1. Peter D. Easton Mary Lea McAnally Greg Sommers Xiao-Jun Zhang ©Cambridge Business Publishers, 2015 M ODULE 6 Asset Recognition and Operating Assets

2. ©Cambridge Business Publishers, 2015 2 Learning Objective 1 Describe accounting for accounts receivable and the importance of the allowance for uncollectible accounts in determining profit.

3. Accounts Receivable  When companies sell to other companies, they offer credit terms, which are called sales on credit (or credit sales or sales on account).  Accounts receivable are reported on the balance sheet of the seller at net realizable value, which is the net amount the seller expects to collect. ©Cambridge Business Publishers, 2015 3

4. Cisco Systems, Inc. Current Assets 4 ©Cambridge Business Publishers, 2015 Note: Cisco’s Accounts Receivable are reported net of a $207 million allowance for uncollectible accounts.

5. Allowance for Uncollectible Accounts  The amount of expected uncollectible accounts is usually computed based on an aging analysis.  Each customer’s account balance is categorized by the number of days or months the underlying invoices have remained outstanding.  Based on prior experience or on other available statistics, bad debts percentages are applied to each of these categorized amounts, with larger percentages being applied to older accounts. ©Cambridge Business Publishers, 2015 5

6. Aging Analysis Example  GAAP requires companies to disclose the amount of the allowance for uncollectible accounts, either on the face of the balance sheet or in the notes.  Companies are also required to disclose their accounting policies with respect to receivables. ©Cambridge Business Publishers, 2015 6

7. Reporting Accounts Receivable Given a  gross balance of $100,000 and  estimated uncollectible accounts of $2,900,  accounts receivable will be reported as follows: ©Cambridge Business Publishers, 2015 7

8. 3M’s Current Assets 8 ©Cambridge Business Publishers, 2015

9. Bad Debt Expense  Bad Debt Expense is equal to the increase in the allowance for uncollectible accounts.  In our previous example,  if the estimated amount of credit losses is $2,900, and  a previous balance of $2,200 existed in the allowance for uncollectible accounts,  the company would record a bad debt expense of $700.  and,  If the allowance for uncollectible accounts has a balance of $1,000,  bad debt expense would be $1,900. ©Cambridge Business Publishers, 2015 9

10. Write-Off or Uncollectible Accounts  The write-off of an uncollectible account does not affect income. The amount written-off is reflected as a reduction of the account receivable balance and the allowance for uncollectible accounts: ©Cambridge Business Publishers, 2015 10

11. Accounts Receivable Transactions 11 ©Cambridge Business Publishers, 2015

12. Cisco’s Receivable Footnote 12 ©Cambridge Business Publishers, 2015

13. Cisco’s Allowance for Doubtful Accounts Footnote 13 ©Cambridge Business Publishers, 2015

14. Oracle’s Allowance for Doubtful Accounts Footnote 14 ©Cambridge Business Publishers, 2015

15. Income Shifting  By underestimating the provision, expense is reduced in the income statement, thus increasing current period income.  In one or more future periods, when write-offs occur for which the company should have provisioned earlier, it must then increase the provision to make up for the underestimated provision for the earlier period.  This reduces income in one or more subsequent periods. Income has, thus, been shifted (borrowed) from a future period into the current period. ©Cambridge Business Publishers, 2015 15

16. Receivables Turnover Rate and Days Sales in Receivables  The accounts receivables turnover (ART) rate is defined as ©Cambridge Business Publishers, 2015 16  The accounts receivable turnover rate reveals how many times receivables have turned (been collected) during the period.  More turns indicate that receivables are being collected quickly.  A companion ratio is the Average Collection Period:

17. Example  Suppose that  sales are $1,000  ending accounts receivable are $230  average accounts receivable are $200. ©Cambridge Business Publishers, 2015 17

18. Insights from Accounts Receivable Turnover 1.If turnover slows, the reason could be deterioration in collectability. However, there are at least three alternative explanations:  A seller can extend its credit terms.  A seller can take on longer-paying customers.  The seller can increase the allowance provision. 2. Asset utilization Asset turnover is often viewed as an important dimension of financial performance, both by managers for internal performance goals, as well as by the market in evaluating investment choices. ©Cambridge Business Publishers, 2015 18

19. Receivable Turnover Rates for Selected Companies 19 ©Cambridge Business Publishers, 2015

20. Average Collection Period for Selected Industries 20 ©Cambridge Business Publishers, 2015

21. 21 Learning Objective 2 Explain accounting for inventories and assess the effects on the balance sheet and income statement from different inventory costing methods.

