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


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
Cash Reporting
 The
only reporting issues for cash is
whether there are restrictions on its
use
 Escrow
 Compensating
Balances
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.

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?
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?
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
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.
Aging Analysis Example
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:
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:
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.

If the allowance for uncollectible accounts has a
prior balance of $1,500, bad debt expense would
be $1,400 (the increase in the allowance for
uncollectible accounts)
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:
1.
2.
They expect to collect the total amount
reported on the balance sheet (remember,
accounts receivable are reported net of the
allowance for uncollectible accounts), and
They expect to collect this amount within the
next year (because of the classification as a
current asset).
Analysis Implications: Adequacy of
Allowance Account


The first issue, from an analysis viewpoint, is
whether the company has adequately provisioned
for its uncollectible accounts. If not, the amount
of cash ultimately collected will be less that the
company is reporting.
To assess the adequacy of the allowance account:


Compare with the percentage the company reported in
prior years.
Compare with the percentage reported by other
companies in its industry.
Income Shifting


Be aware that companies have previously
used the allowance for uncollectible
accounts to shift income from one year into
another.
For example, by underestimating the
provision, expense is reduced in the income
statement, thus increasing current period
income.
Receivables Turnover Rate and Days
Sales in Receivables

The accounts receivables turnover (ART) rate is
defined as

The accounts receivable turnover rate reveals how
many times receivables have turned (been collected)
during the period.
More turns indicate that receivables are being
collected quickly
A companion ratio is the Average Collection Period:


Insights from
accounts receivable turnover
Quality Changes in turnover rates (and corresponding
1.
days outstanding) can yield insights into accounts
receivable quality. If turnover slows (days outstanding
lengthen) compared with prior history, industry averages,
and the credit terms offered, the reason could be
deterioration in collectibility of receivables. Of course,
before such an inference is reached, one must consider a
number of alternative explanations:



The company might have changed its credit policies for
customers.
The company might have changed its sales mix to longer paying
customers.
The company might have changed its estimation of the
provision.
Inventory Issues



What is inventory?
What costs are included in inventory?
How do we separate COGS from End. Inv?
Inventories



The cost of inventories is reported on the balance
sheet and reflects the price of goods purchased
from other companies or the costs to manufacture
those goods if internally produced.
Costs will vary over time and for changes in
market conditions.
Consequently, the goods available for sale will
likely vary in cost from one period to the next—
even if the quantity of goods available remains the
same.
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.
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.
Cost Capitalization



For purchased inventories (such as with
merchandisers), the amount of cost capitalized is
the purchase price.
For manufacturers, the capitalization issue is
more difficult.
Manufacturing costs consist of three
components:
1.
2.
3.
Raw materials
Direct labor
Manufacturing overhead (all manufacturing costs
except raw materials and direct labor)
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
The Cost of Goods Sold
Computation
Inventory Cost Flows to
Financial Statements
Effects of errors




Common source of manipulation
Often difficult for the auditor to catch
Affects two years
Example
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.
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.
CAT’s LIFO Reserve
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.
Gross profit analysis



Gross profit ratio equals gross profit divided by
sales. This is an important ratio and is frequently
monitored by company management and external
equity analysts alike.
The gross profit ratio is frequently used instead of
the dollar amount of gross profit as it allows for
comparisons across companies.
A decline in this ratio is usually cause for concern
since it indicates that the company has less ability
to mark up the cost of its products into selling
prices.
Possible Causes for a Decline in
Gross Profit Ratio

Some possible reasons for a decline in Gross Profit Ratio
follow:
 Product line is stale. Perhaps it is out of fashion and the
company has had to resort to “markdowns” to reduce
overstocked inventories. Or, perhaps the product lines have
lost their technological edge and are no longer in demand.
 New competitors enter the market. Since there are now
substitutes available from competitors, increased selling
prices is less likely.
 General decline in economic activity. This could reduce
demand for its products. The recession of the early 2000s
resulted in reduced gross profits for many companies.
 Inventory is overstocked. If a company produces too many
goods and finds itself in an overstock position, it can
reduce selling prices to move inventory.
Inventory Turnover Rates for
Selected Companies
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 longterm assets often makeup the larger expense
amounts—typically reflected in depreciation
expense and asset write-downs.
Capitalization of Costs

An expenditure is only reflected on the balance
sheet as an asset if it possesses two
characteristics:
1.
2.


It is owned or controlled by the entity, and
It provides future expected benefits.
Companies can only capitalize costs for which the
associated cash inflows are directly linked.
The amount of costs that can be reported as an
asset is limited to an amount no greater than the
expected future cash inflows from the investment.
What is Included in Cost?


All expenditures necessary to make asset ready for
its intended use.
Self constructed assets:


Capital asset acquired for other than cash:


All construction costs (materials, direct labor, overhead).
Record at fair market value (FMV) of consideration given
or received.
Basket purchase:

Allocate cost based on FMV of acquired assets.
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

Capitalizing vs. Expensing


The qualification that only those costs for
which the associated cash inflows are
directly linked is an important one.
The following costs are typically expensed:
Research & Development (R&D)
 Advertising Costs
 Employee Wages

Depreciation Factors and Process
Depreciation requires the following estimates:
1.
Useful life – period of time over which the asset
is expected to generate cash inflows
2.
Salvage value – Expected disposal amount for
the asset at the end of its useful life
3.
Depreciation rate – an estimate of how the asset
will be used up over its useful life.
Depreciation Rate Assumptions
1.
2.
3.
The asset is used up by the same amount
each period
The asset is used up more in the early
years of its useful life
The asset is used up in proportion to its
actual usage
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.
Depreciation Methods

All depreciation methods have the
following general formula:

Depreciation Methods:
1.
2.
Straight-line method
Accelerated Methods (Double-decliningbalance method)
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

Straight-line Depreciation Example

For the straight-line method, we use our illustrative
asset to assign the following amounts to the
depreciation formula:
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.
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:
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:
DDB Depreciation Schedule
Comparison of Depreciation
Methods
Asset Sales
Asset Impairments



Impairment of plant assets other than goodwill 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.
Impairment Analysis
Analysis Implications

PPE Turnover: A main analysis of longterm assets involves their productivity.
1.
2.

For example, what level of long-term assets is
necessary to generate a dollar of revenues?
How capital intensive is the company?
Analysis usually focuses on the fixed asset
turnover ratio to provide insight into these
questions:
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!
Book Value
EBITDA
Depreciation
Net Income
ROA
Age of assets
1/1/99 12/31/99 12/31/00 12/31/01 12/31/02 12/31/03
1,000,000 900,000 800,000 700,000 600,000 500,000
220,000 220,000 220,000 220,000 220,000
100,000 100,000 100,000 100,000 100,000
120,000 120,000 120,000 120,000 120,000
12.6% 14.1% 16.0% 18.5% 21.8%
1
2
3
4
5
Analysis of Useful life and Percent
Used Up

Estimated useful life =

Percent used up =
Internal Control

1.
2.
The purpose of internal control is
twofold:
To safeguard assets
To enhance the accuracy of the financial
accounting system
Internal Control Principles
1.
2.
3.
4.
5.
6.
Establish responsibility
Segregation of duties
Documentation for an audit trail
Physical control
Independent verification
Other controls
Internal Control Limitations
 Reasonable
 Collusion
assurance