Chapter 04 - Analyzing Investing Activities
Chapter 4 Analyzing Investing Activities REVIEW Assets are the driving forces of profitability for a company. Assets Assets produce revenues that compensate or!ers" repay lenders" reard oners" and fund groth. Current assets are resour resources ces or claims claims to resou resources rces readily readily conver convertib tible le to cash. cash. #a$or #a$or curren currentt assets assets includ include e cash cash and cash cash e%uiv e%uivale alents nts"" mar!et mar!etabl able e securit securities ies"" receiva receivable bles" s" deriva derivativ tive e financial instruments" inventories" and prepaid e&penses. 'ur analysis of current assets provides us insights into a company(s li%uidity. )i%uidity is the length of time until assets are are conv convert erted ed to cash cash.. It is an indi indica cato torr of a comp compan any( y(s s abil abilit ity y to meet meet fina financ ncia iall obligati obligations ons.. *he less li%uid li%uid a company company"" the loer loer is its financia financiall fle&ibil fle&ibility ity to pursue pursue promising investment opportunities and the greater its ris! of failure. +oncurrent assets are resources or claims to resources e&pected to benefit more than the current period. #a$or #a$or noncurren noncurrentt assets assets include include property property"" plant" plant" e%uipmen e%uipment" t" intangib intangibles" les" investme investments" nts" and deferred charges. 'ur analysis of noncurrent assets provides us insights into a compan company( y(s s solve solvency ncy and operat operation ional al capacit capacity y. ,olven ,olvency cy refers refers to the abili ability ty of a company to meets its long-term and current/ obligations. 'perational capacity is the ability of of a company to generate future profits. *his chapter shos ho e use financial financial statements statements to better assess li%uid li%uidity ity"" solvency solvency"" and operation operational al capacity using asset values" and to critically evaluate a company(s financial performance and prospects. *he acco accoun unti ting ng prac practi tice ces s un unde derl rlyi ying ng the the meas measur urem emen entt and and repo report rtin ing g of curr curren entt and and noncurrent assets are described. We discuss the accounting for these assets and its implications for analysis of financial statements. ,pecial attention is given to various analytical ad$ustments helping us better understand current and future prospects.
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Chapter 04 - Analyzing Investing Activities
'0*)I+E ,ection 12 Current Assets Assets •
Cash and Cash E%uivalents Analyzing Cash and Cash E%uivalents
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Receivables Valuation of Receivables Analyzing Receivables
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3repaid E&penses
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Inventories Inventory Accounting and Valuation Analyzing Inventories ,ection 2 +oncurrent Assets Assets
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Introduction to )ong-)ived Assets Accounting for )ong-)ived Assets Capitalizing Capitalizing versus E&pensing2 5inancial ,tatement and Ratio Effects
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3lant Assets and +atural Resources Valuing 3lant Assets and +atural Resources 6epreciation and 6epletion
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Intangible Assets Accounting for Intangibles Analyzing Intangibles 7oodill 0nrecorded Intangibles and Contingencies Contingencies
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Chapter 04 - Analyzing Investing Activities
A+A)8 A+A)8,I, '9:EC*IVE, '9:EC*IVE, •
6efine current assets and their relevance for analysis.
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E&plain cash management and its implications implications for analysis.
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Analyze Analyze receivables" alloances for bad debts" and securitization.
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Interpret the effects of alternative inventory methods under varying business conditions.
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E&plain the concept of long-lived assets and its implications implications for analysis.
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Interpret valuation and cost allocation of plant assets and natural resources.
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6escribe and analyze intangible intangible assets and their disclosures.
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Analyze Analyze financial statements for unrecorded and contingent assets.
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Chapter 04 - Analyzing Investing Activities
;0E,*I'+, 1. a. +o. +o. When When anal analyz yzin ing g cash cash"" the the mo most st li%u li%uid id of curr curren entt asse assets ts"" the the anal analys ystt is interested interested in the availabil availability ity of cash in meeting the company(s company(s obligation obligations. s. A restricti restriction on under under compensati compensating ng balance balance arrangement arrangements s does" at orst" orst" remove remove these cash balances from immediate availability as means of payment. Indeed" use of such balances can have repercussions for the company that can affect its future access to ban! credit. b. *h *he e anal analy yst shou should ld e&cl e&clud ude e cash cash rest restri rict cted ed un unde derr comp compen ensa sati ting ng bala balanc nce e agreements from current assets. ,EC Accounting ,eries Release 14< re%uires that a company that has borroed money from a ban! segregate on its balance sheet any cash sub$ect to ithdraal or usage restrictions under compensating balance balance agreements agreements ith the lending lending ban!. *hese re%uireme re%uirements nts may" as is often the case in such situations" move companies and their ban!er to alter the form of their contractual agreements hile retaining their substance. *he analyst must be ever alert to such attempts to distort analysis measurements by presentations hos h ose e form form is no nott a true true refl reflec ecti tion on of thei theirr subs substa tanc nce. e. 'n 'ne e meas measur ure e of a company=s vulnerability vulnerability in this area is the ratio of restricted cash to total cash. . a. *he *he op oper erat atin ing g cycl cycle e conc concep eptt is impo import rtan antt in the clas classi sifi fica cati tion on of asse assets ts and and liabilities as either current or noncurrent. *he operating cycle encompasses the period of time from the commitment of cash for purchases until the collection of receivables resulting from the sale of goods or services. *he diagram near the beginning of Chapter 4 illustrates this concept. b. If the normal normal collectio collection n interval interval of a receivab receivables les is longer longer than than a year such as ith ith longer longer term installment installment receivables/" receivables/" then their inclusion inclusion as current current assets is proper provided the operating cycle is e%ual to or greater than the obligation due date for the receivables. ,imilarly" if inventories" by business need or custom" have to be !ept on average for more than 1 months" then this normal inventory holding period becomes part of the operating cycle and such inventories are included among current assets. c. *he limita limitatio tions ns of the current current ratio ratio hich hich is comput computed ed from items items defined defined as or!ing capital/ as a measure of short-term li%uidity are discussed in Chapter 11. ,till" if e accept the proposition that it is useful to measure the current resources available to pay current obligations" then it is difficult to see ho e&tension of >current> from the customary 1 months to periods of ?@ months or longer can serve a useful purpose. *he operating cycle concept may help companies sho the !ind of positive current position that they otherise might not be able to sho" but this concept is of doubtful value or validity from from the point of vie of a financial analyst that must assess a company=s short-term li%uidity. li%uidity. d. 1/ *obacc *obacco o Indu Industr stry y. *he tobac tobacco co leaf leaf must must go throug through h an aging aging"" curing curing"" and drying drying proces process s e&tendi e&tending ng over over severa severall years. years. *hi *his s tobacc tobacco o inven inventor tory y green green leaves/" that may not be used in the production of a salable product for many years" years" is classi classifie fied d as curren currentt und under er the operat operating ing cycle cycle concep concept. t. *hi *his s ou ould ld occur even if long-term loans classified among noncurrent liabilities/ ere ta!en out to finance the carrying of this inventory. inventory.
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Chapter 04 - Analyzing Investing Activities
/ )i%uor Industry. *he li%uor industry has an operating cycle e&tending beyond the customary 1 months. In this case" the holding of li%uor inventory for aging purposes over many years provides sufficient $ustification for inclusion of such inventories among current assets. ?/ Retailing Industry. Industry. In retailing" the sale of >large tic!et> items on the installment plan can e&tend e&te nd the operating cycle to" for e&le" ?@ months or longer. longer. As As such" these installment receivables are reported among current assets. ?. a. *he *he to to mo most st impor importan tantt %u %ues esti tion ons s faci facing ng the fina financ ncia iall anal analys ystt ith ith respe respect ct to receivables are2 1/ Is the receivable genuine" due" and enforceable" and / Bas the probab probabili ility ty of collec collectio tion n been been proper properly ly assess assessed ed Whil While e the un% un%ual ualifi ified ed opinion of an independent auditor lends some assurance ith regard to these %uesti %uestion ons" s" the financ financial ial analys analystt mu must st recogn recognize ize the possib possibil ilit ity y of an error error of $udgment as ell as the lac! of complete independence. b. 6escripti 6escription on of the receivables receivables in the notes to financia financiall statements statements usually usually do not contain sufficient clues to allo a reliable $udgment as to hether a receivable is genuine" due" and enforceable. Conse%uently" !noledge of industry practices and supplementary sources of information information must be used for additional assurance" e.g.2 In some industries" such as compact discs" toys" or boo!s" a substantial right of merchandise return e&ists and alloance must be made for this. #ost #ost provi provisi sion ons s for uncol uncollec lectib tible le accoun accounts ts are based based on past past e&perie e&perience nce although they should also ma!e alloances for current and emerging industry conditions. In practice" the accountant is li!ely to attach more importance to the former than to the latter. *he analyst must" in such cases" use one=s on $udgment and !noledge of industry conditions to assess the ade%uacy of the provision provision for uncollectible uncollectible accounts. a ccounts. Information that ould be helpful in assessing the general level of collection ris!s ith receivables is not usually found in published financial statements. ,uch ,uch infor informat mation ion can" can" of course" course" be sough soughtt from from the compa company ny direct directly ly.. E&les of such information are2 1/ What is customer concentration What percent of total receivables is due from one or a fe ma$or customers Would failure of any one customer have a material impact on the company(s financial condition condition / What is the age pattern of the receivables ?/ What proportion proportion of notes receivab receivable le represent represent reneals of old old notes 4/ Bave alloanc alloances es been made for trade discounts" returns" or other credits to hich customers are entitled *he analyst" in assessing current financial position and a company(s ability to meet its obligations currentlyas e&pressed by such measures as the current ratiomust recognize the full impact of accounting conventions that relate to classification of receivables as >current.> 5or e&le" the operating cycle concept allos the inclusion inclusion of installment receivables" hich may not be fully collectible for years. In balancing these against current obligations" alloance for such differences in timing of cash flos should be made. •
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a. 5act 5acto oring ring or secu securi rittiza ization ion of rece receiv ivab able les s refe referrs to the the pra pract ctic ice e of of sel selling ing all or a portion of a company=s c ompany=s receivables receivables to a third party. party.
