Chapter 04 - Analyzing Investing Activities

Chapter 4
Analyzing Investing Activities

REVIEW

Assets are the driving forces of profitability for a company. Assets produce revenues
that compensate workers, repay lenders, reward owners, and fund growth. Current
assets are resources or claims to resources readily convertible to cash. Major current
assets include cash and cash equivalents, marketable securities, receivables, derivative
financial instruments, inventories, and prepaid expenses. Our analysis of current assets
provides us insights into a company's liquidity. Liquidity is the length of time until
assets are converted to cash. It is an indicator of a company's ability to meet financial
obligations. The less liquid a company, the lower is its financial flexibility to pursue
promising investment opportunities and the greater its risk of failure. Noncurrent assets
are resources or claims to resources expected to benefit more than the current period.
Major noncurrent assets include property, plant, equipment, intangibles, investments,
and deferred charges. Our analysis of noncurrent assets provides us insights into a
company's solvency and operational capacity. Solvency refers to the ability of a
company to meets its long-term (and current) obligations. Operational capacity is the
ability of a company to generate future profits. This chapter shows how we use
financial statements to better assess liquidity, solvency, and operational capacity using
asset values, and to critically evaluate a company's financial performance and
prospects. The accounting practices underlying the measurement and reporting of
current and noncurrent assets are described. We discuss the accounting for these
assets and its implications for analysis of financial statements. Special attention is
given to various analytical adjustments helping us better understand current and future
prospects.

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OUTLINE

Section 1: Current Assets

 Cash and Cash Equivalents
Analyzing Cash and Cash Equivalents
 Receivables
Valuation of Receivables
Analyzing Receivables
 Prepaid Expenses
 Inventories
Inventory Accounting and Valuation
Analyzing Inventories

Section 2: Noncurrent Assets

 Introduction to Long-Lived Assets
Accounting for Long-Lived Assets
Capitalizing versus Expensing: Financial Statement and Ratio Effects
 Plant Assets and Natural Resources
Valuing Plant Assets and Natural Resources
Depreciation and Depletion
 Intangible Assets
Accounting for Intangibles
Analyzing Intangibles
Goodwill
Unrecorded Intangibles and Contingencies

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ANALYSIS OBJECTIVES

 Define current assets and their relevance for analysis.

 Explain cash management and its implications for analysis.

 Analyze receivables, allowances for bad debts, and securitization.

 Interpret the effects of alternative inventory methods under varying business

conditions.

 Explain the concept of long-lived assets and its implications for analysis.

 Interpret valuation and cost allocation of plant assets and natural resources.

 Describe and analyze intangible assets and their disclosures.

 Analyze financial statements for unrecorded and contingent assets.

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QUESTIONS
1. a. No. When analyzing cash, the most liquid of current assets, the analyst is
interested in the availability of cash in meeting the company's obligations. A
restriction under compensating balance arrangements does, at worst, remove
these cash balances from immediate availability as means of payment. Indeed,
use of such balances can have repercussions for the company that can affect its
future access to bank credit.
b. The analyst should exclude cash restricted under compensating balance
agreements from current assets. SEC Accounting Series Release 148 requires
that a company that has borrowed money from a bank segregate on its balance
sheet any cash subject to withdrawal or usage restrictions under compensating
balance agreements with the lending bank. These requirements may, as is often
the case in such situations, move companies and their banker to alter the form of
their contractual agreements while retaining their substance. The analyst must be
ever alert to such attempts to distort analysis measurements by presentations
whose form is not a true reflection of their substance. One measure of a
company’s vulnerability in this area is the ratio of restricted cash to total cash.

2. a. The operating cycle concept is important in the classification of assets and

liabilities as either current or noncurrent. The operating cycle encompasses the
period of time from the commitment of cash for purchases until the collection of
receivables resulting from the sale of goods or services. The diagram near the
beginning of Chapter 4 illustrates this concept.

b. If the normal collection interval of a receivables is longer than a year (such as

with longer term installment receivables), then their inclusion as current assets is
proper provided the operating cycle is equal to or greater than the obligation due
date for the receivables. Similarly, if inventories, by business need or custom,
have to be kept on average for more than 12 months, then this normal inventory
holding period becomes part of the operating cycle and such inventories are
included among current assets.

c. The limitations of the current ratio (which is computed from items defined as
working capital) as a measure of short-term liquidity are discussed in Chapter 11.
Still, if we accept the proposition that it is useful to measure the current
resources available to pay current obligations, then it is difficult to see how
extension of "current" from the customary 12 months to periods of 36 months or
longer can serve a useful purpose. The operating cycle concept may help
companies show the kind of positive current position that they otherwise might
not be able to show, but this concept is of doubtful value or validity from the
point of view of a financial analyst that must assess a company’s short-term
liquidity.

d. (1) Tobacco Industry. The tobacco leaf must go through an aging, curing, and
drying process extending over several years. This tobacco inventory (green
leaves), that may not be used in the production of a salable product for many
years, is classified as current under the operating cycle concept. This would

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occur even if long-term loans (classified among noncurrent liabilities) were taken
out to finance the carrying of this inventory.

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(2) Liquor Industry. The liquor industry has an operating cycle extending beyond
the customary 12 months. In this case, the holding of liquor inventory for aging
purposes over many years provides sufficient justification for inclusion of such
inventories among current assets.

(3) Retailing Industry. In retailing, the sale of "large ticket" items on the
installment plan can extend the operating cycle to, for example, 36 months or
longer. As such, these installment receivables are reported among current
assets.

3. a. The two most important questions facing the financial analyst with respect to
receivables are: (1) Is the receivable genuine, due, and enforceable?, and (2) Has
the probability of collection been properly assessed? While the unqualified
opinion of an independent auditor lends some assurance with regard to these
questions, the financial analyst must recognize the possibility of an error of
judgment as well as the lack of complete independence.

b. Description of the receivables in the notes to financial statements usually do not

contain sufficient clues to allow a reliable judgment as to whether a receivable is
genuine, due, and enforceable. Consequently, knowledge of industry practices
and supplementary sources of information must be used for additional
assurance, e.g.:
 In some industries, such as compact discs, toys, or books, a substantial right
of merchandise return exists and allowance must be made for this.
 Most provisions for uncollectible accounts are based on past experience
although they should also make allowances for current and emerging industry
conditions. In practice, the accountant is likely to attach more importance to
the former than to the latter. The analyst must, in such cases, use one’s own
judgment and knowledge of industry conditions to assess the adequacy of the
provision for uncollectible accounts.
 Information that would be helpful in assessing the general level of collection
risks with receivables is not usually found in published financial statements.
Such information can, of course, be sought from the company directly.
Examples of such information are: (1) What is customer concentration? What
percent of total receivables is due from one or a few major customers? Would
failure of any one customer have a material impact on the company's financial
condition? (2) What is the age pattern of the receivables? (3) What proportion
of notes receivable represent renewals of old notes? (4) Have allowances
been made for trade discounts, returns, or other credits to which customers
are entitled?
 The analyst, in assessing current financial position and a company's ability to
meet its obligations currently—as expressed by such measures as the current
ratio—must recognize the full impact of accounting conventions that relate to
classification of receivables as "current." For example, the operating cycle
concept allows the inclusion of installment receivables, which may not be
fully collectible for years. In balancing these against current obligations,
allowance for such differences in timing of cash flows should be made.

4. a. Factoring or securitization of receivables refers to the practice of selling

all or a portion of a company’s receivables to a third party.

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b. When receivables are sold with recourse, the third party purchaser of the
receivables retains the right to collect from the company that sold the
receivable if the receivable proves uncollectible. When receivables are sold
without recourse, the purchaser of the receivables assumes the collection
risk.

c. When receivables are sold with recourse, the balance sheet reports the cash
received from the sale of the receivable. However, the balance sheet may or
may not report the contingent liability to the receivables purchaser for
uncollectible receivables purchased with recourse—this depends on who
assumes the risk of ownership.

5. a. Few useful generalizations about the effect of differing methods of inventory

valuation on financial analysis can be made. Yet, we provide some guidance.
 In the case of LIFO, we know that under conditions of fluctuating price levels,
it will have a smoothing effect on income. Moreover, the LIFO method yields,
in times of price inflation, an unrealistically low inventory amount. This, in
turn, lowers the current ratio and tends to increase the inventory turnover
ratio. We also know that the LIFO method affords management an opportunity
to manipulate profits by allowing inventory to be depleted in poor years, thus
drawing on the low cost pool to inflate income. A judgment on all of these
consequences can only be made on the basis of an assessment of all
surrounding circumstances. For example, a slight change in a current ratio of
4:1 may be of no significance, whereas the same change in a ratio of 1.5:1
may be of far greater importance.
 The use of FIFO for the valuation of inventories will generally result in a
higher inventory on the balance sheet and a lower cost of goods sold (and
higher income) in comparison to LIFO.
 The average cost method smoothes out cost fluctuations by using a weighted
average cost in valuing inventories and in pricing cost of goods sold. The
resulting net income will be close to an average of the net income under LIFO
and FIFO.
 The "lower-of-cost-or-market" principle of inventory accounting has additional
implications for the analyst. In times of rising prices it tends to undervalue
inventories regardless of the cost method used. This, in turn, will depress the
current ratio below its true level since the other current assets (as well as
current liabilities) are not valued on a consistent basis with the methods used
in valuing inventories.

b. In practice we can find wide variations in the kinds of costs that are included in
inventory. Practice varies particularly with respect to the inclusion or exclusion
of (1) various classes of overhead costs, (2) freight-in, and (3) general and
administrative costs. This variety in practices can have a significant effect on
comparability across companies.

