Module 5
Reporting and Analyzing
Investing Activities
QUESTIONS
Q5-1. Bad debts expense is recorded in the income statement when the allowance for
uncollectible accounts is increased. If a company overestimates the allowance
account, net income will be understated on the income statement and accounts
receivable (net of the allowance account) will be underestimated on the balance
sheet. In future periods, such a company will not need to add as much to its
allowance account since it is already overestimated from that prior period (or, it
can reverse the excess existing allowance balance). As a result, future net income
will be higher.
On the other hand, if a company underestimates its allowance account, then
current net income will be overstated. In future periods, however, net income will
be understated as the company must add to the allowance account and report
higher bad debts expense in future period(s).
Q5-2. If stable purchase prices prevail, the dollar amount of inventories (beginning or
ending) tends to be approximately the same under different inventory costing
methods and the choice of method does not materially affect net income. To see
this, remember that FIFO profits include holding gains on inventories. If the inflation
rate is low (or inventories turn quickly), there will be less holding (inflationary) profit
in inventory.
Q5-3. FIFO holding gains occur when the costs of earlier inventory acquisitions are
matched against current selling prices. Holding gains on inventories increase with
an increase in the inflation rate and a decrease in the inventory turnover rate.
Conversely, if the inflation rate is low or inventories turn quickly, there will be less
holding (inflationary) profit in inventory.
Q5-4. (a) Last in, first-out, (b) Last-in, first-out, (c) First-in, first-out, (d) First-in, first-out, (e)
Last in, first-out.
Q5-5. A significant tax benefit results from using LIFO when costs are consistently
rising. LIFO results in lower pretax income and, therefore, lower taxes payable,
than other inventory costing methods.
Q5-6. Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule.
When the replacement cost for inventory falls below its (FIFO or LIFO) historical
cost, the inventory must be written down to the lower replacement costs (market
value).
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Solutions Manual, Module 5
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Q5-7
As any asset is used up, its cost is removed from the balance sheet and
transferred into the income statement as expense. Capitalization of costs onto the
balance sheet and subsequent removal as expense is the essence of accrual
accounting. If the cost of a depreciable asset is recognized in full upon purchase,
profit would be inaccurately measured: it would be too low in the year of purchase
when the asset is expensed and too high in later years as revenues earned by the
asset are not matched with a corresponding cost. The proper matching of costs
(expenses) and revenues is essential for the proper recognition of profit.
Q5-8. When a change occurs in the estimate of an asset's useful life or its salvage value,
the revision of depreciation expense is handled by depreciating the current
undepreciated cost of the asset (original cost – accumulated depreciation) using the
revised assumptions of remaining useful life and salvage value.
Present and future periods are affected by such revisions. Depreciation expense
calculated and reported in past periods is not revised.
Q5-9. A PPE asset is considered to be impaired when the sum of the undiscounted
expected cash flows to be derived from the asset is less than its current book value.
An impairment loss is calculated as the difference between the asset's book value
and its current fair market value.
Q5-10. The primary benefit of accelerated depreciation for tax reporting is that the higher
depreciation deductions in early periods reduce taxable income and income taxes.
Cash flow is, therefore, increased and this additional cash can be invested to yield
additional cash inflows (e.g., an "interest-free loan" that can be used to generate
additional income). We would generally prefer to receive cash inflows sooner rather
than later in order to maximize this investment potential.
Q5-11. The gain or loss on the sale of a PPE asset is determined by the difference between
the asset's book value and the sale proceeds. Sales proceeds in excess of book
values create gains; sales proceeds less than book values cause losses. The
relevant factors, then, are the depreciation rate and salvage values used to compute
depreciation expense, accumulated depreciation and the net book value of the asset,
as well as the selling price of the asset.
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
MINI-EXERCISES
M 5-12 (10 minutes)
a. To bring the allowance to the desired balance of $2,100, the company
will need to increase the allowance account by $1,600, resulting in bad
debt expense of that same amount.
b. The net amount of Accounts Receivable is calculated as follows:
$98,000  $2,100 = $95,900.
M 5-13 (15 minutes)
a. Credit losses are incurred in the process of generating sales revenue.