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Chapter 04 - Analyzing Investing Activities
b. When When recei receiva vabl bles es are are sold sold ith ith recour recourse se"" the the thir third d part party y pu purc rcha haser ser of the the recei receiva vabl bles es retai retains ns the the righ rightt to coll collec ectt from from the the comp compan any y that that sold sold the the receivable if the receivable proves uncollectible. When receivables are sold ithout recourse" the purchaser of the receivables assumes the collection ris!. c. When When receivabl receivables es are sold sold ith recour recourse" se" the balance balance sheet sheet reports reports the cash received received from the sale of the receivable. receivable. Boever Boever"" the balance balance sheet may or may may no nott repo report rt the the cont contin inge gent nt liab liabil ilit ity y to the the recei receiva vabl bles es pu purc rcha haser ser for for uncollect uncollectibl ible e receivables receivables purchased ith recoursethis recoursethis depends on ho assumes the ris! of onership. D. a. 5e 5e usef useful ul gener general aliz izat atio ions ns about about the effect effect of diffe differi ring ng metho methods ds of inve invent ntor ory y valuation on financial analysis can be made. 8et" 8et" e provide some guidance. In the case of )I5'" e !no that under conditions of fluctuating price levels" it ill have a smoothing effect on income. #oreover" the the )I5' method yields" in times of price inflation" an unrealistically lo inventory amount. *his" in turn" loers the current ratio and tends to increase the inventory turnover ratio. We also also !no !no that that the )I5' )I5' method method afford affords s manage managemen mentt an opp opport ortun unity ity to manipulate profits by alloing inventory to be depleted in poor years" thus draing on the lo cost pool to inflate income. A $udgment on all of these cons conse% e%ue uence nces s can on only ly be made made on the the basi basis s of an asse assess ssme ment nt of all all surrounding circumstances. 5or e&le" a slight change in a current ratio of 421 may be of no significance" hereas the same change in a ratio of 1.D21 may be of far greater importance. *he use of 5I5' for the valuation of inventories ill generally result in a higher inventory on the balance sheet and a loer cost of goods sold and higher income/ in comparison to )I5'. *he average cost method smoothes out cost fluctuations by using a eighted average cost in valuing inventories and in pricing cost of goods sold. *he resulting net income ill be close to an average of the net income under )I5' and 5I5'. *he >loer-of-cost-or-mar!et> principle of inventory accounting has additional implications for the analyst. In times of rising prices it tends to undervalue inventories regardless of the cost method used. *his" in turn" ill depress the current ratio belo its true level since the other current assets as ell as current liabilities/ are not valued on a consistent basis ith the methods used in valuing inventories. •
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b. In practice practice e can find ide ide variations variations in in the !inds !inds of costs that that are included included in inventory. inventory. 3ractice varies particularly ith respect to the inclusion inclusion or e&clusion of 1/ 1/ vari variou ous s clas classe ses s of over overhe head ad cost costs" s" / / frei freigh ght-i t-in" n" and and ?/ ?/ gene genera rall and and administrative costs. *his variety in practices can have a significant effect on comparability across companies. @. a. *he *he allo alloca cati tion on of ove overh rhead ead cost costs s to all uni units ts of prod produc ucti tion on must must be done done on a rational basis designed to get the best appro&imation a ppro&imation of actual cost. Boever" this is far from easy. *he greatest difficulty stems from the fact that a good part of overhead is fi&ed costs" i.e." costs that do not vary ith production but vary mostly mostly ith the lapse lapse of time. time. E&l E&les es are rent rent paymen payments ts and the the factor factory y manager(s salary. *hus" assuming only a single product is produced" fi&ed costs are 1FF"FFF" and 1F"FFF units are produced" then each unit ill absorb 1F of fi&ed costs. Boever" if D"FFF units are
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Chapter 04 - Analyzing Investing Activities
produced" each unit ill absorb absorb F of fi&ed costs. *his shos that level of act ivity is an important determinant of unit costide fluctuations in output can yield ide fluctuations in unit cost. b. *o allocate allocate fi&ed costs to units" an assumption assumption initially initially must must be made as to ho many units the company e&pects to produce. *his determines over ho many units the overhead costs is allocated. *hat calculation re%uires estimates of sales and related production. *o the e&tent that actual production differs from estimated produc productio tion" n" overh overhead ead costs costs il illl be either either overap overappl plied ied or und undera erappl pplied ied.. *hat *hat means that production and inventory are charged ith more than total overhead costs or ith an insufficient insufficient amount of overhead costs. G. *he ma$or ob$ectiv ob$ective e of the )I5' )I5' method of of inventory inventory accounti accounting ng is to charge charge cost of of goods sold ith the most recent costs incurred. When the price level is stable" the results under either the 5I5' or the )I5' method ill be the same. When price levels change" the use of these different methods can yield significantly different financial results. 'ne of the primary aims of )I5' is to obtain a better matching of costs and revenues in times of inflation. 0nder the )I5' method" the income statement is given priority over the balance sheet. *his means that hile a matching of more current costs costs ith ith revenu revenues es occurs occurs in times times of price price inflat inflatio ion n defla deflati tion on/" /" the inven inventor tory y carrying amounts in the balance sheet ill be unrealistically lo high/. +ote that use of the )I5' method is encouraged by its acceptance for ta& purposes. *he ta& la stipulates that its use for ta& purposes ma!es mandatory its adoption for financial reporting. <. In most annual reports" insufficien insufficientt information information is given to allo allo the analyst to convert convert inventories accounted for under one method to a figure reflecting a different method of inventory accounting. #ost analysts ant such information to better compare the financial statements of companies that use different inventory accounting methods. Conver Convertin ting g an inven inventor tory y figure figure from from one method method to anothe anotherr is made made even even more more difficult by the use of different methods for various components of inventory. ,till" analysts must" in most cases" ma!e an overall assessment of the impact of different inventory methods on the comparability of inventory figures. ,uch an assessment should be based on a thorough understanding of the inventory methods in use and the effect effect they they are li!ely li!ely to have have on invent inventory ory values. values. *he diffe differen rences ces that that arise arise beteen informed appro&imations and e&act figures using additional data generally are not materially different. different. *o be most most usefu useful" l" discl disclos osure ures s of inven inventor tory y method methods s must must give" give" in additi addition on to methods used" an identification of the inventory components in amounts/ here such methods are used. #ore important" disclosure of the dollar difference beteen the method in use and the method most prevalent in the industry ould be very useful. H. a. Cost Cost"" defi define ned d genera generall lly y as the the pric price e paid paid or consi conside dera rati tion on give given n to ac%u ac%uir ire e an asset" is the primary basis in accounting for inventories. inventories. As applied to inventories" cost generally means the sum of the applicable e&penditures and charges directly or indirectly incurred in bringing an article to its e&isting condition and location. *hese applicable e&penditures and charges include all ac%uisition and production cost costs sbu butt they they e&cl e&clud ude e sell sellin ing g e&pe e&pens nses es and and gene genera rall and and admi admini nist stra rati tive ve e&penses not clearly related to production.
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Chapter 04 - Analyzing Investing Activities
b. #ar!et" #ar!et" as applied applied to the valuation valuations s of inventori inventories" es" means the the current bid price price at the balance sheet date for the inventory in the volume for hich it is usually purchased in. *he term is applicable to inventories of purchased goods and to manufactured goods involving materials" labor" and overhead/. #ore generally" mar!et means current replacement costalthough" it must not e&ceed the net realizable value estimated selling price less predicted costs of completion and disposal/ and must not be less than net realizable value reduced by an alloance for a normal profit margin. c. *he *he usual sual basi basis s for for carr carryi ying ng for forar ard d inve inven ntory tory to the the ne&t ne&t peri period od is cost cost.. 6eparture from cost is re%uired" hoever" hen the utility of the goods included in inventory is less than their cost. *his loss in utility should be recognized as a loss of the the curr curren entt per period" iod" the the peri period od in h hic ich h it occu occurr rred ed.. 5u 5urt rthe herm rmor ore" e" the the subse%uent period should be charged for goods at an amount that measures their e&pected e&pected contri contribut butio ion n to that that period period.. In other other ords ords"" the subse% subse%uen uentt period period should be charged for inventory at prices no higher than those that ould have been paid if the inventory had been obtained at the beginning of that period. Bis Bisto tori rica call lly y" the the loer loer-o -off-co cost st-o -orr-ma mar! r!et et rule rule aros arose e from from the the accou account ntin ing g convention of providing for all losses and anticipating no profitsconservatism./ In accordance ith the foregoing reasoning the rule of >cost or mar!et" hichever is loe loer> r> may may be appl applie ied d to each each item item in the the inve invent ntor ory y" to the the tota totall of the the components of each ma$or category" or to the total of the inventory" hichever most clearly reflects the economic reality. *he )C# rule is usually applied to each item" but if individual inventory inventory items enter into the same category or categories of finished product" alternative procedures are suitable. d. Argum rgumen ents ts agai agains nstt use use of the the loe loerr-o of-co f-cost st-o -orr-ma mar! r!et et meth method od of valu valuin ing g inventories include2 1/ *he method re%uires the reporting of estimated losses all or a portion of the e&cess of actual cost over replacement cost/ as income charges even though the losses have not been sustained to date and may never be sustained. 0nder a consistent criterion of realization" a drop in selling price belo cost is no more a sustained loss than a rise above cost is a realized gain. / A price shrin!age is brought into the income statement before the loss has been been sust sustai aine ned d thro throug ugh h sale sale.. 5u 5urt rthe herm rmor ore" e" if the the char charge ge for for the the inve invent ntor ory y riterite-do don n is not made made to a specia speciall loss loss accoun account" t" the cost figure figure for goo goods ds actually sold is inflated by the amount of the estimated shrin!age in price of the unsold goods. *he title >Cost of 7oods 7 oods ,old> therefore becomes a misnomer. ?/ *he method is inconsistent inconsistent in application in a given year because it recognizes the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of price advances. 4/ *he method is inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost at one year-end and at mar!et at the ne&t year-end. D/ *he loer-ofloer-of-costcost-or-ma or-mar!et r!et method method values values inventor inventory y in the balance balance sheet conservatively. Its effect on the income statement" hoever" may be the opposite. Although Although the income statement for the year in hich the unsustained loss is ta!en is reported conservativel conservatively y" the net income income for the subse%uen subse%uentt period period may be distorted if the e&pected reductions in sales prices do not materialize.
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Chapter 04 - Analyzing Investing Activities
@/ In the application of the loer of cost or mar!et rule" a prospective >normal profit> profit> is used in determini determining ng inventory inventory values values in certain cases. ,ince normal normal profit profit is an estima estimated ted figure figure based up upon on past past e&perie e&periences nces and might might no nott be attained in the future/" it is not ob$ective in nature and presents an opportunity for manipulation of the results of operations. 1F. )I5' tends to yield loer loer reported earnings earnings hen prices rise as compared to 5I5 5I5'. '. *he folloing illustration highlights these effects2 3eriod 0nits in Inventory Cost per 0nit *otal Cost 3eriod 1 D D D 3eriod D 1F DF 3eriod ? D 1D GD 0nder )I5'" if 1F units are sold" then cost of goods sold is 1D" computed as D & 1D/ J D & 1F/. 1 F/. Also" Also" the )I5' inventory inventory value is D" computed as D & D. If units are sold for F" then gross profit profit is GD" computed as 1F & F/ - 1D. 0nder 5I5'" 5I5'" if 1F units are sold" then cost of goods sold is GD" computed as D & D/ J D & 1F/. 7ross profi profitt ou ould ld be 1D" 1D" compu computed ted as FF - GD. Inventor Inventory y ou ould ld be valued valued at GD" computed as D & 1Dinflating the balance sheet. *his shos that 5I5' tends to increase income and ta&es in inflationary inflationary periods. 11. 11. Increa Increases ses in ra materi materials als can" in certain certain instance instances" s" be a positi positive ve sign sign that that the company company is bui buildi lding ng inventorie inventories s to meet e&pected demand. Boever Boever"" increases increases in both ra materials and or!-in-process inventories" can reflect inefficient operations that have sloed production. production. Increases in finished finished goods can reflect the building building of arehoused inventory to meet large demand or it can represent the stoc! piling of finish finished ed goods goods that that are not in great great demand. demand. *he crucial crucial part of analy analysis sis is to interpret these changes in the conte&t of current and pro$ected industry conditions. 1. *he ob obser servat vation ion is correct correct in pointin pointing g out that an analy analyst st must must sub$ec sub$ectt the data data regarding regarding an entity(s entity(s depreciatio depreciation n policies policies to critical critical analysis analysis and scrutiny scrutiny.. *he company company can choose choose among among several several acceptable acceptable but vastly different different depreciatio depreciation n methods. *he reasons a particular choices/ is made by the company and the effect on repo report rted ed depr deprec ecia iati tion on e&pe e&pens nse e and and accum accumul ulat ated ed depr depreci eciat atio ion n shou should ld be assessed. 1?. In the absence of more precise data" an analyst is better off ad$usting depreciation charges on the basis of hisKher estimates and assumptions assumptions than not ad$usting them at all. Analyses Analyses such as those described described in the chapter can help to create a more useful estimate of periodic depreciation e&pense and accumulated depreciation.