6. a. The allocation of overhead costs to all units of production must be done on a

rational basis designed to get the best approximation of actual cost. However,
this is far from easy. The greatest difficulty stems from the fact that a good part of
overhead is fixed costs, i.e., costs that do not vary with production but vary
mostly with the lapse of time. Examples are rent payments and the factory

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manager's salary. Thus, assuming only a single product is produced, fixed costs
are $100,000, and 10,000 units are produced, then each unit will absorb $10 of
fixed costs. However, if 5,000 units are

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produced, each unit will absorb $20 of fixed costs. This shows that level of
activity is an important determinant of unit cost—wide fluctuations in output can
yield wide fluctuations in unit cost.

b. To allocate fixed costs to units, an assumption initially must be made as to how

many units the company expects to produce. This determines over how many
units the overhead costs is allocated. That calculation requires estimates of sales
and related production. To the extent that actual production differs from
estimated production, overhead costs will be either overapplied or underapplied.
That means that production and inventory are charged with more than total
overhead costs or with an insufficient amount of overhead costs.

7. The major objective of the LIFO method of inventory accounting is to charge cost of
goods sold with the most recent costs incurred. When the price level is stable, the
results under either the FIFO or the LIFO method will be the same. When price levels
change, the use of these different methods can yield significantly different financial
results. One of the primary aims of LIFO is to obtain a better matching of costs and
revenues in times of inflation. Under the LIFO method, the income statement is given
priority over the balance sheet. This means that while a matching of more current
costs with revenues occurs in times of price inflation (deflation), the inventory
carrying amounts in the balance sheet will be unrealistically low (high). Note that use
of the LIFO method is encouraged by its acceptance for tax purposes. The tax law
stipulates that its use for tax purposes makes mandatory its adoption for financial
reporting.

8. In most annual reports, insufficient information is given to allow the analyst to

convert inventories accounted for under one method to a figure reflecting a different
method of inventory accounting. Most analysts want such information to better
compare the financial statements of companies that use different inventory
accounting methods. Converting an inventory figure from one method to another is
made even more difficult by the use of different methods for various components of
inventory. Still, analysts must, in most cases, make an overall assessment of the
impact of different inventory methods on the comparability of inventory figures.
Such an assessment should be based on a thorough understanding of the inventory
methods in use and the effect they are likely to have on inventory values. The
differences that arise between informed approximations and exact figures using
additional data generally are not materially different.

To be most useful, disclosures of inventory methods must give, in addition to

methods used, an identification of the inventory components (in amounts) where
such methods are used. More important, disclosure of the dollar difference between
the method in use and the method most prevalent in the industry would be very
useful.

9. a. Cost, defined generally as the price paid or consideration given to acquire an

asset, is the primary basis in accounting for inventories. As applied to
inventories, cost generally means the sum of the applicable expenditures and
charges directly or indirectly incurred in bringing an article to its existing
condition and location. These applicable expenditures and charges include all

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acquisition and production costs—but they exclude selling expenses and general
and administrative expenses not clearly related to production.

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b. Market, as applied to the valuations of inventories, means the current bid price at
the balance sheet date for the inventory in the volume for which it is usually
purchased in. The term is applicable to inventories of purchased goods and to
manufactured goods (involving materials, labor, and overhead). More generally,
market means current replacement cost—although, it must not exceed the net
realizable value (estimated selling price less predicted costs of completion and
disposal) and must not be less than net realizable value reduced by an allowance
for a normal profit margin.

c. The usual basis for carrying forward inventory to the next period is cost.
Departure from cost is required, however, when the utility of the goods included
in inventory is less than their cost. This loss in utility should be recognized as a
loss of the current period, the period in which it occurred. Furthermore, the
subsequent period should be charged for goods at an amount that measures
their expected contribution to that period. In other words, the subsequent period
should be charged for inventory at prices no higher than those that would have
been paid if the inventory had been obtained at the beginning of that period.
(Historically, the lower-of-cost-or-market rule arose from the accounting
convention of providing for all losses and anticipating no profits—conservatism.)
In accordance with the foregoing reasoning the rule of "cost or market,
whichever is lower" may be applied to each item in the inventory, to the total of
the components of each major category, or to the total of the inventory,
whichever most clearly reflects the economic reality. The LCM rule is usually
applied to each item, but if individual inventory items enter into the same
category or categories of finished product, alternative procedures are suitable.

d. Arguments against use of the lower-of-cost-or-market method of valuing

inventories include:
(1) The method requires the reporting of estimated losses (all or a portion of the
excess of actual cost over replacement cost) as income charges even though the
losses have not been sustained to date and may never be sustained. Under a
consistent criterion of realization, a drop in selling price below cost is no more a
sustained loss than a rise above cost is a realized gain.
(2) A price shrinkage is brought into the income statement before the loss has
been sustained through sale. Furthermore, if the charge for the inventory
write-down is not made to a special loss account, the cost figure for goods
actually sold is inflated by the amount of the estimated shrinkage in price of the
unsold goods. The title "Cost of Goods Sold" therefore becomes a misnomer.
(3) The method is inconsistent in application in a given year because it
recognizes the propriety of implied price reductions but gives no recognition in
the accounts or financial statements to the effect of price advances.
(4) The method is inconsistent in application in one year as opposed to another
because the inventory of a company may be valued at cost at one year-end and at
market at the next year-end.
(5) The lower-of-cost-or-market method values inventory in the balance sheet
conservatively. Its effect on the income statement, however, may be the opposite.
Although the income statement for the year in which the unsustained loss is
taken is reported conservatively, the net income for the subsequent period may
be distorted if the expected reductions in sales prices do not materialize.

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(6) In the application of the lower of cost or market rule, a prospective "normal
profit" is used in determining inventory values in certain cases. Since normal
profit is an estimated figure based upon past experiences (and might not be
attained in the
future), it is not objective in nature and presents an opportunity for manipulation
of the results of operations.

10. LIFO tends to yield lower reported earnings when prices rise as compared to FIFO.
The following illustration highlights these effects:
Period Units in Inventory Cost per Unit Total Cost
Period 1……………… 5 $5 $25
Period 2……………… 5 10 50
Period 3……………… 5 15 75

Under LIFO, if 10 units are sold, then cost of goods sold is $125, computed as (5 x
$15) + (5 x $10). Also, the LIFO inventory value is $25, computed as 5 x $5. If units
are sold for $20, then gross profit is $75, computed as (10 x $20) - $125. Under FIFO,
if 10 units are sold, then cost of goods sold is $75, computed as (5 x $5) + (5 x $10).
Gross profit would be $125, computed as $200 - $75. Inventory would be valued at
$75, computed as 5 x $15—inflating the balance sheet. This shows that FIFO tends to
increase income and taxes in inflationary periods.

11. Increases in raw materials can, in certain instances, be a positive sign that the
company is building inventories to meet expected demand. However, increases in
both raw materials and work-in-process inventories, can reflect inefficient operations
that have slowed production. Increases in finished goods can reflect the building of
warehoused inventory to meet large demand or it can represent the stock piling of
finished goods that are not in great demand. The crucial part of analysis is to
interpret these changes in the context of current and projected industry conditions.

12. The observation is correct in pointing out that an analyst must subject the data
regarding an entity's depreciation policies to critical analysis and scrutiny. The
company can choose among several acceptable but vastly different depreciation
methods. The reasons a particular choice(s) is made by the company and the effect
on reported depreciation expense and accumulated depreciation should be
assessed.

13. In the absence of more precise data, an analyst is better off adjusting depreciation
charges on the basis of his/her estimates and assumptions than not adjusting them
at all. Analyses such as those described in the chapter can help to create a more
useful estimate of periodic depreciation expense and accumulated depreciation.

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14. There are a number of measures relating to plant assets that are useful in comparing
depreciation policies over time as well as for intercompany comparisons.

The average total life span of plant and equipment can be approximated as:
Gross Plant and Equipment  Current Year Depreciation Expense.

The average age of plant and equipment can be computed as:

Accumulated Depreciation  Current Year Depreciation Expense.

The average remaining life of plant and equipment is computed as:

Net Depreciated Plant and Equipment  Current Year Depreciation
Expense.

Also, drawing on the above relations, we can compute:

Average Total Life Span = Average Age + Average Remaining Life.

The above ratios are helpful in assessing a company's depreciation policies and
assumptions over time. The ratios can be computed on a historical cost basis as
well as on a current cost basis.