Specific losses may not be known until many months after the sale. A
company sets up an allowance for uncollectible accounts to place the
expense of uncollectible accounts in the same accounting period as the
sale and to report accounts receivable at its estimated realizable value
at the end of the accounting period.
b. The balance sheet presentation shows the gross amount of accounts
receivable, the allowance amount, and the difference between the two,
the estimated net realizable value. The balance sheet, thus, reports the
net amount that we expect to collect. That is the amount that is the most
relevant to financial statement users.
c. The matching concept requires that expenses (credit losses) related to a
given revenue be matched with, and deducted from, the revenue in the
determination of net income. This dictates the use of the allowance
method. Recognition of expense only upon the write-off of the account
would delay the reporting of our knowledge that losses are likely and,
thereby, reduce the informativeness of the income statement.
Accountants believe that providing more timely information justifies the
use of estimates that may not be as precise as we would like.
©Cambridge Business Publishers, 2006
Solutions Manual, Module 5
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M 5-14 (20 minutes)
a.
($ millions)
2003
2002
Accounts receivable (net).................................... $3,369
$3,116
Allowance for uncollectible accounts ................ $ 114
$ 119
Gross accounts receivable.................................. $3,483
$3,235
Percentage of uncollectible accounts to
3.27%
gross accounts receivable ................................
($114/$3,483)
3.68%
($119/$3,235)
b. The reduction in the allowance for uncollectible accounts as a
percentage of gross accounts receivable may indicate that the quality of
the accounts receivable has improved, perhaps because the economy
has improved, the company is selling to a more credit-worthy class of
customers, or the company’s management of accounts receivable has
improved. It may also indicate, however, that the receivables are under
reserved (e.g., allowance account is too low). This would result in higher
reported profits in the current year at the expense of future profits when
the allowance for uncollectible accounts is increased.
M 5-15 (20 minutes)
a.
Procter & Gamble
Colgate-Palmolive
Accounts Receivable Turnover rates
For 2003
$43,373/[($3,038+$3,090)/2]=14.16
$9,903/[($1,222+$1,145)/2]=8.37
b. P&G turns its accounts receivable much faster than Colgate-Palmolive.
Receivable turns typically evolve to an equilibrium level for each industry
that arises from the general business models used by industry
competitors. Differences can arise due to variations in the product mix of
competitors, the types of customers they sell to, their willingness to offer
discounts for early payment, and their relative strength vis-à-vis the
companies or individuals owning them money. Both of these companies
sell a significant amount of their product to Wal-Mart. P&G is a sizable
company, and may have greater bargaining power over Wal-Mart than does
the smaller Colgate-Palmolive.
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
M 5-16 (20 minutes)
a. FIFO cost of goods sold = 1,000 @ $100 + 700 @ $150 = $205,000
FIFO ending inventories = $400,000 - $205,000 = $195,000
b. LIFO cost of goods sold = 1,700 @ $150 = $255,000
LIFO ending inventories = $400,000 - $255,000 = $145,000
c. AC cost of goods sold = 1,700 @ $400,000/3,000 = $226,667
AC ending inventories = $400,000 – $226,667 = $173,333
M 5-17 (10 minutes)
a. FIFO cost of goods sold = 400 @ $10 + 200 @ $12 = $6,400
FIFO ending inventories = $12,400 - $6,400 = $6,000
b. LIFO cost of goods sold = 600 @ $12 = $7,200
LIFO ending inventories = $12,400 - $7,200 = $5,200
c. AC cost of goods sold = 600 @ $12,400/1,100 = $6,764
AC ending inventories = $12,400 – $6,764 = 5,636
M 5-18 (20 minutes)
a.
Sears
K-Mart
Inventory Turnover rates
For 2003
$26,202/[($5,335+$5,115)/2]=5.01
$17,638/[($3,238+$4,825)/2]=4.38
b. Sears’ inventory turnover rate is higher than K-Mart’s. There can be
several reasons for this: 1. Sears product lines may be oriented toward
lower margin/higher turnover goods (this seems unlikely given K-Mart’s
value pricing strategy), 2. K-Mart’s sales might have slumped during this
period (it was still in bankruptcy), 3. K-Mart might have been weeding out
slower moving inventories during this period (notice the reduction in
inventories from 2002 to 2003), and the full effects might not have been
realized as of 2003.
c. Inventory turns improve as the dollar volume of goods sold increases
relative to the dollar volume of goods on hand. Retailers must balance the
cost savings from inventory reductions against the marketing implications
of lower inventory levels on hand. Inventory reductions can be realized by
reducing the depth and breadth of product lines carried (e.g., not every
©Cambridge Business Publishers, 2006
Solutions Manual, Module 5
5
style, size and color), eliminating slow moving product lines, working with
suppliers to arrange for delivery when needed rather than inventorying for
a longer holding period, and marking down goods for sale at the end of
product seasons.
