CH 04 PDF

Chapter 04 - Analyzing Investing Activities
Chapter 4
Analyzing Investing Activities
REVIEW
Assets are the driving forces of profitability for a company. Assets Assets produce revenues that
compensate or!ers" repay lenders" reard oners" and fund groth. Current assets are
resour
resources
ces or claims
claims to resou
resources
rces readily
readily conver
convertib
tible
le to cash.
cash. #a$or
#a$or curren
currentt assets
assets
includ
includee cash
cash and cash cash e%uiv
e%uivale
alents
nts"" mar!et
mar!etablable
e securit
securities
ies"" receiva
receivablebles"
s" deriva
derivativ
tivee
financial instruments" inventories" and prepaid e&penses. 'ur analysis of current assets
provides us insights into a company(s li%uidity. )i%uidity is the length of time until assets
are
are conv
converterted
ed to cash
cash.. It is an indiindicacato
torr of a comp
compan any(
y(ss abil
abilit
ity
y to meet
meet fina
financ
ncia
iall
obligati
obligations
ons.. *he less li%uid
li%uid a company
company"" the loer loer is its financia
financiall fle&ibil
fle&ibility
ity to pursue
pursue
promising investment opportunities and the greater its ris! of failure. +oncurrent assets
are resources or claims to resources e&pected to benefit more than the current period.
#a$or
#a$or noncurren
noncurrentt assets
assets include
include property
property"" plant"
plant" e%uipmen
e%uipment" t" intangib
intangibles"
les" investme
investments"
nts"
and deferred charges. 'ur analysis of noncurrent assets provides us insights into a
compan
company( y(s
s solve
solvency
ncy and operat
operation
ional al capacit
capacity y. ,olven
,olvency cy refers
refers to the abiliability
ty of a
company to meets its long-term and current/ obligations. 'perational capacity is the
ability of
of a company to generate future profits. *his chapter shos ho e use financial financial
statements
statements to better assess li%uid li%uidity
ity"" solvency
solvency"" and operation
operational al capacity using asset
values" and to critically evaluate a company(s financial performance and prospects. *he
acco
accoununti
ting
ng prac
practi
tice
ces
s ununde
derl
rlyi
ying
ng thethe meas
measur urem
emen
entt and
and repo
report
rtin
ingg of curr
curren
entt and
and
noncurrent assets are described. We discuss the accounting for these assets and its
implications for analysis of financial statements. ,pecial attention is given to various
analytical ad$ustments helping us better understand current and future prospects.
4-1
'0*)I+E
,ection 12 Current Assets
Assets
• Cash and Cash E%uivalents
Analyzing Cash and Cash E%uivalents
• Receivables
Valuation of Receivables
Analyzing Receivables
• 3repaid E&penses
• Inventories
Inventory Accounting and Valuation
Analyzing Inventories
,ection 2 +oncurrent Assets

Assets
• Introduction to )ong-)ived Assets
Accounting for )ong-)ived Assets
Capitalizing
Capitalizing versus E&pensing2 5inancial ,tatement and Ratio Effects
• 3lant Assets and +atural Resources
Valuing 3lant Assets and +atural Resources
6epreciation and 6epletion
• Intangible Assets
Accounting for Intangibles
Analyzing Intangibles
7oodill
0nrecorded Intangibles and Contingencies
Contingencies
4-2
A+A)8
A+A)8,I, '9:EC*IVE,
'9:EC*IVE,
• 6efine current assets and their relevance for analysis.
• E&plain cash management and its implications

implications for analysis.
• Analyze
Analyze receivables" alloances for bad debts" and securitization.
• Interpret the effects of alternative inventory methods under varying business

conditions.
• E&plain the concept of long-lived assets and its implications

implications for analysis.
• Interpret valuation and cost allocation of plant assets and natural resources.
• 6escribe and analyze intangible

intangible assets and their disclosures.
• Analyze
Analyze financial statements for unrecorded and contingent assets.
4-3
;0E,*I'+,
1. a. +o.
+o. When
When analanalyz
yzin
ingg cash
cash"" the
the mo
mostst li%u
li%uid
id of curr
curren
entt asse
assets
ts"" the
the anal
analys
ystt is
interested
interested in the availabil
availability
ity of cash in meeting the company(s
company(s obligation
obligations.
s. A
restricti
restriction
on under
under compensati
compensating ng balance
balance arrangement
arrangements s does" at orst"
orst" remove
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 ban! credit.
b. *h
*hee anal
analy yst shou
shouldld e&cl
e&clud
ude e cash
cash rest
restri
rict
cted
ed ununde
derr comp
compen
ensa
sati
ting
ng bala
balanc
ncee
agreements from current assets. ,EC Accounting ,eries Release 14< re%uires
that a company that has borroed money from a ban! segregate on its balance
sheet any cash sub$ect to ithdraal or usage restrictions under compensating
balance
balance agreements
agreements ith the lending
lending ban!. *hese re%uireme
re%uirements
nts may" as is often
the case in such situations" move companies and their ban!er to alter the form of
their contractual agreements hile retaining their substance. *he analyst must be
ever alert to such attempts to distort analysis measurements by presentations
hos
h osee form
form is no
nott a true
true refl
reflec
ecti
tion
on of thei
theirr subs
substa
tanc
nce.
e. 'n
'nee meas
measur ure
e of a
company=s vulnerability
vulnerability in this area is the ratio of restricted cash to total cash.
. a. *he
*he opopererat
atin
ing
g cycl
cycle
e conc
concepeptt is impo
import
rtan
antt in the clas
classi
sifi
fica
cati
tion
on of asse
assets
ts and
and
liabilities as either current or noncurrent. *he 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. *he diagram near the
beginning of Chapter 4 illustrates this concept.
b. If the normal
normal collectio
collection
n interval
interval of a receivab
receivables
les is longer
longer than
than a year such as ith
ith
longer
longer term installment
installment receivables/"
receivables/" then their inclusion
inclusion as current
current assets is
proper provided the operating cycle is e%ual to or greater than the obligation due
date for the receivables. ,imilarly" if inventories" by business need or custom"
have to be !ept on average for more than 1 months" then this normal inventory
holding period becomes part of the operating cycle and such inventories are
included among current assets.
c. *he limita
limitatio
tions
ns of the current
current ratio
ratio hich
hich is comput
computed ed from items
items defined
defined as
or!ing capital/ as a measure of short-term li%uidity are discussed in Chapter 11.
,till" if e accept the proposition that it is useful to measure the current resources
available to pay current obligations" then it is difficult to see ho e&tension of
>current> from the customary 1 months to periods of ?@ months or longer can
serve a useful purpose. *he operating cycle concept may help companies sho
the !ind of positive current position that they otherise might not be able to sho"
but this concept is of doubtful value or validity from
from the point of vie of a financial
analyst that must assess a company=s short-term li%uidity.
li%uidity.
d. 1/ *obacc
*obacco o Indu
Industr
stry
y. *he tobac
tobacco
co leaf
leaf must
must go throug
throughh an aging
aging"" curing
curing"" and
drying
drying proces
processs e&tendi
e&tending
ng over
over severa
severall years.
years. *hi
*his
s tobacc
tobacco
o inven
inventor
tory
y green
green
leaves/" that may not be used in the production of a salable product for many
years"
years" is classi
classifie
fied
d as curren
currentt und
under
er the operat
operating
ing cycle
cycle concep
concept.
t. *hi
*hiss ou
ould
ld
occur even if long-term loans classified among noncurrent liabilities/ ere ta!en
out to finance the carrying of this inventory.
inventory.
4-4
/ )i%uor Industry. *he li%uor industry has an operating cycle e&tending beyond
the customary 1 months. In this case" the holding of li%uor inventory for aging
purposes over many years provides sufficient $ustification for inclusion of such
inventories among current assets.
?/ Retailing Industry.