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Chapter 04 - Analyzing Investing Activities
14. *here are a number of measures relating to plant plant assets that are useful in comparing depreciation policies over time as ell ell as for intercompany comparisons. *he average total life span of span of plant and e%uipment can be appro&imated as2 7ross 3lant and E%uipment Current 8ear 8ear 6epreciation E&pense. *he average age of age of plant and e%uipment can be computed as2 Accumulated 6epreciation Current 8ear 8ear 6epreciation E&pense. *he average remaining life of life of plant and e%uipment is computed as2 +et 6epreciated 3lant and E%uipment Current 8ear 8ear 6epreciation E&pense. Also" Also" draing on the above relations" e can compute2 Average *otal )ife ,pan L Average Age J Average Remaining )ife. *he above ratios are helpful helpful in assessing assessing a company(s company(s depreciation depreciation policies policies and assumptions over time. *he ratios can be computed on a historical cost basis as ell as on a current cost basis. 1D. 'ne of the more common solutions applied by analysts to the analysis of goodill is to simply ignore it. *hat is" they ignore the asset shon on the balance sheet. As for the income statement" under current accounting standards" goodill is no longer amort amortize ized" d" but is sub$ec sub$ected ted to an impair impairmen mentt test test annual annually ly and ritte ritten n do don n if re%uired. 'ften" hoever" the rite-don e&pense is treated ith s!epticism and is fre%ue fre%uent ntly ly ign ignore ored. d. 9y ign ignori oring ng goo goodi dill ll"" analy analysts sts ignor ignore e inves investme tment nts s of very very substantial resources in hat may often be a company(s most important and valuable asset. asset. Ignor Ignorin ing g the impact impact of goo goodi dill ll on report reported ed income income is no soluti solution on to the analysis of this comple& item. Even considering the limited information available" an analys analystt is better better off evalua evaluatin ting g the account accounting ing nu numbe mbers rs for goo goodi dill ll rather rather than than dismissing them altogether. 7oodill is measured by the e&cess of cost over the fair mar!et value of tangible net assets ac%uired in a transaction accounted for as a purchase. It is the e&cess of the purchase price over the fair value of all the tangible assets ac%uired" arrived at by carefully ascertaining the value of such assetsat least in theory. *he analyst must be alert to the ma!eup and the method of valuation of 7oodill as ell as to the method of its ultimate disposition. 'ne ay of disposing of the 7oodill account" fre%uently preferred by management" is to rite it off at a time hen it ould have the leas leastt impa impact ct on the the mar! mar!et( et(s s asse assess ssme ment nt of the the comp compan any( y(s s perf perfor orman mance ce.. for for e&le" in a period of losses or reduced earnings/. 1@. Costs are capitalized as assets hen these e&penditures are e&pected to bring the entity value beyond the current year. If the value associated ith the e&penditure ill be used up in the current period" the e&penditure is e&pensed. 1G. Bard assets assets are assets such such as the factory and machineryt machinerythey hey are tangible tangible and identifi identifiable able.. ,oft assets assets are assets such as softare" softare" research and developmen developmentt efforts" and intellectual capitalthey are more intangible in nature.
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Chapter 04 - Analyzing Investing Activities
1<. a. 7enerally 7enerally accepted accepted accountin accounting g principl principles es re%uire re%uire that natura naturall resources resources astin asting/ g/ assets assets be stated stated at histo histori rical cal cost cost plus plus costs costs of discov discovery ery"" e&plor e&plorati ation" on" and development. *his means the large cost outlays that occur folloing the discovery of natura naturall resou resources rces are no nott given given account accounting ing recogniti recognition on as part part of natura naturall resource assets. Rather" they generally are e&pensed as incurred. Conse%uently" relati relation ons s such such as income income to assets assets are disto distorte rted d by a failu failure re to capita capitaliz lize e all relevant costs and by the related implications implications to current and future earnings. b. When a company ac%uires ac%uires natural natural resources resources from another another entity entity" this this cost is more li!ely to reflect the entire fair value of these resources. In such a situation the relation relation beteen the cost of the assets and the revenues" revenues" e&penses" and income they generate is li!ely to be more economically sensible. sensible. 1H. In valuing property" property" plant and e%uipment" and in reporting it in conventional financial statements" accountants emphasize the ob$ectivity of historical cost. *hey also sho an emphasis on conservatism ith an accounting for the number of dollars originally invested in the assets. *he emphasis is not overly focused on the ob$ectives of those that analyze and depend on financial statements for business decisions. *hey are content to proclaim that >a balance sheet does not purport to reflect and could not usefully reflect the value of the enterprise.> 5rom the user=s perspective" historical costs costs po posse ssess ss severa severall limi limitat tation ions. s. *hey *hey are not releva relevant nt to %uesti %uestion ons s of curren currentt replacement costs or of future needs. *hey are not directly comparable to similar data in other other companies companies(( reports. reports. *hey do not enable enable users to measure measure oppo opportun rtunity ity costs of disposal" nor of the alternative uses of funds. *hey do not provide a valid yardstic! against hich to measure return. Also" in times of changing price levels" they they rep represe resent nt an odd cong conglo lome merrati ation of a varie ariety ty of pu purc rcha hasi sing ng poe er r disbursements. F. a. *he basic approach approach in accountin accounting g for identifi identifiable able intangi intangibles bles other other than goodi goodill/ ll/ is to record record at histor historica icall cost cost and subse% subse%uen uently tly amortiz amortize e that that cost cost to benefi benefitt periods. If assets other than cash are given in e&change for the intangible" the intangible must be recorded at the fair mar!et value of the consideration given. +otic +otice e that that if a compan company y spends spends material material and labor labor in the constr construct uction ion of a >tangible> asset" such as a machine" these costs are capitalized and recorded as an asset that is depreciated over its estimated useful life. 'n the other hand" if a company spends a great amount of resources advertising a product or training a sales force to sell and service service ithich ithich is one process for creating goodilli goodillitt usually cannot capitalize such costs. *his is even hen such costs may be as" or more" more" benefi beneficia ciall to the compan company( y(s s future future operat operation ions s than than are any >tang >tangibl ible> e> assets. *he reason for this inconsistency in accounting for these to classes of assets e&tends to several basic accounting conventions such as conservatism. *hese conventions" draing on the level of certainty in future returns" casts more doubt on the future realizations of benefits from intangibles such as advertising or training/ than realizations from tangible" >hard> assets. b. 7oodill 7oodill is an importan importantt intangible intangible asset. asset. ,till" ,till" it represents represents the only only case here the valuation of the asset is restricted to its cost of ac%uisition from a third party. #oreover" #oreover" any costs of defending a patent" copyright" or trademar! or similar/ are properly included as part of the cost of intangible assets. *his e&tends to other intangibles such as leases" leasehold improvements" special processes" licenses" and franchises. franchises. In mar!ed contrast" contrast" internally internally develope developed d goodill goodill cannot cannot be capitalized and carried as an asset.
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Chapter 04 - Analyzing Investing Activities
c. Identifiab Identifiable le intangible intangibles s other other than than go good odil ill/ l/ can be separa separatel tely y identi identifi fied ed and given reasonably descriptive names such as patents" trademar!s" and franchises. Identifiable Identifiable intangibles can be developed internally" internally" ac%uired singly or as part of a group of assets. *hey should be recorded at cost and amortized over their useful lives. Write-don Write-don or complete rite-off at date of ac%uisition is not permitted. Unidentifiable intangibles can intangibles can be developed internally or purchased from others. *hey cannot be ac%uired singlythey are inherently part of a group of assets or part of an entire entity. entity. *he e&cess of cost of an ac%uired ac%uired company or segment/ over the sum total of identifiable net assets is the most common unidentifiable intangible assetthat of Mgoodill.N It is the residual amount in an ac%uisition after the amount of tangible and identifiable intangibles are determined. 7oodill is no longer amortized" but is tested annually for impairment and ritten don if re%uired. d. Identifi Identifiabl able e intangibles intangibles are believed to have limited limited useful useful lives. lives. Accordin Accordingly gly"" they are amortized. 6epending on the type of intangible asset" its useful life may be limi limite ted d by such such fact factor ors s as lega legal" l" cont contra ract ctua ual" l" regu regula lati tion ons" s" dema demand nd and and compet competiti ition on"" life life e&pecta e&pectanci ncies es of emplo employee yees" s" and other other economi economic c and socia sociall factors. *he cost of each intangible should be amortized over its useful life ta!ing into account all factors that determine its life. 7oodill is not amortized" but is tested annually for impairment and ritten don if re%uired. 1. 7ood 7oodill ill is often often a sizable sizable asset. It can be recorded recorded only upon the purchase of an ongoing business enterprise or segment. *he accounting conventions governing the recording recording of good goodill ill mean that only purchased purchased good goodil illl is reported reported among the recorde recorded d assets assets and that that more more goo goodi dill ll li!ely li!ely e&ist e&ist off the balanc balance e sheet. sheet. *h *he e description of hat is being paid for in such a transaction varies and this adds to the uncert uncertain ainty ty surrou surround nding ing this this asset. asset. ,ome ,ome refer refer to an abili ability ty to attract attract and !eep satisfied customers" hile others point to %ualities inherent in an enterprise that is ell organized and efficient in production" service" and sales. ,till others point out that if there is value in goodill it must be reflected in earnings. *hat is" if there is value to goodill" then it should give rise to superior earnings ithin a reasonably short time after ac%uisition. If those earnings are not evidenced" then it is fair to assume that the investment in goodill is of no value regardless of hether it is reported on the balance sheet. Regardless of the amount incurred in the ac%uisition or internal development of an intangible" the carrying amount of any asset is not to be carried at an amount in e&cess of realizabl realizable e value value sales sales price or future future utility utility/. /. Actual implementa implementation tion is another matter" and the analyst must be prepared to form $udgments on the amounts reported for intangible assets. . *here are a number number of categories categories of deferred charges. charges. In each case" the rationale rationale for deferral is that these outlays hold future utility benefits/ for the company. 1/ 9usiness development" e&pansion" merger" and relocation costs. a. 3re-operatin 3re-operating g e&penses" e&penses" initial initial start-u start-up p costs" and and tooling tooling costs. costs. b. Initial Initial operati operating ng losses losses or preoperating preoperating e&penses e&penses of subsidiari subsidiaries. es. c. #oving" #oving" plant plant rearrangemen rearrangement" t" and reinsta reinstallat llation ion costs. costs. d. #erger #erger or ac%u ac%uisi isiti tion on e&pen e&penses ses.. e. 3urchas 3urchased ed custom customer er account accounts. s.
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Chapter 04 - Analyzing Investing Activities
f. +on+on-co comp mpet ete e agre agreem emen ents ts..
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Chapter 04 - Analyzing Investing Activities
/ 6eferred e&penses. a. Advert Advertisin ising g and promoti promotional onal e&penses. e&penses. b. Impu Imputed ted inte intere rest st.. c. ,elling" general and administrative administrative e&penses. d. 3ension plan costs. e. 3roperty and other ta&es. f. Rental and leasing costs. g. Vacation pay. h. ,easonal groing and pac!ing e&penses. ?/ Intangible costs. a. Intangib Intangible le dril drillin ling g and and develop development ment costs costs.. b. Contracts" Contracts" film films" s" copyrig copyright ht material materials" s" art right rights s c. Costs Costs of compu computer ter soft softare are 4/ 6ebt discount and e&penses. D/ 5uture income ta& benefits. @/ 'rganization costs. G/ Advance royalties. ?. a. 'ne categor category y of assets assets not recorde recorded d on the balance balance sheet is inter internal nally ly created created goodi goo dill. ll. In this this case" case" if the intan intangi gibl ble e is inter internal nally ly develo developed ped"" rather rather than than purchased from an outside party" it cannot be capitalized and all costs must be e&pensed as incurred. *his means" to the e&tent an asset is created that can be sold or possesses earning poer/" prior income that is charged ith the e&pense of its its deve develo lopm pmen entt is un unde ders rsta tate ted d and and futu future re inco income me ill ill be over overst stat ated ed/. /. +ume +umero rous us intan intangi gibl ble e asse assets ts fit fit this this categ categor ory y. Ano noth ther er categ categor ory y is that that of cont contin inge gent nt asse assets ts.. 0nde 0nderr the the prin princi cipl ple e of cons conserv ervat atis ism" m" the the cont contin inge gent nt rightsKclaims rightsKclaims to resources are not recognized due to their uncertainty. uncertainty. b. *he analyst analyst must realize realize that reported reported boo! boo! values are not substit substitutes utes for for mar!et values. As illustrated illustrated by the accounting-based e%uity valuation model" unrecorded assets assets mu must st eventu eventuall ally y be realiz realized ed in the form form of residu residual al income income abnor abnormal mal earnings/. If there is no above-normal income" then there is little value in any unrecorded assets.
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Chapter 04 - Analyzing Investing Activities
EOERCI,E, E&ercise 4-1 1 minutes/ a. An alloa alloance nce metho method d based on credit credit sales sales attempts attempts to match bad bad debts ith the revenues generated by the sales in the same period. *hus" it focuses on the income statement statement rather rather than the the balance sheet. sheet. 'n the other other hand" an alloance method based on the balance in the trade receivables accounts attempts to value the accounts receivable receivable at the end of a period at their future collectible amounts. *hus" it focuses on the balance sheet rather than the income statement. +ote that both of these alloance methods are acceptable under 7AA3./ b. Carme Carme Company Company ill ill report report on its balance balance sheet sheet at 6ecember 6ecember ?1" 8ea 8earr 1" the balance in the alloance for bad debts account as a valuation or contra asset accountthat is" as a subtraction from the accounts receivable asset. 9ad debt e&pense can be reported in the income statement as a selling e&pense" or as a general and administrative e&pense" or as a subtraction to arrive at net sales. c. When When e&am e&amin inin ing g the the reas reason onab able lene ness ss of the the allo alloa anc nce e for for bad bad debt debts" s" the the analyst is interested in assessing the collectibility of accounts receivable. *he analyst analyst is especiall especially y interes interested ted in changi changing ng busines business s conditi conditions ons and their their impact on this alloance balance that is" is it sufficient/. In addition" the analyst analyst must assess any changes in collectibility collectibility assumptions assumptions as they have a direct impact on net income through the determination of bad debt e&pense. 5inally 5inally"" there there is some evidence evidence that that manage managers rs use the alloanc alloance e account account among others/ to help manage earnings levels.
