4 chapter analyzing investing activities. current (short- term) assets noncurrent (long-term) assets...

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.


expected to be sold, collected, or used

within one year or the operating cycle,

whichever is longer.


expected to yield benefits that extend beyond one year or the operating cycle, whichever is longer.


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

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Products sold to customers

Cash on hand

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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

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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


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


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


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


Analyzing Accounting Distortions from 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


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 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


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


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


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


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

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 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


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


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


The calculation of depreciation requires three amounts for each

asset:

Cost.

Salvage Value.

Useful Life.

Depreciation Method


Factors in Computing Depreciation

The majority of companies use the straight-line method.


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


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


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


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


Total cost,including

exploration anddevelopment,is charged to

depletion expenseover periods

benefited.

Extracted fromthe natural

environmentand reportedat cost less

accumulateddepletion.

Examples: oil, coal, gold


Depletion is calculated using theunits-of-production method.

Unit depletion rate is calculated as follows:

Total Units of Capacity

Cost – Salvage Value


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


Depletion of 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


Manner of Acquisition

Purchased Developed Internally

Identifiable Capitalize Expense (with some intangible and amortize exceptions)

Capitalize ExpenseGoodwill and test

for impairment


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 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)

4 chapter analyzing investing activities. current (short- term) assets noncurrent (long-term) assets...

Documents

customers cash

cash currency

known cash

cash equivalents shortterm

current assets

liquidity slide

current obligations

bank accounts