15. One of the more common solutions applied by analysts to the analysis of goodwill is
to simply ignore it. That is, they ignore the asset shown on the balance sheet. As for
the income statement, under current accounting standards, goodwill is no longer
amortized, but is subjected to an impairment test annually and written down if
required. Often, however, the write-down expense is treated with skepticism and is
frequently ignored. By ignoring goodwill, analysts ignore investments of very
substantial resources in what may often be a company's most important and
valuable asset. Ignoring the impact of goodwill on reported income is no solution to
the analysis of this complex item. Even considering the limited information available,
an analyst is better off evaluating the accounting numbers for goodwill rather than
dismissing them altogether.

Goodwill is measured by the excess of cost over the fair market value of tangible net
assets acquired in a transaction accounted for as a purchase. It is the excess of the
purchase price over the fair value of all the tangible assets acquired, arrived at by
carefully ascertaining the value of such assets—at least in theory. The analyst must
be alert to the makeup and the method of valuation of Goodwill as well as to the
method of its ultimate disposition. One way of disposing of the Goodwill account,
frequently preferred by management, is to write it off at a time when it would have
the least impact on the market's assessment of the company's performance. (for
example, in a period of losses or reduced earnings).

16. Costs are capitalized as assets when these expenditures are expected to bring the
entity value beyond the current year. If the value associated with the expenditure will
be used up in the current period, the expenditure is expensed.

17. Hard assets are assets such as the factory and machinery—they are tangible and
identifiable. Soft assets are assets such as software, research and development
efforts, and intellectual capital—they are more intangible in nature.

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18. a. Generally accepted accounting principles require that natural resources

(wasting) assets be stated at historical cost plus costs of discovery, exploration,
and development. This means the large cost outlays that occur following the
discovery of natural resources are not given accounting recognition as part of
natural resource assets. Rather, they generally are expensed as incurred.
Consequently, relations such as income to assets are distorted by a failure to
capitalize all relevant costs and by the related implications to current and future
earnings.

b. When a company acquires natural resources from another entity, this cost is
more likely to reflect the entire fair value of these resources. In such a situation
the relation between the cost of the assets and the revenues, expenses, and
income they generate is likely to be more economically sensible.

19. In valuing property, plant and equipment, and in reporting it in conventional financial
statements, accountants emphasize the objectivity of historical cost. They also show
an emphasis on conservatism with an accounting for the number of dollars originally
invested in the assets. The emphasis is not overly focused on the objectives of
those that analyze and depend on financial statements for business decisions. They
are content to proclaim that "a balance sheet does not purport to reflect and could
not usefully reflect the value of the enterprise." From the user’s perspective,
historical costs possess several limitations. They are not relevant to questions of
current replacement costs or of future needs. They are not directly comparable to
similar data in other companies' reports. They do not enable users to measure
opportunity costs of disposal, nor of the alternative uses of funds. They do not
provide a valid yardstick against which to measure return. Also, in times of changing
price levels, they represent an odd conglomeration of a variety of purchasing power
disbursements.

20. a. The basic approach in accounting for identifiable intangibles (other than
goodwill) is to record at historical cost and subsequently amortize that cost to
benefit periods. If assets other than cash are given in exchange for the intangible,
the intangible must be recorded at the fair market value of the consideration
given. Notice that if a company spends material and labor in the construction of a
"tangible" asset, such as a machine, these costs are capitalized and recorded as
an asset that is depreciated over its estimated useful life. On the other hand, if a
company spends a great amount of resources advertising a product or training a
sales force to sell and service it—which is one process for creating goodwill—it
usually cannot capitalize such costs. This is even when such costs may be as, or
more, beneficial to the company's future operations than are any "tangible"
assets. The reason for this inconsistency in accounting for these two classes of
assets extends to several basic accounting conventions such as conservatism.
These conventions, drawing on the level of certainty in future returns, casts more
doubt on the future realizations of benefits from intangibles (such as advertising
or training) than realizations from tangible, "hard" assets.

b. Goodwill is an important intangible asset. Still, it represents the only case where
the valuation of the asset is restricted to its cost of acquisition from a third party.
Moreover, any costs of defending a patent, copyright, or trademark (or similar)
are properly included as part of the cost of intangible assets. This extends to

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other intangibles such as leases, leasehold improvements, special processes,

licenses, and franchises. In marked contrast, internally developed goodwill
cannot be capitalized and carried as an asset.

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c. Identifiable intangibles (other than goodwill) can be separately identified and

given reasonably descriptive names such as patents, trademarks, and
franchises. Identifiable intangibles can be developed internally, acquired singly
or as part of a group of assets. They should be recorded at cost and amortized
over their useful lives. Write-down or complete write-off at date of acquisition is
not permitted.

Unidentifiable intangibles can be developed internally or purchased from others.

They cannot be acquired singly—they are inherently part of a group of assets or
part of an entire entity. The excess of cost of an acquired company (or segment)
over the sum total of identifiable net assets is the most common unidentifiable
intangible asset—that of “goodwill.” It is the residual amount in an acquisition
after the amount of tangible and identifiable intangibles are determined. Goodwill
is no longer amortized, but is tested annually for impairment and written down if
required.

d. Identifiable intangibles are believed to have limited useful lives. Accordingly, they
are amortized. Depending on the type of intangible asset, its useful life may be
limited by such factors as legal, contractual, regulations, demand and
competition, life expectancies of employees, and other economic and social
factors. The cost of each intangible should be amortized over its useful life taking
into account all factors that determine its life. Goodwill is not amortized, but is
tested annually for impairment and written down if required.

21. Goodwill is often a sizable asset. It can be recorded only upon the purchase of an
ongoing business enterprise or segment. The accounting conventions governing the
recording of goodwill mean that only purchased goodwill is reported among the
recorded assets and that more goodwill likely exist off the balance sheet. The
description of what is being paid for in such a transaction varies and this adds to the
uncertainty surrounding this asset. Some refer to an ability to attract and keep
satisfied customers, while others point to qualities inherent in an enterprise that is
well organized and efficient in production, service, and sales. Still others point out
that if there is value in goodwill it must be reflected in earnings. That is, if there is
value to goodwill, then it should give rise to superior earnings within a reasonably
short time after acquisition. If those earnings are not evidenced, then it is fair to
assume that the investment in goodwill is of no value regardless of whether it is
reported on the balance sheet.

Regardless of the amount incurred in the acquisition or internal development of an

intangible, the carrying amount of any asset is not to be carried at an amount in
excess of realizable value (sales price or future utility). Actual implementation is
another matter, and the analyst must be prepared to form judgments on the amounts
reported for intangible assets.

22. There are a number of categories of deferred charges. In each case, the rationale for
deferral is that these outlays hold future utility (benefits) for the company.
(1) Business development, expansion, merger, and relocation costs.
a. Pre-operating expenses, initial start-up costs, and tooling costs.
b. Initial operating losses or preoperating expenses of subsidiaries.

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c. Moving, plant rearrangement, and reinstallation costs.

d. Merger or acquisition expenses.
e. Purchased customer accounts.
f. Non-compete agreements.

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(2) Deferred expenses.

a. Advertising and promotional expenses.
b. Imputed interest.
c. Selling, general and administrative expenses.
d. Pension plan costs.
e. Property and other taxes.
f. Rental and leasing costs.
g. Vacation pay.
h. Seasonal growing and packing expenses.
(3) Intangible costs.
a. Intangible drilling and development costs.
b. Contracts, films, copyright materials, art rights
c. Costs of computer software
(4) Debt discount and expenses.
(5) Future income tax benefits.
(6) Organization costs.
(7) Advance royalties.

23. a. One category of assets not recorded on the balance sheet is internally created
goodwill. In this case, if the intangible is internally developed, rather than
purchased from an outside party, it cannot be capitalized and all costs must be
expensed as incurred. This means, to the extent an asset is created (that can be
sold or possesses earning power), prior income that is charged with the expense
of its development is understated (and future income will be overstated).
Numerous intangible assets fit this category. Another category is that of
contingent assets. Under the principle of conservatism, the contingent
rights/claims to resources are not recognized due to their uncertainty.

b. The analyst must realize that reported book values are not substitutes for market
values. As illustrated by the accounting-based equity valuation model,
unrecorded assets must eventually be realized in the form of residual income
(abnormal earnings). If there is no above-normal income, then there is little value
in any unrecorded assets.

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EXERCISES

Exercise 4-1 (12 minutes)

a. An allowance method based on credit sales attempts to match bad debts with
the revenues generated by the sales in the same period. Thus, it focuses on
the income statement rather than the balance sheet. On the other hand, an
allowance method based on the balance in the trade receivables accounts
attempts to value the accounts receivable at the end of a period at their future
collectible amounts. Thus, it focuses on the balance sheet rather than the
income statement. (Note that both of these allowance methods are
acceptable under GAAP.)

b. Carme Company will report on its balance sheet at December 31, Year 1, the
balance in the allowance for bad debts account as a valuation or contra asset
account—that is, as a subtraction from the accounts receivable asset. Bad
debt expense can be reported in the income statement as a selling expense,
or as a general and administrative expense, or as a subtraction to arrive at net
sales.

c. When examining the reasonableness of the allowance for bad debts, the
analyst is interested in assessing the collectibility of accounts receivable. The
analyst is especially interested in changing business conditions and their
impact on this allowance balance (that is, is it sufficient). In addition, the
analyst must assess any changes in collectibility assumptions as they have a
direct impact on net income through the determination of bad debt expense.
Finally, there is some evidence that managers use the allowance account
(among others) to help manage earnings levels.

