $ 84.6 $ 904.4
+ Purchases (P)c P ---- P
-- Ending inventory (706.7) (89.6) (796.3)
= Cost of goods sold $P + 113.1 $ (5.0) $P + 108.1
Inventories
Analyzing Inventories—Restatement of LIFO to FIFO
Investment securities (also called marketable
securities) are of two types,
Debt Securities
? Government or corporate debt obligations
Equity Securities
? Corporate stock that is readily marketable,
Investment Securities
Composition
Held-to-Maturity
Controlling Interest (above
50% holding)
Classification
Investment Securities
Investment Securities
Debt Securities Equity Securities
Available-for-Sale
Trading
Significant Influence
(between 20% and
50% holding)
No Influence (below 20%
holding)
- Trading
- Available-for-Sale
Investment Securities
Accounting for Debt Securities
Accounting
Balance Sheet Income Statement
Category Description Unrealized
Gains/Losses
Other
Trading Securities
acquired mainly
for short-term or
trading gains
(usually less than
three months)
Fair Value
Recognize in net
income
Recognize realized
gains/losses and
interest income in
net income
Available-for-Sale Securities neither
held for trading
nor held-to-
maturity
Fair Value Not recognized in
net income,but
recognized in
comprehensive
income
Recognize realized
gains/losses and
interest income in
net income
Held-to-Maturity Securities
acquired with both
the intent and
ability to hold to
maturity
Amortized
Cost
Not recognized in
either net income
or comprehensive
income
Recognize realized
gains/losses and
interest income in
net income
Investment Securities
Accounting for Transfers between Security Classes
Transfer Accounting
Effect on Asset Value in
Balance Sheet
Effect on Income
Statement From To
Trading Available-for-Sale No effect Unrealized gain or loss on
date of transfer included
in net income
Available-for-Sale Trading No effect Unrealized gain or loss on
date of transfer included
in net income
Available-for-Sale Held-to-Maturity No effect at transfer;
however,asset reported
at (amortized) cost
instead of fair value at
future dates
Unrealized gain or loss on
date of transfer included
in comprehensive income
Held-to-Maturity Available-for-Sale Asset reported at fair
value instead of
(amortized) cost
Unrealized gain or loss on
date of transfer included
in comprehensive income
Investment Securities
Classification and Accounting for Equity Securities
Category No Influence Significant Influence Controlling
Interest Available-for-Sale Trading
Ownership Less than 20% Less than 20% Between 20% and 50% About 50%
Purpose Long- or
intermediate-term
investment
Short-term
investment or
trading
Degree of business
control
Full business
control
Valuation Basis Fair value Fair value Equity method Consolidation
Balance Sheet
Asset Value
Fair value Fair value Acquisition cost adjusted
for proportionate share of
investee’s retained
earnings and appropriate
amortization
Consolidated
balance sheet
Income Statement,
Unrealized Gains
In comprehensive
income
In income Not recognized Not recognized
Income Statement,
Other Income
Effects
Recognize
dividends and
realized gains and
losses in income
Recognize
dividends and
realized gains
and losses in
income
Recognize proportionate
share of investee’s net
income less appropriate
amortization in income
Consolidated
income
statement
At least three main objectives,
(1) to separate operating from investing (and
financing) performance
(2) to evaluate investment performance and
risk
(3) to analyze accounting distortions due to
accounting rules and
/or earnings management
involving investment
securities
Analyzing Investment Securities
Investment Securities
Determine whether investment securities (and related income
streams) are investing or operating in nature—based on an
assessment of whether each investment is strategic or made
purely for the purpose of investment
Remove all gains (losses) relating to investing activities—
including dividends,interest income,and realized and
unrealized gains and losses—when evaluating the operating
performance of a company
Separate operating and non-operating
assets when determining operating
return on investment
Separating Operating from Investing Assets and Performance
