Module 6

1. Module 6 Reporting and Analyzing Operating Assets

2. 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.

3. Cisco Systems, Inc. Current Assets Note: Cisco’s Accounts Receivable are reported net of a $175 million allowance for uncollectible accounts.

4. 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.

5. 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.

6. Reporting Accounts Receivable Given our gross balance of $100,000 and estimated uncollectible accounts of $2,900, accounts receivable will be reported as follows:

7. Bad Debt Expense • Bad Debt Expense is equal to the increase in the allowance for uncollectible accounts. • In our previous example, if a previous balance of $2,200 existed in the allowance for uncollectible accounts, the company would record a bad debt expense of $700. • If the allowance for uncollectible accounts has a prior balance of $(1,000), bad debt expense would be $1,700.

8. Write-off of Uncollectible Accounts • The write-off of an uncollecitble account does not affect income. The amount written-off is reflected as a reduction of the account receivable balance and the allowance for uncollectible accounts:

9. 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.

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

11. Example • Suppose that • sales are $1,000 • ending accounts receivable are $230 • average accounts receivable are $200.

13. Insights from accounts receivable turnover • If turnover slows, the reason could be deterioration in collectibility. 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. • 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.

14. Receivable Turnover Rates for Selected Companies

15. 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.

16. 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. • Overheadcosts include the manufacturing plant depreciation, utilities, plant supervisory personnel, and so forth.

17. 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

18. The Cost of Goods Sold Computation

19. Inventory Cost Flows to Financial Statements

20. 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.

21. FIFO Inventory Costing:

22. LIFO Inventory Costing

23. Weighted Average Inventory Costing Weight4ed Average = $80,000 / 700 units = $114.286 / unit

24. 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

25. Cisco’s Inventories

26. 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 marketand 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.

27. 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.

28. Inventory Costing Effects on Income Statement

29. FIFO’s “Phantom Profits”

30. 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.

31. CAT’s LIFO Reserve • The use of LIFO has reduced the carrying amount of 2005 inventories by $2,345 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.

32. LIFO’s Cash Savings for CAT • Use of LIFO reduced CAT’s inventories by $2,345 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 $821 million ($2,345 million 35% assumed corporate tax rate).

33. Gross profit analysis • Gross profit ratio equals gross profit divided by 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.

34. Cisco’s Gross Profit Margin

35. Possible Causes for a Decline in Gross Profit Ratio • Some possible reasons for a decline in Gross Profit Ratio follow: • 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.

36. Inventory Turnover Rates for Selected Companies

37. Average Inventory Days for Selected Industries

38. Sears and Kmart

39. Motorola Avg. Inv. Days Outstanding

40. Long-Term Assets • Long-term assets mainly consist of property, plant, and equipment (PPE). • These assets often makeup the largest asset amounts. • Future expenses arising from these long-term assets often makeup the larger expense amounts—typically reflected in depreciation expense and asset write-downs.

41. Depreciation Factors and Process Depreciation requires the following estimates: • Useful life – period of time over which the asset is expected to generate cash inflows • Salvage value – Expected disposal amount for the asset at the end of its useful life • Depreciation rate – an estimate of how the asset will be used up over its useful life.

42. 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.

43. Depreciation Methods • All depreciation methods have the following general formula: • Depreciation Methods: • Straight-line method • Accelerated Methods (Double-declining-balance method)

44. Straight-line Method • Straight-line method: Under the straight-line (SL) method, depreciation expense is recognized evenly over the estimated useful life of the asset. • Consider the following example: An asset (machine) with the following details: (1) cost of $100,000 (2) salvage value of $10,000 (3) useful life of 5 years

45. Straight-line Depreciation Example • For the straight-line method, we use our illustrative asset to assign the following amounts to the depreciation formula:

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

47. 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:

48. Double-declining-balance method • The asset is reported on the balance sheet as follows: • In the second year, $24,000 ($60,000  40%) of depreciation expense is recorded in the income statement and the NBV of the asset on the balance sheet follows:

49. DDB Depreciation Schedule

50. Comparison of Depreciation Methods INSIGHT: All depreciation methods leave the same salvage value. Total depreciation over asset life is identical for all methods.