M 5-19 (15 minutes)
a.
Straight-line: ($18,000 - $1,500)/ 5 years = $3,300 for both 2005 and 2006.
b.
Double-declining-balance: Twice straight-line rate = 2 x 1/5 = 40%
2005: $18,000 x 0.40 = $7,200
2006: ($18,000 - $7,200) x 0.40 = $4,320
Notice that, over the first two years, the company reports $6,600 of
depreciation expense under the straight-line method and $11,520 of
depreciation expense under the double-declining balance method.
M 5-20 (15 minutes)
a. Straight-line depreciation
2005:
($145,800 - $5,400)/3 = $46,800; (8/12) x $46,800 = $31,200
2006:
$46,800
b. Double-declining-balance depreciation
Preliminary computation: Twice straight-line rate = 2 x 100%/3 = 66⅔%
($145,800 x 66⅔%) = $97,200
2005:
(8/12) x $97,200 = $64,800
2006:
($145,800 - $64,800) x 66⅔% = $54,000
M 5-21 (15 minutes)
a.
Texas Instruments
Intel Corp.
PPE turnover rates for 2003
$9,834/[($4,132+$4,794)/2]=2.20
$30,141/[($16,661+$17,847)/2]=1.75
Texas Instruments turns its PPE more quickly than does Intel.
b. PPE turnover rates increase with increases in sales volume relative to the
dollar amount of PPE on the balance sheet. The PPE turnover rate is often
a very difficult turnover rate to change, and typically requires creative
thinking. Many companies are off-loading the manufacturing process in
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
whole or in part to others in the supply chain. This is beneficial so long as
the benefits realized by the reduction of manufacturing assets more than
offset the higher cost of the goods as these are now purchased rather
than manufactured. Another approach is to utilize long-term operating
assets in partnership with another firm, say in a joint venture.
©Cambridge Business Publishers, 2006
Solutions Manual, Module 5
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c.
EXERCISES
E 5-22 (20 minutes)
a. 2005 bad debts expense computation
$90,000  1%
20,000  2%
11,000  5%
6,000  10%
4,000  25%
=
=
=
=
=
Less: Unused balance before adjustment
Bad debt expense for 2005
$ 900
400
550
600
1,000
$3,450
520
$2,930
b. Accounts receivable, net = $131,000 - $3,450 = $127,550
Reported in the balance sheet as follows:
Accounts receivable, net of $3,450 in allowances ......................
$127,550
E 5-23 (30 minutes)
Accounts receivable
Less allowance for uncollectible accounts
$138,100
10,384
$127,716
Computations
Accounts
Receivable
Beginning balance
Sales
Collections
Write-offs
Provision for uncollectibles
$ 122,000
1,173,000
(1,150,000)
(6,900)
_______
$ 138,100
Allowance for
Uncollectible Accounts
$ 7,900
(6,900)
9,384
$ 10,384
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
E 5-24
a,b.
($ millions)
2003
2002
Accounts receivable (net)....................................
$8,921
$8,456
Allowance for uncollectible accounts ................
$ 347
$ 410
Gross accounts receivable..................................
$9,268
$8,866
Percentage of uncollectible accounts to
3.74%
gross accounts receivable ..................................($347/$9,268)
4.62%
($410/$8,866)
c.
($ millions)
2003
Bad debt expense (addition to allowance),
$29
from Note 7 ...........................................................
Amounts actually written off ............................... $92
2002
2001
$90
$206
$96
$102
d. The allowance for uncollectible accounts has decreased as a percentage
of gross accounts receivable from 4.62% in 2002 to 3.74% in 2003 (see
part b). Further, HP had markedly increased its allowance account in
2001 as the provision of $206 substantially exceeded 2001 write-offs of
$102. For 2002, its bad debts expense (addition to allowance account) of
$90 roughly equaled its $96 in write-offs. However, in 2003 HP lowered
its allowance account balance to be but 3.74% of its gross accounts
receivable. This is because its addition to the allowance account of $29
million was markedly less than its write-offs of $92 million for 2003.
