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Review for Analysis and Use of Financial Statements. Financial Reporting Mechanics. Learning Outcome Statements (LOS). After completing this session, students should be able to:

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Review for Analysis and Use of

Financial Statements

learning outcome statements los
Learning Outcome Statements (LOS)

Aftercompleting this session, students should be able to:

identify the groups (operating, investing and financing activities) into which business activities are categorized for financial reporting purposes and classify any business activity into the appropriate group.

state fundamental principles for preparing financial statements as stated in IAS No.1

categories of business activities
Categories of Business Activities

Businesstransactions can be categorized as:

Operating activities- the firm’s ordinary business.

Investing activities- purchasing, selling and disposing of long-term assets.

Financing activities- raising and repaying capital.

fundamental accounting principles under ias no 1
Fundamental Accounting Principles under IAS No.1

Thefundamental principles for preparing financial statements as stated in IAS No.1 include:

learning outcome statements los1
Learning Outcome Statements (LOS)

Aftercompleting this session, students should be able to:

explain the general principles of revenue recognition and accrual accounting.

discuss the general principle of expense recognition and the implications of expense recognition principles for financial analysis.

revenue recognition and accrual accounting
Revenue Recognition and Accrual Accounting

Under the accrual method of accounting, revenue is recognized when earned. Under accrual accounting, revenue is not necessarily earned when cash is received.

In general, revenue should be recognized when:

1) There is evidence of arrangement between the buyer and the seller.

2) The product has been delivered or the service has been rendered.

3) The price is determined or determinable.

4) The seller is reasonably sure of collecting money.

If a firm receives cash before revenue recognition is complete, the firm reports it as unearned revenue. Unearned revenue is reported on the balance sheet as a liability. The liability is reduced in the future as the revenue is earned.

matching principle and implications for financial analysis
Matching Principle and Implications for Financial Analysis

Under the accrual method of accounting, expense recognition is based on the matching principle.

Under the matching principle, expenses to generate revenue are recognized in the same period as the revenue.

Not all expenses can be directly tied to revenue recognition. These costs are known as period costs. Period costs, such as administrative costs, are expensed in the period incurred.

Like revenue recognition, expense recognition requires a number of estimates. Since estimates are involved, it is possible for firms to delay or accelerate the recognition of expenses. Delayed expense recognition increases current net income and is therefore more aggressive.

learning outcome statements los2
Learning Outcome Statements (LOS)

Aftercompleting this session, students should be able to:

illustrate accounting treatment for marketable securities including held-to-maturity securities, trading securities and available-for-sale securities

list and explain the components of owners’ equity.

marketable securities
Marketable Securities

Marketable investment securities are classified as either held-to-maturity, trading or available-for-sale.

Held-to-maturity securities are debt securities acquired with the intent that they will be held to maturity. Held-to-maturity securities are reported on the balance sheet at amortized cost.Subsequent changes in the market value are ignored.

Trading securities are debt and equity securities acquired with the intent to profit over the near term. They are reported on the balance sheet at fair value. Unrealized gains and losses that are changes in market value before the securities are sold are reported in the income statement.

Available-for-sale securities are debt and equity securities that are not expected to be held to maturity or traded in the near term. They are reported on the balance sheet at fair value. However, any unrealized gains and losses are not recognized in the income statement but are reported in other comprehensive income as a part of owners’ equity.

Dividend and interest income and realized gains and losses (actual gains or losses when the securities are sold) are recognized in the income statement for all three classifications of securities.

investment security classifications an example
Investment Security Classifications: An Example

Triple D Corporation purchased a 6 % bond, at par, for $1,000,000 at the beginning of the year. Interest rates have recently increased and the market value of the bond declined $20,000 Determine the bond’s effect on Triple D’s financial statements under each classification of securities.

components of owners equity
Components of Owners’ Equity

Owners’ equity is the residual interest in assets that remains after subtracting an entity’s liabilities. The Owners' Equity section of the balance sheet includescontributed capital, any minority (noncontrolling) interest, retained earnings, treasury stock and accumulated other comprehensive income.

Contributed capital-the amount paid in by common and preferred shareholders.

Minority (noncontrolling) interest- the portion of subsidiary that is not owned by the parent company.

Retained earnings-the cumulative undistributed earnings of the firm since inception, the cumulative earnings that have not been paid out to shareholders as dividends.

Treasury stock- common stock that the firm has repurchased. Treasury stock has no voting rights and does not receive dividends.