Industry. In retailing" the sale of >large tic!et> items on the installment
plan can e&tend
e&te nd the operating cycle to" for e&ample" ?@ months or longer.
longer. As
As such"
these installment receivables are reported among current assets.
?. a. *he
*he to
to mo
mostst impor
importan
tantt %u
%ues
esti
tion
ons
s faci
facing
ng the fina
financ
ncia
iall anal
analys
ystt ith
ith respe
respect
ct to
receivables are2 1/ Is the receivable genuine" due" and enforceable" and / Bas
the probab
probabili
ility
ty of collec
collectio
tion
n been
been proper
properly
ly assess
assessed
ed Whil
Whilee the un%
un%ual
ualifi
ified
ed
opinion of an independent auditor lends some assurance ith regard to these
%uesti
%uestion
ons"
s" the financ
financial
ial analys
analystt mu
must
st recogn
recognize
ize the possib
possibililit
ity
y of an error
error of
$udgment as ell as the lac! of complete independence.
b. 6escripti
6escription
on of the receivables
receivables in the notes to financia
financiall statements
statements usually
usually do not
contain sufficient clues to allo a reliable $udgment as to hether a receivable is
genuine" due" and enforceable. Conse%uently" !noledge of industry practices
and supplementary sources of information
information must be used for additional assurance"
e.g.2
• In some industries" such as compact discs" toys" or boo!s" a substantial right
of merchandise return e&ists and alloance must be made for this.
• #ost
#ost provi
provisi
sion
onss for uncol
uncollec
lectib
tible
le accoun
accountsts are based
based on past
past e&perie
e&perience
nce
although they should also ma!e alloances for current and emerging industry
conditions. In practice" the accountant is li!ely to attach more importance to
the former than to the latter. *he analyst must" in such cases" use one=s on
$udgment and !noledge of industry conditions to assess the ade%uacy of the
provision
provision for uncollectible
uncollectible accounts.
a ccounts.
• Information that ould be helpful in assessing the general level of collection
ris!s ith receivables is not usually found in published financial statements.
,uch
,uch infor
informat
mation
ion can"
can" of course"
course" be sough
soughtt from
from the compa
companyny direct
directly
ly..
E&amples of such information are2 1/ What is customer concentration What
percent of total receivables is due from one or a fe ma$or customers Would
failure of any one customer have a material impact on the company(s financial
condition
condition / What is the age pattern of the receivables ?/ What proportion
proportion
of notes receivab
receivable
le represent
represent reneals of oldold notes 4/ Bave alloanc
alloanceses
been made for trade discounts" returns" or other credits to hich customers
are entitled
• *he analyst" in assessing current financial position and a company(s ability to
meet its obligations currentlyas e&pressed by such measures as the current
ratiomust recognize the full impact of accounting conventions that relate to
classification of receivables as >current.> 5or e&ample" the operating cycle
concept allos the inclusion
inclusion of installment receivables" hich may not be fully
collectible for years. In balancing these against current obligations" alloance
for such differences in timing of cash flos should be made.
4. a. 5act
5actooring
ring or secu
securi
rittiza
ization
ion of rece
receiv
ivab
able
les
s refe
referrs to the
the pra
pract
ctic
ice
e of
of sel
selling
ing all
or a portion of a company=s
c ompany=s receivables
receivables to a third party.
party.
4-5
b. When
When recei
receiva
vabl
bles
es are
are sold
sold ith
ith recour
recourse
se"" the
the thir
third
d part
party
y pu
purc
rcha
haser
ser of the
the
recei
receiva
vabl
bles
es retai
retains
ns the
the righ
rightt to coll
collec
ectt from
from the
the comp
companany
y that
that sold
sold the
the
receivable if the receivable proves uncollectible. When receivables are sold
ithout recourse" the purchaser of the receivables assumes the collection ris!.
c. When
When receivabl
receivables
es are sold
sold ith recour
recourse"
se" the balance
balance sheet
sheet reports
reports the cash
received
received from the sale of the receivable.
receivable. Boever
Boever"" the balance
balance sheet may or
may
may nonott repo
report
rt the
the cont
contin
inge
gent
nt liab
liabil
ilit
ity
y to the
the recei
receiva
vabl
bles
es pu
purc
rcha
haser
ser for
for
uncollect
uncollectibl
ible
e receivables
receivables purchased ith recoursethis
recoursethis depends on ho
assumes the ris! of onership.
D. a. 5e
5e usef
useful
ul gener
general
aliz
izat
atio
ions
ns about
about the effect
effect of diffe
differi
ring
ng metho
methods
ds of inve
invent
ntor
ory
y
valuation on financial analysis can be made. 8et"
8et" e provide some guidance.
•In the case of )I5'" e !no that under conditions of fluctuating price levels"
it ill have a smoothing effect on income. #oreover" the the )I5' method yields" in
times of price inflation" an unrealistically lo inventory amount. *his" in turn"
loers the current ratio and tends to increase the inventory turnover ratio. We
also
also !no
!no that
that the )I5'
)I5' method
method afford
affords
s manage
managemenmentt an opp
opport
ortun
unity
ity to
manipulate profits by alloing inventory to be depleted in poor years" thus
draing on the lo cost pool to inflate income. A $udgment on all of these
cons
conse%e%ue
uence
ncess can ononly
ly be made
made on thethe basi
basiss of an asse
assess
ssme
ment
nt of all
all
surrounding circumstances. 5or e&ample" a slight change in a current ratio of
421 may be of no significance" hereas the same change in a ratio of 1.D21 may
be of far greater importance.
•*he use of 5I5' for the valuation of inventories ill generally result in a higher
inventory on the balance sheet and a loer cost of goods sold and higher
income/ in comparison to )I5'.
•*he average cost method smoothes out cost fluctuations by using a eighted
average cost in valuing inventories and in pricing cost of goods sold. *he
resulting net income ill be close to an average of the net income under )I5'
and 5I5'.
•*he >loer-of-cost-or-mar!et> 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. *his" in turn" ill depress the
current ratio belo its true level since the other current assets as ell as
current liabilities/ are not valued on a consistent basis ith the methods used
in valuing inventories.
b. In practice
practice e can find ide
ide variations
variations in
in the !inds
!inds of costs that
that are included
included in
inventory.
inventory. 3ractice varies particularly ith respect to the inclusion
inclusion or e&clusion of
1/
1/ vari
variou
ouss clas
classe
ses
s of over
overhe
head
ad cost
costs"
s" /
/ frei
freigh
ght-i
t-in"
n" and
and ?/
?/ gene
genera
rall and
and
administrative costs. *his variety in practices can have a significant effect on
comparability across companies.
@. a. *he
*he allo
alloca
cati
tion
on of ove
overh
rhead
ead cost
costss to all uni
units
ts of prod
produc
ucti
tion
on must
must be done
done on a
rational basis designed to get the best appro&imation
a ppro&imation of actual cost. Boever" this
is far from easy. *he greatest difficulty stems from the fact that a good part of
overhead is fi&ed costs" i.e." costs that do not vary ith production but vary
mostly
mostly ith the lapse
lapse of time.
time. E&ampl
E&ampleses are rent
rent paymen
paymentsts and the
the factor
factory
y
manager(s salary. *hus" assuming only a single product is produced" fi&ed costs
are 1FF"FFF" and 1F"FFF units are produced" then each unit ill absorb 1F of
fi&ed costs. Boever" if D"FFF units are
4-6
produced" each unit ill absorb