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Chapter 04 - Analyzing Investing Activities
E&ercise 4- 1D minutes/ a. Inv Inventor entory y costs costs incl includ ude e all reaso reasona nable ble and and neces necessa sary ry costs costs of prep prepari aring ng inventory for sale. *hese costs include not only the purchase price of the inventories" but also other necessary costs of readying inventories for sale. b. *he loer loer of cost or mar!et mar!et rule produc produces es a more realisti realistic c estimate estimate of future future cash flos to be realized from the sale of inventories hen mar!et is less than cost cost.. *h *his is rule rule is cons consis iste tent nt ith ith the the prin princi cipl ple e of cons conser erva vati tism sm"" and and recogni recognizes zes matche matches/ s/ the anticip anticipated ated loss in the income statemen statementt for the period in hich the price decline occurs. c. P(s P(s inv invento entori ries es shou should ld be repo report rted ed on the the bala balanc nce e shee sheett at mar! mar!et et.. ,pecifically" according to the loer of cost or mar!et rule" mar!et is defined as replacement cost. Boever" mar!et cannot e&ceed net realizable value and cannot be less than net realizable value less a normal profit margin. 5or P" replacement cost is beteen net realizable value and net realizable value less a normal profit margin. *herefore" mar!et is established as replacement cost. ,ince ,ince mar! mar!et et is less less than than origi origina nall cost" cost" inve invento ntory ry shou should ld be repor reported ted at mar!et. d. Ending Ending invento inventories ries and net income income ould ould have been the same same under either either loer of average/ cost or mar!et or the loer of 5I5'/ cost or mar!et. In perio periods ds of declin declinin ing g price prices" s" the loer loer of cost cost or mar!e mar!ett rule rule resu results lts in a rite-don of inventory to mar!et under both methods" resulting in similar inventory costs. *herefore" net income using either inventory method is very similar.
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Chapter 04 - Analyzing Investing Activities
E&ercise 4-? 1D minutes/ a. i/ *he avera average ge cost method method is based based on the the assump assumptio tion n that that the the avera average ge costs costs of the the go good ods s in the the begin beginni ning ng inve invento ntory ry and and the the go goods ods pu purch rchase ased d during the period should be used for both the inventory and the cost of goods sold computat computation. ion. ii/ *he 5I5' 5I5' first-in" first-in" first-out/ first-out/ method method is based on the assum assumpti ption on that that the the first first go goods ods pu purc rcha hased sed are are the the first first sold. sold. As a resu result" lt" inventory is reported at the most recent purchase prices" hile cost of goods sold is at older purchas purchase e prices. prices. iii/ *he )I5' last-in" last-in" first-out first-out// method is based on the assumption that the latest goods purchased are the first sold. As a result" the inventory is at the oldest less recent/ purchase prices" hile cost of goods sold is at more recent purchase prices. b. In an inflationa inflationary ry economy economy"" )I5' provides provides a better better matching matching of curren currentt costs ith current revenue on the income statement because cost of goods sold is at more recent purchase prices. Also" net cash inflo is generally increased because ta&able income is generally generally decreased" resulting in payment of loer income ta&es. c. Where Where there there is evidence evidence that the value value of invento inventory ry to be disposed disposed of in the ordinary course of business ill be less than cost" the difference should be recognized recognized as a loss in the current period. *his is done by restating inventory inventory to its mar!et value in the financial statements. *he concept of conservatism" yield yieldin ing g inve invento ntory ry report reported ed at the the loer loer of cost cost or mar!e mar!et" t" is the the prima primary ry $ustification $ustification of this approach. approach. AIC3A Adapte Adapted/ d/
E&ercise 4-4 1 minutes/ a. *he inventory inventory asset is more more meaningful meaningful for for analysis analysis purposes purposes hen calculated calculated using the 5I5' cost flo assumption. *his is because the costs assigned to units remaining in ending inventory are the more recent costs. b. Cost of goods sold is usually usually more meaning meaningful ful for analysi analysis s purposes purposes hen calculated using the )I5' cost flo assumption. *his is because the costs assigned to units sold are the costs from the more recently purchased units. c. When When a company company uses uses )I5'" the costs costs assigned assigned to uni units ts in ending ending inventory inventory are the costs from older less recent/ units. As a result" analysts ould prefer to calculate hat ending inventory ould have been had 5I5' been used. *his can be accomplished by adding the )I5' reserve value to the )I5' ending inventory value.
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Chapter 04 - Analyzing Investing Activities
E&ercise 4-D D minutes/ a. Computation Computation of 8ear 8ear 1F Cost of 7oods 7oods ,old ,old and 7ross 7ross 3rofit/2 3rofit/2 LI LIFO FIFO 9eginning <1 <
[email protected] a/ HF HF4.F b/ inventory... Cost of goods 4"@.F 4"@ .F c/ 4"@ .F c/ purchased... 7oods available for sale.. D"FG<.F D"1@@.F )ess ending inventory.. <1H <1H. . ?4/ ?4/ HF4 HF4.4/ .4/1D 1D/ / Cost of sold...
goods 4"D<. 14/
Revenues @"FD.< 1 1?/ Cost of goods sold above/ .. 4"D<./ 7ross profit2 As reported .. ... . 1"H4G.@ 0nder 5I5'
4"@1.@ @"FD.< 1 1?/ 4"@1.@/ 1"H44.
a/ 7ivenfrom 8ear H balance sheet. b/ <
[email protected] J <<.F givenfrom 8ear H balance sheet/. c/ Cost of goods purchased is the same under either methodderived.
b. *he primary analysis analysis ob$ective ob$ective in ma!ing ma!ing the )I5'-to-5I5' )I5'-to-5I5' restatement restatement of of cost of good goods s purcha purchases ses and gross profit profit is to achiev achieve e comparab comparability ility beteen beteen firms using different inventory methods. c. 5I5' 5I5' Invent Inventory ory L )I5 )I5' ' Invento Inventory ry 8ear 8ear 1F see see Campbell note note 14/2 HF4.4 L <1H.< 8ear 8ear 11 11 see see Campbell note note 14/2 GH@.? L
[email protected]
J )I5' Reserv Reserve e J
<4.@
J
d. When When a company company uses the the )I5' cost flo flo assumptio assumption" n" it can be valuable valuable to convert the reported inventory asset to a 5I5' basis for analysis purposes. *his is because the inventory value reported under 5I5' is more reflective of the curren currentt cost of invento inventory ry since since reported reported costs costs reflect reflect the more recent recent costs of units purchased. E&ercise 4-@ 1F minutes/ In a period of rising inventory costs" the most recently purchased units are more e&pensive. As a result" the cost of goods sold is higher under )I5' and loer under 5I5'. *hus" if output prices are stable" then net income is higher under 5I5' than under )I5'. Also" the ending inventory asset value" and therefore total assets" assets" is hig higher her under under 5I5' and loer under under )I5'. )I5'. In contras contrast" t" in a period of declining inventory costs and stable output prices" all of the ansers here ill reverse.
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Chapter 04 - Analyzing Investing Activities
E&ercise 4-G F minutes/ E&les of potentially unrecorded assets on balance sheets include2 E&cess of replacement values over costs for plant assets. )I5' inventory reserve. E&ces E&cess s of mar!e mar!ett valu value e over over ad$u ad$uste sted d cost cost of e%uit e%uity y in no nonc ncon onso solid lidate ated d subsidiaries and in affiliates. Inta Intang ngib ible less--r -rec ecog ogni nize zed d firm firm name name"" prod produc uctt name name"" or bran brand d name name no nott capitalized. ,ucc ,ucces essf sful ul RQ6 RQ6 such such as a ne ne drug drug that that has has pass passed ed all all bu butt fina finall 56A 56A clearance. 3roved 3roved reserv reserves es of e&tracti e&tractive-ty ve-type pe compani companies es carried carried at substan substantial tially ly less than mar!et value of the product less e&traction costs. Buman intellectual/ capital. Value of savings on short-term credit lines here ma&imum interest payable is currently belo ban! prime rate. • • •
•
•
•
• •
*he anal *he analys ystt mu must st reme remembe mberr that that bo boo! o! valu values es are are on only ly the starti starting ng po point int for accounting-based accounting-based valuation. valuation. If unrecorded unrecorded assets have economic value" they ill eventu eventually ally be recogni recognized zed throug through h hig higher her future future abnorma abnormall earning earnings s residu residual al income/. *his means the analyst must consider the impact of unrecorded assets hen pro$ecting future profitability for valuation purposes. C5A Adapte Adapted/ d/
E&ercise 4-< D minutes/ a. A cost cost should should be capitalized capitalized that that is" treated as an asset/ asset/ hen it is e&pected e&pected that the asset ill produce benefits in future periods. *he important concept here is that the incurrence of such a cost results in the ac%uisition of an asset future service potential/. +ot only should the incurrence of the cost result in the ac%uisition of an asset possessing e&pected future benefits" but also the cost should be measurable ith a reasonable degree of ob$ectivity. E&les of cost costs s that that are are typi typica call lly y capi capita tali lize zed d as asse assets ts incl includ ude e the the cost costs s of merch merchan andi dise se avai availab lable le at the the end end of an acco accoun untin ting g perio period" d" the the costs costs of insurance coverage relating to future periods" and the costs of self-constructed plant or e%uipment. In contrast" if a cost is incurred that results in benefits not e&pected to persist beyond beyond the current current period" then the cost is e&pensed. *his e&pense treatment reflects the cost of service potential that e&pired in producing current period revenues. b. In the the absence absence of a direct direct basis for associating associating asset asset cost ith revenue" revenue" and and if the asset asset provi provides des bene benefit fits s for to or mo more re accou accounti nting ng perio periods" ds" its cost cost should be allocated to these periods as an e&pense/ in a systematic and rational manner. E&les of systematic and rational allocation of asset cost ould include depreciation of fi&ed assets" amortization of intangibles" and allocation of rent and insurance costs. When it is impractical" or impossible" to find a reasonable cause-and-effect relation beteen revenue and cost" this relation is often assumed to e&ist. In this case" the asset cost is allocated to some assumed benefit period in a systematic manner. *he allocation method 4-19
Chapter 04 - Analyzing Investing Activities
used should be reasonable and should be applied consistently from period to period.
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Chapter 04 - Analyzing Investing Activities
E&ercise 4-H F minutes/ a. 1. Average erage tota totall life life span span of of plan plantt and and e%ui e%uipm pmen ent2 t2 7ross plant and e%uipment Current year depreciation e&pense
2006
DD D D4H ?H
a
L 1@.
b
a
,ee note 1@. +ote that land must not be included. Amortization should be subtracted" but it is not bro!en out in the Colgate cash flo statement. b
. Average verage age age of plant plant and and e%uipm e%uipment2 ent2 Accumulated Accumulated depreciation Current year depreciation e&pense
2006
HHH ?H
L H.1 years
a
a
Amort Amortiza izatio tion n shoul should d be subtr subtract acted" ed" but it is not bro!en bro!en out in the 6ell incom income e statement.
