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MBA Module 3 PPT


Title: MBA Module 3 PPT Author: Halsey, Robert Last modified by: Computer 10 Created Date: 2/8/2004 7:37:47 PM Document presentation format: On-screen Show – PowerPoint PPT presentation

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Title: MBA Module 3 PPT

Financial Statement Analysis Valuation Third
Peter D. Mary Lea Gregory A. Xiao-Jun Easton McAn
ally Sommers Zhang
Module 6 Asset Recognition and Operating
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

Cisco Systems, Inc. Current Assets
Note Ciscos Accounts Receivable are reported
net of a 235 million allowance for uncollectible
Allowance for Uncollectible Accounts
  • The amount of expected uncollectible accounts is
    usually computed based on an aging analysis.
  • 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
  • Given our gross balance of 100,000 and estimated
    uncollectible accounts of 2,900, accounts
    receivable will be reported as follows

3Ms Current Assets
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.

Write-off of 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

Accounts Receivable Transactions
Ciscos Receivable Footnote
Ciscos Allowance for Doubtful Accounts Footnote
Oracles Allowance for Doubtful Accounts Footnote
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

Receivables Turnover Rate and Days Sales in
  • 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

  • Suppose that
  • sales are 1,000
  • ending accounts receivable are 230
  • average accounts receivable are 200

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.

Receivable Turnover Rates for Selected Companies
Average Collection Period for Selected Industries
  • 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.

3Ms Current Assets
Manufacturing Costs
  • Raw materials cost is relatively easy to compute.
    Design specifications list the components of each
    product, and their purchase costs are readily
  • 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 Methods
FIFO Inventory Costing
Inventory Costing Methods
LIFO Inventory Costing
Inventory Costing Methods
Average Inventory Costing
Average cost 80,000 / 700 units 114.286 /
Ciscos 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

Ciscos Inventories
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.

LCM Illustration
  • To illustrate, assume that a company has
    inventory on its balance sheet at a cost of
  • Management learns that the inventorys
    replacement cost is 23,000 and writes
    inventories down to a balance of 23,000.
  • The following financial statement effects
    template shows the adjustment.

Inventory Costing Effects on Income Statement
FIFOs Phantom Profits
Assume a FIFO inventory costing
method   Beginning Inventory 1/01/04 35
units _at_ 1.20 Purchase of 20 units
_at_ 1.35 Ending Inventory 03/31/04 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 _at_ 1.20 10 _at_ 1.35) 55.50 Gross
Profit 68.25    Q What portion of the gross
profit is economic and what portion is the
holding gain?
FIFOs Phantom Profits Solution
Economic Profit 45 units x (2.75-1.35) 63.00
Holding Gain 35 units x (1.35-1.20) 5.25
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 sold
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
Inventory Costing Effects on Cash Flows
  • One reason frequently cited for using LIFO is the
    reduced tax liability in periods of rising
  • 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.

CATs LIFO Reserve
  • The use of LIFO has reduced the carrying amount
    of 2010 inventories by 2,575 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.

LIFOs Cash Savings for CAT
  • Use of LIFO reduced CATs inventories by 2,617
    million, resulting in a cumulative increase in
    cost of goods sold and a cumulative decrease in
    gross profit and pretax profit of that same
  • Because CAT also uses LIFO for tax purposes, the
    decrease in pretax profits reduced CATs
    cumulative tax bill by about 901 million (2,575
    million 35 assumed corporate tax rate).

Gross Profit Analysis
  • Gross profit ratio equals gross profit divided by
  • 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.

Ciscos Gross Profit Margin
Possible Causes for a Decline in Gross Profit
  • 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.

Inventory Turnover Rates for Selected Companies
Average Inventory Days for Selected Industries
Newell Rubbermaid's LIFO Liquidation Footnote
Long-Term Assets
  • Long-term assets mainly consist of property,
    plant, and equipment (PPE).
  • These assets often makeup the largest asset
  • Future expenses arising from these long-term
    assets often makeup the larger expense
    amountstypically reflected in depreciation
    expense and asset write-downs.

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

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.

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

Straight-Line Method
  • Straight-line method Under the straight-line
    (SL) method, depreciation expense is recognized
    evenly over the estimated useful life of the
  • 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 x 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
  • 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
  • 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
INSIGHT All depreciation methods leave the same
salvage value. Total depreciation over asset life
is identical for all methods.
Asset Sales
International Paper Co.s sale of land
International Paper sold land, carried on its
balance sheet at 1.7 billion (computed as 6.1
billion sale less 4.4 billion gain), for 6.1
billion, and realized a gain on the sale of 4.4
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.

Starbucks Asset Impairment
Potential Problems with Asset Write-Downs
  • Asset write-downs present two potential problems
  • Insufficient write-down
  • Writing down more than is necessary

Footnote Disclosures
  • Cisco reports the following PPE asset amounts in
    its balance sheet

Ciscos Depreciation Policy
Supplemental information
Analysis Implications
  • PPE Turnover analysis of the productivity of
    long-term assets

PPE Turnover for Selected Companies
PPE Turnover for Selected Industries
Analysis of Useful life and Percent Used Up
  • Estimated useful life
  • Percent used up

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

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.

End Module 6