absorb F of fi&ed costs. *his shos that level of act ivity
is an important determinant of unit costide fluctuations in output can yield
ide fluctuations in unit cost.
b. *o allocate
allocate fi&ed costs to units" an assumption
assumption initially
initially must
must be made as to ho
many units the company e&pects to produce. *his determines over ho many
units the overhead costs is allocated. *hat calculation re%uires estimates of sales
and related production. *o the e&tent that actual production differs from estimated
produc
productio
tion"
n" overh
overhead
ead costs
costs il
illl be either
either overap
overappl
plied
ied or und
undera
erappl
pplied
ied.. *hat
*hat
means that production and inventory are charged ith more than total overhead
costs or ith an insufficient
insufficient amount of overhead costs.
G. *he ma$or ob$ectiv

ob$ectivee of the )I5'
)I5' method of
of inventory
inventory accounti
accounting
ng is to charge
charge cost of
of
goods sold ith the most recent costs incurred. When the price level is stable" the
results under either the 5I5' or the )I5' method ill be the same. When price levels
change" the use of these different methods can yield significantly different financial
results. 'ne of the primary aims of )I5' is to obtain a better matching of costs and
revenues in times of inflation. 0nder the )I5' method" the income statement is given
priority over the balance sheet. *his means that hile a matching of more current
costs
costs ith
ith revenu
revenues
es occurs
occurs in times
times of price
price inflat
inflatio
ion
n defla
deflati
tion
on/"
/" the inven
inventor
tory
y
carrying amounts in the balance sheet ill be unrealistically lo high/. +ote that use
of the )I5' method is encouraged by its acceptance for ta& purposes. *he ta& la
stipulates that its use for ta& purposes ma!es mandatory its adoption for financial
reporting.
<. In most annual reports" insufficien

insufficientt information
information is given to allo
allo the analyst to convert
convert
inventories accounted for under one method to a figure reflecting a different method
of inventory accounting. #ost analysts ant such information to better compare the
financial statements of companies that use different inventory accounting methods.
Conver
Convertin
ting
g an inven
inventor
toryy figure
figure from
from one method
method to anothe
anotherr is made
made even
even more
more
difficult by the use of different methods for various components of inventory. ,till"
analysts must" in most cases" ma!e an overall assessment of the impact of different
inventory methods on the comparability of inventory figures. ,uch an assessment
should be based on a thorough understanding of the inventory methods in use and
the effect
effect they
they are li!ely
li!ely to have
have on invent
inventory
ory values.
values. *he diffe
differen
rences
ces that
that arise
arise
beteen informed appro&imations and e&act figures using additional data generally
are not materially different.
different.
*o be most
most usefu
useful"
l" discl
disclos
osure
ures
s of inven
inventor
tory
y method
methods
s must
must give"
give" in additi
addition
on to
methods used" an identification of the inventory components in amounts/ here
such methods are used. #ore important" disclosure of the dollar difference beteen
the method in use and the method most prevalent in the industry ould be very
useful.
H. a. Cost
Cost"" defi
define
nedd genera
generall
lly
y as the
the pric
price
e paid
paid or consi
conside
dera
rati
tion
on give
given
n to ac%u
ac%uir
ire
e an
asset" is the primary basis in accounting for inventories.
inventories. As applied to inventories"
cost generally means the sum of the applicable e&penditures and charges directly
or indirectly incurred in bringing an article to its e&isting condition and location.
*hese applicable e&penditures and charges include all ac%uisition and production
cost
costs
sbu
butt they
they e&cl
e&clud
ude
e sell
sellin
ing
g e&pe
e&pens
nses
es and
and gene
generarall and
and admi
admini
nist
stra
rati
tive
ve
e&penses not clearly related to production.
4-7
b. #ar!et"
#ar!et" as applied
applied to the valuation
valuations
s of inventori
inventories"
es" means the
the current bid price
price at
the balance sheet date for the inventory in the volume for hich it is usually
purchased in. *he term is applicable to inventories of purchased goods and to
manufactured goods involving materials" labor" and overhead/. #ore generally"
mar!et means current replacement costalthough" it must not e&ceed 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 alloance
for a normal profit margin.
c. *he
*he usual
sual basi
basis
s for
for carr
carryi
ying
ng for
forar
ardd inve
invenntory
tory to the
the ne&t
ne&t peri
period
od is cost
cost..
6eparture from cost is re%uired" hoever" hen the utility of the goods included in
inventory is less than their cost. *his loss in utility should be recognized as a loss
of the
the curr
curren
entt per
period"
iod" the
the peri
period
od in h hic
ich
h it occu
occurr
rred
ed.. 5u
5urt
rthe
herm
rmor
ore"
e" the
the
subse%uent period should be charged for goods at an amount that measures their
e&pected
e&pected contri
contribut
butio
ionn to that
that period
period.. In other
other ords
ords"" the subse%
subse%uen
uentt period
period
should be charged for inventory at prices no higher than those that ould have
been paid if the inventory had been obtained at the beginning of that period.
Bis
Bisto
tori
rica
call
lly
y" the
the loer
loer-o-of-
f-co
cost
st-o
-or-
r-ma
mar!r!et
et rule
rule aros
arose
e from
from thethe accou
accountntin
ing
g
convention of providing for all losses and anticipating no profitsconservatism./
In accordance ith the foregoing reasoning the rule of >cost or mar!et" hichever
is loe
loer>r> may
may be applapplie
ied
d to each
each item
item in the
the inve
invent
ntor
oryy" to the
the tota
totall of the
the
components of each ma$or category" or to the total of the inventory" hichever
most clearly reflects the economic reality. *he )C# rule is usually applied to each
item" but if individual inventory
inventory items enter into the same category or categories of
finished product" alternative procedures are suitable.
d. Argum
rgumen
ents
ts agai
agains
nstt use
use of thethe loe
loer-
r-o
of-co
f-cost
st-o
-or-
r-ma
mar!
r!et
et meth
method
od of valu
valuin
ing
g
inventories include2
1/ *he method re%uires the reporting of estimated losses all or a portion of the
e&cess of actual cost over replacement cost/ as income charges even though the
losses have not been sustained to date and may never be sustained. 0nder a
consistent criterion of realization" a drop in selling price belo cost is no more a
sustained loss than a rise above cost is a realized gain.
/ A price shrin!age is brought into the income statement before the loss has
been
been sust
sustai
aine
nedd thro
throug
ughh sale
sale.. 5u
5urt
rthe
herm
rmor
ore"
e" if the
the char
charge
ge for
for the
the inve
invent
ntor
oryy
rite-
rite-do
don
n is not mademade to a specia
speciall loss
loss accoun
account"t" the cost figure
figure for goo
goodsds
actually sold is inflated by the amount of the estimated shrin!age in price of the
unsold goods. *he title >Cost of 7oods
7 oods ,old> therefore becomes a misnomer.
?/ *he method is inconsistent
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/ *he 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
mar!et at the ne&t year-end.
D/ *he loer-of-
loer-of-cost-
cost-or-ma
or-mar!et
r!et method
method values
values inventor
inventoryy in the balance
balance sheet
conservatively. Its effect on the income statement" hoever" may be the opposite.
Although
Although the income statement for the year in hich the unsustained loss is ta!en
is reported conservativel
conservativelyy" the net income
income for the subse%uen
subse%uentt period
period may be
distorted if the e&pected reductions in sales prices do not materialize.
4-8
@/ In the application of the loer of cost or mar!et rule" a prospective >normal
profit>
profit> is used in determini
determiningng inventory
inventory values
values in certain cases. ,ince normal
normal
profit
profit is an estima
estimated
ted figure
figure based up
upon
on past
past e&perie
e&periences
nces and might
might no
nott be
attained in the
future/" it is not ob$ective in nature and presents an opportunity for manipulation
of the results of operations.
1F. )I5' tends to yield loer