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Exercise 4-2 (15 minutes)

a. Inventory costs include all reasonable and necessary costs of preparing

inventory for sale. These costs include not only the purchase price of the
inventories, but also other necessary costs of readying inventories for sale.

b. The lower of cost or market rule produces a more realistic estimate of future
cash flows to be realized from the sale of inventories when market is less
than cost. This rule is consistent with the principle of conservatism, and
recognizes (matches) the anticipated loss in the income statement for the
period in which the price decline occurs.

c. K2's inventories should be reported on the balance sheet at market.

Specifically, according to the lower of cost or market rule, market is defined
as replacement cost. However, market cannot exceed net realizable value and
cannot be less than net realizable value less a normal profit margin. For K2,
replacement cost is between net realizable value and net realizable value less
a normal profit margin. Therefore, market is established as replacement cost.
Since market is less than original cost, inventory should be reported at
market.

d. Ending inventories and net income would have been the same under either
lower of (average) cost or market or the lower of (FIFO) cost or market. In
periods of declining prices, the lower of cost or market rule results in a
write-down of inventory to market under both methods, resulting in similar
inventory costs. Therefore, net income using either inventory method is very
similar.

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Exercise 4-3 (15 minutes)

a. (i) The average cost method is based on the assumption that the average
costs of the goods in the beginning inventory and the goods purchased
during the period should be used for both the inventory and the cost of
goods sold computation. (ii) The FIFO (first-in, first-out) method is based on
the assumption that the first goods purchased are the first sold. As a result,
inventory is reported at the most recent purchase prices, while cost of goods
sold is at older purchase prices. (iii) The LIFO (last-in, first-out) method is
based on the assumption that the latest goods purchased are the first sold.
As a result, the inventory is at the oldest (less recent) purchase prices, while
cost of goods sold is at more recent purchase prices.

b. In an inflationary economy, LIFO provides a better matching of current costs

with current revenue on the income statement because cost of goods sold is
at more recent purchase prices. Also, net cash inflow is generally increased
because taxable income is generally decreased, resulting in payment of lower
income taxes.

c. Where there is evidence that the value of inventory to be disposed of in the

ordinary course of business will be less than cost, the difference should be
recognized as a loss in the current period. This is done by restating inventory
to its market value in the financial statements. The concept of conservatism,
yielding inventory reported at the lower of cost or market, is the primary
justification of this approach.
(AICPA Adapted)

Exercise 4-4 (12 minutes)

a. The inventory asset is more meaningful for analysis purposes when

calculated using the FIFO cost flow assumption. This is because the costs
assigned to units remaining in ending inventory are the more recent costs.

b. Cost of goods sold is usually more meaningful for analysis purposes when
calculated using the LIFO cost flow assumption. This is because the costs
assigned to units sold are the costs from the more recently purchased units.

c. When a company uses LIFO, the costs assigned to units in ending inventory
are the costs from older (less recent) units. As a result, analysts would prefer
to calculate what ending inventory would have been had FIFO been used.
This can be accomplished by adding the LIFO reserve value to the LIFO
ending inventory value.

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Exercise 4-5 (25 minutes)

a. Computation of Year 10 Cost of Goods Sold (and Gross Profit):

LIFO FIFO
Beginning $ 816.0 (a) $ 904.0 (b)
inventory………………………………...
Cost of goods 4,262.0 (c) 4,262.0 (c)
purchased………………………...
Goods available for sale……………………….. $5,078.0 $5,166.0
Less ending inventory………………………….. (819.8) (34) (904.4)(152)
Cost of goods $4,258.2 (14) $4,261.6
sold………………………………...

Revenues…………………………………………… $6,205.8 (13) $6,205.8 (13)

Cost of goods sold (above) …….………. (4,258.2) (4,261.6)
Gross profit:
As reported …..…………………………………. $1,947.6
Under FIFO ……………………………………… $1,944.2
(a) Given—from Year 9 balance sheet.
(b) $816.0 + $88.0 (given—from Year 9 balance sheet).
(c) Cost of goods purchased is the same under either method—derived.

b. The primary analysis objective in making the LIFO-to-FIFO restatement of

cost of goods purchases and gross profit is to achieve comparability between
firms using different inventory methods.

c. FIFO Inventory = LIFO Inventory + LIFO Reserve

Year 10 (see Campbell note 14):
$904.4 = $819.8 + $84.6
Year 11 (see Campbell note 14):
$796.3 = $706.7 + $89.6

d. When a company uses the LIFO cost flow assumption, it can be valuable to
convert the reported inventory asset to a FIFO basis for analysis purposes.
This is because the inventory value reported under FIFO is more reflective of
the current cost of inventory since reported costs reflect the more recent
costs of units purchased.

Exercise 4-6 (10 minutes)

In a period of rising inventory costs, the most recently purchased units are more
expensive. As a result, the cost of goods sold is higher under LIFO and lower
under FIFO. Thus, if output prices are stable, then net income is higher under
FIFO than under LIFO. Also, the ending inventory asset value, and therefore total
assets, is higher under FIFO and lower under LIFO. In contrast, in a period of

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declining inventory costs and stable output prices, all of the answers here will
reverse.

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Exercise 4-7 (20 minutes)

Examples of potentially unrecorded assets on balance sheets include:
 Excess of replacement values over costs for plant assets.
 LIFO inventory reserve.
 Excess of market value over adjusted cost of equity in nonconsolidated
subsidiaries and in affiliates.
 Intangibles--recognized firm name, product name, or brand name not
capitalized.
 Successful R&D such as a new drug that has passed all but final FDA
clearance.
 Proved reserves of extractive-type companies carried at substantially less
than market value of the product less extraction costs.
 Human (intellectual) capital.
 Value of savings on short-term credit lines where maximum interest payable
is currently below bank prime rate.
The analyst must remember that book values are only the starting point for
accounting-based valuation. If unrecorded assets have economic value, they will
eventually be recognized through higher future abnormal earnings (residual
income). This means the analyst must consider the impact of unrecorded assets
when projecting future profitability for valuation purposes.
(CFA Adapted)

Exercise 4-8

a. Biaya harus dikapitalisasi (yaitu, diperlakukan sebagai aset) ketika

diharapkan bahwa aset akan menghasilkan manfaat di periode mendatang.
Konsep penting di sini adalah bahwa incurrence dari biaya tersebut
menghasilkan akuisisi aset (potensi layanan di masa depan). Tidak hanya
harus terjadinya biaya yang mengakibatkan akuisisi aset yang memiliki
manfaat di masa depan yang diharapkan, tetapi juga biaya harus terukur
dengan tingkat objektivitas yang wajar. Contoh biaya yang biasanya
dikapitalisasi sebagai aset termasuk biaya barang dagangan yang tersedia
pada akhir periode akuntansi, biaya pertanggungan asuransi yang berkaitan
dengan periode mendatang, dan biaya pabrik atau peralatan yang dibangun
sendiri. Sebaliknya, jika biaya dikeluarkan yang menghasilkan manfaat yang
tidak diharapkan bertahan melampaui periode saat ini, maka biayanya
dibebankan. Perlakuan pengeluaran ini mencerminkan biaya potensi layanan
yang kedaluwarsa dalam menghasilkan pendapatan periode berjalan.
b. Dengan tidak adanya dasar langsung untuk mengaitkan biaya aset dengan
pendapatan, dan jika aset memberikan manfaat untuk dua periode akuntansi
atau lebih, biayanya harus dialokasikan untuk periode ini (sebagai biaya)
secara sistematis dan rasional. Contoh alokasi biaya aset yang sistematis dan
rasional akan mencakup penyusutan aset tetap, amortisasi intangibles, dan
alokasi biaya sewa dan asuransi. Ketika tidak praktis, atau tidak mungkin,
untuk menemukan hubungan sebab dan akibat yang wajar antara pendapatan

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dan biaya, hubungan ini sering diasumsikan ada. Dalam hal ini, biaya aset
dialokasikan untuk beberapa periode manfaat secara sistematis. Metode
alokasi yang digunakan harus masuk akal dan harus diterapkan secara
konsisten dari periode ke periode.

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Exercise 4-9 (20 minutes)

a. 1. Average total life span of plant and equipment:
Gross plant and equipment
Current year depreciation expense
2006
a
$5549
= 16.87 years
b
$329
a
See note 16. Note that land must not be included.
b
Amortization should be subtracted, but it is not broken out in the Colgate cash flow
statement.

2. Average age of plant and equipment:

Accumulated depreciation
Current year depreciation expense
2006
$2999
= 9.12 years
a
$329
a
Amortization should be subtracted, but it is not broken out in the Dell income
statement.

3. Average remaining life of plant equipment:

Net plant and equipment
Current year depreciation expense
2005
$2550
= 7.76 years
$329b
a
Land should be subtracted, see note 16.
b
Amortization should be subtracted, but it is not broken out in the Colgate cash flow
statement.

b. Generally, these ratios can be used to assess a company's depreciation

policies both over time (temporal) and for comparative purposes with other
companies in the same industry. An analyst must take care whenever
comparisons are made between companies. There often are economic
reasons for different depreciation methods and assumptions, which can be
obscured in a simple restatement of results. For example, Colgate uses
straight-line depreciation for plant and equipment; another company may use
an accelerated method such as double-declining-balance. The selection of
different methods may reflect fundamental differences in management
philosophy and action toward capital financing and maintenance. Also, with
capital intensive companies, profit margins may not reflect the higher costs
that may be expended to replace existing plant assets.