Accumulated other comprehensive income-includes all changes to equity from sources other than net income and transactions with shareholders, such as issuing stock, reacquiring stock and paying dividends.

learning outcome statements los3
Learning Outcome Statements (LOS)

Aftercompleting this session, students should be able to:

compare and contrast cash flows from operating, investing and financing activities.

classify cash flow items as relating to cash flows from operating, investing and financing activities, given a description of the items.

analyze and interpret a cash flow statement.

illustrate the statement of cash flow presentation.

cash flows from operating investing and financing activities
Cash Flows from Operating, Investing and Financing Activities

Items on the cash flow statement come from two sources: 1) income statement items and 2) change in balance sheet accounts.

A firm’s cash receipts and payments are classified on the cash flow statement as either operating, investing or financing activities.

Cash flow from operating activities (CFO), sometimes referred to as “cash flow from operations" or “operating cash flow," consists of the inflows and outflows of cash resulting from transactions related to a firm’s normal operation.

Cash flow from investing activities (CFI)consists of the inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments.

Cash flow from financing activities (CFF)consists of the inflows and outflows of cash resulting from transactions affecting the firm’s capital structure.

direct and indirect methods of cash flow statement
Direct and Indirect Methods of Cash Flow Statement

There are two methods of presenting the cash flow statement: the direct method and the indirect method.

The difference between the two methods relates to the presentation ofcash flow from operating activities. The presentation of cash flows from investing activities and financing activities is exactly the same under both methods.

Under the direct method, each line item of the accrual-based income statement is converted into cash receipts or cash payments.

Under the indirect method, net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions. The adjustments include eliminating noncash expenses (e.g., depreciation and amortization), nonoperating items (e.g., gains and losses) and changes in balance sheet accounts resulting from accrual accounting events.

direct method of presenting operating cash flow
Direct Method of Presenting Operating Cash Flow

Seagraves Supply Company

Operating Cash Flow-Direct Method

For the Year ended December 31, 20xx

Notice the similarities of the direct method cash flow presentation and an income statement. The direct method begins with cash inflows from customers and then deduct cash outflows for purchases, operating expenses, interest and taxes.

indirect method of presenting operating cash flow
Indirect Method of Presenting Operating Cash Flow

Seagraves Supply Company

Operating Cash Flow-Indirect Method

For the Year ended December 31, 20xx

learning outcome statements los4
Learning Outcome Statements (LOS)

Aftercompleting this session, students should be able to:

describe the limitations of ratio analysis.

calculate, classify and interpret activity, liquidity, solvency, and profitability ratios.

demonstrate the application of and interpret changes in the component parts of the DuPont analysis (the decomposition of return on equity).

calculate the sustainable growth rate for a company.

limitations of ratio analysis
Limitations of Ratio Analysis
  • Financial ratios are not useful when viewed in isolation. They are
  • valid only whencompared to those of other firms or to the
  • company’s historical performance.
  • Comparisons with other companies are made more difficult due to
  • different accounting treatments across firms.
  • It is difficult to find comparable industry ratios when analyzing
  • companies that operate in multiple industries.
  • Conclusions cannot be made from viewing one set of ratios. All
  • ratios must be viewed relative to one another.
decomposition of roe using the dupont analysis
Decomposition of ROE Using the DuPont Analysis
  • The DuPont system of analysis is an approach that can be used to analyze return on equity (ROE).
  • The DuPont System can be expressed in the so-called “three-part approach”.
  • For the original approach, ROE could be expressed as:

Net Income

Equity

=

  • We can also expand the ROE formula above into the following formula:
  • ROE= Net IncomeX Net SalesX Total Assets
  • Net SalesTotal AssetsTotal Equity

ROE = Net Profit MarginX Total Assets Turnover X Leverage Ratio

decomposition of roe an example
Decomposition of ROE: An Example

StarterInc. has maintained a stable and relatively high ROE of approximately 18 % over the last three years. Use traditional DuPont analysis to decompose this ROE into its three components and comment on trends in company performance.