loer reported earnings
earnings hen prices rise as compared to 5I5
5I5'.
'.
*he folloing illustration highlights these effects2
3eriod 0nits in Inventory Cost per 0nit *otal Cost
3eriod 1 D D  D
3eriod  D 1F DF
3eriod ? D 1D GD
0nder )I5'" if 1F units are sold" then cost of goods sold is 1D" computed as D &
1D/ J D & 1F/.
1 F/. Also"
Also" the )I5' inventory
inventory value is D" computed as D & D. If units are
sold for F" then gross profit
profit is GD" computed as 1F & F/ - 1D. 0nder 5I5'"
5I5'" if 1F
units are sold" then cost of goods sold is GD" computed as D & D/ J D & 1F/. 7ross
profi
profitt ou
ould
ld be 1D"
1D" compu
computedted as FF - GD. Inventor
Inventory
y ou
ould
ld be valued
valued at GD"
computed as D & 1Dinflating the balance sheet. *his shos that 5I5' tends to
increase income and ta&es in inflationary
inflationary periods.
11.
11. Increa
Increases
ses in ra materi
materials
als can" in certain
certain instance
instances"
s" be a positi
positive
ve sign
sign that
that the
company
company is bui
buildi
lding
ng inventorie
inventories
s to meet e&pected demand. Boever
Boever"" increases
increases in
both ra materials and or!-in-process inventories" can reflect inefficient operations
that have sloed production.
production. Increases in finished
finished goods can reflect the building
building of
arehoused inventory to meet large demand or it can represent the stoc! piling of
finish
finished
ed goods
goods that
that are not in great
great demand.
demand. *he crucial
crucial part of analy
analysis
sis is to
interpret these changes in the conte&t of current and pro$ected industry conditions.
1. *he ob
obser
servat
vation
ion is correct
correct in pointin
pointing
g out that an analy
analyst
st must
must sub$ec
sub$ectt the data
data
regarding
regarding an entity(s
entity(s depreciatio
depreciation
n policies
policies to critical
critical analysis
analysis and scrutiny
scrutiny.. *he
company
company can choose
choose among
among several
several acceptable
acceptable but vastly different
different depreciatio
depreciation n
methods. *he reasons a particular choices/ is made by the company and the effect
on repo
report
rted
ed depr
deprec
ecia
iati
tion
on e&pe
e&pens
nse
e and
and accum
accumululat
ated
ed depr
depreci
eciat
atio
ion
n shou
should ld be
assessed.
1?. In the absence of more precise data" an analyst is better off ad$usting depreciation
charges on the basis of hisKher estimates and assumptions
assumptions than not ad$usting them at
all. Analyses
Analyses such as those described
described in the chapter can help to create a more useful
estimate of periodic depreciation e&pense and accumulated depreciation.
4-9
14. *here are a number of measures relating to plant

plant assets that are useful in comparing
depreciation policies over time as ell
 ell as for intercompany comparisons.
*he average total life span of

span of plant and e%uipment can be appro&imated as2
7ross 3lant and E%uipment Current 8ear 8ear 6epreciation E&pense.
*he average age of

age of plant and e%uipment can be computed as2
Accumulated 6epreciation Current 8ear
8ear 6epreciation E&pense.
*he average remaining life of

life of plant and e%uipment is computed as2
+et 6epreciated 3lant and E%uipment Current 8ear8ear 6epreciation
E&pense.
Also"
Also" draing on the above relations" e can compute2
Average *otal )ife ,pan L Average Age J Average Remaining )ife.
*he above ratios are helpful

helpful in assessing
assessing a company(s
company(s depreciation
depreciation policies
policies and
assumptions over time. *he ratios can be computed on a historical cost basis as ell
as on a current cost basis.
1D. 'ne of the more common solutions applied by analysts to the analysis of goodill is
to simply ignore it. *hat is" they ignore the asset shon on the balance sheet. As for
the income statement" under current accounting standards" goodill is no longer
amort
amortize
ized"
d" but is sub$ec
sub$ected
ted to an impair
impairmen
mentt test
test annual
annually
ly and ritte
rittenn do
don
n if
re%uired. 'ften" hoever" the rite-don e&pense is treated ith s!epticism and is
fre%ue
fre%uent
ntly
ly ign
ignore
ored.
d. 9y ign
ignori
oring
ng goo
goodi
dill
ll"" analy
analysts
sts ignor
ignoree inves
investme
tmentnts
s of very
very
substantial resources in hat may often be a company(s most important and valuable
asset.
asset. Ignor
Ignorin
ing
g the impact
impact of goo
goodi
dill
ll on report
reported
ed income
income is no soluti
solution
on to the
analysis of this comple& item. Even considering the limited information available" an
analys
analystt is better
better off evalua
evaluatin
ting
g the account
accountinging nu
numbe
mbers rs for goo
goodi
dill
ll rather
rather than
than
dismissing them altogether.
7oodill is measured by the e&cess of cost over the fair mar!et value of tangible net
assets ac%uired in a transaction accounted for as a purchase. It is the e&cess of the
purchase price over the fair value of all the tangible assets ac%uired" arrived at by
carefully ascertaining the value of such assetsat least in theory. *he analyst must
be alert to the ma!eup and the method of valuation of 7oodill as ell as to the
method of its ultimate disposition. 'ne ay of disposing of the 7oodill account"
fre%uently preferred by management" is to rite it off at a time hen it ould have the
leas
leastt impa
impact
ct on the
the mar!
mar!et(
et(s
s asse
assess
ssme
mentnt of the
the comp
companany(
y(s
s perf
perfor
orman
mance
ce.. for
for
e&ample" in a period of losses or reduced earnings/.
1@. Costs are capitalized as assets hen these e&penditures are e&pected to bring the
entity value beyond the current year. If the value associated ith the e&penditure ill
be used up in the current period" the e&penditure is e&pensed.
1G. Bard assets