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Exercise 4-10 (20 minutes)

a. 1. Average total life span of plant and equipment:
Gross plant and equipment
Current year depreciation expense
11 10
a a
$2,538.0 $2,404.1
= 13.05 years = 13.06 years
$194.5b $184.1b
a
Buildings [159] ($758.7 in Year 11, $746.5 in Year 10) plus machinery and
equipment [160] ($1779.3 in Year 11 and $1657.6 in Year 10).
b
From Form 10-K, item [187].
2. Average age of plant and equipment:
Accumulated depreciation
Current year depreciation expense
11 10
c c
$1,131.5 $1,017.2
= 5.82 years = 5.53 years
$194.5 $184.1
c
From Campbell note 16 [162].
3. Average remaining life of plant equipment:
Net plant and equipment
Current year depreciation expense
11 10
d
$2,538.0 – $1,131.5 $2,404.1 – $1,017.2d
= 7.23 yrs = 7.53 yrs
$194.5 184.1
d
Gross plant and equipment minus accumulated depreciation.

b. Generally, these ratios can be used to assess a company's depreciation

policies both over time (temporal) and for comparative purposes with other
companies in the same industry. An analyst must take care whenever
comparisons are made between companies. There often are economic
reasons for different depreciation methods and assumptions, which can be
obscured in a simple restatement of results. For example, Campbell uses
straight-line depreciation for plant and equipment; another company may use
an accelerated method such as double-declining-balance. The selection of
different methods may reflect fundamental differences in management
philosophy and action toward capital financing and maintenance. Also, with
capital intensive companies, profit margins may not reflect the higher costs
that may be expended to replace existing plant assets.
Specifically, all three of these measures for Campbell reveal no marked
changes from Year 10 to Year 11. Still, a more complete analysis of this
conjecture would involve comparisons of Campbell’s measures with those
from competitors.

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Exercise 4-11 (10 minutes)

Balance sheet assets are: c, d (in some cases), e, g, h, i, j, m, p, q

Exercise 4-12 (10 minutes)

Ending inventory under FIFO would be $796.3 million [151+152].

Gross profit would be higher by the amount of the increase in the LIFO reserve,
or $89.6 million - $84.6 million = $5 million.

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PROBLEMS

Problem 4-1 (30 minutes)

a. Under the FIFO method of accounting for inventories, cost of goods sold
reflects the cost of inventories purchased earlier (less recent costs). During
periods of rising costs, operating margins are higher under FIFO because
sales at current prices are matched with older, lower cost inventory. During
periods of declining costs, operating margins are compressed because older,
higher cost inventories are matched with current, lower priced sales. More
specifically, in the case of ABEX Corp. we estimate the following impacts:
(1) During the period Year 5 through Year 7, according to Exhibit I, cost per
pound produced declined from 34 cents to 31 cents to 29 cents. The use of
FIFO compresses ABEX's margins because higher cost, older inventory is
being expensed.
(2) During the period Year 7 through Year 9, according to Exhibit I, unit costs
were rising. Namely, unit costs rose from 29 cents in Year 7 to 35 cents
and 39 cents in Year 8 and Year 9, respectively. The use of FIFO would
increase ABEX's operating margins during this period as older, lower cost
inventory is being expensed first.

b. According to Exhibit I, prices and costs are expected to decline in Year 10. In
contrast, for Year 11, prices (and presumably costs) are expected to increase.
Consequently, adopting LIFO at in Year 11, prior to the projected rise in prices
would produce tax savings, increased cash flows, and a better matching of
costs and revenues on the income statement. This supports a
recommendation to adopt LIFO in Year 11.

Problem 4-2 (15 minutes)

a. Year 9 retained earnings adjustment for LIFO to FIFO change:

LIFO Reserve x (1- Tax rate) =
($50,000) x (1 - .35) = $32,500 increase

b. Year 9 net income adjustment for LIFO to FIFO change for both Years 8 and 9:
Change in LIFO Reserve x (1- Tax rate) =
[ $(46,000) - $(50,000) ] x (1 - .35) = $2,600 increase

c. The primary analysis objective when making a LIFO to FIFO restatement is to

(1) achieve better comparability between firms using different inventory
methods, and (2) obtain better measures, using more recent costs, of the
value of inventory on the balance sheet.

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Problem 4-3 (30 minutes)

a. Ending Inventory Adjusted from LIFO to FIFO:

At Jan. 29, 1999: = LIFO Inventory + LIFO Reserve
= $219,686 + $26,900
= $246,586
At Jan. 30, 1998: = LIFO Inventory + LIFO Reserve
= $241,154 + $25,100
= $266,254

b. Net Income as Adjusted from LIFO to FIFO:

Year ended Jan. 29, 1999: = LIFO Income + After-Tax Change in LIFO Reserve
= $31,185 + [ ($26,900 – $25,100) x (1 - .37) ]
= $32,319

c. The primary analysis objective when making a LIFO to FIFO restatement is to

(1) achieve better comparability between firms using different inventory
methods, and (2) obtain better measures, using more recent costs, of the
value of inventory on the balance sheet.

Problem 4-4 (25 minutes)

a. Reconstruction of Transactions using T-Account Analysis:

Property, Plant & Equipment (gross)

[161A] Beg. 2,734.9
[186] Additions 371.1 156.7 Retirements/sales [186]
[186] Acquired assets 4.7 32.1 Rate variance
[186]
[161A] End. 2,921.9

Accumulated Depreciation
1,017.2 Beg [162]
194.5 Depreciation [186]
[187] Retirement/sale 69.5
[187] Translation Adj. 10.7
1,131.5 End [162]

b. The reconstruction of transactions through T-account analysis enables the

financial statement reader to examine the economic substance behind the
accounting disclosures and to better interpret the changes in key accounts.

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Problem 4-5 (55 minutes)

Software Development Costs:

Current Unamortized Bal. – Prior Unamortized Bal. + Current Amortization Expense

2000: $18 = $31 - $20 + $7
2001: $5 = $27 - $31 + $9
2002: $7 = $22 - $27 + $12
2003: $22 = $31 - $22 + $13
2004: $26 = $42 - $31 + $15
2005: $16 = $43 - $42 + $15
2006: $7 = $36 - $43 + $14

b. Software development costs typically (arguably) lead to more direct products.

The success or failure of software development efforts is determined by
whether functioning software is ultimately produced that can be sold to
customers. When salable software is reasonably expected to be developed,
the cost of the software development can be capitalized and amortized to the
presumed benefit periods. The product that results from other R&D efforts is
often less identifiable. Indeed, many R&D efforts fail. Moreover, many R&D
efforts are only indirectly related to future products. This has resulted in
GAAP requirements that expense R&D costs in the periods when incurred.
That is, R&D costs are not capitalized and allocated against future revenues
generated by any products developed from those efforts.

c. A review of the data suggests a one-year lag between R&D expenditures and
additional income. Specifically, income appears to increase in the year
following substantial R&D efforts and to decline in the year following reduced
R&D efforts. Also, this analysis should use income before R&D expenses
when assessing the impact of R&D on income.

($000s) 1999 2000 2001 2002 2003 2004 2005 2006

R&D $400 $491 $216 $212 $355 $419 $401 $455
Income
Pre- 712 858 604 418 410 500 568 634
R&D

d. All else equal, if Trimax invests more in software development in a given year,
net income will be higher because the company can capitalize many software
development costs. In contrast, expenditures for other R&D projects must be
expensed in the year when incurred. Of course, this response ignores the
economic implications for which we require additional information to judge
the relative successes of these expenditures.

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Problem 4-5—continued

e. Ratio Implications of Alternative Accounting Treatments for R&D and

Software:
[Note: Answers disregard income tax consequences.]

(Year 2006) Net income Return on Assets Return on

Equity
(1) $186,000a .040b .057c
(2) $287,250d .050e .066f

a: Net income +Add back amortized costs –Actual software development expenditures = $179 + $14 – $7.
b: Revised income (col. 1)/ (Total assets –Capitalized software development costs) = $186 / ($4,650 – $36).
c: Revised income (col. 1)/ (Total equity –Capitalized software development costs) = $186 / ($3,312 – $36).
d: Net income + Add back expensed R&D - Amortization = $179 + $455 – ($212/4) – ($355/4) – ($419/4) –
($401/4)
= $179 + $455 - $346.75 = $287.25
e: Revised income (col.1)/(Total assets +Unamortized R&D) =$287.25/ ($4,650 +$455 +$300.75 +$209.50 +
$88.75)
=$287.25 / $5,704
f: Revised income (col.1)/(Total equity +Unamortized R&D) =$287.25 / ($3,312 +$455 +$300.75 +
$209.50 +$88.75)
=$287.25 / $4,366

f. Cash flow from operations are unaffected by the capitalizing versus

expensing issue. However, cash flow from operations is affected by the
decision regarding the quantity of software development and other R&D
efforts that will be carried out in a given year.