Thus, it appears that HP’s addition to the allowance account in 2001 was
overestimated, whereas its addition in 2003 appears to be
underestimated.
E5-25 (20 minutes)
a.
Aging schedule at December 31, 2005
Current $304,000 × 1% =
$ 3,040
0–60 days past due 44,000 × 5% =
2,200
61–180 days past due18,000 × 15% = 2,700
Over 180 days past due 9,000 × 40% = 3,600
Amount required
$ 11,540
Balance of allowance
4,200
Provision
$ 7,340 = 2005 bad debt expense
©Cambridge Business Publishers, 2006
Solutions Manual, Module 5
9
b.
Current Assets
Accounts Receivable
Less allowance for uncollectible accounts
$375,000
11,540
$363,460
E5-26 (30 minutes)
a.
Year
2003
2004
2005
Total
Sales
$ 751,000
876,000
972,000
$2,599,000
Collections
$ 733,000
864,000
938,000
$2,535,000
Accounts Written Off
$ 5,300
5,800
6,500
$17,600
Accounts Receivable at the end of 2005 is:
$46,400, computed as ($2,599,000-$2,535,000-$17,600).
Uncollectible Accounts Expense is:
2003
$ 7,510 computed as 1% × $751,000
2004
8,760 computed as 1% × $876,000
2005
9,720 computed as 1% × $972,000
2003–2005
$25,990 computed as 1% × $2,599,000
Allowance for Uncollectible Accounts is:
$8,390, computed as $25,990 total provision for uncollectible
accounts less $17,600 in total write-offs.
b.
The 1% rate appears to be too high. A 0.8% rate would have provided
$20,792, which still exceeds the $17,600 total write-off by $3,192.
Moreover, this lower rate would appear to provide an adequate
margin for future write-offs.
E5-27 (30 minutes)
Beginning Inventory
Purchases: #1
#2
#3
Goods available for sale
Units
1,000
1,800
800
1,200
4,800
Cost
$ 20,000
39,600
20,800
34,800
$115,200
Units in ending inventory = 4,800 – 2,800 = 2,000
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
a.
First-in, first-out
Ending Inventory
Units
1,200
800
2,000
@
@
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
b.
=
=
Total
$34,800
20,800
$55,600
$115,200
55,600
$ 59,600
Last-in, first-out
Ending inventory
Units
1,000
1,000
2,000
@
@
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
c.
Cost
$29
$26
Cost
$20
$22
Total
= $20,000
= 22,000
$42,000
$115,200
42,000
$ 73,200
Average cost
$115,200/4,800 = $24 average unit cost
2,000 x $24 = $48,000 ending inventory
$115,200 - $48,000 (or 2,800x$24) = $67,200 cost of goods sold
d.
1. The first-in, first-out method in most circumstances represents
physical flow. This inventory system applies to perishables or to
situations in which the earliest items acquired are moved out first
because of risk of deterioration or obsolescence.
2. Last-in, first-out results in the lowest inventory amount during
periods of rising unit costs, which in turn results in the lowest net
income and the lowest income tax.
3. The first-in, first-out results in the lowest cost of goods sold in
periods of rising prices. This is the inventory method Chen should
use to report the largest amount of income. Of course, this
assumes that prices will be continually rising as they have been up
to this point. Companies cannot change inventory costing methods
without justification and the change may be prohibited by tax laws
as well.
©Cambridge Business Publishers, 2006
Solutions Manual, Module 5
11
E5-28 (25 minutes)
a. $8,555
b. $9,187
c. Pretax income has been reduced by $632 million cumulatively since GE
adopted LIFO inventory costing. This is because it has matched current
inventory costs against current selling prices, thus avoiding the
recognition of holding gains that would have resulted had FIFO
inventory costing been used.
d. Pretax income has been reduced by $632 million (see part c). Assuming
a 35% tax rate, taxes have been reduced by $632 x 0.35 = $221.2 million.
Cumulative taxes have been decreased by the use of LIFO inventory
costing.
e. For 2003, the change in the LIFO reserve is $26 million ($632 million $606 million). Pretax income has been reduced by this amount, thus
reducing taxes by $26 million x 0.35 = $9.1 million.
E5-29 (25 minutes)
Beginning inventory
Purchases:
Purchase #1
Purchase #2
Purchase #3
Cost of goods available for sale
a.