?. Average verage remai remainin ning g life of plant plant e%uipme e%uipment2 nt2 +et plant plan t and e%uipme e%ui pment nt Current year depreciation e&pense
2005
DDF
?H
L G.G@ years
b
a
)and should be subtracted" see note 1@. Amortization should be subtracted" but it is not bro!en out in the Colgate cash flo statement. b
b. 7ene 7enera rally lly"" these these ratios ratios can can be used used to assess assess a compa company ny(s (s depre deprecia ciatio tion n policies both over time temporal/ and for comparative purposes ith other comp compan anie ies s in the the same same indu indust stry ry.. An anal analys ystt mu must st ta!e ta!e care care h hen enev ever er compa comparis rison ons s are are made made bete beteen en compa compani nies. es. *h *here ere often often are are econ economi omic c reasons for different depreciation methods and assumptions" hich can be obscu obscured red in a simpl simple e rest restate atemen mentt of resu results lts.. 5o 5orr e& e&le" le" Colga Colgate te uses uses straight-line depreciation for plant and e%uipment another company may use an accelera accelerated ted method method such such as dou double-decl ble-declinin ining-bal g-balanc ance. e. *he selectio selection n of differ differen entt metho methods ds may may refle reflect ct fund fundame ament ntal al differ differen ence ces s in mana manage gemen mentt philosophy and action toard capital financing and maintenance. Also" ith capital intensive companies" profit margins may not reflect the higher costs that may be e&pended to replace e&isting plant assets.
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Chapter 04 - Analyzing Investing Activities
E&ercise 4-1F F minutes/ a. 1. Average erage tota totall life life span span of of plan plantt and and e%ui e%uipm pmen ent2 t2 7ross plant and e%uipment Current year depreciation e&pense 11
"D "D?< ?<.F .F 1H4.D
10
a
"4 "4F4 F4.1 .1
L 1?.FD years
b
1<4.1
a
L 1?.F@ years
b
a
9uildings S1DHT GD<.G in 8ear 11"
[email protected] in 8ear 1F/ plus machinery and e%uipment S1@FT 1GGH.? in 8ear 8ear 11 and 1@DG.@ in 8ear 8ear 1F/. b 5rom 5orm 1F-P" item S1
. Average verage age age of plant plant and and e%uipm e%uipment2 ent2 Accumulated depreciation Current year depreciation e&pense 11
1"1 1"1?1 ?1.D .D
10
c
1"F 1"F1G 1G. .
L D.< years
1H4.D c
c
L D.D? years
1<4.1
5rom Campbell note 1@ S1@T.
?. Average verage remai remainin ning g life of plant plant e%uipme e%uipment2 nt2 +et plant and e%uipment Current year depreciation e&pense 11
"D?<.F "D? <.F U 1"1?1.D 1"1 ?1.D
10 "4F4.1 "4F 4.1 U 1"F1G. 1"F 1G. d
d
L G.? yrs
1H4.D d
L G.D? yrs
1<4.1
7ross plant and e%uipment minus accumulated depreciation.
b. 7ene 7enera rally lly"" these these ratios ratios can can be used used to assess assess a compa company ny(s (s depre deprecia ciatio tion n policies both over time temporal/ and for comparative purposes ith other comp compan anie ies s in the the same same indu indust stry ry.. An anal analys ystt mu must st ta!e ta!e care care h hen enev ever er compa comparis rison ons s are are made made bete beteen en compa compani nies. es. *h *here ere often often are are econ economi omic c reasons for different depreciation methods and assumptions" hich can be obscured in a simple restatement of results. 5or e&le" Campbell uses straight-line depreciation for plant and e%uipment another company may use an accelera accelerated ted method method such such as dou double-decl ble-declinin ining-bal g-balanc ance. e. *he selectio selection n of differ differen entt metho methods ds may may refle reflect ct fund fundame ament ntal al differ differen ence ces s in mana manage gemen mentt philosophy and action toard capital financing and maintenance. Also" ith capital intensive companies" profit margins may not reflect the higher costs that may be e&pended to replace e&isting plant assets. ,peci ,pecific ficall ally y" all all thre three e of these these meas measur ures es for Campb Campbell ell reve reveal al no mar!e mar!ed d chan change ges s from from 8ear ear 1F to 8ear 11. ,till" ,till" a mo more re compl complete ete analy analysis sis of this this con$ect con$ecture ure ould ould involv involve e compari comparison sons s of Campbel Campbell=s l=s measure measures s ith those those from competitors.
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Chapter 04 - Analyzing Investing Activities
E&ercise 4-11 1F minutes/ 9alance sheet assets are2 c " d in in some cases/" e" g " h" i " j " m" p" q
E&ercise 4-1 1F minutes/ Ending inventory under 5I5' ould be GH@.? million S1D1J1DT. 7ross profit ould be higher by the amount of the increase in the )I5' reserve" or
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Chapter 04 - Analyzing Investing Activities
3R'9)E#, 3roblem 4-1 ?F minutes/ a. 0nde 0nderr the 5I5' 5I5' metho method d of acco accoun untin ting g for inven inventor tories ies"" cost cost of goo goods ds sold sold reflects the cost of inventories purchased earlier less recent costs/. 6uring periods of rising costs" operating margins are higher under 5I5' because sales at current prices are matched ith older" loer cost inventory. 6uring periods of declining declining costs" operating margins are compressed because older" higher cost inventories are matched ith current" loer priced sales. #ore specifically" in the case of A9EO Corp. e estimate the folloing impacts2 1/ 6uring the period 8ear D through 8ear G" according to E&hibit I" cost per pound produced produced declined from ?4 cents to ?1 cents to H cents. *he use of 5I5' compresses A9EO(s margins because higher cost" older inventory is being e&pensed. / 6uring 6uring the period 8ear 8ear G through 8ear 8ear H" according to E&hibit I" unit costs ere rising. +amely" unit costs rose from H cents in 8ear G to ?D cents and ?H cents in 8ear < and 8ear H" respectively. *he use of 5I5' ould increase A9EO(s operating margins during this period as older" loer cost inventory is being e&pensed first. b. Accord According ing to E&hibit E&hibit I" prices and costs costs are e&pected e&pected to decline decline in 8ea 8earr 1F. In contrast" for 8ear 11" prices and presumably costs/ are e&pected to increase. Conse%uently" adopting )I5' at in 8ear 11" prior to the pro$ected rise in prices ould produce ta& savings" increased cash flos" and a better matching of costs and revenues on the income statement. *his supports a recommendation to adopt )I5' in 8ear 11. 3roblem 4- 1D minutes/ a. 8ear H retained earnings ad$ustment for )I5' to 5I5' change2 )I5' Reserve Reserve & 1- *a& *a& rate/ L DF"FFF/ & 1 - .?D/ L ?"DFF increase b. 8ear H net income ad$ustment for )I5' to 5I5' change for both 8ears < and H2 Chan Change ge in in )I5 )I5' ' Rese Reserv rve e & 11- *a *a& rate/ rate/ L S 4@"FFF/ - DF"FFF/ T & 1 - .?D/ L "@FF increase c. *he primary primary analy analysis sis ob$ectiv ob$ective e hen ma!ing ma!ing a )I5' to 5I5' restate restatemen mentt is to 1/ achi achiev eve e better better comp compara arabil bility ity bete beteen en firms firms usin using g differ differen entt inve invent ntory ory methods" and / obtain better measures" using more recent costs" of the value of inventory on the balance sheet.
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Chapter 04 - Analyzing Investing Activities
3roblem 4-? ?F minutes/ a. Ending Ending Inve Invento ntory ry Ad$us Ad$usted ted from )I5' )I5' to 5I5'2 5I5'2 At :an. :an. H" H" 1HH 1HHH2 H2 L )I5' )I5' Inv Inven ento tory ry J )I5' )I5' Res Reser erv ve L 1H"@<@ J @"HFF L 4@"D<@ At :an. :an. ?F" ?F" 1HH 1HH<2 <2 L )I5' )I5' Inv Inven ento tory ry J )I5' )I5' Res Reser erv ve L 41"1D4 J D"1FF L @@"D4 b. +et Incom Income e as Ad$us Ad$usted ted from from )I5' to 5I5' 5I5'22 8ear 8ear ended ended :an. H" 1HHH2 L )I5' Income Income J After-*a After-*a& & Change in in )I5' Reserv Reserve e L ?1"1
3roblem 4-4 D minutes/ a. Reconstruction Reconstruction of of *ransactio *ransactions ns using *-A *-Account ccount Analysis2 Analysis2 ropert!" lant # $q%ipment &gross' S1@1AT 9eg. "G?4.H S1<@ S1<@TT Add ddit itio ions ns ?G1. ?G1.1 1 1D@.
[email protected] G Reti Retire reme ment ntsK sKsa sale les s S1<@ S1<@TT S1<@ S1<@TT Ac%ui c%uire red d asse assets ts 4.G 4.G ?.1 ?.1 Rate Rate varia arianc nce e S1<@ S1<@TT S1@1AT End. "H1.H
S1
(cc%m%lated )epreciation 1"F1G. 1H4.D @H.D 1F.G 1"1?1.D
9eg S1@T 6epreciation S1<@T End S1@T
b. *he reconstru reconstructio ction n of transac transactio tions ns throug through h *-acco *-accoun untt analysi analysis s enables enables the financial statement reader to e&amine the economic substance behind the accounting disclosures and to better interpret the changes in !ey accounts.
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Chapter 04 - Analyzing Investing Activities
3roblem 4-D DD minutes/ ,oftare 6evelopment Costs2 Current 0namortized 9al. U 3rior 0namortized 9al. J Current Amortization E&pense FFF FFF22 1< 1< L ?1 ?1 - F F J G FF12 D L G - ?1 J H FF2 G L - G J 1 FF? FF?22 L ?1 ?1 - J 1? 1? FF4 FF422 @ @ L 4 4 - ?1 ?1 J 1D 1D FFD FFD22 1@ 1@ L 4? 4? - 4 4 J 1D 1D FF@2 G L ?@ - 4? J 14
b. ,oftare developm development ent costs typically typically arguably/ arguably/ lead lead to more direct direct products. products. *he succ success ess or failu failure re of soft softar are e deve develo lopme pment nt effor efforts ts is deter determi mine ned d by heth hether er func functio tioni ning ng soft softar are e is ulti ultimat mately ely produ produce ced d that that can can be sold sold to customers. customers. When salable salable softare is reasonably reasonably e&pected e&pected to be developed" developed" the cost of the softare development can be capitalized and amortized to the presumed benefit periods. *he product that results from other RQ6 efforts is often less identifiable. Indeed" many RQ6 efforts fail. #oreover" many RQ6 efforts efforts are only ind indirec irectly tly related to future future products products.. *his has resulte resulted d in 7AA3 re%uirements that e&pense RQ6 costs in the periods hen incurred. *hat is" RQ6 costs are not capitalized and allocated against future revenues generated by any products developed from those efforts. c. A revie revie of the data suggests suggests a one-year one-year lag beteen beteen RQ6 e&pendi e&penditure tures s and additi additiona onall inco income. me. ,peci ,pecific ficall ally y" inco income me appea appears rs to incr increas ease e in the the year year folloing substantial substantial RQ6 efforts and to decline in the year folloing reduced RQ6 RQ6 effor efforts. ts. Also" lso" this this analy analysi sis s shou should ld use use inco income me before RQ6 e&penses hen assessing the impact of RQ6 on income. &*000s'
RQ6 Income 3reRQ6
1HHH 4FF
FFF 4H1
FF1 1@
FF 1
FF? ?DD
FF4 41H
FFD 4F1
FF@ 4DD
G1
@F4
41<
41F
DFF
D@<
@?4
d. All else e%ual" e%ual" if *rima& *rima& invests invests more in softare softare development development in a given year" year" net income ill be higher because the company can capitalize many softare development costs. In contrast" e&penditures for other RQ6 pro$ects must be e&pensed in the year hen incurred. 'f course" this response ignores the economic implications for hich e re%uire additional information to $udge the relative successes of these e&penditures.
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Chapter 04 - Analyzing Investing Activities
3roblem 4-Dcontinued e. Ratio Implications of Alternative Accounting Accounting *reatments for RQ6 RQ6 and ,oftare2 S+ote, Ansers disregard income ta& conse%uences.T &-ear 2006' E%uity 1/
+et income
Return on Assets
Return
1<@"FFF a
.F4Fb
.FDGc
/
.FDFe
.F@@f
on
a2 +et income JAdd bac! amortized costs UActual softare development e&penditures L 1GH J 14 U G. b2 Revised income col. 1/K *otal assets UCapitalized softare development costs/ L 1<@ K 4"@DF U ?@/. c2 Revised income col. 1/K *otal e%uity UCapitalized softare development costs/ L 1<@ K ?"?1 U ?@/. d2 +et income income J Add Add bac! bac! e&pensed e&pensed RQ6 - Amortizatio Amortization n L 1GH J 4DD U 1K4/ 1K4/ U ?DDK4/ ?DDK4/ U 41HK4/ 41HK4/ U 4F1K4/ L 1GH J 4DD -
[email protected] L
f. Cash flo from from operations operations are are unaffected unaffected by by the capitalizing capitalizing versus versus e&pensing e&pensing issu issue. e. Boe Boev ver" er" cash cash flo flo from from op oper erat atio ions ns is affe affect cted ed by the the deci decisi sion on regarding the %uantity of softare development and other RQ6 efforts that ill be carried out in a given year. 3roblem 4-@ 4D minutes/ ,*RAI7B*-)I+E & * 0 0 0 s'
-$(. 1
-$(. 2
-$(. /
-$(.