Problem 4-6 (45 minutes)

STRAIGHT-LINE
($000s) YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5
Earnings before taxes
& depreciation:. . . $1,500.0 $2,000.0 $2,500.0 $3,000.0 $3,500.0
(a) Depreciation.......... (200.0) (200.0) (200.0) (200.0) (200.0)
Net Before Taxes. . $1,300.0 $1,800.0 $2,300.0 $2,800.0 $3,300.0
(b) Income Taxes........ (650.0) (900.0) (1,150.0) (1,400.0) (1,650.0)
(c) Net Income............ $ 650.0 $ 900.0 $1,150.0 $1,400.0 $1,650.0
Depreciation.......... 200 .0 200 .0 200 .0 200 .0 200 .0
(d) Cash Flow.............. $ 850.0 $1,100.0 $1,350.0 $1,600.0 $1,850.0

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SUM-OF-THE-YEARS'-DIGITS
($000s) YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5
Earnings before taxes
& depreciation ....... $1,500.0 $2,000.0 $2,500.0 $3,000.0 $3,500.0
(a) Depreciation............. (363.6) (327.3) (290.9) (254.5) (218.2)
Net Before Taxes..... $1,136.4 $1,672.7 $2,209.1 $2,745.5 $3,281.8
(b) Income Taxes........... (568.2) (836.4) (1,104.6) (1,372.8) (1,640.9
(c) Net Income............... $ 568.2 $ 836.3 $1,104.5 $1,372.7 $1,640.9
Depreciation............. 363 .6 327 .3 290 .9 254 .5 218 .2
(d) Cash Flow................ $ 931.8 $1,163.6 $1,395.4 $1,627.2 $1,859.1

Note: Vs. Straight-Line—Cash flow larger; Net Income smaller; Depreciation

larger

DOUBLE-DECLINING-BALANCE
($000s) YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5
Earnings before taxes
& depreciation:. . . $1,500.0 $2,000.0 $2,500.0 $3,000.0 $3,500.0
(a) Depreciation.......... (400.0) (320.0) (256.0) (204.8) (163.8)
Net Before Taxes. . $1,100.0 $1,680.0 $2,244.0 $2,795.2 $3,336.2
(b) Income Taxes........ (550.0) (840.0) (1,122.0) (1,397.6) (1,668.1)
(c) Net Income............ $ 550.0 $ 840.0 $1,122.0 $1,397.6 $1,668.1
Depreciation.......... 400 .0 320 .0 256 .0 204 .8 163 .8
(d) Cash Flow.............. $ 950.0 $1,160.0 $1,378.0 $1,602.4 $1,831.9

Note: Cash flow higher than straight line*, lower than S.Y.D. (except Year 1).
Net income lower than straight line*, higher than S.Y.D. (except Year 1).
Depreciation higher than straight line*, lower than S.Y.D. (except Year 1).
*(except year 5)
(CFA adapted)

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Problem 4-7 (30 minutes)

STRAIGHT-LINE
Beginning Depreciation Net income Net income
Year book value expense before taxes after taxes ROA
1 $300,000 $60,000 $40,000 $30,000 10%
2 $240,000 $60,000 $40,000 $30,000 12.5%
3 $180,000 $60,000 $40,000 $30,000 16.67%
4 $120,000 $60,000 $40,000 $30,000 25%
5 $ 60,000 $60,000 $40,000 $30,000 50%

SUM-OF-THE-YEARS’-DIGITS
Beginning Depreciation Net income Net income
Year book value expense before taxes after taxes ROA
1 $300,000 $100,000 $0 $0 0%
2 $200,000 $80,000 $20,000 $15,000 7.5%
3 $120,000 $60,000 $40,000 $30,000 25%
4 $ 60,000 $40,000 $60,000 $45,000 75%
5 $ 20,000 $20,000 $80,000 $60,000 300%

Problem 4-8

a. The expenditures that should be capitalized when equipment is acquired

include the invoice price of the equipment (net of discounts), all incidental
outlays relating to its purchase or preparation for use, any insurance during
transit, freight, duties, ownership search costs, ownership registration costs,
installation fees, and break-in costs. All available discounts, whether taken or
not, should be deducted from the capitalizable cost of the equipment.

b. (1) When the market value of the equipment is not determinable by reference
to a similar cash purchase, the capitalizable cost of equipment purchased
with bonds that have an established market price should be the market
value of the bonds.
(2) When the market value of the equipment is not determinable by reference
to a similar cash purchase, and the common stock used in the exchange
does not have an established market price, the capitalizable cost of
equipment should be the equipment's estimated fair value if that is more
clearly evident than the fair value of the common stock. Independent
appraisals may be used to determine the fair values of the assets involved.
(3) When the market value of equipment acquired is not determinable by
reference to a similar cash purchase, the capitalizable cost of equipment
purchased by exchanging dissimilar equipment having a determinable
market value should be the market value of the dissimilar equipment
exchanged.

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c. The factors that determine whether expenditures toward property, plant, and
equipment already in use should be capitalized are as follows:
 Expenditures are relatively large in amount
 They are nonrecurring in nature
 They extend the useful life of the property, plant, and equipment
 They increase the usefulness (for example, quantity or quality of goods
produced) of the property, plant, and equipment

d. The net book value at the date of the sale (cost of the property, plant, and
equipment less the accumulated depreciation) should be removed from the
accounts. The excess of cash from the sale over the net book value removed
is accounted for as a gain on the sale, while the excess of net book value
removed over cash from the sale is accounted for as a loss on the sale.

e. Considerations in analyzing property, plant, and equipment include: (1)

recognition that book values are at historical cost, (2) need for sufficient
capacity to meet anticipated demand, (3) need for writedowns of impaired
assets, (4) assess effects of changes in price levels, (5) identify use of assets
under operating lease arrangements, and (6) review for existence of idle
facilities.

Problem 4-9 (40 minutes)

a. Assuming a 25-year useful life for Bellagio, annual depreciation would be $64
million. Thus, net income would be:
Year 1: $(10.5) million ($50 - $64 depreciation + $3.5 tax benefit)
Year 2: $4.5 million ($70 - $64 depreciation – $1.5 tax expense)
Year 3: $8.25 million ($75 – $64 depreciation – $2.75 tax expense)
Net assets total $1,536 million, $1,472 million, and $1,408 million in 2001,
2002, and 2003, respectively. Accordingly, return on assets is -0.68%, 0.31%,
and 0.59% for 2001, 2002, and 2003, respectively.

b. Assuming a 15-year useful life for Bellagio, annual depreciation would be

$106.67 million. Thus, net income would be:
2001: $(42.5) million ($50 - $106.67 depreciation + $14.17 tax benefit)
2002: $(27.5) million ($70 - $106.67 depreciation + $9.17 tax benefit)
2003: $(23.75) million ($75 – $106.67 depreciation + $7.92 tax benefit)
Net assets total $1,493 million, $1,387 million, and $1,280 million in 2001,
2002, and 2003 respectively. Accordingly, return on assets is -2.85%, -1.98%,
and

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-1.86% for 2001, 2002, and 2003, respectively.

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c. Assuming a 10-year useful life for Bellagio, annual depreciation would be

$160 million. Thus, net income would be:
2001: $(82.5) million ($50 - $160 depreciation + $27.5 tax benefit)
2002: $(67.5) million ($70 - $160 depreciation + $22.5 tax benefit)
2003: $(63.75) million ($75 – $160 depreciation + $21.25 tax benefit)
Net assets total $1,440 million, $1,280 million, and $1,120 million in 2001,
2002, and 2003, respectively. Accordingly, return on assets is -5.73%, -5.27%,
and
-5.69% for 2001, 2002, and 2003, respectively.

d. Assuming a 1-year useful life for Bellagio, depreciation would be $1,600

million in 2001. Thus, net income would be:
2001: $(1,162.5) million ($50 - $1,600 depreciation + $387.5 tax benefit)
2002: $52.5 million ($70 - $17.5 tax expense)
2003: $56.25 million ($75 – $18.75 tax expense)
The net assets are written down to zero. Thus, return on assets is infinite for
2001, 2002, and 2003.

Problem 4-10 (30 minutes)

a. A company may wish to construct its own fixed assets rather than acquire
them from outsiders to utilize idle facilities and/or personnel. In some cases,
fixed assets may be self-constructed to effect an expected cost saving. In
other cases, the requirements for the asset demand special knowledge, skills,
and talents not readily available outside the company. Also, the company may
want to keep the manufacturing process for a particular product as a trade
secret.

b. Costs that should be capitalized for a self-constructed fixed asset include all
direct and indirect material and labor costs identifiable with the construction.
All direct overhead costs identifiable with the asset being constructed should
also be capitalized. Examples of cost elements which should be capitalized
during the construction period include charges for licenses, permits, fees,
depreciation of equipment used in the construction, taxes, insurance, interest
on borrowings, and other similar charges related to the asset being
constructed.