Investment Securities
ROI
= Investment income
(Beginning fair value of investment + Ending fair value of investment)/2
Evaluating Investment
Performance and Risk
Investment Securities
Investment income consists of three parts,Interest
(and dividend) income + Realized gains and losses +
Unrealized gains and losses
Held-to-Maturity Available-for-Sale Total
Investment income (1998),
Interest and dividend 219 219
Realized gains and losses
Unrealized gains and losses (70) (70)
Total before tax 219 (70) 149
Tax adjustment (33%) (72) 23 (49)
Total after tax 147 (47) 100
Average investment base (1998),
1997 Fair value 1,591 526 2,117
1998 Fair value 1,431 422 1,853
Average 1,511 474 1,985
Return on investment (ROI)
Before tax 14.5% -14.8% 7.5%
After tax 9.7% -9.9% 5.0%
Investment Securities
Evaluating Investment Performance and Risk—Coca-Cola Case
Analyzing Accounting Distortions from
Investment Securities
Investment Securities
Potential accounting distortions an analyst
must be alert to,
? Classification based on intent
? Opportunities for gains trading
? Liabilities recognized at cost
? Inconsistent definition of equity
securities
Auditors
Derivative Securities
commodity price risk
foreign currency risk
interest rate risk
Background
Market risks
Derivative Securities
Hedges are contracts that seek to insulate companies from
market risks—securities such as futures,options,and swaps are
commonly used as hedges
Derivative securities,or simply derivatives,are contracts whose
value is derived from the value of another asset or economic item
such as a stock,bond,commodity price,
interest rate,or currency exchange rate
— they can expose companies to considerable
risk because it can be difficult to find a
derivative that entirely hedges the risks or
because the parties to the derivative contract
fail to understand the risk exposures
Background
Derivative Securities
Derivative is a contract possessing each of the following characteristics,
? One or more underlying indexes and one or more notional amounts
(and/or payments)—the underlying indexes and the notional amounts
determine the settlement amount,if any,
? No initial net investment or an initial net investment less than that
required for a normal transaction yielding similar responses to
market risk changes,
? Permits a net settlement,
Underlying index,or simply underlying (also called a primitive),is the
main driver of derivative value--it can be any economic variable such as a
commodity price,security price,index,interest rate,or exchange rate
Notional amount is the number of units—expressed in figures,weight,
volume,dollars,or other unit measure—as specified in the contract
Net settlement is a cash resolution for the contracting parties in lieu of
settling up in full amounts (or quantities)
Definitions
Derivative Securities
Classification of Derivatives
Derivatives
Hedge Speculative
Fair Value
Hedge
Cash Flow
Hedge
Foreign
Currency
Hedge
Fair Value
Hedge
Hedge of Net
Investment in
Foreign
Operation
Cash Flow
Hedge
Derivative Securities
Accounting for Derivatives
Derivative
Balance Sheet
Income Statement
Speculative
Derivative recorded at fair
value
Unrealized gains and losses included in
income
Fair value hedge Both derivative and hedged asset and/or liability
recorded at fair value
Unrealized gains and losses on both
derivative and hedged asset and/or liability
included in income
Cash flow hedge Derivative recorded at fair value (offset by accumulated
comprehensive income)
Unrealized gains and losses on effective
portion of derivative are recorded in other
comprehensive income until settlement date,
afterwhich transferred to income; unrealized
gains and losses on the ineffective portion of
derivative are included in income
Foreign currency
fair value hedge
Same as fair value hedge
Same as fair value hedge
Foreign currency
cash flow hedge
Same as cash flow hedge
Same as cash flow hedge
Foreign currency
hedge of net
investment in
foreign operation
Derivative (and cumulative
unrealized gain or loss)
recorded at fair value (part of
cumulative translation
adjustment in accumulated
comprehensive income)
Unrealized gains and losses reported in other
comprehensive income as part of translation
