4 chapter analyzing investing activities. current (short- term) assets noncurrent (long-term) assets...
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4CHAPTER
Analyzing Investing Activities
Current (short-term) Assets
Current (short-term) Assets
Noncurrent (Long-Term)
Assets
Noncurrent (Long-Term)
Assets
Resources or claims to resources that are
expected to be sold, collected, or used
within one year or the operating cycle,
whichever is longer.
Resources or claims to resources that are
expected to be sold, collected, or used
within one year or the operating cycle,
whichever is longer.
Resources or claims to resources that are
expected to yield benefits that extend beyond one year or the operating cycle, whichever is longer.
Resources or claims to resources that are
expected to yield benefits that extend beyond one year or the operating cycle, whichever is longer.
Current Asset Introduction Classification
Current Asset Introduction Operating Cycle
Services sold to customers
Cash on hand
1
2
Ca
sh
pa
id to
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mp
loye
es
3
4
Cu
sto
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rs p
ay
fo
r s
ervi
ces
Products sold to customers
Cash on hand
1
2
Ca
sh
pa
id fo
r p
rod
uc
ts
4
Cu
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me
rs p
ay
fo
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3
Cash
Currency, coins and amounts on deposit in bank accounts, checking accounts, and
some savings accounts.
Cash
Currency, coins and amounts on deposit in bank accounts, checking accounts, and
some savings accounts.
Current Asset Introduction Cash, Cash Equivalents and Liquidity
Cash Equivalents
Short-term, highly liquid investments that are: Readily convertible to a known cash amount. Close to maturity date and not sensitive to interest rate changes.
Cash Equivalents
Short-term, highly liquid investments that are: Readily convertible to a known cash amount. Close to maturity date and not sensitive to interest rate changes.
Current Asset Introduction Cash, Cash Equivalents and Liquidity
• Does not present serious valuation problems because of its liquidity
• Requires special precautions against theft and defalcation
• Examine for restrictions on disposition
— remove restricted balances from current assets since they are not available for paying current obligations
— in assessing liquidity, consider repercussions of violating these agreements
— exposure often measured by the ratio of restrictedbalances to the total
• Does not present serious valuation problems because of its liquidity
• Requires special precautions against theft and defalcation
• Examine for restrictions on disposition
— remove restricted balances from current assets since they are not available for paying current obligations
— in assessing liquidity, consider repercussions of violating these agreements
— exposure often measured by the ratio of restrictedbalances to the total
Current Asset Introduction Analysis of Cash and Cash Equivalents
Cash and Cash Equivalents as a Percent of Total Assets
0.00%5.00%
10.00%15.00%20.00%
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Receivables are amounts due from others that arise from the sale of goods or services, or the loaning of money
Accounts receivable refer to oral promises of indebtedness due from customers
Notes receivable refer to formal written promises of indebtedness due from others
Receivables are amounts due from others that arise from the sale of goods or services, or the loaning of money
Accounts receivable refer to oral promises of indebtedness due from customers
Notes receivable refer to formal written promises of indebtedness due from others
Current Asset Introduction Receivables
Receivables are reported at their net realizable value —total amount of receivables less an allowance for uncollectible accounts
Management estimates the allowance for uncollectibles based on experience, customer fortunes, economy and industry expectations, and collection policies
Receivables are reported at their net realizable value —total amount of receivables less an allowance for uncollectible accounts
Management estimates the allowance for uncollectibles based on experience, customer fortunes, economy and industry expectations, and collection policies
Current Asset Introduction Valuation of Receivables
Assessment of earnings quality is often affected by an analysis of receivables and their collectibilityAnalysis must be alert to changes in the allowance—computed relative to sales, receivables, or industry and market conditions.Two special analysis questions: (1) Collection Risk
Review allowance for uncollectibles in light of industry conditionsApply special tools for analyzing collectibility:
• Determining competitors’ receivables as a percent of sales—vis-à-vis the company under analysis
• Examining customer concentration—risk increases when receivables are concentrated in one or a few customers