assets are assets such
such as the factory and machineryt
machinerythey hey are tangible
tangible and
identifi
identifiable
able.. ,oft assets
assets are assets such as softare"
softare" research and developmen
developmentt
efforts" and intellectual capitalthey are more intangible in nature.
4-10
1<. a. 7enerally
7enerally accepted
accepted accountin
accounting g principl
principles
es re%uire
re%uire that natura
naturall resources
resources astin
asting/
g/
assets
assets be stated
stated at histo
histori
rical
cal cost
cost plus
plus costs
costs of discov
discovery
ery"" e&plor
e&plorati
ation"
on" and
development. *his means the large cost outlays that occur folloing the discovery
of natura
naturall resou
resources
rces are no
nott given
given account
accounting
ing recogniti
recognition
on as part
part of natura
naturall
resource assets. Rather" they generally are e&pensed as incurred. Conse%uently"
relati
relation
ons
s such
such as income
income to assets
assets are disto
distorte
rted
d by a failu
failure
re to capita
capitaliz
lize
e all
relevant costs and by the related implications
implications to current and future earnings.
b. When a company ac%uires

ac%uires natural
natural resources
resources from another
another entity
entity" this
this cost is more
li!ely to reflect the entire fair value of these resources. In such a situation the
relation
relation beteen the cost of the assets and the revenues"
revenues" e&penses" and income
they generate is li!ely to be more economically sensible.
sensible.
1H. In valuing property"

property" plant and e%uipment" and in reporting it in conventional financial
statements" accountants emphasize the ob$ectivity of historical cost. *hey also sho
an emphasis on conservatism ith an accounting for the number of dollars originally
invested in the assets. *he emphasis is not overly focused on the ob$ectives of those
that analyze and depend on financial statements for business decisions. *hey are
content to proclaim that >a balance sheet does not purport to reflect and could not
usefully reflect the value of the enterprise.> 5rom the user=s perspective" historical
costs
costs po
posse
ssess
ss severa
severall limi
limitat
tation
ions.
s. *hey
*hey are not releva
relevant
nt to %uesti
%uestion
onss of curren
currentt
replacement costs or of future needs. *hey are not directly comparable to similar
data in other
other companies
companies(( reports.
reports. *hey do not enable
enable users to measure
measure oppo
opportun
rtunity
ity
costs of disposal" nor of the alternative uses of funds. *hey do not provide a valid
yardstic! against hich to measure return. Also" in times of changing price levels"
they
they rep
represe
resent
nt an odd cong conglo
lome
merrati
ation of a varie
ariety
ty of pu
purc
rcha
hasi
sing
ng poeer
r
disbursements.
F. a. *he basic approach

approach in accountin
accounting g for identifi
identifiable
able intangi
intangibles
bles other
other than goodi
goodill/
ll/
is to record
record at histor
historica
icall cost
cost and subse%
subse%uen
uently
tly amortiz
amortize
e that
that cost
cost to benefi
benefitt
periods. If assets other than cash are given in e&change for the intangible" the
intangible must be recorded at the fair mar!et value of the consideration given.
+otic
+oticee that
that if a compan
company y spends
spends material
material and labor
labor in the constr
construct
uction
ion 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. 'n the other hand" if a
company spends a great amount of resources advertising a product or training a
sales force to sell and service
service ithich
ithich is one process for creating goodilli
goodillitt
usually cannot capitalize such costs. *his is even hen such costs may be as" or
more"
more" benefi
beneficia
ciall to the compan
company( y(s
s future
future operat
operation
ions
s than
than are any >tang
>tangibl
ible>
e>
assets. *he reason for this inconsistency in accounting for these to classes of
assets e&tends to several basic accounting conventions such as conservatism.
*hese conventions" draing 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. 7oodill
7oodill is an importan
importantt intangible
intangible asset.
asset. ,till"
,till" it represents
represents the only
only case here
the valuation of the asset is restricted to its cost of ac%uisition from a third party.
#oreover"
#oreover" any costs of defending a patent" copyright" or trademar! or similar/ are
properly included as part of the cost of intangible assets. *his e&tends to other
intangibles such as leases" leasehold improvements" special processes" licenses"
and franchises.
franchises. In mar!ed contrast"
contrast" internally
internally develope
developed
d goodill
goodill cannot
cannot be
capitalized and carried as an asset.
4-11
c. Identifiab
Identifiable
le intangible
intangibles
s other
other than
than go
good
odil
ill/
l/ can be separa
separatel
tely
y identi
identifi
fied
ed and
given reasonably descriptive names such as patents" trademar!s" and franchises.
Identifiable
Identifiable intangibles can be developed internally"
internally" ac%uired singly or as part of a
group of assets. *hey should be recorded at cost and amortized over their useful
lives. Write-don
Write-don or complete rite-off at date of ac%uisition is not permitted.
Unidentifiable intangibles can
intangibles can be developed internally or purchased from others.
*hey cannot be ac%uired singlythey are inherently part of a group of assets or
part of an entire entity.
entity. *he e&cess of cost of an ac%uired
ac%uired company or segment/
over the sum total of identifiable net assets is the most common unidentifiable
intangible assetthat of Mgoodill.N It is the residual amount in an ac%uisition
after the amount of tangible and identifiable intangibles are determined. 7oodill
is no longer amortized" but is tested annually for impairment and ritten don if
re%uired.
d. Identifi
Identifiabl
ablee intangibles
intangibles are believed to have limited
limited useful
useful lives.
lives. Accordin
Accordingly
gly"" they
are amortized. 6epending on the type of intangible asset" its useful life may be
limi
limite
ted
d by such such fact
factor
ors
s as lega
legal"
l" cont
contra
ract
ctua
ual"
l" regu
regula
lati
tion
ons"
s" dema
demandnd andand
compet
competitiition
on"" life
life e&pecta
e&pectanci
ncies
es of emplo
employee
yees"
s" and other
other economi
economicc and socia
sociall
factors. *he cost of each intangible should be amortized over its useful life ta!ing
into account all factors that determine its life. 7oodill is not amortized" but is
tested annually for impairment and ritten don if re%uired.
1. 7ood
7oodill
ill is often
often a sizable
sizable asset. It can be recorded
recorded only upon the purchase of an
ongoing business enterprise or segment. *he accounting conventions governing the
recording
recording of good
goodill
ill mean that only purchased
purchased good
goodil
illl is reported
reported among the
recorde
recorded d assets
assets and that
that more
more goo
goodi
dill
ll li!ely
li!ely e&ist
e&ist off the balanc
balancee sheet.
sheet. *h
*he
e
description of hat is being paid for in such a transaction varies and this adds to the
uncert
uncertain
ainty
ty surrou
surround
nding
ing this
this asset.
asset. ,ome
,ome refer
refer to an abili
ability
ty to attract
attract and !eep
satisfied customers" hile others point to %ualities inherent in an enterprise that is
ell organized and efficient in production" service" and sales. ,till others point out
that if there is value in goodill it must be reflected in earnings. *hat is" if there is
value to goodill" then it should give rise to superior earnings ithin a reasonably
short time after ac%uisition. If those earnings are not evidenced" then it is fair to
assume that the investment in goodill is of no value regardless of hether it is
reported on the balance sheet.
Regardless of the amount incurred in the ac%uisition or internal development of an

