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Module 5

Module 5. Reporting and Analyzing Operating Assets. Cash. The cash account is the first asset listed in the current asset section of the balance sheet. It consists of coin, checks, and bank drafts received by the company. Helpful Tip.

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Module 5

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  1. Module 5 Reporting and Analyzing Operating Assets

  2. Cash • The cash account is the first asset listed in the current asset section of the balance sheet. • It consists of coin, checks, and bank drafts received by the company.

  3. Helpful Tip • Transpositions occur when you switch the place of numbers (e.g., 79 becomes 97, 157 becomes 517, 6794 becomes 7649, 16945 becomes 61954) • A simple trick can identify this as the reason things do not reconcile

  4. Proper Management of Cash • Proper management requires that enough cash be available to meet the needs of the company’s operations. • Too much cash is undesirable as it loses purchasing power in periods of inflation.

  5. Accounts Receivable • When companies sell to other companies, they offer credit terms, which are called sales on credit (or credit sales or sales on account). • An example of a common credit term is 2/10, net 30. • Why offer a discount for early payment?

  6. Accounts Receivable • Accounts receivable are reported on the balance sheet of the seller at net realizable value, which is the net amount the seller expects to collect. • Gross amount less an allowance for uncollectable accounts • Sellers realize that they will not be able to collect on all of the accounts that are owed to them and they must therefore match this bad debt expense with the sales revenue. • Is it optimal to have no bad debts?

  7. Allowance for Uncollectible Accounts • There are two widely accepted methods to estimate the amount of accounts receivable that will not be collected: • Aging schedule • Percentage of sales • A third method, direct write-offs, is not allowable per GAAP

  8. Percentage of Sales • Estimate of bad debt expense is computed as a percentage of credit sales. • Example: If sales are $100,000 and we expect 2% will not be collected, then our estimate of bad debt expense will be $2,000 • The other side of this entry is to increase the allowance for bad debt account.

  9. Aging Schedule • When aging the accounts, an analysis is prepared of the receivables as of the balance sheet date. • Each customer’s account balance is categorized by the number of days or months the underlying invoices have remained outstanding. • Based on prior experience or on other available statistics, bad debts percentages are applied to each of these categorized amounts, with larger percentages being applied to older accounts.

  10. Aging Analysis Example

  11. Write-off of Uncollectible Accounts • The write-off of an uncollecitble account does not affect income. The amount written-off is reflected as a reduction of the account receivable balance and the allowance for uncollectible accounts:

  12. Reporting Accounts Receivable • Accounts receivable are reported on the balance sheet at net realizable value, that is, the gross amount owed to them less the allowance for uncollectible accounts. • Given our gross balance of $100,000 and estimated uncollectible accounts of $2,900, accounts receivable will be reported as follows:

  13. Bad Debt Expense • Bad Debt Expense is equal to the increase in the allowance for uncollectible accounts. • In our previous example, if no previous balance existed in the allowance for uncollectible accounts, the company would record a bad debt expense of $2,900.

  14. Analysis Implications: Adequacy of Allowance Account • Companies are making two representations by reporting the accounts receivable (net) in the current asset section of the balance sheet: • They expect to collect the total amount reported on the balance sheet. • They expect to collect this amount within the next year (because of the classification as a current asset).

  15. Analysis Implications: Adequacy of Allowance Account • The first issue, from an analysis viewpoint, is whether the company has adequately provisioned for its uncollectible accounts. • Compare with the percentage the company reported in prior years. • Compare with the percentage reported by other companies in its industry. • Could be used for shifting income between years.

  16. Receivables Turnover Rate and Days Sales in Receivables • The accounts receivables turnover (ART) rate is defined as • A companion ratio is the Average Collection Period:

  17. Inventory Issues • What is inventory? • What costs are included in inventory? • How do we separate COGS from End. Inv?

  18. Inventory Cost Flows to Financial Statements

  19. Inventories • Inventory costs either are reported on the balance sheet or they are transferred to the income statement as an expense (cost of goods sold) to match against sales revenues. • The process for which costs are removed from the balance sheet is important.

  20. Capitalization Costs • “Capitalization” means that a cost is recorded on the balance sheet and is not immediately expensed on the income statement. • Once costs are capitalized, they remain on the balance sheet as assets until they are used up, at which time they are transferred from the balance sheet to the income statement as expense. • If costs are capitalized rather than expensed, then assets, current income, and current equity are all greater.