• Investigating the age pattern of receivables—overdue and for how long• Determining portion of receivables that is a renewal of prior receivables• Analyzing adequacy of allowances for discounts, returns, and other credits
(2) Authenticity of Receivables Review credit policy for changes Review return policies for changes Review any contingencies on receivables
Assessment of earnings quality is often affected by an analysis of receivables and their collectibilityAnalysis must be alert to changes in the allowance—computed relative to sales, receivables, or industry and market conditions.Two special analysis questions: (1) Collection Risk
Review allowance for uncollectibles in light of industry conditionsApply special tools for analyzing collectibility:
• Determining competitors’ receivables as a percent of sales—vis-à-vis the company under analysis
• Examining customer concentration—risk increases when receivables are concentrated in one or a few customers
• Investigating the age pattern of receivables—overdue and for how long• Determining portion of receivables that is a renewal of prior receivables• Analyzing adequacy of allowances for discounts, returns, and other credits
(2) Authenticity of Receivables Review credit policy for changes Review return policies for changes Review any contingencies on receivables
Current Asset Introduction Analyzing Receivables
Securitization (or factoring) is when a company sells all or a portion of its receivables to a third party
Receivables can be sold with or without recourse to a seller (recourse refers to guarantee of collectibility)
Sale of receivables with recourse does not effectively transfer risk of ownership
Securitization (or factoring) is when a company sells all or a portion of its receivables to a third party
Receivables can be sold with or without recourse to a seller (recourse refers to guarantee of collectibility)
Sale of receivables with recourse does not effectively transfer risk of ownership
Current Asset Introduction Securitization of Receivables
For securitizations with any type of recourse, the seller must record both an asset and a compensating liability for the amount factored
For securitizations without any recourse, the seller removes the receivables from the balance sheet
For securitizations with any type of recourse, the seller must record both an asset and a compensating liability for the amount factored
For securitizations without any recourse, the seller removes the receivables from the balance sheet
Current Asset Introduction Analysis of Securitization
Current Asset Introduction Analysis of Securitization
Balance Sheet Effects of Securitization Assets Before After Adjusted Cash 50$ 450$ 450$ Receivables 400 0 400 Other current assets 150 150 150 Total current assets 600 600 1,000 Noncurrent assets 900 900 900 Total assets 1,500$ 1,500$ 1,900$
LiabilitiesCurrent liabilities 400$ 400$ 800$ Noncurrent liabilites 500 500 500 Equity 600 600 600
Total liabilities and equity 1,500$ 1,500$ 1,500$
Key ratiosCurrent ratio 1.50 1.50 1.25Total Debt to Equity 1.50 1.50 2.17
Prepaid expenses are advance payments for services or goods not yet received that extend beyond the current accounting period—examples are advance payments for rent, insurance, utilities, and property taxes
Prepaid expenses are advance payments for services or goods not yet received that extend beyond the current accounting period—examples are advance payments for rent, insurance, utilities, and property taxes
Current Asset Introduction Prepaid Expenses
Two analysis issues:
(1) For reasons of expediency, noncurrent prepaids sometimes are included among prepaid expenses classified as current--when their magnitude is large, they warrant scrutiny
(2) Any substantial changes in prepaid expenses warrant scrutiny
Two analysis issues:
(1) For reasons of expediency, noncurrent prepaids sometimes are included among prepaid expenses classified as current--when their magnitude is large, they warrant scrutiny
(2) Any substantial changes in prepaid expenses warrant scrutiny
Analysis of Prepaids
InventoriesDefinitions
Inventories are goods held for sale, or goods acquired (or in process of being readied) for sale, as part of a company’s normal operations
Expensing treats inventory costs like period costs—costs are reported in the period when incurred
Capitalizing treats inventory costs like product costs—costs are capitalized as an asset and subsequently charged against future period(s)revenues benefiting from their sale
MerchandiseAvailable
for Sale
Net Costof Purchases
Cost ofGoods Sold
BeginningInventory
EndingInventory
InventoriesInventory Cost Flows
Use of Inventory Methods in Practice
InventoriesInventory Costing Method
Costs of Goods Sold
Costs of Goods Sold
Ending InventoryEnding
Inventory
Oldest Costs
Oldest Costs
Recent Costs
Recent Costs
InventoriesFirst-In, First-Out (FIFO)
Costs of Goods Sold
Costs of Goods Sold
Ending InventoryEnding
Inventory
Recent Costs
Recent Costs
Oldest Costs
Oldest Costs
InventoriesLast-In, First-Out (LIFO)
When a unit is sold, the average cost of each unit in
inventory is assigned to cost of
goods sold.