intangible" the carrying amount of any asset is not to be carried at an amount in
e&cess of realizabl
realizable
e value
value sales
sales price or future
future utility
utility/.
/. Actual implementa
implementation
tion is
another matter" and the analyst must be prepared to form $udgments on the amounts
reported for intangible assets.
. *here are a number

number of categories
categories of deferred charges.
charges. In each case" the rationale
rationale for
deferral is that these outlays hold future utility benefits/ for the company.
1/ 9usiness development" e&pansion" merger" and relocation costs.
a. 3re-operatin
3re-operating g e&penses"
e&penses" initial
initial start-u
start-up
p costs" and
and tooling
tooling costs.
costs.
b. Initial
Initial operati
operating
ng losses
losses or preoperating
preoperating e&penses
e&penses of subsidiari
subsidiaries.
es.
c. #oving"
#oving" plant
plant rearrangemen
rearrangement" t" and reinsta
reinstallat
llation
ion costs.
costs.
d. #erger
#erger or ac%u
ac%uisi
isiti
tion
on e&pen
e&penses
ses..
e. 3urchas
3urchased ed custom
customer er account
accounts.s.
4-12
f. +on-
+on-co
comp
mpet
ete
e agre
agreem
emen
ents
ts..
4-13
/ 6eferred e&penses.

a. Advert
Advertisin
isingg and promoti
promotional
onal e&penses.
e&penses.
b. Impu
Imputed
ted inte
intere
rest
st..
c. ,elling" general and administrative
administrative e&penses.
d. 3ension plan costs.
e. 3roperty and other ta&es.
f. Rental and leasing costs.
g. Vacation pay.
h. ,easonal groing and pac!ing e&penses.
?/ Intangible costs.
a. Intangib
Intangible
le dril
drillin
ling
g and
and develop
development
ment costs
costs..
b. Contracts"
Contracts" film
films"
s" copyrig
copyright
ht material
materials"
s" art right
rights
s
c. Costs
Costs of compu
computer ter soft
softare
are
4/ 6ebt discount and e&penses.
D/ 5uture income ta& benefits.
@/ 'rganization costs.
G/ Advance royalties.
?. a. 'ne categor

category y of assets
assets not recorde
recorded d on the balance
balance sheet is inter
internal
nally
ly created
created
goodi
goo dill.
ll. In this
this case"
case" if the intan
intangi
gibl
ble
e is inter
internal
nally
ly develo
developed
ped"" rather
rather than
than
purchased from an outside party" it cannot be capitalized and all costs must be
e&pensed as incurred. *his means" to the e&tent an asset is created that can be
sold or possesses earning poer/" prior income that is charged ith the e&pense
of its
its deve
develo lopm
pmen
entt is un
unde
ders
rsta
tate
ted
d and
and futu
future
re inco
income
me ill
ill be over
overst
stat
ated
ed/.
/.
+ume
+umero rous
us intan
intangigibl
ble
e asse
assets
ts fit
fit this
this categ
categor
ory
y. Ano
noth
ther
er categ
categor
oryy is that
that of
cont
contin
inge
gent
nt asse
assets
ts.. 0nde
0nderr the
the prin
princi
cipl
plee of cons
conserv
ervat
atis
ism"
m" the
the cont
contin
inge
gent
nt
rightsKclaims
rightsKclaims to resources are not recognized due to their uncertainty.
uncertainty.
b. *he analyst
analyst must realize
realize that reported
reported boo!
boo! values are not substit
substitutes
utes for
for mar!et
values. As illustrated
illustrated by the accounting-based e%uity valuation model" unrecorded
assets
assets mu
must
st eventu
eventuall
allyy be realiz
realized
ed in the form
form of residu
residual
al income
income abnor
abnormal
mal
earnings/. If there is no above-normal income" then there is little value in any
unrecorded assets.
4-14
EOERCI,E,
E&ercise 4-1 1 minutes/
a. An alloa
alloance
nce metho
method
d based on credit
credit sales
sales attempts
attempts to match bad
bad debts ith
the revenues generated by the sales in the same period. *hus" it focuses on
the income statement
statement rather
rather than the
the balance sheet.
sheet. 'n the other
other hand" an
alloance method based on the balance in the trade receivables accounts
attempts to value the accounts receivable
receivable at the end of a period at their future
collectible amounts. *hus" it focuses on the balance sheet rather than the
income statement. +ote that both of these alloance methods are acceptable
under 7AA3./
b. Carme
Carme Company
Company ill
ill report
report on its balance
balance sheet
sheet at 6ecember
6ecember ?1" 8ea
8earr 1" the
balance in the alloance for bad debts account as a valuation or contra asset
accountthat is" as a subtraction from the accounts receivable asset. 9ad
debt e&pense can be reported in the income statement as a selling e&pense"
or as a general and administrative e&pense" or as a subtraction to arrive at net
sales.
c. When
When e&ame&amin
inin
ing
g the
the reas
reason
onab
able
lene
ness
ss of the
the allo
alloa
anc
nce
e for
for bad
bad debt
debts"
s" the
the
analyst is interested in assessing the collectibility of accounts receivable. *he
analyst
analyst is especiall
especially
y interes
interested
ted in changi
changing
ng busines
businesss conditi
conditions
ons and their
their
impact on this alloance balance that is" is it sufficient/. In addition" the
analyst
analyst must assess any changes in collectibility
collectibility assumptions
assumptions as they have a
direct impact on net income through the determination of bad debt e&pense.
5inally
5inally"" there
there is some evidence
evidence that
that manage
managers rs use the alloanc
alloancee account
account
among others/ to help manage earnings levels.
4-15
E&ercise 4- 1D minutes/
a. Inv
Inventor
entory
y costs
costs incl
includ
udee all reaso
reasona
nable
ble and
and neces
necessa
sary
ry costs
costs of prep
prepari
aring
ng
inventory for sale. *hese costs include not only the purchase price of the
inventories" but also other necessary costs of readying inventories for sale.
b. *he loer
loer of cost or mar!et
mar!et rule produc
produces
es a more realisti
realistic
c estimate
estimate of future
future
cash flos to be realized from the sale of inventories hen mar!et is less than
cost
cost.. *h
*his
is rule
rule is cons
consis
iste
tent
nt ith
ith the
the prin
princi
cipl
ple
e of cons
consererva
vati
tism
sm"" and
and
recogni
recognizes
zes matche
matches/
s/ the anticip
anticipated
ated loss in the income statemen
statementt for the
period in hich the price decline occurs.
c. P(s
P(s inv
invento
entoriries
es shou
should
ld be repo
report
rted
ed on the
the bala
balanc
ncee shee
sheett at mar!
mar!et
et..
,pecifically" according to the loer of cost or mar!et rule" mar!et is defined as
replacement cost. Boever" mar!et cannot e&ceed net realizable value and
cannot be less than net realizable value less a normal profit margin. 5or P"
replacement cost is beteen net realizable value and net realizable value less
a normal profit margin. *herefore" mar!et is established as replacement cost.
,ince
,ince mar!
mar!etet is less
less than
than origi
origina
nall cost"
cost" inve
invento
ntory
ry shou
should
ld be repor
reported
ted at
mar!et.
d. Ending
Ending invento
inventories
ries and net income
income ould
ould have been the same
same under either
either
loer of average/ cost or mar!et or the loer of 5I5'/ cost or mar!et. In
perio
periods
ds of declin
declinin
ing
g price
prices"
s" the loer
loer of cost
cost or mar!e
mar!ett rule
rule resu
results
lts in a
rite-don of inventory to mar!et under both methods" resulting in similar
inventory costs. *herefore" net income using either inventory method is very
similar.
4-16
E&ercise 4-? 1D minutes/
a. i/ *he avera