Answer:

ROE 20X3: 21.5/119 = 18.1 %

20X4: 22.3/124 = 18.0 %

20X5: 21.9/126 = 17.4 %

decomposition of roe an example cont
Decomposition of ROE: An Example(Cont)

Answer:

ROE 20X3: (21.5/305) x (305/230) x (230/119) = 7.0 % x 1.33 x 1.93 = 18.1 %

20X4: (22.3/350) x (350/290) x (290/124) = 6.4 % x 1.21 x 2.34 = 18.0 %

20X5: (21.9/410) x (410/350) x (350/126) = 5.3 % x 1.17 x 2.78 = 17.4 %

  • While the ROE has dropped only slightly, both the total assets turnover and the net profit margin have declined.
  • The effects of declining net margins and assets turnover on ROE have been offset by a significant increase in leverage. The company has become more risky due to increased debt financing.
determination sustainable growth rate
Determination Sustainable Growth Rate
  • Thesustainable growth rateis how fast a firm can grow without additional external equity issues while holding leverage constant.
  • Sustainable growth rate (g) could be calculated using the following formula:
  • g = Retention Rate (RR) x ROE
  • where Retention Rate (RR) = 1- dividend payout ratio
  • Dividend Payout Ratio = Dividend per Share/EPS

Ex: Calculation of Sustainable Growth Rate

Please calculate the sustainable growth rate of each company.

determination sustainable growth rate cont
Determination Sustainable Growth Rate (Cont)

RR = 1-dividend payout ratio

RRA = 1- (1.50/3.00) = 1-0.50 = 0.50

RRB = 1- (1.00/4.00) = 1-0.25 = 0.75

RRC = 1- (2.00/5.00) = 1-0.40 = 0.60

g = RR x ROE

gA = 0.50 x 14 % = 7 %

gB = 0.75 x 12 % = 9 %

gC = 0.60 x 10 % = 6 %

learning outcome statements los5
Learning Outcome Statements (LOS)

Aftercompleting this session, students should be able to:

determine whether a debt security or equity security should be classified as held to maturity, available for sale or as trading security.

compute the effect of debt-security and equity-security classification on financial statements and financial ratios.

determine, given various ownership and/or control levels and relevant accounting standards, whether the cost method, the equity method or the consolidation method should be used.

compute and compare the effects of using the cost method, the equity method and the consolidation method on a company’s financial statements and financial ratios.

categories of intercorporate investments
Categories of Intercorporate Investments

Intercorporate investments are categorized as either:

(1) Investments in financial assets (when the investing firm has no

significant control over the operations of the investee firm)

(2) Investments in associates (when the investing firm has significant

influence over the operations of the investee firm, but not control

(3) Business combinations (when the investing firm has control over

the operations of the investee firm).

Percentage of ownership (or voting control) is typically used to determine the appropriate category for financial reporting purposes.

However, the ownership percentage is only a guideline. Ultimately, the category is based on the investor’s ability to influence or control the investee.

categories of financial assets
Categories of Financial Assets

An ownership interest of less than 20 % is usually considered a passive investment. In this case, the investor cannot significantly influence or control the investee.

Investments in financial assets could be classified as:

1) Held-to-maturity

2) Available-for-sale

3) Held-for-trading

Debt securities held-to-maturity are securities that a company has the positive intent and ability to hold to maturity. These securities are carried at amortized cost and cannot be sold prior to its maturity except under unusual circumstances. This classification applies only to debt securities. It does not apply to equity investments.

Debt and equity securities available-for-sale may be sold to address the liquidity and other needs of a company. They are carried at fair market value on the balance sheet.

Debt and equity trading securities are securities acquired for the purpose of selling them in the near term. They are measured at fair market value and are listed as current assets on the balance sheet.

example investment in financial assets
Example: Investment in Financial Assets

At the beginning of the year, Midland Corporation purchased a 9 %bond with a fair value of $100,000. The bond was issued for $96,209 to yield 10 %. The coupon payments are made annually at year-end. The fair value of the bond at the end of the year is $98,500.

Determine the impact on Midland’s balance sheet and income statement if the bond investment is classified as held-to-maturity, held-for-trading and available-for-sale.

Held-to-Maturity

  • The balance sheet value is based on amortized cost. At year-end, Midland recognizes interest revenue of $9,621 ($96,209 beginning bond investment x 10 % market rate at issuance).
  • The interest revenue includes the coupon payment of $9,000 ($100,000 face value x 9 % coupon rate) and the amortized discount of $621 ($9,621 interest revenue-$9,000 coupon payment).
  • At year-end, the bond is reported on the balance sheet at $96,830 ($96,209 beginning bond investment +$621 amortized discount).
example investment in financial assets1
Example: Investment in Financial Assets

Held-for-Trading

  • The balance sheet value is based on fair value of $98,500.
  • Interest revenue of $9,000 ($100,000 x 9 % coupon rate) is recognized in the income statement.
  • An unrealized gain of $2,291 ($98,500 fair value-$96,209 beginning bond investment) is also recognized in the income statement.