When a unit is sold, the average cost of each unit in
inventory is assigned to cost of
goods sold. Cost of Goods
Available for Sale
Units available on the date of
sale
÷
InventoriesAverage Cost
Inventory on January 1, Year 2 40 @ $500 $ 20,000
Inventories purchased
during the year 60 @ $600 36,000
Cost of Goods available
for sale 100 units $ 56,000
Note: 30 units are sold in Year 2 for $800 each = Total Revenue-$24,000
Inventory on January 1, Year 2 40 @ $500 $ 20,000
Inventories purchased
during the year 60 @ $600 36,000
Cost of Goods available
for sale 100 units $ 56,000
Note: 30 units are sold in Year 2 for $800 each = Total Revenue-$24,000
InventoriesIllustration of Costing Methods
Beginning Net Cost of EndingInventory + Purchases = Goods Sold + Inventory
FIFO $20,000 + $36,000 = $15,000 + $41,000
LIFO $20,000 + $36,000 = $18,000 + $38,000
Average $20,000 + $36,000 = $16,800 + $39,200
Assume sales of $35,000 for the period—then gross profit under each method is:
Sales – Cost of Goods Sold = Gross Profit
FIFO $24,000 -- 15,000 = $7000 LIFO $24,000 -- 18,000 = $6,000
Average $24,000 -- 16,800 = $7,200
Beginning Net Cost of EndingInventory + Purchases = Goods Sold + Inventory
FIFO $20,000 + $36,000 = $15,000 + $41,000
LIFO $20,000 + $36,000 = $18,000 + $38,000
Average $20,000 + $36,000 = $16,800 + $39,200
Assume sales of $35,000 for the period—then gross profit under each method is:
Sales – Cost of Goods Sold = Gross Profit
FIFO $24,000 -- 15,000 = $7000 LIFO $24,000 -- 18,000 = $6,000
Average $24,000 -- 16,800 = $7,200
InventoriesIllustration of Costing Methods
A company is required to use the same accounting methods from period to period.
A change is only acceptable when it improves financial reporting.
A company is required to use the same accounting methods from period to period.
A change is only acceptable when it improves financial reporting.
Inventories
Inventory must be reported at market value when market is lower than cost.
Inventory must be reported at market value when market is lower than cost.
Defined as current replacement cost (not sales price).
Defined as current replacement cost (not sales price).
Can be applied three ways:
(1) separately to each individual item.
(2) to major categories of assets.
(3) to the whole inventory.
Can be applied three ways:
(1) separately to each individual item.
(2) to major categories of assets.
(3) to the whole inventory.Dictated by the conservatism
principle.
Dictated by the conservatism
principle.
Inventories
Compute LCM for individual items, inventory groups, and overall inventory.
Compute LCM for individual items, inventory groups, and overall inventory.
Inventories
•Purchase Commitments are contracts with other entities to purchase inventory several months or years in advance
•Accounting does not reflect these commitments since title to the goods has not passed to the buyer
•Disclosure exists for certain noncancelable purchase commitments
•Purchase Commitments are contracts with other entities to purchase inventory several months or years in advance
•Accounting does not reflect these commitments since title to the goods has not passed to the buyer
•Disclosure exists for certain noncancelable purchase commitments
InventoriesInventory Purchase Commitments
Three step process:
(1) Inventory + LIFO reserve(2) Deferred tax payable + [LIFO reserve x Tax rate](3) Retained earnings + [LIFO reserve x (1-Tax rate)] LIFO reserve is the amount by which current cost exceeds reported cost of LIFO inventories
Three step process:
(1) Inventory + LIFO reserve(2) Deferred tax payable + [LIFO reserve x Tax rate](3) Retained earnings + [LIFO reserve x (1-Tax rate)] LIFO reserve is the amount by which current cost exceeds reported cost of LIFO inventories
InventoriesAnalyzing Inventories—Restatement of LIFO to FIFO
(1) Companies maintain LIFO inventories in separate cost pools.
(2) When inventory quantities are reduced, each cost layer is matched against current selling prices.
(3) In periods of rising prices, dipping into lower cost layers can inflate profits.
(1) Companies maintain LIFO inventories in separate cost pools.
(2) When inventory quantities are reduced, each cost layer is matched against current selling prices.
(3) In periods of rising prices, dipping into lower cost layers can inflate profits.