-$(. 5
Earnings before ta&es Q depreciation2. . . 1 " D F F .F a/ 6e 6epreciation.......... FF.F/ +et 9efore *a&es... 1 " ? F F .F b/ Income *a&es........ @DF.F/ c/ +et Income............ @D @ D F .F
"F F F .F FF.F/ 1 "< F F .F HFF.F/ HF H F F .F
" D F F .F FF.F/ " ? F F .F 1"1DF.F/ 1 " 1 D F .F
? " F F F .F FF.F/ "< F F .F 1"4FF.F/ 1 "4 F F . F
? "D F F .F FF.F/ ? "? F F .F 1"@DF .F/ 1 "@ D F .F
6epreciation.......... d/ Cash 5lo..............
FF .F 1 "1 F F .F
FF.F 1 " ? D F .F
FF.F 1 "@ F F . F
FF.F 1 "< D F .F
FF.F
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Chapter 04 - Analyzing Investing Activities
,0#-'5-*BE- 8EAR,(-6I7I*, &*0 0 0 s ' -$(. 1 a/ b/ c/ d/
Earnings before ta&es Q depreciation ........ 6epreciation............. +et 9efore *a&es. . . . . Income *a&es........... +et Income............... 6epreciation............. Cash 5lo.................
1 " D F F .F ?@?.@/ 1 " 1 ? @ .4 D@<./ D@ D @ < . ?@?.@ H?1.<
-$(. 2
-$(. /
-$(.
-$(. 5
"F F F .F ?G.?/ 1 "@ G .G < ? @ .4 / < ? @ .? ?G .? 1 " 1 @ ? .@
" D F F .F HF.H/ " F H .1 1 "1 F 4 .@ / 1 " 1 F 4 .D HF.H 1 " ? H D .4
? "F F F .F D4.D/ " G 4 D .D 1 "? G .< / 1 "? G .G D4.D 1 " @ G .
? "D F F .F 1<./ ? " < 1 . < 1"@4F .H / 1 " @ 4 F .H 1<. 1 " < D H .1
,traight-)i t-)ineC neCash ash flo larger larger +et Income Income smaller smaller 6epreci 6epreciatio ation n +ote2 Vs. ,traigh larger
6'09)E-6EC)I+I+7-9A)A+CE &*0 0 0 s ' -$(. 1
-$(. 2
-$(. /
-$(.
-$(. 5
Earnings before ta&es Q depreciation2. . . 1 " D F F .F a/ 6e 6epreciation.......... 4FF.F/ +et 9efore *a&es... 1 " 1 F F .F b/ Income *a&es........ DDF.F/ c/ +e +et Income............ DD D D F .F
"F F F .F ?F.F/ 1 "@ < F .F <4F.F/ <4 < 4 F .F
" D F F .F
[email protected]/ " 4 4 .F 1"1.F/ 1 " 1 .F
? " F F F .F F4. "G H D . 1"?HG.@/ 1 " ? H G .@
? "D F F .F 1@?. ? "? ? @ . 1"@@< .1/ 1 "@ @ < .1
6epreciation.......... d/ Cash 5lo..............
?F .F 1 "1 @ F .F
[email protected] 1 " ? G < .F
F4.< 1 "@ F . 4
1@?.< 1 "< ? 1 .H
4FF.F HDF.F
higher than straight line" line" loer than ,.8. ,.8.6. e&cept 8ear 8ear 1/. +ote2 Cash flo higher +et income loer than straight line" higher than ,.8.6. e&cept 8ear 1/. 6epreciation higher than straight line" loer than ,.8.6. e&cept 8ear 1/. e&cept year D/ C5A adapted/
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Chapter 04 - Analyzing Investing Activities
3roblem 4-G ?F minutes/ ,*RAI7B*-)I+E 8ear 8ear
9eginn 9eginning ing boo! value
1 ? 4 D
?FF"FFF 4F"FFF 1
6eprec 6epreciat iation ion e&pense
@F"FFF @F"FFF @F"FFF @F"FFF @F"FFF
+et +et income income +et incom income e before ta&es after ta&es
R'A
4F"FFF 4F"FFF 4F"FFF 4F"FFF 4F"FFF
1F 1.D 1@.@G D DF
?F"FFF ?F"FFF ?F"FFF ?F"FFF ?F"FFF
,0#-'5-*BE- 8EAR,=-6I7I*, 8ear 8ear
9eginn 9eginning ing boo! value
1 ? 4 D
?FF"FFF FF"FFF 1F"FFF @F"FFF F"FFF
6eprec 6epreciat iation ion e&pense
1FF"FFF
+et +et income income +et incom income e before ta&es after ta&es
R'A
F F"FFF 4F"FFF @F"FFF
F G.D D GD ?FF
F 1D"FFF ?F"FFF 4D"FFF @F"FFF
3roblem 4-< 4D minutes/ a. *he e&pen e&pendit ditur ures es that that shou should ld be capita capitaliz lized ed h hen en e%uipme e%uipment nt is ac%ui ac%uired red include the invoice price of the e%uipment net of discounts/" all incidental outlays relating to its purchase or preparation for use" any insurance during transit" freight" duties" onership search costs" onership registration costs" installation installation fees" and brea!-in costs. All available discounts" hether ta!en or not" should be deducted from the capitalizable cost of the e%uipment. b. 1/ When When the mar!et mar!et value value of the e%uipme e%uipment nt is not determin determinabl able e by reference reference to a similar cash purchase" the capitalizable cost of e%uipment purchased ith bonds that have an established mar!et price should be the mar!et value of the bonds. / When the mar!et mar!et value of the e%uipment is not determinable by reference reference to a similar cash purchase" and the common stoc! used in the e&change does do es no nott have have an establ establis ished hed mar! mar!et et price price"" the the capita capitaliz lizab able le cost cost of e%uipment should be the e%uipment(s estimated fair value if that is more clearl clearly y evid evident ent than than the the fair fair valu value e of the the common common stoc!. stoc!. Inde Indepen pende dent nt appraisals may be used to determine the fair values of the assets involved. ?/ When When the the mar!e mar!ett valu value e of e%ui e%uipm pment ent ac%u ac%uire ired d is no nott determ determin inab able le by reference to a similar cash purchase" the capitalizable cost of e%uipment purcha purchased sed by e&chan e&changing ging dissimil dissimilar ar e%uipme e%uipment nt having having a determin determinabl able e mar!e mar!ett valu value e shou should ld be the the mar!e mar!ett valu value e of the the dissim dissimil ilar ar e%ui e%uipme pment nt e&changed.
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Chapter 04 - Analyzing Investing Activities
c. *he factors that determine determine hether hether e&penditu e&penditures res toard property property"" plant" and e%uipment already in use should be capitalized are as follos2 E&penditures are relatively large in amount *hey are nonrecurring in nature *hey e&tend the useful life of the property" plant" and e%uipment *hey increase the usefulness for e&le" %uantity or %uality of goods produced/ of the property" plant" and e%uipment • • • •
d. *he net boo! boo! valu value e at the date of the the sale sale cost cost of the prope property rty"" plant" plant" and e%uipment less the accumulated depreciation/ should be removed from the accounts. *he e&cess of cash from the sale over the net boo! value removed is accounted for as a gain on the sale" hile the e&cess of net boo! value removed over cash from the sale is accounted for as a loss on the sale. e. Cons Consid ider erat atio ions ns in anal analyz yzin ing g prop proper erty ty"" plan plant" t" and and e%ui e%uipm pmen entt incl includ ude2 e2 1/ 1/ recognit recognition ion that that boo! values values are at historic historical al cost" cost" / need need for sufficien sufficientt capacity capacity to meet meet anticipa anticipated ted demand" demand" ?/ need need for ritedo ritedons ns of impaired impaired assets" 4/ assess effects of changes in price levels" D/ identify use of assets unde un derr op opera eratin ting g lease lease arra arrang ngem emen ents" ts" and and @/ @/ revie revie for e&ist e&isten ence ce of idle idle facilities. 3roblem 4-H 4F minutes/ a. Assumi Assuming ng a D-year D-year useful useful life for 9ellagio" 9ellagio" annual annual deprecia depreciation tion ould ould be @4 million. *hus" net income ould be2 8ear 8ear 12 1F.D/ 1F.D/ million DF DF - @4 depreciation depreciation J ?.D ?.D ta& benefit/ benefit/ 8ear 8ear 2 4.D million million GF GF - @4 depreciation depreciation U 1.D 1.D ta& e&pense/ e&pense/ 8ear 8ear ?2 <.D <.D million GD GD U @4 depreciation depreciation U .GD ta& e&pense/ e&pense/ +et assets total 1"D?@ million" 1"4G million" and 1"4F< million in FF1" FF" and FF?" respectively. Accordingly" return on assets is -F.@<" F.?1" and F.DH for FF1" FF" and FF?" respectively. b. Assumi ssuming ng a 1D-ye 1D-year ar usefu usefull life life for 9ella 9ellagio gio"" annu annual al depre deprecia ciatio tion n ou ould ld be 1F@.@G million. *hus" net income ould be2 FF12 4.D/ million DF - 1F@.@G depreciation J 14.1G ta& benefit/ FF2 G.D/ million GF - 1F@.@G depreciation J H.1G ta& benefit/ FF?2 ?.GD/ million GD U 1F@.@G depreciation J G.H ta& benefit/ +et assets total 1"4H? million" 1"?
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Chapter 04 - Analyzing Investing Activities
c. Assuming Assuming a 1F-year 1F-year useful life life for 9ellagio" 9ellagio" annual annual depreciation depreciation ould be 1@F million. *hus" net income ould be2 FF12 <.D/ million DF - 1@F depreciation J G.D ta& benefit/ FF2 @G.D/ million GF - 1@F depreciation J .D ta& benefit/ FF?2 @?.GD/ million GD U 1@F depreciation J 1.D ta& benefit/ +et assets total 1"44F million" 1"
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Chapter 04 - Analyzing Investing Activities
c. 1/ *he increas increase e in overhe overhead ad caused caused by the the self-constru self-constructio ction n of fi&ed assets assets should be capitalized. *hese costs ould not have been incurred if the assets assets had not been been constru constructed cted.. *hi *his s proposit proposition ion holds holds regardl regardless ess of hether or not the plant is operating at full capacity. It is improper to increase the cost of finished goods ith costs that ere not incurred in their manufacture and that ould not have been incurred if fi&ed assets had had no nott been been prod produc uced ed.. Boe Boeve verr" if the the tota totall cons constr truc ucti tion on cost costs s on self-constructed fi&ed assets ere substantially in e&cess of their business and economic usefulness" the e&cess cost is not capitalized but instead is recorded as a loss. / It is clear clear that that the the capit capitali alize zed d costs costs of self-co self-cons nstru tructe cted d asset assets s shou should ld inclu include de a prop proport ortion ionate ate share share of overh overhead ead on the the same same basis basis as that that applied to goods manufactured for sale hen the plant is operating at full capa capaci city ty at the the time time the the fi&e fi&ed d asse assett is cons constr truc ucte ted. d. 0nd 0nder thes these e circumstances costs of finished goods produced should not be increased for overhead for goods for hich production as foregone. *he activity replacing the production of goods for sale should be charged ith the related overhead. When idle plant capacity is used for the construction of a fi&ed asset" opinion varies as to the propriety of capitalizing a share of general factory ove overhe rhead all allocat ocated ed on the the same basi asis as that appl applie ied d to go good ods s manufactured for sale. *he arguments to allocate overhead maintain that cons constru tructe cted d fi&ed fi&ed asset assets s shoul should d be accor accorded ded the the same same treatm treatmen entt as inve invent ntor ory y" ne ne produ products cts"" or $oint $oint prod product ucts. s. It is maint maintain ained ed that that this this proce procedu dure re is neces necessa sary ry"" or speci special al favor favors s or e&emp e&emptio tions ns from from un unde derrcosting of fi&ed assets ill cause a conse%uent over-costing of inventory assets. *hose argu *hose arguin ing g again against st alloca allocatin ting g over overhe head ad to fi&ed fi&ed assets assets h her ere e the the assets assets are are cons constru truct cted ed h hen en idle idle capaci capacity ty e&ists e&ists maint maintain ain that" that" since since normal prod roduction tion i illl not be affec ffectted or ove overhea rhead d increased ased"" capita capitali lizat zatio ion n il illl resu result lt in incre increas ased ed repo reporte rted d inco income me for for the the perio period d resulting from construction rather than production of goods for sale. It is also also somet sometime imes s maint maintain ained ed that that the full full cost cost of the the cons constr truc ucted ted asset asset should not include overhead that ould be incurred in the absence of such construction.