Available-for-Sale

  • The balance sheet value is based on fair value of $98,500.
  • Interest revenue of $9,000 ($100,000 x 9 % coupon rate) is recognized in the income statement.
  • An unrealized gain of $2,291 ($98,500 fair value-$96,209 beginning bond investment) is reported in stockholders’ equity as a component of other comprehensive income.
investments in associates
Investments in Associates

Investment ownership of between 20 % and 50 % is usuallyconsidered influential. Influential investments are accounted for using the equity method. Under the equity method, the initial investment is recorded at cost and reported on the balance sheet as a noncurrent asset.

In subsequent periods, the proportionate share of the investee’s earnings increases the investment account on the investor’s balance sheet and is recognized in the investor’s income statement.Dividends received from the investee are treated as a return of capital and thus, reduce the investment account. Unlike investments in financial assets, dividends received from the investee are not recognized in the investor’s income statement.

If the investee reports a loss, the investor’s proportionate share of the loss reduces the investment account and also lower earnings in the investor’s income statement.

example implementing the equity method
Example: Implementing the Equity Method

Assume the following:

December 31, 20X5, Company P (the investor) invests $1,000 in return for 30 % of the common shares of Company S (the investee).

During 20X6. Company S earns $400 and pays dividends of $100.

During 20X7, Company S earns $600 and pays dividends of $150

Calculate the effects of the investment on Company P’s balance sheet, reported income and cash flow for 20X6 and 20X7.

20X6

  • Under the equity method for 20X6, Company P will:
  • Recognize $120 ($400 x 30 %) in the income statement from its proportionate share of the net income of Company S.
  • Increase its investment account on the balance sheet by $120 to $1,120, reflecting its proportionate share of the net assets of Company S.
  • Receive $30 ($100 x 30 %) in cash dividends from Company S and reduce its investment in Company S by that amount to reflect the decline in the net assets of Company S due to the dividend payments.
  • At the end of 20X6, the carrying value of Company S on Company P’s balance sheet will be $1,090 ($1,000+$120-$30).
example implementing the equity method cont
Example: Implementing the Equity Method (Cont)

20X7

  • Under the equity method for 20X7, Company P will:
  • Recognize $180 ($600 x 30 %) in the income statement from its proportionate share of the net income of Company S.
  • Increase its investment account on the balance sheet by $180 to $1,270, reflecting its proportionate share of the net assets of Company S.
  • Receive $45 ($150 x 30 %) in cash dividends from Company S and reduce its investment in Company S by that amount to reflect the decline in the net assets of Company S due to the dividend payments.
  • At the end of 20X7, the carrying value of Company S on Company P’s balance sheet will be $1,225 ($1,090+$180-$45).
consolidated method
Consolidated Method

Direct or indirect ownership of more than 50 % of the voting shares requires the parent to use consolidated reporting.

Consolidated reporting results in two firms being presented as one economic entity, even though the firms may be separate legal entities.

All income of the affiliate (less any minority interests) is reported on the parent’s income statement.

There are two exceptions: (1) if control is temporary or (2) if barriers to control exist such as governmental intervention, bankruptcy, civil order, or if a nonconvertible currency is involved. These exceptions exist to accommodate situations where the parent cannot use the subsidiaries’ assets or control its actions.

learning outcome statements los6
Learning Outcome Statements (LOS)

Aftercompleting this session, students should be able to:

differentiate between a simple capital structure and a complex capital structure.

understand the difference between basic EPS and diluted EPS.

compute basic EPS given required information.

explain the effect of stock dividends on computation of basic EPS.

earnings per share eps what is it
Earnings per share (EPS): What is it?

Earnings per share (EPS) is one of the most commonly used corporate profitability performance measures for both publicly-traded and non-publicly traded firms.

EPS is reported only for shares of common stock.

A company may have either a simple or complex capital structure.

A simple capital structure is one that contains no potentially dilutive securities. Asimple capital structure contains only common stock, nonconvertible debt and nonconvertible preferred stock.

A complex capital structure is one that contains potentially dilutive securities such as options, warrants or convertible securities.

basic eps
Basic EPS

The basic EPS calculation does not consider the effects of any dilutive securities in the computation of EPS.