InventoriesLIFO Liquidations
Campbell Soup Balance Sheet Adjustment—using an analytical entry:
Inventories 89.6 Deferred Tax Payable 30.5 Retained Earnings 59.1
Campbell Soup Income Statement Adjustment:
Year 11 Under LIFO Difference Under FIFO
Beginning Inventory $ 819.8 $ 84.6 $ 904.4 + Purchases (P)c P ---- P-- Ending inventory (706.7) (89.6) (796.3)= Cost of goods sold $P + 113.1 $ (5.0) $P + 108.1
Campbell Soup Balance Sheet Adjustment—using an analytical entry:
Inventories 89.6 Deferred Tax Payable 30.5 Retained Earnings 59.1
Campbell Soup Income Statement Adjustment:
Year 11 Under LIFO Difference Under FIFO
Beginning Inventory $ 819.8 $ 84.6 $ 904.4 + Purchases (P)c P ---- P-- Ending inventory (706.7) (89.6) (796.3)= Cost of goods sold $P + 113.1 $ (5.0) $P + 108.1
InventoriesAnalyzing Inventories—Restatement of LIFO to FIFO
Investment securities (also called marketable securities) are of two types:
Debt Securities
• Government or corporate debt obligations
Equity Securities
• Corporate stock that is readily marketable.
Investment securities (also called marketable securities) are of two types:
Debt Securities
• Government or corporate debt obligations
Equity Securities
• Corporate stock that is readily marketable.
Investment SecuritiesComposition
Held-to-MaturityHeld-to-Maturity
Controlling Interest (above 50% holding)
Controlling Interest (above 50% holding)
ClassificationInvestment Securities
Investment Securities
Debt Securities Equity Securities
Available-for-SaleAvailable-for-Sale
TradingTrading
Significant Influence (between 20% and 50% holding)
Significant Influence (between 20% and 50% holding)
No Influence (below 20% holding)
- Trading- Available-for-Sale
No Influence (below 20% holding)
- Trading- Available-for-Sale
Investment SecuritiesAccounting for Debt Securities
Accounting
Balance Sheet Income Statement
Category Description Unrealized Gains/Losses
Other
Trading Securities acquired mainly for short-term or trading gains (usually less than three months)
Fair Value Recognize in net income
Recognize realized gains/losses and interest income in net income
Available-for-Sale Securities neither held for trading nor held-to-maturity
Fair Value Not recognized in net income, but recognized in comprehensive income
Recognize realized gains/losses and interest income in net income
Held-to-Maturity Securities acquired with both the intent and ability to hold to maturity
Amortized Cost
Not recognized in either net income or comprehensive income
Recognize realized gains/losses and interest income in net income
Investment SecuritiesAccounting for Transfers between Security Classes
Transfer Accounting
Effect on Asset Value in Balance Sheet
Effect on Income Statement From To
Trading Available-for-Sale No effect Unrealized gain or loss on date of transfer included in net income
Available-for-Sale Trading No effect Unrealized gain or loss on date of transfer included in net income
Available-for-Sale Held-to-Maturity No effect at transfer; however, asset reported at (amortized) cost instead of fair value at future dates
Unrealized gain or loss on date of transfer included in comprehensive income
Held-to-Maturity Available-for-Sale Asset reported at fair value instead of (amortized) cost
Unrealized gain or loss on date of transfer included in comprehensive income
Investment SecuritiesClassification and Accounting for Equity Securities
Category No Influence Significant Influence Controlling Interest
Available-for-Sale Trading
Ownership Less than 20% Less than 20% Between 20% and 50% About 50%
Purpose Long- or intermediate-term investment
Short-term investment or trading
Degree of business control
Full business control
Valuation Basis Fair value Fair value Equity method Consolidation
Balance Sheet Asset Value
Fair value Fair value Acquisition cost adjusted for proportionate share of investee’s retained earnings and appropriate amortization
Consolidated balance sheet
Income Statement: Unrealized Gains
In comprehensive income
In income Not recognized Not recognized
Income Statement: Other Income Effects
Recognize dividends and realized gains and losses in income
Recognize dividends and realized gains and losses in income
Recognize proportionate share of investee’s net income less appropriate amortization in income
Consolidated income statement
At least three main objectives:(1) to separate operating from investing (and
financing) performance(2) to evaluate investment performance and
risk (3) to analyze accounting distortions due to
accounting rules and/or earnings management involving investment securities