  21. Cost of Goods Sold • When inventories are used up in production or are sold, their cost is transferred from the balance sheet to the income statement as cost of goods sold (COGS). COGS is then matched against sales revenue to yield gross profit: Sales revenue - COGS Gross profit

  22. Effects of errors • Common source of manipulation • Often difficult for the auditor to catch • Affects two years • Example

  23. Inventory Costing Methods • First-In. First-Out (FIFO). This method assumes that the first units purchased are the first units sold. • Last-In, First-Out (LIFO). The LIFO inventory costing method assumes that the last units purchased are the first to be sold. • Average cost. The average cost method assumes that the units are sold without regard to the order in which they are purchased. Instead, it computes COGS and ending inventories as a simple weighted average. • Specific identification. Uniquely identified items.

  24. Inventory Costing Effects on Cash Flows • One reason frequently cited for using LIFO is the reduced tax liability in periods of rising prices. The IRS requires, however, that companies using LIFO for tax purposes also use it for financial reporting. This is the LIFO conformity rule. • Companies using LIFO are also required to disclose the amount at which inventories would have been reported had it used FIFO. The difference between these two amounts is called the LIFO reserve.

  25. Impairment of Inventories • Companies are required to write down the carrying amount of inventories on the balance sheet if, at the statement date, the reported cost exceeds their market value (determined as the current replacement cost). • This is called reporting inventories at the lower of cost or market. • Inventory book value is written down to market value. • Inventory write-down is reflected as an expense (part of cost of goods sold) on the income statement.

  26. Inventory Turnover Rates for Selected Companies

  27. Long-Term Assets • Long-term assets mainly consist of property, plant, and equipment (PPE). • These assets often makeup the largest asset amounts. • Future expenses arising from these long-term assets often makeup the larger expense amounts—typically reflected in depreciation expense and asset write-downs.

  28. What is Included in Cost? • All expenditures necessary to make asset ready for its intended use.

  29. Postacquisition Expenditures:Betterments or Maintenance? • Betterments: • Increase asset’s useful life • Improve quality of asset’s output • Increase quantity of asset’s output • Reduce asset’s operating costs • Accounting treatment • Betterments are capitalized • Maintenance expenditures are expensed

  30. Depreciation Factors and Process Depreciation requires the following estimates: • Useful life – period of time over which the asset is expected to generate cash inflows • Salvage value – Expected disposal amount for the asset at the end of its useful life • Depreciation rate – an estimate of how the asset will be used up over its useful life.

  31. Variance in Depreciation • A company can depreciate different assets using different depreciation rates (and different useful lives). • Whatever depreciation rate is chosen, however, it must generally be used throughout the useful life of that asset. • Changes to depreciation rates can be made, but they must be justified as providing “better quality” financial reports.

  32. Depreciation Methods • Depreciation Methods: • Straight-line method • Accelerated Methods (Double-declining-balance method)

  33. Straight-line Method • Straight-line method: Under the straight-line (SL) method, depreciation expense is recognized evenly over the estimated useful life of the asset. • Consider the following example An asset (machine) with the following details: (1) cost of $100,000 (2) salvage value of $10,000 (3) useful life of 5 years

  34. Straight-line Depreciation Example • For the straight-line method, we use our illustrative asset to assign the following amounts to the depreciation formula:

  35. SL Example • For the asset’s first year of usage, $18,000 ($90,000 * 20%) of depreciation expense is reported in the income statement. At the end of that first year the asset is reported on the balance sheet as follows: Net book value (NBV) is cost less accumulated depreciation. • At the end of year 2, the net book value will be reduced by another $18,000 to $64,000.

  36. Double-declining-balance method • Double-declining-balance method. For the double-declining-balance (DDB) method, we use our illustrative asset to assign the following amounts to the depreciation formula: (2 x BV) / Useful Life

  37. Double-declining-balance method • The asset is reported on the balance sheet as follows: • In the second year, $24,000 ($60,000  40%) of depreciation expense is recorded in the income statement and the NBV of the asset on the balance sheet follows:

  38. DDB Depreciation Schedule

  39. Comparison of Depreciation Methods

  40. Asset Sales

  41. Asset Impairments • Impairment of plant assets is determined by comparing the sum of the expected future (undiscounted) cash flows generated by the asset with its net book value. • Companies must recognize a loss if the asset is deemed to be impaired. • When a company takes an impairment charge, assets are reduced by the amount of the write-down and the loss is recognized in the income statement, which reduces current period income.

  42. Accumulated Depreciation • Does not represent the accumulation of any tangible thing. • Sum of the original cost that has been expensed. • Funding the purchase of new assets is usually unrelated to depreciation. • Can distort ROA calculations!

  43. Analysis of Useful life and Percent Used Up • Estimated useful life = • Percent used up =

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