Units
100
650
550
200
1,500
@
@
@
@
Cost
$46
42
38
36
@
@
Cost
$36
38
=
=
=
=
Total
$ 4,600
27,300
20,900
7,200
$60,000
=
=
Total
$ 7, 200
5,700
$12,900
First-in, first out
Ending inventory ...............................
Cost of goods available for sale ......
Less: Ending inventory ....................
Cost of goods sold ............................
Units
200
150
350
$60,000
12,900
47,100
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Financial Accounting for MBAs, 2nd Edition
b.
Average cost
Cost of Goods Available for Sale/Total Units Available for Sale
= $60,000/1,500 = $40 Average Unit Cost
Ending Inventory = 350 units x $40 = 14,000
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
c.
$60,000
14,000
$46,000
Last-in, first-out
Ending inventory
Units
100
@
250
@
350
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
Cost
$46
42
=
=
Total
$ 4,600
10,500
$15,100
$60,000
15,100
$44,900
E5-30 (25 minutes)
a. $3,343 million
b. $3,498 million ($3,343 million + $155 million)
c. Pretax income has been reduced by $155 million cumulatively since
Kraft adopted LIFO inventory costing. This is because it has matched
current inventory costs against current selling prices, thus avoiding the
recognition of holding gains that would have resulted had FIFO
inventory costing been used.
d. Pretax income has been reduced by $155 million (see part c). Assuming
a 35% tax rate, taxes have been reduced by $155 x 0.35 = $54.25 million.
Cumulative taxes have been decreased by the use of LIFO inventory
costing.
e. For 2003, the change in the LIFO reserve is a reduction of $60 million
($215 million - $155 million). Pretax income has been increased by this
amount, thus increasing taxes by $60 million x 0.35 = $21 million.
©Cambridge Business Publishers, 2006
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E5-31 (20 minutes)
a.
Straight line:
($80,000 - $5,000)/4 years = $18,750 per year
b.
Double declining balance: Twice straight-line rate = 2 x 100%/4 = 50%
Year
1
2
3
4
Book Value x Rate Depreciation Expense
$80,000 x 0.50 = $40,000
($80,000 - $40,000) x 0.50 =
20,000
($80,000 - $60,000) x 0.50 =
10,000
($80,000 - $70,000) x 0.50 =
5,000
E5-32 (25 minutes)
a. 1. Cumulative depreciation expense to date of sale:
[($800,000-$80,000)/10 years] x 6 years = $432,000
2. Net book value of the plane at date of sale:
$800,000 - $432,000 = $368,000
b. 1. $ 0
2. Loss on sale of: $195,000 - $368,000 = $173,000
3. Gain on sale of: $600,000 - $368,000 = $232,000
E5-33 (20 minutes)
a.
Straight-line
2005 and 2006 ($218,700-$23,400)/6 years = $32,550
b.
Double-declining-balance
Twice straight-line rate = 100% x 2/6 = 33⅓%
2005
2006
$218,700 x 33⅓% =
$72,900
($218,700 - $ 72,900) x 33⅓% = $48,600
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Financial Accounting for MBAs, 2nd Edition
E5-34 (20 minutes)
a.
Depreciation expense to date of sale is [($27,200-$2,000)/6] x 3=$12,600.
The net book value of the van is, therefore, $27,200-$12,600=$14,600.
b.
1. 0
2. $400 gain ($15,000-$14,600)
3. $2,600 loss ($12,000-$14,600)
E5-35 (15 minutes)
a. Average useful life = Cost / Depreciation expense
= ($5,834-$68-$92)/$631.4 = 8.99 years
(Note: We eliminate land and construction in progress from the
computation as these assets are not depreciated). The footnote
indicates that buildings have estimated useful lives ranging from 10-33
years, Machinery and Equipment of 12 years, Dies, etc of 8 years , and
All Other of 3-8 years.
b. Percent used up
= Accumulated depreciation / Asset cost
= $3,758 million / ($5,834-$68-$92) million = 66%
(Note: We eliminate land and construction in progress from the
computation as these assets are not depreciated). Assuming that
assets are placed evenly as they are used up, we would expect assets to
be 50% depreciated, on average. Deere’s 66% is higher than this level.
Our concern is that it will require higher capital expenditures in the near
future to replace aging assets.