Basic EPS could be computed using the following formula:

Basic EPS= Net Income-Preferred Dividends

Weightedaverage number of

common shares outstanding

  • The current year’s preferred dividendsare subtracted from net income as EPS refers to the per-share earnings available to common shareholders.Net income minus preferred dividends is the income available to common stockholders.
  • The weighted average number of common shares outstanding is the number of common shares outstanding during the year, weighted by the portion of the year they were outstanding.
weighted average shares and basic eps an example
Weighted Average Shares and Basic EPS: An Example

Johnson Companyhas net income of $10,000 and paid $1,000 cash dividends to its preferred shareholders and $1,750 cash dividends to its common shareholders. At the beginning of the year, there were 10,000 shares of common stock outstanding. 2,000 new shares of common stock were issued on July 1. Assuming a simple capital structure, what is Johnson’s basic EPS?

1) Calculate Johnson’s weighted average number of common shares outstanding.

Shares outstanding all year = 10,000 x 12 = 120,000

Shares outstanding ½ year = 2,000 x 6 = 12,000

Weighted average number of shares outstanding = (120,000+12,000)/12 = 11,000 shares

2) Calculate Johnson’s basic EPS

Basic EPS= (Net income-Preferred dividends)/Weighted average number of shares

= (10,000-1,000)/11,000

= $0.82

effect of stock dividends on basic eps
Effect of Stock Dividends on Basic EPS

A stock dividend is the distribution of additional shares to each shareholder in an amount proportion to their current number of shares.If a 10 % stock dividend is paid, the holder of 100 shares of stock would receive 10 additional shares.

The important thing to remember is that each shareholder’s proportional ownership in the company is unchanged by a stock dividend. Each shareholder has more shares but the same percentage of the total shares outstanding.

A stock dividend is applied to all shares outstanding prior to the dividend and to the beginning-of-period weighted average shares. A stock dividend adjustment is not applied to any shares issued or repurchased after the dividend date.

effect of stock dividends an example
Effect of Stock Dividends: An Example

During the past year, Johnson Company had net income of $100,000, paid dividends of $50,000 to its preferred shareholders, and paid $30,000 in dividends to its common shareholders. Johnson Company’s common stock account showed the following:

Compute the weighted average number of common shares outstanding during the year and compute EPS.

effect of stock dividends an example cont
Effect of Stock Dividends: An Example (Cont)
  • Adjust the number of pre-stock-dividend shares to post-stock-dividend units (to reflect the 10 % stock dividend) by multiplying all share numbers prior to the stock dividend by 1.1. Shares issued or retired after the stock dividend are not affected.
effect of stock dividends an example cont1
Effect of Stock Dividends: An Example(Cont)

2) Compute the weighted average number of post-stock dividend shares.

3) Calculate Johnson’s basic EPS

Basic EPS= (Net income-Preferred dividends)/Weighted average number of shares

= (100,000-50,000)/13,300

= $3.76

learning outcome statements los7
Learning Outcome Statements (LOS)

Aftercompleting this session, students should be able to:

discuss the impact of sales or abandoning of long-lived assets on financial statements.

define impairment of long-lived tangible assets and explain what effect such impairment has on a company’s financial statements and ratios.

capitalization of expenditures v s expensing
Capitalization of Expenditures v.s. Expensing

When a firm makes an expenditure, it can either capitalize the cost as an asset on the balance sheet or expense the cost in the income statement, depending on the nature of the expenditure.

As a general rule, an expenditure that is expected to provide a future economic benefit over multiple accounting periods is capitalized. However, if the future economic benefit is unlikely or highly uncertain, the expenditure is expensed.

An expenditure that is capitalized is classified as an investing cash flow. An operating expenditure that is not capitalized is classified asan operating cash flow.

The cost of capitalized assets is then allocated to each subsequent income statement over the useful life of the asset as depreciation expense (for tangible assets) or amortization expense ( for intangible assets with finite lives).

capitalized interest
Capitalized Interest

When a firm constructs an asset for its own use, the interest that accrues during the construction period is capitalized as a part of the asset’s cost.

The objective of capitalizing interest is to accurately measure the cost of the asset and to better match the cost with the revenues generated by the constructed asset. This treatment is required under IFRS.

The interest rate used to capitalize interest is based on debt specifically related to the construction of the asset.