At least three main objectives:(1) to separate operating from investing (and
financing) performance(2) to evaluate investment performance and
risk (3) to analyze accounting distortions due to
accounting rules and/or earnings management involving investment securities
Analyzing Investment Securities
Investment Securities
Determine whether investment securities (and related income streams) are investing or operating in nature—based on an assessment of whether each investment is strategic or made purely for the purpose of investment
Remove all gains (losses) relating to investing activities—including dividends, interest income, and realized and unrealized gains and losses—when evaluating the operating performance of a company
Separate operating and non-operating assets when determining operating return on investment
Determine whether investment securities (and related income streams) are investing or operating in nature—based on an assessment of whether each investment is strategic or made purely for the purpose of investment
Remove all gains (losses) relating to investing activities—including dividends, interest income, and realized and unrealized gains and losses—when evaluating the operating performance of a company
Separate operating and non-operating assets when determining operating return on investment
Separating Operating from Investing Assets and Performance
Investment Securities
Analyzing Accounting Distortions from Investment Securities
Investment Securities
Potential accounting distortions an analyst must be alert to:
• Classification based on intent• Opportunities for gains trading• Liabilities recognized at cost• Inconsistent definition of equity securities
Potential accounting distortions an analyst must be alert to:
• Classification based on intent• Opportunities for gains trading• Liabilities recognized at cost• Inconsistent definition of equity securities
Auditors
Derivative Securities
commodity price risk
foreign currency risk
interest rate risk
Background
Market risks
Derivative Securities
Hedges are contracts that seek to insulate companies from market risks—securities such as futures, options, and swaps are commonly used as hedges Derivative securities, or simply derivatives, are contracts whose value is derived from the value of another asset or economic item such as a stock, bond, commodity price, interest rate, or currency exchange rate — they can expose companies to considerable risk because it can be difficult to find a derivative that entirely hedges the risks or because the parties to the derivative contract
fail to understand the risk exposures
Hedges are contracts that seek to insulate companies from market risks—securities such as futures, options, and swaps are commonly used as hedges Derivative securities, or simply derivatives, are contracts whose value is derived from the value of another asset or economic item such as a stock, bond, commodity price, interest rate, or currency exchange rate — they can expose companies to considerable risk because it can be difficult to find a derivative that entirely hedges the risks or because the parties to the derivative contract
fail to understand the risk exposures
Background
Derivative Securities
Derivative is a contract possessing each of the following characteristics:• One or more underlying indexes and one or more notional amounts (and/or payments)—the underlying indexes and the notional amounts determine the settlement amount, if any.
• No initial net investment or an initial net investment less than that required for a normal transaction yielding similar responses to market risk changes.
• Permits a net settlement. Underlying index, or simply underlying (also called a primitive), is the main driver of derivative value--it can be any economic variable such as a commodity price, security price, index, interest rate, or exchange rateNotional amount is the number of units—expressed in figures, weight, volume, dollars, or other unit measure—as specified in the contractNet settlement is a cash resolution for the contracting parties in lieu of settling up in full amounts (or quantities)
Derivative is a contract possessing each of the following characteristics:• One or more underlying indexes and one or more notional amounts (and/or payments)—the underlying indexes and the notional amounts determine the settlement amount, if any.
• No initial net investment or an initial net investment less than that required for a normal transaction yielding similar responses to market risk changes.