E 5-36 (25 minutes)
a.
Receivable turnover rate
$18, 232
2003
$3 ,162 $2 , 840
2
 6.08
Inventory turnover rate
$8,321
$1, 816 $1, 931
2
 4.44
PPE turnover rate
$18, 232
$5 , 609 $5 , 621
 3.25
2
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$16,332
2002
$2 , 840 $2 , 786
 5.81
$7 , 482
$1, 931 $2 , 091
2
2
 3.72
$16, 332
$5 , 621 $5 , 615
 2.91
2
b. 3M has improved its turnover rates in all three areas. Receivable
turnover rates can be improved by monitoring more closely the quality
of customers to which credit is granted, implementing better collection
procedures, and offering discounts as an incentive for early payment.
Inventory turnover rates can be improved by weeding out slowly moving
product lines, by reducing the depth and breadth of products carried,
and by implementing just-in-time deliveries. PPE turns can be improved
by off-loading manufacturing to other companies in the supply chain
and acquiring long-term operating assets in partnership with other
companies, say in a joint venture.
E5-37 (15 minutes)
a.
Yes, the equipment is impaired at July 1, 2004. This is because its book
value is not recoverable through future cash flows. Specifically, on July
1, 2004, its book value is $145,000 ($225,000 initial cost less $80,000
accumulated depreciation*) and the estimated future (undiscounted)
cash flows are only $125,000.
*4 years of [($225,000-$25,000)/10 years].
b.
The impairment loss in a is computed as the equipment's book value
minus its current fair value:
$145,000  $90,000 = $55,000
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
d.
Problems
P5-38 (30 minutes)
a. Best Buy and Sharper Image, both retailers, report much higher
receivables turnover rates than do the manufacturers, Caterpillar and
Harley. The likely reason for this is that sales for these retailers are
usually via credit cards, which are like cash for the retailers. The
manufacturers, on the other hand, usually sell to their retailers or
customers on credit and the funds are not collected for a much longer
period of time.
b. Harley’s relatively higher inventory turnover rate, compared with the
retailer, Sharper Image, is surprising as manufacturers typically turn
their inventories much more slowly than do retailers. There are at least
two possible reasons for Harley’s low inventory levels relative to cost of
goods sold: i. Harley has a very efficient manufacturing process that
minimizes raw materials and work-in-process inventories, and/or ii.
Harley’s products are very much in demand and are sold before
production begins, thus minimizing finished goods inventories.
Oracle is a software development and service company and does not
carry inventories of products for sale.
c. Carnival, the cruise ship line, is very capital-intensive. Microsoft, on the
other hand, requires relatively few long-term assets to support its
operations as most of its costs are expensed under GAAP as wages and
R&D expense, rather than capitalized on the balance sheet.
d. The relative asset turnover rates reported generally conform to our
expectations across industries. Those industries that sell on credit,
rather than using credit cards, normally stock inventories for production
and sale, require substantial investment in long-term assets yield much
lower turnover rates. These lower turnover rates must be accompanied
by higher profit margins and/or higher financial leverage so as to yield
satisfactory levels of ROE.
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P 5-39 (30 minutes)
a.,b.
($ 000s)
2003
2002
2001
Accounts receivable (net) ....................
$431,896
$423,240
$454,180
Allowance for uncollectible
$24,736
accounts .............................................
$26,868
$30,552
Gross accounts receivable ..................
$456,632
$450,108
$484,732
Percentage of uncollectible
5.42%
5.97%
6.30%
accounts to gross
($24,736/$456,632) ($26,868/$450,108) ($30,552/$484,732)
accounts receivable ..........................
c.
($ 000s)
2003
Bad debts expense (titled
provision for uncollectible
$9,263
accounts), see Note 7 ........................
2002
2001
$13,328
$21,483
d. The allowance for uncollectible accounts has decreased as a percentage
of gross accounts receivable from 6.30% in 2001 to 5.42% in 2003 (see
part b solution). Management’s estimated allowance probably decreased
because write-offs of uncollectible accounts have exceeded the
provision for each of 2002 and 2003.
e. In 2002, the allowance for uncollectible accounts was 5.97% of gross
accounts receivable. Applying that percentage to the 2003 gross
accounts receivable of $456,632,000 yields an allowance for
uncollectible accounts of $27,261,000 which is $2,525,000 higher than
the $24,736,000 reported in the allowance account for 2003. Thus,
maintaining the allowance account at the 2002 level would have reduced
2003 profit by $2,525,000.