22. Inventories  Inventory costs either are reported on the balance sheet or they are transferred to the income statement as an expense (cost of goods sold) to match against sales revenues.  The process for which costs are removed from the balance sheet is important. ©Cambridge Business Publishers, 2015 22

23. 3M’s Current Assets 23 ©Cambridge Business Publishers, 2015

24. Manufacturing Costs  Raw materials cost is relatively easy to compute. Design specifications list the components of each product, and their purchase costs are readily determined.  Labor cost in a unit of inventory is based on how long each unit takes to build and the rates for each labor class working on that product.  Overhead costs include the manufacturing plant depreciation, utilities, plant supervisory personnel, and so forth. ©Cambridge Business Publishers, 2015 24

25. Cost of Goods Sold  When inventories are used up in production or are sold, their cost is transferred from the balance sheet to the income statement as cost of goods sold (COGS).  COGS is then matched against sales revenue to yield gross profit: Sales revenue -COGS Gross profit ©Cambridge Business Publishers, 2015 25

26. The Cost of Goods Sold Computation 26 ©Cambridge Business Publishers, 2015

27. Inventory Cost Flows to Financial Statements 27 ©Cambridge Business Publishers, 2015

28. Inventory Costing Methods  First-In, First-Out (FIFO) – This method assumes that the first units purchased are the first units sold.  Last-In, First-Out (LIFO) – The LIFO inventory costing method assumes that the last units purchased are the first to be sold.  Average cost – The average cost method assumes that the units are sold without regard to the order in which they are purchased. Instead, it computes COGS and ending inventories as a simple weighted average. ©Cambridge Business Publishers, 2015 28

29. FIFO Inventory Costing FIFO Inventory Costing: 29 ©Cambridge Business Publishers, 2015

30. LIFO Inventory Costing LIFO Inventory Costing: 30 ©Cambridge Business Publishers, 2015

31. Average Inventory Costing Average Inventory Costing: Average cost = $80,000 / 700 units = $114.286 / unit 31 ©Cambridge Business Publishers, 2015

32. Lower of Cost or Market  Companies must write down the carrying amount of inventories on the balance sheet if the reported cost exceeds market value.  This process is called reporting inventories at the lower of cost or market and creates the following financial statement effects:  Inventory book value is written down to current market value (replacement cost); reducing inventory and total assets.  Inventory write-down is reflected as an expense on the income statement. ©Cambridge Business Publishers, 2015 32

33. LCM Illustration  To illustrate,  assume that a company has inventory on its balance sheet at a cost of $27,000.  Management learns that the inventory’s replacement cost is $23,000 and writes inventories down to a balance of $23,000.  The following financial statement effects template shows the adjustment. ©Cambridge Business Publishers, 2015 33

34. Cisco’s Inventory Footnote  This footnote includes at least two items of interest for our analysis of inventory:  Cisco uses the FIFO method of inventory costing.  Inventories are reported at the lower of cost or market (LCM), which means that inventory is written down if its replacement cost, referred to as ‘market,’ declines below its balance sheet cost. ©Cambridge Business Publishers, 2015 34

35. Cisco’s Inventories 35 ©Cambridge Business Publishers, 2015

36. Inventory Costing Effects on Income Statement 36 ©Cambridge Business Publishers, 2015

37. FIFO’s “Phantom Profits” Assume a FIFO inventory costing method: Beginning Inventory: 35 units @ $1.20 Purchase of 20 units @ $1.35 Ending Inventory: 10 units 45 units were sold at a price of $2.75/unit Gross profit is computed as follows: Sales (45 x $2.75)$123.75 FIFO COGS (35 @ $1.20 + 10 @ $1.35) 55.50 Gross Profit$ 68.25 Q: What portion of the gross profit is “economic” and what portion is the “holding gain”? 37 ©Cambridge Business Publishers, 2015