adjustment
Derivative Securities
Tabular Presentation—group derivatives with common characteristics,but
separately report information for each type of risk category (for example,interest rate
risk or foreign currency risk) and by maturity dates; disclosures must be sufficient to
evaluate the cash flow impacts of derivatives under alternative scenarios for the
underlying economic variable
Sensitivity Analysis—report the effects of hypothetical changes in the underlying
market risk (for example,interest rate,foreign currency exchange rate or commodity
price) on future earnings,cash flows,or fair values (as appropriate) over a period of
time; disclosures can be separately reported for each risk class
Value-at-risk—reports the potential loss in earnings,
cash flows,or fair values from a company’s derivatives
based on market movements with a given likelihood
(probability) of occurrence,usually expressed as a percent,
over some holding period (method often is viewed as a
measure of maximum normal loss from derivatives)
Disclosures for Derivatives
Derivative Securities
Value-at-Risk for a Hypothetical Derivative
-4 0 0 -3 0 0 -2 0 0 -1 0 0 0 100 200 300 400
V a l u e o f D e r i v a t i v e i n $ M i l l i o n
L
i
k
e
l
i
h
o
o
d
o
f
O
c
c
u
r
r
e
n
c
e
Value-at-Risk at 95%
confidence level
$ 125 million
Derivative Securities
Identify Objectives for Using Derivatives—risk associated with derivatives is
much higher for speculation than for hedging; many companies implicitly speculate
with derivatives
Risk Exposure and Effectiveness of Hedging Strategies—evaluate the
underlying risks,the risk management strategy,the activities to hedge its risks,and
the effectiveness of hedging operations; also consider counterparty risk
Transaction Specific versus Companywide Risk Exposure—evaluate
companywide effects of derivatives; hedging specific risk exposures to transactions,
commitments,assets,and/or liabilities does not necessarily ensure hedging of
companywide risk
Inclusion in Operating or Nonoperating Income—to the
extent derivatives are hedges,then unrealized and realized
gains and losses should be excluded from operating income
and their fair values should be excluded from operating assets
Analysis of Derivatives
Long-Lived Asset Introduction
Long-lived assets—resources or claims to resources are used to
generate revenues (or reduce costs) in the long run
Definitions
Tangible fixed assets such as
property,plant,and equipment
Deferred charges such as
research and development
(R&D) expenditures,and natural
resources
Intangible assets such as
patents,trademarks,
copyrights,and goodwill
Long-Lived Asset Introduction
Capitalization—process of deferring a cost that is incurred in the
current period and whose benefits are expected to extend to one or
more future periods
For a cost to be capitalized,it must meet each of the following
criteria,
? It must arise from a
past transaction or event
? It must yield identifiable and
reasonably probable future benefits
? It must allow owner (restrictive)
control over future benefits
Capitalization
Long-Lived Asset Introduction
Allocation—process of periodically expensing a
deferred cost (asset) to one or more future expected
benefit periods; determined by benefit period,salvage
value,and allocation method
Terminology
? Depreciation for tangible fixed
assets
? Amortization for intangible assets
? Depletion for natural resources
Allocation
Long-Lived Asset Introduction
Impairment—process of writing down asset value
when its value-in-use falls below its carrying (book)
value
Two distortions arise from impairment,
? Conservative biases distort
long-lived asset valuation
because assets are written
down but not written up
? Earnings management
opportunities increase in a
trade-off for more useful
balance sheets
Impairment
Long-Lived Asset Introduction
Capitalizing versus Expensing,An Illustration
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Assets and Capacities
Assets (units),
Acquisitions 1 – 1 – 1 – – – – –
Replacement – – – – 1 – 1 – 2 –
Total 1 0 1 0 2 0 1 0 2 0
Productive Capacity 1 1 2 2 3 3 3 3 3 3
Cash Flows ($)