P5-40 (40 minutes)
(all in $ millions)
a. Gross receivables as of 2002 are $5,667 + $2,379 = $8,046.
Gross receivables as of 2001 are $6,054 + $1,889 = $7,943.
b. Estimated uncollectible accounts to gross accounts receivable are:
30% ($2,379/$8,046) in 2002
24% ($1,889/$7,943) in 2001
Gross receivables to sales are:
19.6% ($8,046/$40,961) in 2002
21.4% ($7,943/$37,166) in 2001
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Financial Accounting for MBAs, 2nd Edition
Although receivables are a lower percentage of sales in 2002, it appears
that their collectibility is less certain.
$40,961
 6.99
$5,667 $6,054
2
The days sales in accounts receivable is
$5,667/ ($40,961/365) = 50.5 days
c. The receivables turnover rate is
The AOL part of the business is mainly a cash basis operation and we
would expect relatively minor receivables. The Time, Inc., portion of the
business contains publishing, cable, film and music. Although the
magazine publishing business does not carry significant receivables,
the other lines of business do.
On the whole, 52 days sales on average in accounts receivable for this
type of business seems high and our concern is increased by the
relatively high levels of estimated uncollectible accounts.
d. AOL significantly increased its allowance for uncollectible accounts as a
percentage of gross accounts receivable. There are two possible
reasons for this, neither of which are particularly good for AOL:
1. The financial condition of its customers has deteriorated significantly,
thus warranting a higher reserve, or
2. AOL arbitrarily increased its allowance account.
The second alternative would be consistent with the “big bath” theory.
By increasing its allowance account more than necessary, it might have
recorded more expense in 2002 than was warranted and created an
allowance account that was higher than warranted. In future years, then,
AOL might have the ability to reverse this allowance account to
immediately improve earnings, or it might just allow the allowance
account to decline gradually as credit losses are recognized. In either
case, future profits would be higher as AOL would not have the current
period expense to increase the allowance account.
P5-41 (25 Minutes)
a. $3,047 million
b. $4,910 million ($3,047 million + $1,863 million)
c. Pretax income has been reduced by $1,863 million cumulatively since
CAT adopted LIFO inventory costing. This is because it has matched
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Solutions Manual, Module 5
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current inventory costs against current selling prices, thus avoiding the
recognition of holding gains that would have resulted had FIFO
inventory costing been used.
d. Pretax income has been reduced by $1,863 million (see part c).
Assuming a 35% tax rate, taxes have been reduced by $1,863 x 0.35 =
$652 million.
Cumulative taxes have been decreased by the use of LIFO inventory
costing.
e. For 2003, the change in the LIFO reserve is a reduction of $114 million
($1,977 million - $1,863 million). Pretax income has been increased by
this amount, thus increasing taxes by $114 million x 0.35 = $39.9 million.
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
P5-42 (45 minutes)
($ thousands)
a. Inventories as a percent of current assets follows:
30% ($81,925/$270,100) of current assets in 2003
39% ($98,213/$254,122) of current assets in 2002
As long as the Stride Rite retailing outlets have sufficient product to
meet demand, the reduction of inventories is positive as it likely
represents more efficient manufacturing processes. The reduction of
inventories might be of concern, however, if Stride Rite is in financial
difficulty and is unable to purchase the raw materials necessary for its
production. We have no evidence of its financial difficulty for 2003.
b. The inventory turnover rate follows:
2003:
2002:
$340,614
 3.78
$81,925 $98,213
2
$337,951
 3.21
$98,213 $112,481
2
The inventory turnover rate has increased from 2002 to 2003. This is
positive as it represents increased manufacturing/retailing efficiency.
c. Stride Rite uses the LIFO inventory costing method.
The LIFO reserve, the difference between LIFO and FIFO inventories,
decreased by $1,610 from 2002 to 2003 and by $758 from 2001 to 2002.
This represents a decrease in prices. As a result, reported profits
actually increased rather than decreased, as we would expect in a
period of rising prices.
From 2000 to 2001, the LIFO reserve increased by $314, thus reducing
gross profit by that amount.