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Chapter 04 - Analyzing Investing Activities
d. *he *he HF" HF"FF FFF F cost cost by hich hich the init initia iall mach machin ine e e&ce e&ceed eded ed the the cost cost of the the subse subse%u %uen entt machi machine nes s shou should ld be capita capitaliz lized ed.. Witho Without ut %u %uest estion ion there there are are substantial future benefits e&pected from the use of this machine. 9ecause future periods ill benefit from the e&tra outlays re%uired to develop the initial machi machine ne"" all deve develo lopme pment nt costs costs shou should ld be capita capitaliz lized ed and and subs subse% e%ue uentl ntly y asso associ ciat ated ed ith ith the the rela relate ted d rev revenue enue prod produc uced ed by the the sale sale of prod produc ucts ts manuf manufact actur ured ed.. If" ho hoev ever er"" it can can be deter determi mine ned d that that the the e&cess e&cess cost cost of producing the first machine as the result of inefficiencies or failure hich did not contribute to the machine(s successful development" these costs should be recognized as an e&traordinary loss. ,ubse%uent periods should not be burdened ith charges arising from costs that are not e&pected to yield future benefits. Capitalizing the e&cess costs as a cost of the initial machine can be $ustified under the general rules of asset valuation. valuation. *hat is" an asset ac%uired should be charged ith all costs incurred incurred in obtaining the asset and placing it in service. AIC3A Adapte Adapted/ d/
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Chapter 04 - Analyzing Investing Activities
3roblem 4-11 DF minutes/ a. Intang Intangible ible assets assets represe represent nt rights rights or claims claims to future future benefits benefits.. An intangib intangible le asset is usually defined as a noncurrent asset having no physical e&istence ith a high degree of uncertainty regarding future benefitsits value being dependent on the rights that possession confers upon the oner. b. 1/ A dolla dollarr to be receiv received ed in the futu future re is orth orth less less than than a do dolla llarr recei receive ved d today because of an interest or discount factoroften referred to as the time value of money. *he discounted value of the e&pected royalty receipts can be thought of either in terms of the present value of an annuity of 1 or in terms of the sum of several present values of 1. / If the royalty royalty receipts receipts are e&pected e&pected to occur occur at regula regularr interva intervals ls and the amounts are to be fairly constant" their discounted value can be calculated by multiplying the value of one such receipt by the present value of an annuity of 1 for the number of periods the receipts are e&pected. 'n the other hand" hand" if receipts are e&pected to be irregular in amount" or if they are to occur at irregular intervals" each e&pected future receipt ould have to be multiplied by the present value of 1 for the number of periods of delay e&pected. In each case some interest rate discount factor/ per period must be assumed and used. As an e&le" if receipts of 1F"FFF are e&pected each si& months over the ne&t 1F years and an < percent annual interest rate is selected" the present value of the tenty 1F"FFF payments is e%ual to 1F"FFF times the present value of an annuity of 1 for F periods at 4 percent. *ice as many periods as years" and half the annual interest rate of < percent" are used because the payments are e&pected at semiannual intervals. *hus the discounted present/ value of these receipts is 1?D"HF? 1F"FFF & 1?.DHF?/. 9ecause of the interest rate" this discounted value is cons consid ider erab ably ly less less than than the the tota totall e&pe e&pect cted ed coll collec ecti tion ons s of FF FF"F "FFF FF.. Cont Contin inui uing ng the the e& e&le" le" if instea instead d it is e&pe e&pecte cted d that that 1F"F 1F"FFF FF il illl be received si& months hence" F"FFF one year from no" and a terminal payment of 1D"FFF is e&pected 1< months hence" the calculation is as belo2 1F"FFF & present value of 1 at 4 for 1 period L 1F"FFF & .H@1D4 F"FFF & present value of 1 at 4 for periods L F"FFF & .H4D@ 1D"FFF & present value of 1 at 4 for ? periods L 1D"FFF & .<
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Chapter 04 - Analyzing Investing Activities
3roblem 4-11 4- 11continued continued c. *he basis of valuation valuation for the patents patents that is generally generally accepted in accounting accounting is cost. cost. Evide Evidentl ntly y the the carto cartons ns e ere re develo developed ped and and the the paten patents ts ob obtai tained ned dire direct ctly ly by the the clie client nt corp corpor orat atio ion. n. *h *her eref efor ore" e" thei theirr cost cost o oul uld d incl includ ude e government and legal fees" and the costs of any models and draings. *he proper initial valuation ould be the sum of these costs plus any other costs incident to obtaining the to patents. *his is in accord ith the accounting principle that the initial valuation of any asset generally includes virtually all costs necessary to ac%uire and ma!e it ready for normal use. ,uch values are ob$ectively determined and rest upon actual completed transactions rather than upon estimates and future e&pectations. d. 1/ Intang Intangible ible assets assets represe represent nt rights rights to future future benefits. benefits. *he ideal ideal measure measure of the the valu value e of intan intangib gible le assets assets is the the disco discoun unted ted prese present nt valu value e of thei their r futu future re bene benefit fits. s. 5o 5orr the the Vand ndiv iver er Corpo Corporat ratio ion" n" this this ou ould ld incl includ ude e the the discounted value of e&pected net receipts from royalties as suggested by the financial vice-president as ell as the discounted value of the e&pected net receipt receipts s to be derive derived d from from the Vandi Vandiver ver Corporatio Corporation(s n(s productio production. n. 'the 'therr valua aluati tion on base bases s that that hav have been been sugg sugges este ted d are are curr curren entt cash cash e%uivalent or fair mar!et value. / *he amortization amortization policy is implied in the definition definition of intangible intangible assets as rights to future benefits. As the firm receives the benefits" the cost or other value should be charged to e&pense or to inventory to provide a proper matching of revenues and e&penses. 0nder the discounted value approach the the perio periodic dic amorti amortiza zatio tion n ou ould ld be the the decli decline ne du durin ring g the the year year in the the present value of e&pected net receipts. e. *he litigatio litigation n can and probably probably shoul should d be mentioned mentioned in notes notes to the financial financial statements. statements. ,ome indication of the e&pectations of legal counsel in respect to the the outco tcome can can prop oper erly ly accomp compa any the state tateme men nts. It o ou uld be inappropriate inappropriate to record a contingent asset reflecting the e&pected damages to be recovered. Costs incurred to ,eptember ?F" 8ear 1" in connection ith the litigation should be carried forard and charged to e&pense or to loss if the cases are lost/ as royalties or damages/ are collected from the parties against hom the litigation has been instituted hoever" the conventional treatment ould ou ld be to charg charge e these these costs costs as ordin ordinar ary y legal legal e&pen e&penses ses.. If the the final final outcome of the litigation is successful" the costs of prosecuting it should be capita capitaliz lized. ed. ,imil ,imilarl arly y" if the the clien clientt ere ere the the succ success essfu full defen defenda dant nt in an infringement suit on these patents" the generally accepted accounting practice oul o uld d be to add add the the cost costs s of the the lega legall defe defens nse e to the the 3ate 3atent nts s acco accoun unt. t. 6evelopments to the time that the statements are prepared and released can be refl reflec ecte ted d in no note tes s to the the stat statem emen ents ts as a po post-b st-bal alan ance ce shee sheett or or subse%uent event/ disclosure. AIC3A Adapte Adapted/ d/
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Chapter 04 - Analyzing Investing Activities
CA,E, Case 4-1 ?F minutes/ a. *he main determin determinants ants of the valuation valuation of feature feature films" televisio television n programs" programs" and general release feature productions productions by Columbia Columbia 3ictures are 1/ the cost of productions and / estimates on ho to allocate those costs over the earnings-generating capacity of the films. b. *he reasonab reasonablene leness ss of the bases bases of valua valuation tion depends depends almost almost entirely entirely on the reasonableness of the estimates of the e&piration of value of the inventory costs. :udging from the second paragraph of the note" it appears that some of the company(s estimates of the value of films ere overly optimistic and that this prior optimism re%uired subse%uent subse%uent and substantial substantial ritedons. If this is an indication of management(s ability to estimate the potential earnings of its film releases" then the analyst should treat its inventory values ith suspicion and caution. c. An un unse secu cured red lender lender ou ould ld ant ant to caref careful ully ly asses assess s the the valu valuati ation on of film film inven invento torie ries s in the light light of past past e&peri e&perien ence ce and and of futu future re prospe prospects cts in the the industry. *his is particularly crucial here because inventories form such an important part of total assets for Columbia 3ictures and other companies in this this ind indus ustry try.. *h *he e analy analyst st ou ould ld a ant nt to !no !no Colu Columb mbia= ia=s s e&peri e&perien ence ce in valuing its inventoryfrom available evidence in Columbia(s note this is not reass reassur urin ing. g. *h *he e analy analyst st o ould uld ant ant to compa compare re Colu Columbi mbia= a=s s estim estimati ation on process ith that folloed by other companies in the industry" and also ould ant to compare Columbia=s Columbia=s estimates ith forecasted conditions and trends in the industry.
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Chapter 04 - Analyzing Investing Activities
Case 4- 4D minutes/ a. 1/ 5I5 5I5' ' allocate allocates s costs to sales sales in in the order order good goods s are purch purchased ased22 ,ales 1"FFF units & 1.GF/ ................... ............................ ................. ................. ........................ ............... 1"GFF Cost of goods sold 1"FFF units & 1.FF" hich is all beginning-year beginning-year inventory/... inventory/............ ................. ................. .................................. ......................... 1"FFF/ +et income before ta&es....................... ta&es.... ...................................... ..................................... ...................... .... GFF 3rovision for federal income ta&es DF/............................... DF/.............. ...................... ..... ?DF/ +et Income *ransferred *ransferred to Retained Earnings...................... Earnings............... ............. ...... ?DF / )I5' allocates allocates recent recent cost to sales2 sales2 ,ales 1"FFF units units & 1.GF/ ................................................. .............................. .......................... ........... .... Cost of goods sold 1"FFF units & 1.DF" hich are the most recent recent 1"FFF units ac%uired/....................................... ac%uired/....................................... +et income before ta&es................ ta&es......................... .................. .................. .................. ..................... ............ 3rovision for federal income ta&es DF/............................... DF/.............. ...................... ..... +et Income *ransferred *ransferred to Retained Earnings...................... Earnings............... ............. ......