• Permits a net settlement. Underlying index, or simply underlying (also called a primitive), is the main driver of derivative value--it can be any economic variable such as a commodity price, security price, index, interest rate, or exchange rateNotional amount is the number of units—expressed in figures, weight, volume, dollars, or other unit measure—as specified in the contractNet settlement is a cash resolution for the contracting parties in lieu of settling up in full amounts (or quantities)
Definitions
Derivative SecuritiesClassification of Derivatives
Derivatives
Hedge Speculative
Fair Value Hedge
Cash Flow Hedge
Foreign Currency
Hedge
Fair Value Hedge
Hedge of Net Investment in
Foreign Operation
Cash Flow Hedge
Derivative SecuritiesAccounting for Derivatives
Derivative Balance Sheet Income Statement
Speculative Derivative recorded at fair value
Unrealized gains and losses included in income
Fair value hedge Both derivative and hedged asset and/or liability recorded at fair value
Unrealized gains and losses on both derivative and hedged asset and/or liability included in income
Cash flow hedge Derivative recorded at fair value (offset by accumulated comprehensive income)
Unrealized gains and losses on effective portion of derivative are recorded in other comprehensive income until settlement date, afterwhich transferred to income; unrealized gains and losses on the ineffective portion of derivative are included in income
Foreign currency fair value hedge
Same as fair value hedge Same as fair value hedge
Foreign currency cash flow hedge
Same as cash flow hedge Same as cash flow hedge
Foreign currency hedge of net investment in foreign operation
Derivative (and cumulative unrealized gain or loss) recorded at fair value (part of cumulative translation adjustment in accumulated comprehensive income)
Unrealized gains and losses reported in other comprehensive income as part of translation adjustment
Derivative Securities
Identify Objectives for Using Derivatives—risk associated with derivatives is much higher for speculation than for hedging; many companies implicitly speculate with derivatives Risk Exposure and Effectiveness of Hedging Strategies—evaluate the underlying risks, the risk management strategy, the activities to hedge its risks, and the effectiveness of hedging operations; also consider counterparty risk Transaction Specific versus Companywide Risk Exposure—evaluate companywide effects of derivatives; hedging specific risk exposures to transactions, commitments, assets, and/or liabilities does not necessarily ensure hedging of companywide risk Inclusion in Operating or Nonoperating Income—to the extent derivatives are hedges, then unrealized and realized gains and losses should be excluded from operating income and their fair values should be excluded from operating assets
Identify Objectives for Using Derivatives—risk associated with derivatives is much higher for speculation than for hedging; many companies implicitly speculate with derivatives Risk Exposure and Effectiveness of Hedging Strategies—evaluate the underlying risks, the risk management strategy, the activities to hedge its risks, and the effectiveness of hedging operations; also consider counterparty risk Transaction Specific versus Companywide Risk Exposure—evaluate companywide effects of derivatives; hedging specific risk exposures to transactions, commitments, assets, and/or liabilities does not necessarily ensure hedging of companywide risk Inclusion in Operating or Nonoperating Income—to the extent derivatives are hedges, then unrealized and realized gains and losses should be excluded from operating income and their fair values should be excluded from operating assets
Analysis of Derivatives
Long-Lived Asset Introduction
Long-lived assets—resources or claims to resources are used to generate revenues (or reduce costs) in the long run
Long-lived assets—resources or claims to resources are used to generate revenues (or reduce costs) in the long run
Definitions
Tangible fixed assets such as property, plant, and equipment
Deferred charges such as research and development (R&D) expenditures, and natural resources
Intangible assets such as patents, trademarks, copyrights, and goodwill
Long-Lived Asset Introduction
Capitalization—process of deferring a cost that is incurred in the current period and whose benefits are expected to extend to one or more future periods For a cost to be capitalized, it must meet each of the following criteria:
• It must arise from a past transaction or event
• It must yield identifiable and reasonably probable future benefits
• It must allow owner (restrictive) control over future benefits
Capitalization—process of deferring a cost that is incurred in the current period and whose benefits are expected to extend to one or more future periods For a cost to be capitalized, it must meet each of the following criteria:
• It must arise from a past transaction or event
• It must yield identifiable and reasonably probable future benefits
• It must allow owner (restrictive) control over future benefits
Capitalization
Long-Lived Asset Introduction
Allocation—process of periodically expensing a deferred cost (asset) to one or more future expected benefit periods; determined by benefit period, salvage value, and allocation method
Terminology
• Depreciation for tangible fixed assets
• Amortization for intangible assets
• Depletion for natural resources
Allocation—process of periodically expensing a deferred cost (asset) to one or more future expected benefit periods; determined by benefit period, salvage value, and allocation method
Terminology
• Depreciation for tangible fixed assets
• Amortization for intangible assets
• Depletion for natural resources
Allocation
Long-Lived Asset Introduction
Impairment—process of writing down asset value when its value-in-use falls below its carrying (book) value Two distortions arise from impairment: • Conservative biases distort
long-lived asset valuation because assets are written down but not written up
• Earnings management opportunities increase in a trade-off for more useful balance sheets
Impairment—process of writing down asset value when its value-in-use falls below its carrying (book) value Two distortions arise from impairment: • Conservative biases distort
long-lived asset valuation because assets are written down but not written up
• Earnings management opportunities increase in a trade-off for more useful balance sheets
Impairment
Tangible
Expected to Benefit Future Periods
Actively Used in Operations
Property, Plant and Equipment
Plant Assets & Natural Resources
Plant Assets
Plant Assets & Natural Resources
Plant Assets
Historical cost principle is used for valuation—justification includes:
• Conservatism—in not anticipating subsequent replacement costs
• Accountability—in dollar amounts for management
• Objectivity—in cost determination
Historical cost principle is used for valuation—justification includes:
• Conservatism—in not anticipating subsequent replacement costs
• Accountability—in dollar amounts for management
• Objectivity—in cost determination
Acquisitioncost
Acquisition cost excludes financing charges and
cash discounts.