Capitalized interest is not reported in the income statement as interest expense. Once construction interest is capitalized, the interest cost is allocated to the income statement through depreciation expense (if the asset is held for use), or COGS (if the asset is held for sale).

impact of sales and abandoning of long lived assets on financial statements
Impact of Sales and Abandoning of Long-Lived Assets on Financial Statements

When a long-lived asset is sold, the difference between the sale proceeds and the carrying (book) value of the asset is reported as a gain or loss in the income statement. The book value is equal to original cost minus accumulated depreciation, adjusted for any impairment charges.

If the firm presents its cash flow statement using the indirect method, the gain or loss is removed from net income to compute cash flow from operations. Selling a long-lived asset is still recognized as an investing cash flow.

If a long-lived asset is abandoned, the treatment is similar to a sale, except there are no proceeds. In this case, carrying value of the abandoned asset is removed from the balance sheet and a loss of that amount is recognized in the income statement.

impairment of long lived tangible assets
Impairment of Long-Lived Tangible Assets

Long-lived tangible assets that are held for use are tested for impairment when events and circumstances indicate the firm may not be able to recover the carrying value through future use. For example, there may have been a significant decline in the MV of the asset or a significant change in the asset’s physical condition.

Under the IFRS, impairment accounting involves two steps. In the first step, the asset is tested for impairment by applying a recoverability test. If the asset is impaired, the second step involves measuring the loss.

Recoverability Test. An asset is considered impaired if the carrying value (original cost less accumulated depreciation) is greater than the asset’s future undiscounted cash flows.

Loss Measurement. If the asset is impaired, the impairment loss is equal to the excess of the carrying value over the fair value of the asset (or the discounted value of future cash flows if the fair value is not known).

impairment of long lived tangible assets an example
Impairment of Long-Lived Tangible Assets: An Example

Information related to equipment owned by Brownfield Company is as follows:

- Original cost = $900,000

- Accumulated depreciation to date = $100,000

Expected future cash flows = $700,000

Fair value = $580,000

Assume Brownfield will continue to use the equipment in the future. Test the asset for impairment and discuss the result.

Answer

1) Carrying value of the asset is $800,000 ($900,000-$100,000). As the carrying

value ($800,000) is greater than the expected future cash flows ($700,000), the

equipment is impaired.

2) The impairment loss is equal to $220,000 ($800,000-$580,000). Thus, the

carrying value of the equipment on the balance sheet is reduced to $580,000

and a $220,000 impairment loss is recognized in the income statement.

impact of impairment on financial statement and financial ratios
Impact of Impairment on Financial Statement and Financial Ratios

Impairment reduces the carrying value of the asset on the balance sheet and is recognized as a loss in the income statement. Thus, impairment will result in lower assets and lower equity (retained earnings).

In the year of impairment, ROA and ROE will decrease as earnings are lower. In subsequent periods, ROA and ROE will increase due to higher earnings and lower assets and equity. Asset turnover will also increase due to the lower assets.

An impairment loss has no impact on cash flow. The cash flow occurred when the firm paid for the asset.

learning outcome statements los8
Learning Outcome Statements (LOS)

Aftercompleting this session, students should be able to:

compute ending inventory balances and cost of goods sold using the FIFO and the LIFO methods to account for product inventory and explain the relationship among and the usefulness of inventory and cost of goods sold data provided by the FIFO and LIFO methods when prices are 1) stable, 2) decreasing, or 3)increasing.

analyze the financial statements of companies using the different methods on cost of goods sold, inventory balances and other financial statement items and describe the effects of the choice of inventory method on profitability, liquidity, activity and solvency ratios.

fifo and lifo cost flow methods
FIFO and LIFO Cost Flow Methods

Under the FIFO method, the first item purchased (the oldest inventory) is assumed to be the first item sold.

The advantage of FIFO is that ending inventory is valued based on the most recent purchases, arguably the best approximation of current replacement cost.

FIFO COGS is based on the earliest purchase costs.

When prices are rising, COGS will be understated compared to current replacement cost, as a result, earnings will be overstated.

fifo and lifo cost flow methods cont
FIFO and LIFO Cost Flow Methods (Cont)

Under the LIFO method, the item purchased most recently is assumed to be the first item sold.

LIFO produces better matching in the income statement as COGS and sales revenue are both measures using recent prices.

When prices are rising, LIFO COGS will be higher than FIFO COGS, and earnings will be lower. Lower earnings translate into lower income taxes, which increase cash flow.