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c. (1) The increase in overhead caused by the self-construction of fixed assets

should be capitalized. These costs would not have been incurred if the
assets had not been constructed. This proposition holds regardless of
whether or not the plant is operating at full capacity. It is improper to
increase the cost of finished goods with costs that were not incurred in
their manufacture and that would not have been incurred if fixed assets
had not been produced. However, if the total construction costs on
self-constructed fixed assets were substantially in excess of their
business and economic usefulness, the excess cost is not capitalized but
instead is recorded as a loss.

(2) It is clear that the capitalized costs of self-constructed assets should

include a proportionate share of overhead on the same basis as that
applied to goods manufactured for sale when the plant is operating at full
capacity at the time the fixed asset is constructed. Under these
circumstances costs of finished goods produced should not be increased
for overhead for goods for which production was foregone. The activity
replacing the production of goods for sale should be charged with the
related overhead.

When idle plant capacity is used for the construction of a fixed asset,
opinion varies as to the propriety of capitalizing a share of general factory
overhead allocated on the same basis as that applied to goods
manufactured for sale. The arguments to allocate overhead maintain that
constructed fixed assets should be accorded the same treatment as
inventory, new products, or joint products. It is maintained that this
procedure is necessary, or special favors or exemptions from under-
costing of fixed assets will cause a consequent over-costing of inventory
assets.

Those arguing against allocating overhead to fixed assets where the

assets are constructed when idle capacity exists maintain that, since
normal production will not be affected or overhead increased,
capitalization will result in increased reported income for the period
resulting from construction rather than production of goods for sale. It is
also sometimes maintained that the full cost of the constructed asset
should not include overhead that would be incurred in the absence of
such construction.

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d. The $90,000 cost by which the initial machine exceeded the cost of the
subsequent machines should be capitalized. Without question there are
substantial future benefits expected from the use of this machine. Because
future periods will benefit from the extra outlays required to develop the initial
machine, all development costs should be capitalized and subsequently
associated with the related revenue produced by the sale of products
manufactured. If, however, it can be determined that the excess cost of
producing the first machine was the result of inefficiencies or failure which
did not contribute to the machine's successful development, these costs
should be recognized as an extraordinary loss. Subsequent periods should
not be burdened with charges arising from costs that are not expected to
yield future benefits. Capitalizing the excess costs as a cost of the initial
machine can be justified under the general rules of asset valuation. That is,
an asset acquired should be charged with all costs incurred in obtaining the
asset and placing it in service.
(AICPA Adapted)

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Problem 4-11 (50 minutes)

a. Intangible assets represent rights or claims to future benefits. An intangible

asset is usually defined as a noncurrent asset having no physical existence
with a high degree of uncertainty regarding future benefits—its value being
dependent on the rights that possession confers upon the owner.

b. (1) A dollar to be received in the future is worth less than a dollar received
today because of an interest or discount factor—often referred to as the
time value of money. The discounted value of the expected royalty receipts
can be thought of either in terms of the present value of an annuity of 1 or
in terms of the sum of several present values of 1.

(2) If the royalty receipts are expected to occur at regular intervals and the
amounts are to be fairly constant, their discounted value can be calculated
by multiplying the value of one such receipt by the present value of an
annuity of 1 for the number of periods the receipts are expected. On the
other hand, if receipts are expected to be irregular in amount, or if they are
to occur at irregular intervals, each expected future receipt would have to
be multiplied by the present value of 1 for the number of periods of delay
expected.
In each case some interest rate (discount factor) per period must be
assumed and used. As an example, if receipts of $10,000 are expected
each six months over the next 10 years and an 8 percent annual interest
rate is selected, the present value of the twenty $10,000 payments is equal
to $10,000 times the present value of an annuity of 1 for 20 periods at 4
percent. Twice as many periods as years, and half the annual interest rate
of 8 percent, are used because the payments are expected at semiannual
intervals. Thus the discounted (present) value of these receipts is $135,903
($10,000 x 13.5903). Because of the interest rate, this discounted value is
considerably less than the total expected collections of $200,000.
Continuing the example, if instead it is expected that $10,000 will be
received six months hence, $20,000 one year from now, and a terminal
payment of $15,000 is expected 18 months hence, the calculation is as
below:
$10,000 x present value of 1 at 4% for 1 period = $10,000 x .96154
$20,000 x present value of 1 at 4% for 2 periods = $20,000 x .92456
$15,000 x present value of 1 at 4% for 3 periods = $15,000 x .88900
Adding the results of these three calculations yields a total of $41,441
(rounded), considerably less than the $45,000 total collections, again due
to the discount factor.

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Problem 4-11—continued

c. The basis of valuation for the patents that is generally accepted in accounting
is cost. Evidently the cartons were developed and the patents obtained
directly by the client corporation. Therefore, their cost would include
government and legal fees, and the costs of any models and drawings. The
proper initial valuation would be the sum of these costs plus any other costs
incident to obtaining the two patents. This is in accord with the accounting
principle that the initial valuation of any asset generally includes virtually all
costs necessary to acquire and make it ready for normal use. Such values are
objectively determined and rest upon actual completed transactions rather
than upon estimates and future expectations.

d. (1) Intangible assets represent rights to future benefits. The ideal measure of
the value of intangible assets is the discounted present value of their
future benefits. For the Vandiver Corporation, this would include the
discounted value of expected net receipts from royalties as suggested by
the financial vice-president as well as the discounted value of the
expected net receipts to be derived from the Vandiver Corporation's
production. Other valuation bases that have been suggested are current
cash equivalent or fair market value.

(2) The amortization policy is implied in the definition of intangible assets as

rights to future benefits. As the firm receives the benefits, the cost or other
value should be charged to expense or to inventory to provide a proper
matching of revenues and expenses. Under the discounted value approach
the periodic amortization would be the decline during the year in the
present value of expected net receipts.

e. The litigation can and probably should be mentioned in notes to the financial
statements. Some indication of the expectations of legal counsel in respect to
the outcome can properly accompany the statements. It would be
inappropriate to record a contingent asset reflecting the expected damages to
be recovered. Costs incurred to September 30, Year 1, in connection with the
litigation should be carried forward and charged to expense (or to loss if the
cases are lost) as royalties (or damages) are collected from the parties
against whom the litigation has been instituted; however, the conventional
treatment would be to charge these costs as ordinary legal expenses. If the
final outcome of the litigation is successful, the costs of prosecuting it
should be capitalized. Similarly, if the client were the successful defendant in
an infringement suit on these patents, the generally accepted accounting
practice would be to add the costs of the legal defense to the Patents
account. Developments to the time that the statements are prepared and
released can be reflected in notes to the statements as a post -balance sheet
(or subsequent event) disclosure.
(AICPA Adapted)

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CASES

Case 4-1 (30 minutes)

a. The main determinants of the valuation of feature films, television programs,

and general release feature productions by Columbia Pictures are (1) the cost
of productions and (2) estimates on how to allocate those costs over the
earnings-generating capacity of the films.

b. The reasonableness of the bases of valuation depends almost entirely on the

reasonableness of the estimates of the expiration of value of the inventory
costs. Judging from the second paragraph of the note, it appears that some
of the company's estimates of the value of films were overly optimistic and
that this prior optimism required subsequent and substantial writedowns. If
this is an indication of management's ability to estimate the potential
earnings of its film releases, then the analyst should treat its inventory values
with suspicion and caution.

c. An unsecured lender would want to carefully assess the valuation of film

inventories in the light of past experience and of future prospects in the
industry. This is particularly crucial here because inventories form such an
important part of total assets for Columbia Pictures and other companies in
this industry. The analyst would want to know Columbia’s experience in
valuing its inventory—from available evidence in Columbia's note this is not
reassuring. The analyst would want to compare Columbia’s estimation
process with that followed by other companies in the industry, and also
would want to compare Columbia’s estimates with forecasted conditions and
trends in the industry.

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Case 4-2 (45 minutes)

a. (1) FIFO allocates costs to sales in the order goods are purchased:
Sales (1,000 units x $1.70) ............................................................ $ 1,700
Cost of goods sold (1,000 units x $1.00, which is
all beginning-year inventory)...................................................... (1,000)
Net income before taxes................................................................ $ 700
Provision for federal income taxes (50%)................................... (350)
Net Income Transferred to Retained Earnings........................... $ 350

(2) LIFO allocates recent cost to sales:

Sales (1,000 units x $1.70) ............................................................ $ 1,700
Cost of goods sold (1,000 units x $1.50, which are
the most recent 1,000 units acquired)....................................... (1,500)
Net income before taxes................................................................ $ 200
Provision for federal income taxes (50%)................................... (100)
Net Income Transferred to Retained Earnings........................... $ 100

b. (1) FIFO: Balance Sheet

ASSETS
Cash................................................................................................. $ 200
Inventory (FIFO method)............................................................... 1,500
Total Assets ................................................................................... $1,700

LIABILITIES AND EQUITY

Federal income taxes payable...................................................... $ 350
Total equity .................................................................................... 1,350
Total Liabilities and Equity........................................................... $1,700

(2) LIFO: Balance Sheet

ASSETS
Cash................................................................................................. $ 200
Inventory (LIFO method)............................................................... 1,000
Total Assets.................................................................................... $1,200