Revenues $ 500 $ 500 $1,000 $1,000 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500
Capital 1,000 0 1,000 0 2,000 0 1,000 0 2,000 0
Expenditure
Interest expense 100 100 100 100 100 100 100 100 100 100
Long-Lived Asset Introduction
Capitalizing versus Expensing,An Illustration
Capitalizing versus Expensing Example,Income and Ratios with and without Capitalization
I n c o m e w i t h a n d w i t h o u t C a p i t a l i z a t i o n
- 1 0 0 0
- 5 0 0
0
500
1000
1500
1 2 3 4 5 6 7 8 9 10
Y e a r
In
c
o
m
e
(
$
)
W it h o u t
W it h
R e t u r n o n A s s e t s w i t h a n d w i t h o u t C a p i t a l i z a t i o n
- 0, 6
- 0, 4
- 0, 2
0
0, 2
0, 4
0, 6
1 2 3 4 5 6 7 8 9 10
Y e a r
R
a
t
io W it h o u t
W it h
D e b t - t o - E q u i t y w i t h a n d w i t h o u t C a p i t a l i z a t i o n
0
0, 5
1
1, 5
2
2, 5
3
1 2 3 4 5 6 7 8 9 10
Y e a r
R
a
t
io W it h o u t
W it h
R e t u r n o n E q u i t y w i t h a n d w i t h o u t C a p i t a l i z a t i o n
-2
- 1, 5
-1
- 0, 5
0
0, 5
1
1 2 3 4 5 6 7 8 9 10
Y e a r
R
a
t
io W it h o u t
W it h
Tangible
Expected to Benefit Future Periods
Actively Used in Operations
Property,Plant and Equipment
Plant Assets & Natural Resources
Plant Assets
Plant Assets & Natural Resources
Plant Assets
Historical cost principle is used for valuation—
justification includes,
? Conservatism—in not anticipating
subsequent replacement costs
? Accountability—in dollar amounts for
management
? Objectivity—in cost
determination
Acquisition
cost
Acquisition cost excludes
financing charges and
cash discounts,
All
expenditures
needed to
prepare the
asset for its
intended use
Purchase
price
Plant Assets & Natural Resources
Plant Assets Costing Rule
Total cost,
including
exploration and
development,
is charged to
depletion expense
over periods
benefited,
Extracted from
the natural
environment
and reported
at cost less
accumulated
depletion,
Examples,oil,coal,gold
Plant Assets & Natural Resources
Natural Resources
Natural resources (wasting assets)—rights to extract or consume natural resources
Valuation emphasizes objectivity of historical cost,the
conservatism principle,and accounting for the monies
invested; represent a company’s capacity to produce
goods and services
Limitations of historical costs,
? Balance sheets do not purport to reflect market values
? Not especially relevant in assessing replacement values
? Not comparable across companies
? Not particularly useful in measuring opportunity costs
? Collection of expenditures reflecting different
purchasing power
Plant Assets & Natural Resources
Valuation Analysis
Depreciation is the process of allocating
the cost of a plant asset to expense in the
accounting periods benefiting from its
use,
Cost
Allocation
Acquisition
Cost
(Unused)
Balance Sheet
(Used)
Income Statement
Expense
Depreciation
Plant Assets & Natural Resources
The calculation of depreciation requires
three amounts for each asset,
? Cost,
? Salvage Value,
? Useful Life,
? Depreciation Method
Plant Assets & Natural Resources
Factors in Computing Depreciation
80%
9%
4%
7%
Str a i g h t- l i n e
A c c e l e r a te d &
O th e r
D e c l i n i n g -
b a l a n c e
U n i ts -o f-
p r o d u c ti o n
The majority of companies use the straight-line
method,
Plant Assets & Natural Resources
Comparing Depreciation Methods
Cost - Salvage Value
Useful life in periods
Depreciation
Expense per Year
=
SL
Plant Assets & Natural Resources
Comparing Depreciation Methods
Facts,Asset cost=$110,000; Useful life=10 years;
Salvage value=$10,000
End of Accumulated Book
Year Depreciation Depreciation Value
$110,000
1 $ 10,000 $ 10,000 100,000
2 10,000 20,000 90,000
,
,
9 10,000 90,000 20,000
10 10,000 100,000 10,000
Plant Assets & Natural Resources
Straight-Line Depreciation Illustration
Step 1,
Step 2,
Double-declining-
balance rate = 2 ×
Straight-line
depreciation rate
Step 3,
Depreciation
expense =
Double-declining-
balance rate ×
Beginning period
book value
Ignores salvage value
Straight-line
depreciation rate =
100 %
Useful life
Plant Assets & Natural Resources
Double-Declining-Balance Method
Plant Assets & Natural Resources
Double-Declining-Balance (and SYD) Depreciation
Illustration
Depreciation Cumulative Amount