38. FIFO’s “Phantom Profits” Phantom profit consists of both economic profit and holding gain.  Economic profit is the number of units sold multiplied by the difference between the sales price and the replacement cost of the inventories.  Holding gain is the increase in replacement cost since the inventories were acquired, which equals the number of units on hand at the start of the period multiplied by the difference between the current replacement cost and the original acquisition cost.  This is typically approximated by the LIFO reserve (the difference between LIFO and FIFO inventories). 38 ©Cambridge Business Publishers, 2015 Solution: Economic Profit: 45 units x ($2.75-$1.35)$63.00 Holding Gain: 35 units x ($1.35-$1.20)5.25 $68.25

39. Inventory Costing Effects on Cash Flows  One reason frequently cited for using LIFO is the reduced tax liability in periods of rising prices.  Companies using LIFO are required to disclose the amount at which inventories would have been reported had it used FIFO.  The difference between these two amounts is called the LIFO reserve. ©Cambridge Business Publishers, 2015 39

40. CAT’s LIFO Reserve  The use of LIFO has reduced the carrying amount of 2012 inventories by $2,750 million.  This difference, referred to as the LIFO reserve, is the amount that must be added to LIFO inventories to adjust them to their FIFO value. ©Cambridge Business Publishers, 2015 40

41. LIFO’s Cash Savings for CAT  Use of LIFO reduced CAT’s inventories by $2,750 million, resulting in a cumulative increase in cost of goods sold and a cumulative decrease in gross profit and pretax profit of that same amount.  Because CAT also uses LIFO for tax purposes, the decrease in pretax profits reduced CAT’s cumulative tax bill by about $963 million ($2,750 million X 35% assumed corporate tax rate). ©Cambridge Business Publishers, 2015 41

42. Gross Profit Analysis  Gross profit ratio = gross profit ÷ sales.  A decline in this ratio is usually cause for concern since it indicates that the company has less ability to mark up the cost of its products into selling prices. ©Cambridge Business Publishers, 2015 42

43. Cisco’s Gross Profit Margin 43 ©Cambridge Business Publishers, 2015

44. Possible Causes for a Decline in Gross Profit Ratio  Some possible reasons for a decline in Gross Profit Ratio:  Product line is stale.  New competitors enter the market.  General decline in economic activity.  Inventory is overstocked.  Manufacturing costs have increased.  Changes in product mix. ©Cambridge Business Publishers, 2015 44

45. Inventory Turnover Rates for Selected Companies 45 ©Cambridge Business Publishers, 2015

46. Average Inventory Days for Selected Companies 46 ©Cambridge Business Publishers, 2015

47. Rite Aid’s LIFO Liquidation Footnote 47 ©Cambridge Business Publishers, 2015

48. 48 Learning Objective 3 Describe accounting for property, plant and equipment and explain the impacts on profit and cash flows from depreciation methods, disposals and impairments.

49. Long-Term Assets  Long-term assets mainly consist of property, plant, and equipment (PPE).  These assets often make up the largest asset amounts, and  Future expenses arising from these long-term assets often make up the larger expense amounts—typically reflected in depreciation expense and asset write-downs. ©Cambridge Business Publishers, 2015 49

50. Depreciation Factors and Process Depreciation requires the following estimates: 1.Useful life – period of time over which the asset is expected to generate cash inflows 2.Salvage value – Expected disposal amount for the asset at the end of its useful life 3.Depreciation rate – an estimate of how the asset will be used up over its useful life ©Cambridge Business Publishers, 2015 50

51. Variance in Depreciation  A company can depreciate different assets using different depreciation rates (and different useful lives).  The using up of an asset generally relates to physical or technological obsolescence. ©Cambridge Business Publishers, 2015 51

52. Depreciation Methods  All depreciation methods have the following general formula: ©Cambridge Business Publishers, 2015 52  Depreciation Methods: 1.Straight-line method 2.Accelerated Methods (Double-declining-balance method)