All expenditures
needed to prepare the asset for its intended use
Purchaseprice
Plant Assets & Natural Resources
Plant Assets Costing Rule
Total cost,including
exploration anddevelopment,is charged to
depletion expenseover periods
benefited.
Extracted fromthe natural
environmentand reportedat cost less
accumulateddepletion.
Examples: oil, coal, gold
Plant Assets & Natural Resources
Natural Resources Natural resources (wasting assets)—rights to extract or consume natural resources
Valuation emphasizes objectivity of historical cost, the conservatism principle, and accounting for the monies invested; represent a company’s capacity to produce goods and services Limitations of historical costs: • Balance sheets do not purport to reflect market values • Not especially relevant in assessing replacement values • Not comparable across companies • Not particularly useful in measuring opportunity costs • Collection of expenditures reflecting different purchasing power
Plant Assets & Natural Resources
Valuation Analysis
Depreciation is the process of allocating the cost of a plant asset to expense in the
accounting periods benefiting from its use.
Cost
AllocationAcquisition
Cost
(Unused)
Balance Sheet
(Used)
Income Statement
Expense
Depreciation
Plant Assets & Natural Resources
The calculation of depreciation requires three amounts for each
asset:
Cost.
Salvage Value.
Useful Life.
Depreciation Method
Plant Assets & Natural Resources
Factors in Computing Depreciation
The majority of companies use the straight-line method.
Plant Assets & Natural Resources
Comparing Depreciation Methods
Percent of Companies Employing Verious Depreciation Methods
83%
12%5%
Straight Line
Accelerated
Units of Produstion
Cost - Salvage Value
Useful life in periods
Depreciation
Expense per Year=
SL
Plant Assets & Natural Resources
Comparing Depreciation Methods
Straight-Line Method
Facts: Asset cost=$110,000; Useful life=10 years; Salvage value=$10,000
End of Accumulated BookYear Depreciation Depreciation Value
$110,0001 $ 10,000 $ 10,000 100,0002 10,000 20,000 90,000::9 10,000 90,000 20,00010 10,000 100,000 10,000
Plant Assets & Natural Resources
Straight-Line Depreciation Illustration
Step 1:
Step 2:
Double-declining-balance rate
= 2 ×Straight-line
depreciation rate
Step 3:
Depreciationexpense
=Double-declining-
balance rate×
Beginning periodbook value
Ignores salvage value
Straight-linedepreciation rate
= 100 % Useful life
Plant Assets & Natural Resources
Double-Declining-Balance Method
Plant Assets & Natural Resources Double-Declining-Balance (and SYD) Depreciation
Illustration
Depreciation Cumulative AmountDouble- Sum-of-the Double- Sum-of-theYear Declining Years’-Digits Declining Years’-Digits
1 $22,000 $18,182 $22,000 $18,182
2 17,600 16,364 39,600 34,546
3 14,080 14,545 53,680 49,091
4 11,264 12,727 64,944 61,818
5 9,011 10,909 73,955 72,727
6 7,209 9,091 81,164 81,818
7 5,767 7,273 86,931 89,091
8 4,614 5,455 91,545 94,546
9* 4,228 3,636 95,773 98,182
10* 4,228 1,818 100,000 100,000*reverts to straight-line
DepreciationPer Unit
= Cost - Salvage Value Total Units of Production
Step 1:
Step 2:
Depreciation Expense
=Depreciation
Per Unit×
Units Producedin Period
Activity (Units-of-Production) Method
Plant Assets & Natural Resources
Total cost,including
exploration anddevelopment,is charged to
depletion expenseover periods
benefited.
Extracted fromthe natural
environmentand reportedat cost less
accumulateddepletion.
Examples: oil, coal, gold
Plant Assets & Natural Resources
Depletion is calculated using theunits-of-production method.
