Module 5

Reporting and Analyzing Operating Assets

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). An example of a common credit term is 2/10, net 30. From the sellers standpoint, offering the discount is often warranted since it receives cash more quickly and can invest it to yield a return greater than the discount it is offering. The buyer often wishes to avail itself of the discount even if it has to borrow money to do so.

Accounts Receivable

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. Sellers expect that some buyers will not be able to pay their accounts when they come due and the sellers will not be able to collect on all of the accounts that are owed to them. There is risk in the collectibility of accounts receivable, and the collectibility risk is the issue of paramount importance when analyzing accounts receivable.

Allowance for Uncollectible Accounts

The amount of expected uncollectible accounts is usually computed based on an aging analysis. When aging the accounts, an analysis is prepared of the receivables as of the balance sheet date. Each customers 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.

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.

Reporting Accounts Receivable

Accounts receivable are reported on the balance sheet at net realizable value, that is, the gross amount owed to them less the allowance for uncollectible accounts. Given our gross balance of $100,000 and estimated uncollectible accounts of $2,900, accounts receivable will be reported as follows:

Bad Debt Expense

Bad Debt Expense is equal to the increase in the allowance for uncollectible accounts. It is recorded only upon recording the increase (provision). Writing off an uncollectible account does not result in expense. In our previous example, if no previous balance existed in the allowance for uncollectible accounts, the company would record a bad debt expense of $2,900.

If the allowance for uncollectible accounts has a prior balance of $1,500, bad debt expense would be $1,400 (the increase in the allowance for uncollectible accounts)

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:

Gillettes Receivables Footnote

Gillettes Allowance for Doubtful Accounts Footnote

Analysis Implications: Adequacy of Allowance Account

Companies are making two representations by reporting the accounts receivable (net) in the current asset section of the balance sheet:
1.

2.

They expect to collect the total amount reported on the balance sheet (remember, accounts receivable are reported net of the allowance for uncollectible accounts), and They expect to collect this amount within the next year (because of the classification as a current asset).

Analysis Implications: Adequacy of Allowance Account

The first issue, from an analysis viewpoint, is whether the company has adequately provisioned for its uncollectible accounts. If not, the amount of cash ultimately collected will be less that the company is reporting. To assess the adequacy of the allowance account:

Compare with the percentage the company reported in prior years. Compare with the percentage reported by other companies in its industry.

Income Shifting

Be aware that companies have previously used the allowance for uncollectible accounts to shift income from one year into another. For example, 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.

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:

Insights from accounts receivable turnover

1.

Quality Changes in turnover rates (and corresponding

days outstanding) can yield insights into accounts receivable quality. If turnover slows (days outstanding lengthen) compared with prior history, industry averages, and the credit terms offered, the reason could be deterioration in collectibility of receivables. Of course, before such an inference is reached, one must consider a number of alternative explanations:

The company might have changed its credit policies for customers. The company might have changed its sales mix to longer paying customers. The company might have changed its estimation of the provision.

Insights from accounts receivable turnover

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.

High performing companies must be both efficient (controlling margins and operating expenses) and productive (getting the most out of their asset base). An increase in receivables ties up more cash. This is expensive as the receivables must be financed and slower-turning receivables present an increased risk of loss. One of the first of low hanging fruit that companies attack in their efforts to reduce assets is to become more effective in the collection of receivables. This is an important area of focus for both internal and external analysis.

Receivable Turnover Rates for Selected Companies

Inventories

The cost of inventories is reported on the balance sheet and reflects the price of goods purchased from other companies or the costs to manufacture those goods if internally produced. Costs will vary over time and for changes in market conditions. Consequently, the goods available for sale will likely vary in cost from one period to the next even if the quantity of goods available remains the same.

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.

Capitalization Costs

Capitalization means that a cost is recorded on the balance sheet and is not immediately expensed on the income statement. Once costs are capitalized, they remain on the balance sheet as assets until they are used up, at which time they are transferred from the balance sheet to the income statement as expense. If costs are capitalized rather than expensed, then assets, current income, and current equity are all greater.

Cost Capitalization

For purchased inventories (such as with merchandisers), the amount of cost capitalized is the purchase price. For manufacturers, the capitalization issue is more difficult. Manufacturing costs consist of three components:
1.

2.
3.

Raw materials Direct labor Manufacturing overhead (all manufacturing costs except raw materials and direct labor)

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.

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

The Cost of Goods Sold Computation

Inventory Cost Flows to Financial Statements

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.

Inventory Costing Effects on Income Statement

Inventory Costing Effects on Balance Sheet

In periods of rising prices, and assuming that the company has not previously liquidated older layers of inventories, using LIFO would yield ending inventories at costs that can be markedly lower than replacement cost. As a result, balance sheets using LIFO do not accurately represent the current investment in inventories.