53. Straight-Line Method  Straight-line method: Under the straight-line (SL) method, depreciation expense is recognized evenly over the estimated useful life of the asset.  Consider the following example: An asset (machine) with the following details:  cost of $100,000  salvage value of $10,000  useful life of 5 years ©Cambridge Business Publishers, 2015 53

54. Straight-Line Depreciation Example  For the straight-line method, we use our illustrative asset to assign the following amounts to the depreciation formula: ©Cambridge Business Publishers, 2015 54

55. SL Example  For the asset’s first year of usage,  $18,000 ($90,000 * 20%) of depreciation expense is reported in the income statement.  At the end of that first year the asset is reported on the balance sheet as follows: Net book value (NBV) is cost less accumulated depreciation. ©Cambridge Business Publishers, 2015 55  At the end of year 2, the net book value will be reduced by another $18,000 to $64,000:

56. Double-Declining-Balance Method  Double-declining-balance method – For the double-declining-balance (DDB) method, we use our illustrative asset to assign the following amounts to the depreciation formula: ©Cambridge Business Publishers, 2015 56

57. Double-Declining-Balance Method  The asset is reported on the balance sheet as follows: ©Cambridge Business Publishers, 2015 57  In the second year, $24,000 ($60,000  40%) of depreciation expense is recorded in the income statement and the NBV of the asset on the balance sheet follows:

58. DDB Depreciation Schedule 58 ©Cambridge Business Publishers, 2015

59. Comparison of Depreciation Methods INSIGHT: All depreciation methods leave the same salvage value. Total depreciation over asset life is identical for all methods. 59 ©Cambridge Business Publishers, 2015

60. Asset Sales 60 ©Cambridge Business Publishers, 2015 Alcoa carries the sale of the hydroelectric project on its balance sheet at $277 million, computed as $597 million cash from the sale less the $320 million realized gain on sale. Alcoa’s sale of land:

61. Asset Impairments  Impairment of plant assets other than goodwill is determined by comparing the sum of the expected future (undiscounted) cash flows generated by the asset with its net book value.  Companies must recognize a loss if the asset is deemed to be impaired. ©Cambridge Business Publishers, 2015 61

62. Abercrombie & Fitch’s Asset Impairment 62 ©Cambridge Business Publishers, 2015

63. Potential Problems with Asset Write-Downs  Asset write-downs present two potential problems: 1.Insufficient write-down 2.Writing down more than is necessary ©Cambridge Business Publishers, 2015 63

64. Footnote Disclosures  Cisco reports the following PPE asset amounts in its balance sheet: ©Cambridge Business Publishers, 2015 64

65. Cisco’s Depreciation Policy Supplemental Information: 65 ©Cambridge Business Publishers, 2015

66. Analysis Implications  PPE Turnover: analysis of the productivity of long-term assets ©Cambridge Business Publishers, 2015 66

67. PPE Turnover for Selected Companies 67 ©Cambridge Business Publishers, 2015

68. PPE Turnover for Selected Industries 68 ©Cambridge Business Publishers, 2015

69. Analysis of Useful Life and Percent Used Up  Estimated useful life = ©Cambridge Business Publishers, 2015 69  Percent used up =

70. Global Accounting  Accounts Receivable - Accounts receivable are accounted for identically with one notable exception. Under IFRS, all receivables are treated as financial assets.  Inventory - There are three notable differences in accounting for inventory:  IFRS does not permit use of the LIFO method.  Under U.S. GAAP, inventory is carried at lower of cost or market; under IFRS it is lower of cost or net realizable value.  IFRS permits companies to reverse inventory write- downs. ©Cambridge Business Publishers, 2015 70

71. Global Accounting  Fixed Assets - In accounting for fixed assets, four notable differences deserve mention:  Under IFRS, fixed assets are disaggregated into individual components and then each component is separately depreciated over its useful life.  Property, plant and equipment can be carried at depreciated cost under U.S. GAAP and IFRS, but can be revalued at fair market value under IFRS.  IFRS uses discounted expected future cash flows for both steps, which means IFRS uses one step.  IFRS fair-value impairments for fixed assets can be reversed. ©Cambridge Business Publishers, 2015 71

72. The End