Under LIFO, ending inventory on the balance sheet is valued using the earlier costs. Thus, when prices are rising, LIFO ending inventory is less than replacement value.

inventory cost flow methods an example
Inventory Cost Flow Methods: An Example

Use the inventory data in the following figure to calculate the cost of goods sold and ending inventory under the FIFO and LIFO methods.

Inventory Data

lifo and fifo under different economic environments
LIFO and FIFO under Different Economic Environments
  • In most economic environments, prices are rising. In those cases, inventory levelsunder the FIFO will be higher than levels under LIFO.
  • COGS will be higher under LIFO than COGS under FIFO.
  • When prices are stable, both FIFO and LIFO will produce the sane values for inventory and cost of goods sold.
  • In periods of rising prices and stable or increasing inventory quantities:
lifo and fifo under different economic environments cont
LIFO and FIFO under Different Economic Environments (Cont)
  • When prices are falling, inventory levels under FIFO will be lower than levels under LIFO.
  • COGS will be higher under FIFO than COGS under LIFO.
  • Nevertheless, FIFO still provides the more useful estimate of inventory, and LIFO still provides the more useful estimate of COGS.
  • In periods of falling prices:
lifo and fifo and their impacts to financial ratios
LIFO and FIFO and Their Impacts to Financial Ratios

A firm’s choice of inventory cost flow method can have a significant impact on

profitability, liquidity, activity and solvency.

Profitability

As compared to FIFO, LIFO produces higher COGS in the income statement and

will result in lower earnings. Any profitability measure that includes COGS will

be lower under LIFO. Higher COGS under LIFO will result in lower gross,

operating, EBIT and net profit margins compared to FIFO.

Liquidity

As compared to FIFO, LIFO results in a lower inventory value on the balance sheet. Since inventory (a current asset) is lower under LIFO, the current ratio, a popular measure of liquidity, is also lower under LIFO and under FIFO. Working capital (current assets-current liabilities) is also lower under LIFO as well because current assets are lower.

lifo and fifo and their impacts to financial ratios cont
LIFO and FIFO and Their Impacts to Financial Ratios (Cont)

Activity

Inventory turnover (COGS/average inventory) is higher for firms that use LIFO

compared to firms that use FIFO. Under LIFO, COGS is valued at more recent

higher prices, while inventory is valued at older lower prices. Number of days of

Inventory (365/inventory turnover) is therefore lower under LIFO compared to

FIFO.

Solvency

LIFO results in lower total assets compared to FIFO, as LIFO inventory is lower. Lower total assets under LIFO result in lower stockholders' equity (assets-liabilities). Since total assets and stockholders’ equity are lower under LIFO, the debt ratio and the debt-to-equity ratios are higher under LIFO compared to FIFO.

learning outcome statements los9
Learning Outcome Statements (LOS)

Aftercompleting this session, students should be able to:

explain key risks associated with bond investment.

determine the effects of financial and operating leases on the financial statements and ratios of the lessees.

risks associated with bond investment
Risks Associated with Bond Investment
  • There are many types of risk associated with fixed income securities. They include:
  • Interest Rate Risk-uncertainty about bond prices due to changes in market interest rates.
  • Call Risk- the risk that a bond will be called (redeemed) prior to maturity under terms of the call provision and that the funds must then be reinvested at the then current (lower) yield.
  • Prepayment Risk- the uncertainty about the amount of bond principal that will be repaid prior to maturity.
  • Credit Risk- includes the risk of default and the risk of a decrease in bond value due to a rating downgrade.
  • Liquidity Risk- the risk that an immediate sale will result in a price below fair value (the prevailing market price).
  • Exchange Rate Risk-the risk that the domestic currency value of bond payment in a foreign currency will decrease due to exchange rate changes.
  • Inflation Risk- the risk that inflation will be higher than expected, eroding the purchasing power of the cash flows from a fixed-income security.
  • Event Risk- the risk of decreases in a security’s value from disasters, corporate restructurings or regulatory changes that negatively affect the firm.
lease and why it is important
Lease and Why It Is Important
  • A lease is a contractual arrangement whereby the lessor, the owner of the asset, allows the lessee to use the asset for a specified period of time in return for periodic payments.
  • Leases are classified as either operating leases or finance leases (capital leases).
  • An operating lease is essentially a rental arrangement. No asset or liability is reported by the lessee and the periodic lease payments are simply recognized as rental expense in the income statement.
  • A finance lease is, in substance, a purchase of an asset that is financed with debt. Thus, at the inception of the lease, the lessee will add equal amount to both assets and liabilities on the balance sheet. Over the term of the lease, the lessee will recognize depreciation expense on the asset and interest expense on the liability.
benefits of lease
Benefits of Lease
  • Leasing can have certain benefits. They include
  • Less costly financing. Typically, a lease requires no initial payment. Thus, the lessee conserves cash.
  • Reduce risk of obsolescence. At the end of the lease, the asset can be returned to the lessor.
  • Less Restrictive Provisions. Leases can provide more flexibility than other forms of financing as the lease agreement can be negotiated to better suit the circumstances of each party.
  • Off-Balance-Sheet Financing. Operating leases do not require a liability to be entered on the balance sheet, improving leverage ratios compared to borrowing the funds to purchase the asset.
operating lease v s finance capital lease
Operating Lease v.s. Finance (Capital) Lease
  • Under relevant accounting standards, a lessee must classify a lease as a finance (capital) lease if any one of the following criteria is met:
  • 1) Title to the leased asset is transferred to the lessee at the end of lease period.
  • 2) A bargain purchase option exists. A bargain purchase option is a provision that
  • permits the lessee to purchase the leased asset for a price that is significantly
  • lower than the fair market value of the asset at some future date.
  • 3) The lease period is 75 % or more of the asset’s economic life.
  • 4) The present value of the lease payment is 90 % or more of the fair value of the
  • leased asset.
  • A lease not meeting any of these criteria is classified as an operating lease.
reporting by the lessee
Reporting by the Lessee