1"GFF 1"DFF/ FF 1FF/ 1FF
b. 1/ 1/ 5I5'2 9ala alance ,he ,heet A,,E*, Cash.......... Cash................... .................. .................. .................. .................. ................. ................. ...................... ......................... ............ FF Invent Inventory ory 5I5' 5I5' method method/.... /........ ........ ....... ....... ........ ........ ........ ........ ........ ........ ........ ........ ........ .......... ......... ... 1"DFF 1"DFF *otal *o tal Assets Assets ................. .......................... .................. .................. ...................................... ....................................... .......... 1"GFF )IA9I)I*IE, A+6 E;0I*8 5ederal income ta&es payable............. payable..................... ................. ................................. ........................ ?DF *otal *o tal e%uity .................. ........................... .................. ................. ................. .................. .................. .................. .............. ..... 1"?DF *otal *o tal )iabilities )iabilitie s and E%uity..................................... E%uity.................. .................................. ...................... ......... 1"GFF / )I5 )I5'2 '2 9alance 9alance ,heet ,heet A,,E*, Cash.......... Cash................... .................. .................. .................. .................. ................. ................. ...................... ......................... ............ FF Invent Inventory ory )I5' )I5' method method/.... /........ ........ ....... ....... ........ ........ ........ ........ ........ ........ ........ ........ ........ .......... ......... ... 1"FFF 1"FFF *otal *o tal Assets........ Assets................. .................. ................. ................. .................................. ......................................... ................ 1"FF )IA9I)I*IE, A+6 E;0I*8 5ederal income ta&es payable............. payable..................... ................. ................................. ........................ 1FF *otal *o tal e%uity .................. ........................... .................. ................. ................. .................. .................. .................. .............. ..... 1"1FF *otal *o tal )iabilities )iabilitie s and E%uity..................................... E%uity.................. .................................. ...................... ......... 1"FF
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Chapter 04 - Analyzing Investing Activities
Case 4-continued c. 6uring a period of rising rising costs" costs" the )I5' method is more more conservativ conservative e in profit determination and in the evaluation of the financial position of a company than the 5I5' method. )I5' allocates recent costs of inventory to sales" the result being that these costs are higher in light of cost increases. Accordingly" inventory is valued more conservatively" and income reported is loer than those under the 5I5' method. 3arts a/ and b/ of this case reveal this relation. *hat is" under )I5'" income reported is 1FF after ta&es as compared to ?DF under 5I5'. )i!eise" inventory is reported at 1"FFF under )I5' as opposed to 1"DFF under 5I5'. Evidence of rising costs is that e&isting inventory is valued at 1.FF per unit hile goods purchased during the year ran at 1.DF per unit. *a& considerations also are important. As e can see from parts a/ and b/" the )I5' method produces produces a ta& liability of 1FF" hereas ta&es under the 5I5' method amount to ?DF. As long as inventory is maintained at a given level or increases" )I5' produces an interest-free" perpetual loan from the government. 'f course" should inventory be li%uidated" cost of goods sold ill be very lo compared to sales" ith a resulting higher income ta& liability ma!ing up for the prior deferrals/. d. Compani Companies es use a dollar pool pool )I5' method method to prevent prevent li%uidati li%uidation on of lo-cos lo -costt )I5' inventory units. 0nder this method" groups of items are vieed as a dollar pool" and if one item is sold" it may be replaced by ne items of the same same or grea greater ter do dolla llarr valu value" e" and and there there is no li%ui li%uidat datio ion n of the pool. pool. *h *he e problem for a company that prepares interim statements is to decide hether li%uidated items in one %uarter ill be replaced before the end of the fiscal year. year. If the items are replaced" income ta&es allocated to profits of the current current %uarter ill be loer than if the items are not replaced. C5A Adapted/
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Chapter 04 - Analyzing Investing Activities
Case 4-? 4D minutes/ a. +et Inco Income me Comp Comput utati ation on22 5I5'
)I5'
Average cost
,ales 1"FFF & D/.......................... D/.......................... Cost of sales2 9eginning inventory............... inventory........ ............ ....... Add2 Add2 3urchase 3urchases............................ s............................ )ess2 Ending inventory............. inventory....... ......... ... Cost of sales................................... sales................................... 7ross profit.................... profit..................................... ................. 'perating 'perating e&penses....................... e&penses....................... +et income.......................................
D"FFF
D"FFF
D"FFF
F ?"FF 11"GFF/ 11"DFF 1?"DFF D"FFF <"DFF
F ?"FF H"1FF/ 14"1FF 1F"HFF D"FFF D"HFF
F ?"FF 1F"?1/ 1"<<< 1"11 D"FFF G"11
+et income per share.....................
4.D
.HD
?.D@
+'*E,2 +'*E,2 1/ 5I5' 5I5' invent inventory ory comp computa utatio tion n is based based on DFF units units at 1D and ?FF at 14. / )I5' inventor inventory y computation computation is based based on 1FF units units at 1F" ?FF units at 11" and 4FF units at 1. ?/ ?/ Average age cost cost is obta btained ined by div dividi iding ?" ?"F FF F by 1"
b. 5inanci 5inancial al Ratio Ratio Comput Computatio ations ns
5I5' )I5' Average Cost 1/ Current ratio .. / 6ebt-to-e%uity ratio . ?/ Inventory turnover 4/ Return on total assets D/ 7ross margin ratio. @/ +et profit as percent of sales.
.4G @G.< .FF H.< D4.F
.?@ G1.? ?.1F G.F 4?.@
.41 @H.@ .DF <.? 4<.D
?4.F
?.@
<.D
c. LIFO 0nderr cond conditi ition ons s of fluctu fluctuati ating ng inve invent ntory ory costs costs"" the the )I5' )I5' LIFO $ffects $ffects. 0nde inventory method ill have a smoothing effect on income. #oreover" the )I5' method results" in times of cost increases" in an unrealistically lo reported inventory figure. *his" in turn" ill loer the current ratio of a company and at the same time tend to increase its inventory turnover ratio. *he )I5' method also affords management an opportunity to manipulate profits by alloing inventory to be depleted in poor years" thus draing on the lo cost base
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Chapter 04 - Analyzing Investing Activities
pool.. FIFO $ffects pool *he e use use of 5I5' 5I5' in the valua valuatio tion n of inve invent ntor ories ies il illl $ffects. *h generally result in a higher inventory on the balance sheet and a loer cost of goods goo ds sold sold than than un unde derr )I5' )I5' resu resulti lting. ng. *h *his is ou ould ld resu result lt in a high higher er net net income. (verage ost $ffects. *he average cost method smoothes out cost fluctuations by using a eighted average cost in the valuation of inventories and cost of goods sold. *he resulting net income ill be close to an average of the net income under )I5' and 5I5'.
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Chapter 04 - Analyzing Investing Activities
Case 4-4 4D minutes/ a. 1"D1<.D 1"D1<.D S?@T - 1"G< 1"G<.F .F S4DT S4DT L 4F.D. 4F.D. b. Campbell Campbell ,oup ,oup sells to retailers" retailers" li!e grocery grocery stores. stores. +ote +ote 1? reports reports that the company has established an alloance for uncollectible accounts of 1@.? million as of the end of the year. *his amount represents ?.4 of gross accounts receivable from trade creditors see +ote 1?/. c. *h *he e compa company ny employ employs s )I5' )I5' inve invent ntor ory y costin costing. g. Inve Invento ntorie ries s are are ritte ritten n don to the loer of cost or mar!et. d. Invent Inventory ory turnov turnover er L 4FHD.D 4FHD.D million million K
[email protected] K
[email protected] million million J<1H.< J<1H.< million/K million/K L D.?G times. Companies can improve the inventory turnover rate by reducing ra ra mater material ials s on hand hand ith ith $ust$ust-in in-ti -time me deliv deliveri eries/ es/"" or!-i or!-inn-pr proce ocess ss inventories by improved manufacturing processes/" and finished goods inventories by producing to order rather than to demand forecasts/. e. *he )I5' reserv reserve e is
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Chapter 04 - Analyzing Investing Activities
Case 4-D 4D minutes/ a. 6epre 6eprecia ciatio tion n is a syst system em hose hose pu purpo rpose se is to allocate allocate the cost of tangib tangible le capital assets" less salvage" over their useful lives in a systematic and rational manner manner.. 0nder 0nder 7A 7AA A3" deprecia depreciation tion is a process process of cost allocatio allocation" n" not of valuation" through hich the productive effort cost/ is to be matched ith produ producti ctive ve accom accompli plish shme ment nt reve revenu nue/. e/. *h *his is proce process ss is found founded ed on the the matchin matching g princip principle. le. 6eprecia 6epreciation tion"" therefo therefore" re" is mainly mainly concer concerned ned ith the timing of the e&piration of the cost of tangible fi&ed assets. b. *he propose proposed d deprec deprecia iatio tion n metho method d is" is" of cours course" e" syste systemat matic ic.. Whet Whethe herr it is ratio rationa nall in terms of cost cost alloca allocatio tion n depend depends s on the facts facts of the the case. case. It produces an increasing depreciation charge" hich is usually not $ustifiable in terms terms of the the bene benefit fits s deriv derived ed from from the use of an asset. asset. *h *his is is beca becaus use e manuf manufact actur urer ers s typic typicall ally y prefer prefer to use use their their ne ne e%ui e%uipm pmen entt as mu much ch as possible and their old e%uipment only as needed" such as to meet production %uotas during periods of pea! demand. As a general rule" benefits decline ith age. Assuming that the actual operations including including e%uipment e%uipment usage/ of each year are identical" then maintenance and repair costs are li!ely to be higher in the later years of usage than in the earlier years. *his means the proposed method ould match loer depreciation ith loer repair charges in the early years" hile it ould match higher depreciation ith higher repair charges in the later years. Boever" reported net income in the early years ould be much higher than reported net income in the later years of the asset=s life. *his is an unreasonable and undesirable variation during periods of identical operation. 'n the other hand" if the e&pected level of operations including e%uipment usage/ in the early years of the asset=s life is e&pected to be lo relative to that of later years" then the pattern of depreciation charges of the the propos proposed ed metho method d appro& appro&ima imatel tely y paral parallel lels s e&pect e&pected ed bene benefit fits s and and revenues/. In this admittedly unusual case" the method may be vieed as reasonab reasonable. le. Although lthough"" the uni units-of-p ts-of-prod roducti uction on depreci depreciation ation method method is the more usual method selected to fit this case. c. 1/ 6epreci 6epreciatio ation n charges charges neither neither recover recover nor create create cash. cash. Revenue-p Revenue-produ roducing cing activiti activities es are the sources sources of cash cash from operation operations. s. If revenu revenues es e&ceed e&ceed out-of-poc!et costs during a period" then cash is available to cover other than than out-o t-of-p f-poc!e oc!ett costs. sts. Boe ev ver" if rev revenues do not e&ce &ceed out-of-poc!et costs" then no cash is made available no matter ho much" or little" depreciation is charged.
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Chapter 04 - Analyzing Investing Activities
/ 6epre 6eprecia ciatio tion n can can affect affect cash cash in at least least to ays. ays. 5irst 5irst"" depr depreci eciati ation on char charge ges s affe affect ct repo report rted ed inco income me and" and" henc hence" e" can can affe affect ct mana manage geri rial al deci decisi sion ons s such such as thos those e rega regard rdin ing g pric pricin ing" g" prod produc uctt sele select ctio ion" n" and and divide dividend nds. s. 5o 5orr e&l e&le" e" the the propo proposed sed metho method d ou ould ld resu result lt initi initiall ally y in higher reported income than ould the straight-line method. Conse%uently" shareholders shareholders might demand higher higher dividends in the earlier years than they ould ou ld other otheris ise e e&pect e&pect.. *h *he e strai straigh ght-li t-line ne metho method" d" by yield yieldin ing g a loer loer reported income during the early years of asset life and by reducing the amou amount nt of po pote tent ntia iall div dividen idends ds in earl early y year years s as comp compar ared ed ith ith the the prop propos osed ed meth method od"" coul could d enco encou urag rage earl earlie ierr rein reinv vestm estmen entt in othe other r profit-earning assets to meet increasing demand. ,econd" depreciation charges affect reported ta&able income. *his means they affect directly the amount of income ta&es payable in the year of deduction. 0sing the proposed method for ta& purposes ould reduce the total ta& bill over the life of the assets 1/ if the ta& rates ere increased in future years or / if the business ere doing poorly no but ere to do sign signif ific ican antl tly y bett better er in the the futu future re.. *h *he e firs firstt cond condit itio ion n is po poli liti tica call and and speculative" speculative" but the second condition condition may be applicable to *o *oro ro in vie of its recent recent origin origin and its rapid rapid e&pansi e&pansion on progra program. m. Conse%u Conse%uent ently ly"" more funds might be available for reinvestment in fi&ed assets in years of larger deductions deductions if the business remains remains profitable. If *o *oro ro is not profitable no" it ould not benefit from higher deductions no and should consider an increasing charge method for ta& purposes" such as the one proposed. If *oro is profi profitab table le no no" " the the presid presiden entt shou should ld reco recons nside iderr his his prop proposa osall because it ill delay the availability of cash that must be paid to cover ta&e ta&es. s. Also lso the the pro propo pose sed d met metho hod d coul could d resu result lt in loe loerr esti estima mate ted d production costs in earlier years" hich could lead to underpricing of the product. AIC3A Adapte Adapted/ d/
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