averagege cost method
method is based
based on the the assump
assumptio tionn that
that the
the avera
average
ge
costs
costs of thethe go
good
odss in the
the begin
beginni
ning
ng inve
invento
ntory
ry and
and the
the gogoods
ods pu purch
rchase
ased
d
during the period should be used for both the inventory and the cost of goods
sold computat
computation.
ion. ii/ *he 5I5'
5I5' first-in"
first-in" first-out/
first-out/ method
method is based on the
assum
assumpti
ption
on that
that the
the first
first go
goods
ods pu
purcrcha
hased
sed are
are the
the first
first sold.
sold. As a resu
result"
lt"
inventory is reported at the most recent purchase prices" hile cost of goods
sold is at older purchas
purchase e prices.
prices. iii/ *he )I5' last-in"
last-in" first-out
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" hile cost
of goods sold is at more recent purchase prices.
b. In an inflationa
inflationary
ry economy
economy"" )I5' provides
provides a better
better matching
matching of curren
currentt costs
ith current revenue on the income statement because cost of goods sold is
at more recent purchase prices. Also" net cash inflo is generally increased
because ta&able income is generally
generally decreased" resulting in payment of loer
income ta&es.
c. Where
Where there
there is evidence
evidence that the value
value of invento
inventory
ry to be disposed
disposed of in the
ordinary course of business ill be less than cost" the difference should be
recognized
recognized as a loss in the current period. *his is done by restating inventory
inventory
to its mar!et value in the financial statements. *he concept of conservatism"
yield
yieldin
ing
g inve
invento
ntory
ry report
reported
ed at the
the loer
loer of cost
cost or mar!e
mar!et"
t" is the
the prima
primary
ry
$ustification
$ustification of this approach.
approach.
AIC3A Adapte
Adapted/
d/
E&ercise 4-4 1 minutes/
a. *he inventory
inventory asset is more
more meaningful
meaningful for
for analysis
analysis purposes
purposes hen calculated
calculated
using the 5I5' cost flo assumption. *his is because the costs assigned to
units remaining in ending inventory are the more recent costs.
b. Cost of goods sold is usually

usually more meaning
meaningful
ful for analysi
analysis
s purposes
purposes hen
calculated using the )I5' cost flo assumption. *his is because the costs
assigned to units sold are the costs from the more recently purchased units.
c. When
When a company
company uses
uses )I5'" the costs
costs assigned
assigned to uni
unitsts in ending
ending inventory
inventory
are the costs from older less recent/ units. As a result" analysts ould prefer
to calculate hat ending inventory ould have been had 5I5' been used. *his
can be accomplished by adding the )I5' reserve value to the )I5' ending
inventory value.
4-17
E&ercise 4-D D minutes/
a. Computation
Computation of 8ear
8ear 1F Cost of 7oods
7oods ,old
,old and 7ross
7ross 3rofit/2
3rofit/2
LI
LIFO FIFO
9eginning  <1
<1@.F a/  HF
HF4.F b/
inventory...
Cost of goods 4"@.F
4"@ .F c/ 4"@ .F c/
purchased...
7oods available for sale.. D"FG<.F D"1@@.F
)ess ending inventory.. <1H
<1H.</
.</ ?4/
?4/ HF4
HF4.4/
.4/1D
1D/
/
Cost of goods 4"D<. 14/ 4"@1.@
sold...
Revenues @"FD.< 1 1?/ @"FD.< 11?/

Cost of goods sold above/ .. 4"D<./ 4"@1.@/
7ross profit2
As reported ..
... . 1"H4G.@
0nder 5I5' 
  1"H44.
a/ 7ivenfrom 8ear H balance sheet.
b/ <1@.F J <<.F givenfrom 8ear H balance sheet/.
c/ Cost of goods purchased is the same under either methodderived.
b. *he primary analysis

analysis ob$ective
ob$ective in ma!ing
ma!ing the )I5'-to-5I5'
)I5'-to-5I5' restatement
restatement ofof cost
of good
goods
s purcha
purchases
ses and gross profit
profit is to achiev
achieve
e comparab
comparability
ility beteen
beteen
firms using different inventory methods.
c. 5I5'
5I5' Invent
Inventory
ory L )I5
)I5'
' Invento
Inventory
ry J )I5' Reserv
Reserve
e
8ear
8ear 1F see
see Campbell note
note 14/2
HF4.4 L <1H.< J <4.@
8ear
8ear 11
11 see
see Campbell note
note 14/2
GH@.? L GF@.G J <H.@
d. When
When a company
company uses the
the )I5' cost flo
flo assumptio
assumption"
n" it can be valuable
valuable to
convert the reported inventory asset to a 5I5' basis for analysis purposes.
*his is because the inventory value reported under 5I5' is more reflective of
the curren
currentt cost of invento
inventory
ry since
since reported
reported costs
costs reflect
reflect the more recent
recent
costs of units purchased.
E&ercise 4-@ 1F minutes/
In a period of rising inventory costs" the most recently purchased units are more
e&pensive. As a result" the cost of goods sold is higher under )I5' and loer
under 5I5'. *hus" if output prices are stable" then net income is higher under
5I5' than under )I5'. Also" the ending inventory asset value" and therefore total
assets"
assets" is hig
higher
her under
under 5I5' and loer under
under )I5'.
)I5'. In contras
contrast"
t" in a period of
declining inventory costs and stable output prices" all of the ansers here ill
reverse.
4-18
E&ercise 4-G F minutes/