Operating Lease

  • At the inception of the lease, no entry is made. During the term of the lease, rent expense, equal to the lease payment, is recognized in the lessee’s income statement. In the cash flow statement, the lease payment is reported as an outflow from operating activities.

Finance Lease

  • At the inception of the lease, the present value of future minimum lease payment is recognized as an asset and as a liability on the lessee’s balance sheet.
  • Over the term of the lease, the asset is depreciated in the income statementand interest expense is recognized. Interest expense is equal to the lease liability at the begging of the period multiplied by the interest rate implicit in the lease.
accounting for a finance lease an example
Accounting for a Finance Lease: An Example
  • Affordable Leasing Company leases a machine for its own use for 4 years with annual payments of $10,000. At the end of the lease, the machine is returned to the lessor. The appropriate interest rate is 6 %.
  • Assuming the lease is classified as a finance (capital) lease, calculate the impact of the lease on Affordable Lease’s balance sheet and income statement for each of the four years, including the immediate impact. Affordable Leasing depreciates all assets on a straight-line basis. Assume the lease payments are made at the end of the year.
  • Ans
  • The present value of the lease payments at 6 % is $34,651. [N=4, I/Y = 6%, PMT =-
  • 10,000, FV = 0, CPT PV=$34,651
  • The amount is immediately recorded as both an asset and a liability on the lessee’s
  • balance sheet.
  • Over the next 4 years, depreciation will be $34,651/4 = $8,663 per year. The book
  • value of the asset will decline each year by the depreciation expense.
accounting for a finance lease an example cont
Accounting for a Finance Lease: An Example (Cont)

The interest expense and liability values are showed in the following table. Note that the principal repayment amount each period is equal to the lease payment minus the interest expense for the period (6 % x the liability at the beginning of the period)

Affordable Leasing: Finance Lease Calculation

financial statement and ratio effects of operating and financial leases
Financial Statement and Ratio Effects of Operating and Financial Leases

Effects to Balance Sheet

  • A finance lease results in an asset and a liability. Thus, turnover ratios that use total or fixed assets in their denominatorwill be lower when a lease is treated as a finance lease rather than as an operating lease.
  • Return on assets will also be lower for finance leases.
  • Most importantly, leverage ratios such as debt-to-assets ratio and debt-to-equity ratio will be higher with finance leases due to the recorded liability.
  • Since the liability for an operating lease does not appear on the lessee’s balance sheet, operating leases are sometimes referred to as off-balance-sheet financing activities.
financial statement and ratio effects of operating and financial leases cont
Financial Statement and Ratio Effects of Operating and Financial Leases (Cont)

Effects to Income Statement

  • All else held constant, operating income (EBIT) will be higher for companies that use finance (capital) leases relative to companies that use operating leases. With an operating lease, the entire lease payment is recognized as an operating expense, while for a finance lease, only the depreciation of the leased asset is treated as an operating expense.
  • Let’s assume Affordable Leasing can treat the lease in the previous example as either an operating lease or a finance lease. Table below compares the income statement effects.