Double- Sum-of-the Double- Sum-of-the
Year Declining Years’-Digits Declining Years’-Digits
1 $22,000 $18,182 $22,000 $18,182
2 17,600 16,364 39,600 34,546
3 14,080 14,545 53,680 49,091
4 11,264 12,727 64,944 61,818
5 9,011 10,909 73,955 72,727
6 7,209 9,091 81,164 81,818
7 5,767 7,273 86,931 89,091
8 4,614 5,455 91,545 94,546
9 3,691 3,636 95,236 98,182
10 2,953 1,818 98,189 100,000
Depreciation
Per Unit =
Cost - Salvage Value
Total Units of Production
Step 1,
Step 2,
Depreciation
Expense =
Depreciation
Per Unit ×
Units Produced
in Period
Activity (Units-of-Production) Method
Plant Assets & Natural Resources
Total cost,
including
exploration and
development,
is charged to
depletion expense
over periods
benefited,
Extracted from
the natural
environment
and reported
at cost less
accumulated
depletion,
Examples,oil,coal,gold
Plant Assets & Natural Resources
Depletion is calculated using the
units-of-production method,
Unit depletion rate is calculated as follows,
Total Units of Capacity
Cost – Salvage Value
Plant Assets & Natural Resources
Depletion of Natural Resources
Total depletion cost for a period is,
Unit Depletion
Rate
Number of Units
Extracted in Period ×
Total
depletion
cost Unsold
Inventory
Cost of
goods sold
Plant Assets & Natural Resources
Depletion of Natural Resources
Plant Assets & Natural Resources
Analyzing Depreciation and Depletion
? Assess reasonableness of depreciable base,useful life,and
allocation method
? Review any revisions of useful lives
? Evaluate adequacy of depreciation—ratio of depreciation to total
assets or to another size-related factors
? Analyze plant asset age—measures include
Average total life span = Gross plant and equipment assets /
Current year depreciation expense,
Average age = Accumulated depreciation / Current
year depreciation expense,
Average remaining life = Net plant and equipment assets /
Current year depreciation expense,
Average total life span = Average age + Average remaining life
(these measures also reflect on profit margins and financing requirements)
Noncurrent assets
without physical
substance,
Useful life is
often difficult
to determine,
Usually acquired
for operational
use,
Intangible
Assets
Often provide
exclusive rights
or privileges,
Intangible Assets
? Patents
? Copyrights
? Leaseholds
? Leasehold
Improvements
? Goodwill
? Trademarks and
Trade Names
Record at
cost,including
purchase
price,legal
fees,and
filing fees,
Intangible Assets
Accounting for Intangible Assets
?Amortize over shorter of economic
life or legal life,subject to a maximum
of 40 years,
?Use straight-line method,
?Research and development costs are
normally expensed as incurred,
Intangible Assets
Accounting for Intangible Assets
Intangible Assets
Accounting for Intangible Assets
Manner of Acquisition
Purchased Developed Internally
Identifiable Capitalize Expense (with some
intangible and amortize exceptions)
Unidentifiable Capitalize Expense
intangible and amortize
Intangible Assets
Goodwill
Goodwill is the value assigned
to a rate of earnings above the
norm-it translates into excess
earnings called superearnings
Goodwill (1) can be a sizable asset,(2) is
recorded only upon purchase of another entity
or segment,and (3) varies considerably in
composition
Occurs when one
company buys
another company,
Only purchased
goodwill is an
intangible asset,
The amount by which the
purchase price exceeds the fair
market value of net assets acquired,
Intangible Assets
Goodwill
39%
22%
10%4%
6%
19%
4 0 y e a r s
O t h e r
L e g a l / E s t i m a t e d
l i f e
1 0 - 1 5 y e a r s
2 0 - 3 0 y e a r s
N o t e x c e e d i n g
4 0 y e a r s
Intangible Assets
Goodwill Amortization Period
Intangible Assets
Analyzing Intangibles and Goodwill
? Search for unrecorded intangibles and
goodwill—often misvalued and
most likely exist off-balance-sheet
? Examine for superearnings as
evidence of goodwill
? Review amortization periods—any bias likely is in the
direction of less amortization and can call for
adjustments
? Recognize goodwill has a limited useful life--whatever
the advantages of location,market dominance,
competitive stance,sales skill,or product
acceptance,they are affected by changes in business