Inventory Costing Effects on Cash Flows

In periods of rising prices, companies can get caught in a cash flow squeeze as they pay higher taxes and must replenish inventories at higher replacement costs than originally purchased. This can lead to liquidity problems. One reason frequently cited for using LIFO is the reduced tax liability in periods of rising prices. The IRS requires, however, that companies using LIFO for tax purposes also use it for financial reporting. This is the LIFO conformity rule. Companies using LIFO are also 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.

CATs LIFO Reserve

Gillettes Inventory Footnote

Impairment of Inventories

Companies are required to write down the carrying amount of inventories on the balance sheet if, at the statement date, the reported cost exceeds their market value (determined as the current replacement cost). This is called reporting inventories at the lower of cost or market.

Inventory book value is written down to market value. Inventory write-down is reflected as an expense (part of cost of goods sold) on the income statement.

Gross profit analysis

Gross profit ratio equals gross profit divided by sales. This is an important ratio and is frequently monitored by company management and external equity analysts alike. The gross profit ratio is frequently used instead of the dollar amount of gross profit as it allows for comparisons across companies. 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.

Possible Causes for a Decline in Gross Profit Ratio

Some possible reasons for a decline in Gross Profit Ratio follow: Product line is stale. Perhaps it is out of fashion and the company has had to resort to markdowns to reduce overstocked inventories. Or, perhaps the product lines have lost their technological edge and are no longer in demand. New competitors enter the market. Since there are now substitutes available from competitors, increased selling prices is less likely. General decline in economic activity. This could reduce demand for its products. The recession of the early 2000s resulted in reduced gross profits for many companies. Inventory is overstocked. If a company produces too many goods and finds itself in an overstock position, it can reduce selling prices to move inventory.

Inventory Turnover Rates for Selected Companies

GMs LIFO Liquidation Footnote

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 longterm assets often makeup the larger expense amountstypically reflected in depreciation expense and asset write-downs.

Capitalization of Costs

An expenditure is only reflected on the balance sheet as an asset if it possesses two characteristics:
1. 2.

It is owned or controlled by the entity, and It provides future expected benefits.

Owning the asset means the entity has title to the asset as provided in a purchase contract. Future expected benefits usually mean cash inflows. Companies can only capitalize costs for which the associated cash inflows are directly linked. The amount of costs that can be reported as an asset is limited to an amount no greater than the expected future cash inflows from the investment.

Capitalizing vs. Expensing

The qualification that only those costs for which the associated cash inflows are directly linked is an important one. The following costs are typically expensed:
Research & Development (R&D) Advertising Costs Employee Wages

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.

Depreciation Rate Assumptions

1.

2.

3.

The asset is used up by the same amount each period The asset is used up more in the early years of its useful life The asset is used up in proportion to its actual usage

Variance in Depreciation

A company can depreciate different assets using different depreciation rates (and different useful lives). Whatever depreciation rate is chosen, however, it must generally be used throughout the useful life of that asset. Changes to depreciation rates can be made, but they must be justified as providing better quality financial reports. The using up of an asset generally relates to physical or technological obsolescence.

Physical obsolescence relates to an assets diminished capacity to

produce output.

Technological obsolescence relates to an assets diminished

efficiency in producing output in a competitive manner.

Depreciation Methods

All depreciation methods have the following general formula:

Depreciation Methods:
1.

2.

Straight-line method Accelerated Methods (Double-decliningbalance method)

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

Straight-line Depreciation Example

For the straight-line method, we use our illustrative asset to assign the following amounts to the depreciation formula:

SL Example

For the assets 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.

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:

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:

DDB Depreciation Schedule

Comparison of Depreciation Methods

Asset Sales

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. When a company takes an impairment charge, assets are reduced by the amount of the write-down and the loss is recognized in the income statement, which reduces current period income.

Impairment Analysis

Potential Problems with Asset Write-downs

Asset write-downs present two potential problems:

1.

Insufficient write-down. Assets can be impaired to a

2.

greater extent than is actually recognized. Underestimation of the loss results in a succession of smaller charges rather than one large charge. Writing down more than is necessary. This is the big bath scenario and can arise if income is severely depressed. The argument is that the market will not penalize the extra write-off, and that doing so purges the balance sheet of costs that will burden future years profitability.

Analysis Implications

PPE Turnover: A main analysis of longterm assets involves their productivity.

1.

2.

For example, what level of long-term assets is necessary to generate a dollar of revenues? How capital intensive is the company?

Analysis usually focuses on the fixed asset turnover ratio to provide insight into these questions:

PPE Turnover (PPET) for Selected Companies

Analysis of Useful life and Percent Used Up

Estimated useful life =

Percent used up =