Unit depletion rate is calculated as follows:
Total Units of Capacity
Cost – Salvage Value
Plant Assets & Natural Resources
Depletion of Natural Resources
Total depletion cost for a period is:Unit Depletion
Rate
Number of Units
Extracted in Period×
Totaldepletion
cost UnsoldInventory
Cost ofgoods sold
Plant Assets & Natural Resources
Depletion of Natural Resources
Plant Assets & Natural Resources
Analyzing Depreciation and Depletion
• Assess reasonableness of depreciable base, useful life, and allocation method
• Review any revisions of useful lives• Evaluate adequacy of depreciation—ratio of depreciation to total
assets or to another size-related factors• Analyze plant asset age—measures include
Average total life span = Gross plant and equipment assets / Current year depreciation expense. Average age = Accumulated depreciation / Current year depreciation expense. Average remaining life = Net plant and equipment assets /
Current year depreciation expense.
Average total life span = Average age + Average remaining life
(these measures also reflect on profit margins and financing requirements)
Noncurrent assetswithout physical
substance.
Noncurrent assetswithout physical
substance.
Useful life isoften difficultto determine.
Useful life isoften difficultto determine.
Usually acquired for operational
use.
Usually acquired for operational
use.
IntangibleAssets
Often provideexclusive rights
or privileges.
Often provideexclusive rights
or privileges.
Intangible Assets
Patents Copyrights Leaseholds Leasehold
Improvements Goodwill Trademarks and
Trade Names
Record at cost, including
purchase price, legal
fees, and filing fees.
Intangible AssetsAccounting for Intangible Assets
Amortize identifiable intangibles over shorter of economic life or legal life, subject to a maximum of 40 years.
Use straight-line method.
Research and development costs arenormally expensed as incurred.
Goodwill is not amortized, but is tested annually for impairment
Intangible AssetsAccounting for Intangible Assets
Manner of Acquisition
Purchased Developed Internally
Identifiable Capitalize Expense (with some intangible and amortize exceptions)
Capitalize ExpenseGoodwill and test
for impairment
Intangible AssetsAccounting for Intangible Assets
Intangible AssetsGoodwill
Goodwill is the value assigned to a rate of earnings above the norm-it translates into excess earnings called superearnings
Goodwill (1) can be a sizable asset, (2) is recorded only upon purchase of another entity or segment, and (3) varies considerably in composition
Occurs when onecompany buys
another company.
Only purchased goodwill is an
intangible asset.
The amount by which thepurchase price exceeds the fair
market value of net assets acquired.
Intangible AssetsGoodwill
Intangible AssetsAnalyzing Intangibles and Goodwill
Search for unrecorded intangibles and goodwill—often misvalued and most likely exist off-balance-sheet
Examine for superearnings as evidence of goodwill
Review amortization periods—any bias likely is in the direction of less amortization and can call for adjustments
Recognize goodwill has a limited useful life--whatever the advantages of location, market dominance, competitive stance, sales skill, or product acceptance, they are affected by changes in business
ROI
= Investment income (Beginning fair value of investment + Ending fair value of investment)/2
ROI
= Investment income (Beginning fair value of investment + Ending fair value of investment)/2
Evaluating Investment Performance and Risk
Investment Securities
Investment income consists of three parts: Interest (and dividend) income + Realized gains and losses + Unrealized gains and losses
Investment income consists of three parts: Interest (and dividend) income + Realized gains and losses + Unrealized gains and losses
(Appendix 4A)
Held-to-Maturity Available-for-Sale TotalInvestment income (1998):Interest and dividend 219 219 Realized gains and lossesUnrealized gains and losses (70) (70)Total before tax 219 (70) 149 Tax adjustment (33%) (72) 23 (49)Total after tax 147 (47) 100
Average investment base (1998):1997 Fair value 1,591 526 2,117 1998 Fair value 1,431 422 1,853 Average 1,511 474 1,985
Return on investment (ROI)Before tax 14.5% -14.8% 7.5%After tax 9.7% -9.9% 5.0%
Held-to-Maturity Available-for-Sale TotalInvestment income (1998):Interest and dividend 219 219 Realized gains and lossesUnrealized gains and losses (70) (70)Total before tax 219 (70) 149 Tax adjustment (33%) (72) 23 (49)Total after tax 147 (47) 100
Average investment base (1998):1997 Fair value 1,591 526 2,117 1998 Fair value 1,431 422 1,853 Average 1,511 474 1,985
Return on investment (ROI)Before tax 14.5% -14.8% 7.5%After tax 9.7% -9.9% 5.0%
Investment SecuritiesEvaluating Investment Performance and Risk—Coca-Cola Case
(Appendix 4A)