Over the three-year period, the cost of its inventories has, therefore,
overall been decreasing. LIFO inventory costing has, therefore, had a
positive effect on gross profit.
d. Stride Rite’s reduction in its quantities of inventories is positive as the
holding costs of inventories (financing, insurance, handling costs, etc.)
are substantial. As a general rule, companies should keep inventories at
the lowest level possible without impairing their manufacturing
efficiency or reducing the stock of finished goods to the point that sales
are adversely impacted.
e. Stride Rite’s reduction of inventory quantities resulted in matching
lower cost inventories against higher current selling prices. This
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increased its profits by $141 for 2003. This reduction in inventory
quantities is called LIFO liquidation.
In 2002, however, the reduction of inventory quantities actually
decreased reported profits by $120 as Stride Rite dipped into higher
cost inventory layers. As inventory costs fluctuate, higher and lower
cost layers are established, thus leading to fluctuating effects on profits
as inventory quantities are reduced.
As this example demonstrates, it is not always the case that reported
profits increase as inventory quantities are reduced as this outcome is
predicated on the assumption of continually rising prices.
P5-43 (15 minutes)
a. Average useful life = Cost / Depreciation expense
= ($13,290,747- $356,757- $792,923)/$910,785
= 13.33 years
(Note: We eliminate land and construction in progress from the
computation as these assets are not depreciated). The footnote
indicates that buildings have estimated useful lives ranging from 10-50
years (27 year average) and Equipment from 3-20 years (11 year
average).
b. Percent used up
= Accumulated depreciation / Asset cost
= $7,008,941 / ($13,290,747- $356,757- $792,923)
= 57.7%
(Note: We eliminate land and construction in progress from the
computation as these assets are not depreciated). Assuming that
assets are placed evenly as they are used up, we would expect assets to
be 50% depreciated, on average. Abbott Labs 57.7% is slightly higher
than this level, but not high enough to cause concern that it will need
significantly higher capital expenditures in the near future to replace
aging assets.
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Financial Accounting for MBAs, 2nd Edition
P5-44 (45 minutes)
a. Plant asset turnover for 2002 is: $5,727 / [($2,954+$2,905)/2] = 1.95
Plant asset turnover for 2001 is: $5,666 / [($2,905+$2,916)/2] = 1.95
The lack of change in the plant asset turnover rate is indicative of
similar productivity from the company’s capital investment over the past
two years.
The level of the plant asset turnover is not particularly low (see exhibit
3.10 in Module 3 regarding profit margins and asset turnovers for
several industries). This finding indicates a less than average level of
capital intensity.
Rohm and Haas’ balance sheet does not reflect all of its capital
investment. For example, most or all of its R&D expenditures are
expensed under GAAP. While R&D expenditures may not be particularly
large for this company, they are normally a substantial cost for chemical
companies. Substantial R&D costs not reflected on the balance sheet
would yield an overstated plant asset turnover rate as the sales
resulting from these investments are realized, but not the investments
required.
b. The average period of time over which Rohm and Haas is depreciating
its assets, assuming straight-line depreciation, can be estimated as
Acquisition cost of depreciable assets / Depreciation expense
($7,246 - $142*- $345) / $388 = 17.4 years
*Note that land and construction in progress are not depreciable assets and are subtracted.
c. As of 2002, the company’s plant assets were approximately 60% “used
up,” which is computed as follows:
Accumulated depreciation / Acquisition cost of depreciable assets
$4,292 / ($1,541 + $4,926 + $292 ) = 0.635
If plant assets are replaced at a constant rate, we would expect those
assets to be about 50% “used up,” on average. A substantially higher
percentage “used up” indicates that the assets are closer to the end of
their useful lives and will require replacement. Such a situation would
negatively impact future cash flows.
d. Plant assets are deemed to be impaired if the expected cash flows to be
derived from those assets is not sufficient to recover their net book
value. That is, the sum of the undiscounted expected cash flows is less
than the net book value. If fixed assets are deemed to be impaired, they
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are written down to their market value, which is the discounted value of
those expected cash flows.
An asset impairment charge reduces net income, but has no effect on
current period cash flows as it is a non-cash charge for that period.
Moreover, the impairment loss is not deductible for tax purposes until
the asset is disposed of, that is, until the loss is realized.
Since asset impairment losses are nonrecurring, we would be justified
in treating them as transitory items for analysis purposes.
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Financial Accounting for MBAs, 2nd Edition