LIABILITIES AND EQUITY

Federal income taxes payable...................................................... $ 100
Total equity .................................................................................... 1,100
Total Liabilities and Equity........................................................... $1,200

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Case 4-2—continued

c. During a period of rising costs, the LIFO method is more conservative in

profit determination and in the evaluation of the financial position of a
company than the FIFO method. LIFO allocates recent costs of inventory to
sales, the result being that these costs are higher in light of cost increases.
Accordingly, inventory is valued more conservatively, and income reported is
lower than those under the FIFO method. Parts (a) and (b) of this case reveal
this relation. That is, under LIFO, income reported is $100 after taxes as
compared to $350 under FIFO. Likewise, inventory is reported at $1,000 under
LIFO as opposed to $1,500 under FIFO. Evidence of rising costs is that
existing inventory is valued at $1.00 per unit while goods purchased during
the year ran at $1.50 per unit. Tax considerations also are important. As we
can see from parts (a) and (b), the LIFO method produces a tax liability of
$100, whereas taxes under the FIFO method amount to $350. As long as
inventory is maintained at a given level or increases, LIFO produces an
interest-free, perpetual loan from the government. Of course, should
inventory be liquidated, cost of goods sold will be very low compared to
sales, with a resulting higher income tax liability (making up for the prior
deferrals).

d. Companies use a dollar pool LIFO method to prevent liquidation of low-cost

LIFO inventory units. Under this method, groups of items are viewed as a
dollar pool, and if one item is sold, it may be replaced by new items of the
same or greater dollar value, and there is no liquidation of the pool. The
problem for a company that prepares interim statements is to decide whether
liquidated items in one quarter will be replaced before the end of the fiscal
year. If the items are replaced, income taxes allocated to profits of the current
quarter will be lower than if the items are not replaced.
(CFA Adapted)

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Case 4-3 (45 minutes)

a. Net Income Computation:

FIFO LIFO Average cost
Sales (1,000 x $25).......................... $25,000 $25,000 $25,000
Cost of sales:
Beginning inventory..................... 0 0 0
Add: Purchases............................ 23,200 23,200 23,200
Less: Ending inventory................ (11,700) (9,100) (10,312)
Cost of sales................................... 11,500 14,100 12,888
Gross profit..................................... 13,500 10,900 12,112
Operating expenses....................... 5,000 5,000 5,000
Net income...................................... $ 8,500 $ 5,900 $ 7,112
Net income per share..................... $4.25 $2.95 $3.56
NOTES: (1) FIFO inventory computation is based on 500 units at $15 and 300 at
$14.
(2) LIFO inventory computation is based on 100 units at $10, 300 units at
$11, and 400 units at $12.
(3) Average cost is obtained by dividing $23,200 by 1,800 units
purchased, yielding an average unit price of $12.89.

b. Financial Ratio Computations

FIFO
LIFO
Average
Cost
(1) Current ratio …………………….. 2.47 2.36 2.41
(2) Debt-to-equity ratio ……………. 67.8% 71.3% 69.6%
(3) Inventory turnover ……………… 2.00 3.10 2.50
(4) Return on total assets ………… 9.8% 7.0% 8.3%
(5) Gross margin 54.0% 43.6% 48.5%
ratio………………….
(6) Net profit as percent of 34.0% 23.6% 28.5%
sales…….

c. LIFO Effects. Under conditions of fluctuating inventory costs, the LIFO

inventory method will have a smoothing effect on income. Moreover, the LIFO
method results, in times of cost increases, in an unrealistically low reported
inventory figure. This, in turn, will lower the current ratio of a company and at
the same time tend to increase its inventory turnover ratio. The LIFO method

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also affords management an opportunity to manipulate profits by allowing

inventory to be depleted in poor years, thus drawing on the low cost base
pool. FIFO Effects. The use of FIFO in the valuation of inventories will
generally result in a higher inventory on the balance sheet and a lower cost of
goods sold than under LIFO resulting. This would result in a higher net
income. Average Cost Effects. The average cost method smoothes out cost
fluctuations by using a weighted average cost in the valuation of inventories
and cost of goods sold. The resulting net income will be close to an average
of the net income under LIFO and FIFO.

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Case 4-4 (45 minutes)

a. $1,518.5 [36] - $1,278.0 [45] = $240.5.

b. Campbell Soup sells to retailers, like grocery stores. Note 13 reports that
the company has established an allowance for uncollectible accounts of
$16.3 million as of the end of the year. This amount represents 3.4% of
gross accounts receivable from trade creditors (see Note 13).
c. The company employs LIFO inventory costing. Inventories are written
down to the lower of cost or market.
d. Inventory turnover = $4095.5 million /($706.7 million +$819.8 million)/2 =
5.37 times. Companies can improve the inventory turnover rate by
reducing raw materials on hand (with just-in-time deliveries), work-in-
process inventories (by improved manufacturing processes), and finished
goods inventories (by producing to order rather than to demand
forecasts).
e. The LIFO reserve is $89.6 million (Note 14). The cumulative tax savings are
$89.6 million x 35% = $31.4 million.
f. Had it used FIFO inventory costing, gross profit would have been higher
by the increase in the LIFO reserve, or $89.6 million - $84.6 million = $5
million. The pre-tax profit would have been $667.4 million + 5 million =
$672.4 million.
g. PPE represents $1,790.4 million / $4,149.0 million = 43% of total assets.
Campbell Soup uses straight-line depreciation (Note 1). Accumulated
depreciation is $1,131.5 million / ($2,921.9 million - $56.3 million - $327.6
million) = 44.6% of total gross long-term depreciable assets. The
accumulated depreciation to gross depreciable assets yields information
about the percentage that these assets have been “used up.” As this
percentage increases, the company will have to expend more cash on
repairs and upgrades.
h. Intangible assets arise from acquisitions. They represent the portion of the
purchase price for acquired companies that has been allocated to
intangible assets.

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Case 4-5 (45 minutes)

a. Depreciation is a system whose purpose is to allocate the cost of tangible

capital assets, less salvage, over their useful lives in a systematic and
rational manner. Under GAAP, depreciation is a process of cost allocation,
not of valuation, through which the productive effort (cost) is to be matched
with productive accomplishment (revenue). This process is founded on the
matching principle. Depreciation, therefore, is mainly concerned with the
timing of the expiration of the cost of tangible fixed assets.

b. The proposed depreciation method is, of course, systematic. Whether it is

rational in terms of cost allocation depends on the facts of the case. It
produces an increasing depreciation charge, which is usually not justifiable
in terms of the benefits derived from the use of an asset. This is because
manufacturers typically prefer to use their new equipment as much as
possible and their old equipment only as needed, such as to meet production
quotas during periods of peak demand. As a general rule, benefits decline
with age. Assuming that the actual operations (including equipment usage) of
each year are identical, then maintenance and repair costs are likely to be
higher in the later years of usage than in the earlier years. This means the
proposed method would match lower depreciation with lower repair charges
in the early years, while it would match higher depreciation with higher repair
charges in the later years. However, reported net income in the early years
would be much higher than reported net income in the later years of the
asset’s life. This is an unreasonable and undesirable variation during periods
of identical operation. On the other hand, if the expected level of operations
(including equipment usage) in the early years of the asset’s life is expected
to be low relative to that of later years, then the pattern of depreciation
charges of the proposed method approximately parallels expected benefits
(and revenues). In this admittedly unusual case, the method may be viewed as
reasonable. Although, the units-of-production depreciation method is the
more usual method selected to fit this case.

c. (1) Depreciation charges neither recover nor create cash. Revenue-producing

activities are the sources of cash from operations. If revenues exceed
out-of-pocket costs during a period, then cash is available to cover other
than out-of-pocket costs. However, if revenues do not exceed
out-of-pocket costs, then no cash is made available no matter how much,
or little, depreciation is charged.

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(2) Depreciation can affect cash in at least two ways. First, depreciation
charges affect reported income and, hence, can affect managerial
decisions such as those regarding pricing, product selection, and
dividends. For example, the proposed method would result initially in
higher reported income than would the straight-line method.
Consequently, shareholders might demand higher dividends in the earlier
years than they would otherwise expect. The straight-line method, by
yielding a lower reported income during the early years of asset life and by
reducing the amount of potential dividends in early years as compared
with the proposed method, could encourage earlier reinvestment in other
profit-earning assets to meet increasing demand.

Second, depreciation charges affect reported taxable income. This means

they affect directly the amount of income taxes payable in the year of
deduction. Using the proposed method for tax purposes would reduce the
total tax bill over the life of the assets (1) if the tax rates were increased in
future years or (2) if the business were doing poorly now but were to do
significantly better in the future. The first condition is political and
speculative, but the second condition may be applicable to Toro in view of
its recent origin and its rapid expansion program. Consequently, more
funds might be available for reinvestment in fixed assets in years of larger
deductions if the business remains profitable. If Toro is not profitable now,
it would not benefit from higher deductions now and should consider an
increasing charge method for tax purposes, such as the one proposed. If
Toro is profitable now, the president should reconsider his proposal
because it will delay the availability of cash that must be paid to cover
taxes. Also the proposed method could result in lower estimated
production costs in earlier years, which could lead to underpricing of the
product.
(AICPA Adapted)

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