E&amples of potentially unrecorded assets on balance sheets include2
• E&cess of replacement values over costs for plant assets.
• )I5' inventory reserve.
• E&ces
E&cesss of mar!e
mar!ett valu
valuee over
over ad$u
ad$uste
sted
d cost
cost of e%uit
e%uityy in no
nonc
ncon
onso
solid
lidate
ated
d
subsidiaries and in affiliates.
• Inta
Intang
ngib
ible
les-
s--r
-rec
ecog
ogni
nize
zed
d firm
firm name
name"" prod
produc
uctt name
name"" or bran
brandd name
name no nott
capitalized.
• ,ucc
,ucces
essf
sful
ul RQ6
RQ6 such
such as a ne ne drug
drug that
that has
has pass
passed
ed all
all bu
butt fina
finall 56A
56A
clearance.
• 3roved
3roved reserv
reserves
es of e&tracti
e&tractive-ty
ve-type
pe compani
companies
es carried
carried at substan
substantial
tially
ly less
than mar!et value of the product less e&traction costs.
• Buman intellectual/ capital.
• Value of savings on short-term credit lines here ma&imum interest payable is
currently belo ban! prime rate.
*he anal
*he analys
ystt mu
must
st reme
remembe
mberr that
that bo
boo!
o! valu
values
es are
are on
only
ly the starti
starting
ng po
point
int for
accounting-based
accounting-based valuation.
valuation. If unrecorded
unrecorded assets have economic value" they ill
eventu
eventually
ally be recogni
recognized
zed throug
through h hig
higher
her future
future abnorma
abnormall earning
earningss residu
residual
al
income/. *his means the analyst must consider the impact of unrecorded assets
hen pro$ecting future profitability for valuation purposes.
C5A Adapte
Adapted/
d/
E&ercise 4-< D minutes/
a. A cost
cost should
should be capitalized
capitalized that
that is" treated as an asset/
asset/ hen it is e&pected
e&pected
that the asset ill produce benefits in future periods. *he important concept
here is that the incurrence of such a cost results in the ac%uisition of an asset
future service potential/. +ot only should the incurrence of the cost result in
the ac%uisition of an asset possessing e&pected future benefits" but also the
cost should be measurable ith a reasonable degree of ob$ectivity. E&amples
of cost
costss that
that are
are typi
typica
call
lly
y capi
capita
tali
lize
zed
d as asse
assets
ts incl
includ
ude
e the
the cost
costs
s of
merch
merchanandi
dise
se avai
availab
lable
le at the
the end
end of an accoaccoun
untin
ting
g perio
period"
d" the
the costs
costs of
insurance coverage relating to future periods" and the costs of
self-constructed plant or e%uipment. In contrast" if a cost is incurred that
results in benefits not e&pected to persist beyond
beyond the current
current period" then the
cost is e&pensed. *his e&pense treatment reflects the cost of service potential
that e&pired in producing current period revenues.
b. In the
the absence
absence of a direct
direct basis for associating
associating asset
asset cost ith revenue"
revenue" and
and if
the asset
asset provi
provides
des bene
benefit
fits
s for to or mo
more
re accou
accounti
nting
ng perio
periods"
ds" its cost
cost
should be allocated to these periods as an e&pense/ in a systematic and
rational manner. E&amples of systematic and rational allocation of asset cost
ould include depreciation of fi&ed assets" amortization of intangibles" and
allocation of rent and insurance costs. When it is impractical" or impossible"
to find a reasonable cause-and-effect relation beteen revenue and cost" this
relation is often assumed to e&ist. In this case" the asset cost is allocated to
some assumed benefit period in a systematic manner. *he allocation method
4-19
used should be reasonable and should be applied consistently from period to

period.
4-20
E&ercise 4-H F minutes/

a. 1. Average
erage tota
totall life
life span
span of
of plan
plantt and
and e%ui
e%uipm
pmen
ent2
t2
7ross plant and e%uipment
Current year depreciation e&pense
2006
a
DD
D D4H
L 1@.<G years
b
?H
a
,ee note 1@. +ote that land must not be included.
b
Amortization should be subtracted" but it is not bro!en out in the Colgate cash flo
statement.
. Average
verage age
age of plant
plant and
and e%uipm
e%uipment2
ent2
Accumulated
Accumulated depreciation
2006
HHH
L H.1 years
a
?H
a
Amort
Amortiza
izatio
tion
n shoul
should
d be subtr
subtract
acted"
ed" but it is not bro!en
bro!en out in the 6ell incom
income
e
statement.
?. Average
verage remai
remainin
ning
g life of plant
plant e%uipme
e%uipment2
nt2
+et plant
plan t and e%uipme
e%ui pment
nt
2005
DDF
L G.G@ years
b
?H
a
)and should be subtracted" see note 1@.
b
Amortization should be subtracted" but it is not bro!en out in the Colgate cash flo
statement.
b. 7ene
7enerarally
lly"" these
these ratios
ratios can
can be used
used to assess
assess a compa
company ny(s
(s depre
deprecia
ciatio
tion
n
policies both over time temporal/ and for comparative purposes ith other
comp
compan anie
iess in the
the same
same indu
indust
stry
ry.. An anal
analys
ystt mumust
st ta!e
ta!e care
care hhen
enev
ever
er
compa
comparisrison
onss are
are made
made bete
beteenen compa
compani
nies.
es. *h *here
ere often
often are
are econ
economi
omicc
reasons for different depreciation methods and assumptions" hich can be
obscu
obscured
red in a simpl
simple
e rest
restate
atemen
mentt of resu
results
lts.. 5o
5orr e&amp
e&ample"
le" Colga
Colgate
te uses
uses
straight-line depreciation for plant and e%uipment another company may use
an accelera
acceleratedted method
method such
such as dou
double-decl
ble-declinin
ining-bal
g-balanc
ance.
e. *he selectio
selection
n of
differ
differen
entt metho
methodsds may
may refle
reflect
ct fund
fundame
ament
ntal
al differ
differen
ence
cess in mana
manage
gemen
mentt
philosophy and action toard capital financing and maintenance. Also" ith
capital intensive companies" profit margins may not reflect the higher costs
that may be e&pended to replace e&isting plant assets.
4-21
E&ercise 4-1F F minutes/

a. 1. Average
erage tota
totall life
life span
span of
of plan
plantt and
and e%ui
e%uipm
pmen
ent2
t2
7ross plant and e%uipment
11 10
a a
"D
"D?<
?<.F
.F "4
"4F4
F4.1
.1
L 1?.FD years L 1?.F@ years
b b
1H4.D 1<4.1
a
9uildings S1DHT GD<.G in 8ear 11" G4@.D in 8ear 1F/ plus machinery and
e%uipment S1@FT 1GGH.? in 8ear
8ear 11 and 1@DG.@ in 8ear
8ear 1F/.
b
5rom 5orm 1F-P" item S1<GT.
. Average
verage age
age of plant
plant and
and e%uipm
e%uipment2
ent2
Accumulated depreciation
11 10
c c
1"1
1"1?1
?1.D
.D 1"F
1"F1G
1G.
.
L D.< years L D.D? years
1H4.D 1<4.1
c
5rom Campbell note 1@ S1@T.
?. Average
verage remai
remainin
ningg life of plant
plant e%uipme
e%uipment2
nt2
+et plant and e%uipment
11 10
d
"D?<.F
"D? <.F U 1"1?1.D
1"1 ?1.D "4F4.1 1"F 1G. d
"4F 4.1 U 1"F1G.
L G.? yrs L G.D? yrs
1H4.D 1<4.1
d
7ross plant and e%uipment minus accumulated depreciation.
b. 7ene
7enerarally
lly"" these
these ratios
ratios can
can be used
used to assess
assess a compa
company ny(s
(s depre
deprecia
ciatio
tion
n
policies both over time temporal/ and for comparative purposes ith other
comp
compan anie
iess in the
the same
same indu
indust
stry
ry.. An anal
analys
ystt mu
must
st ta!e
ta!e care
care h
henenev
ever
er
compa
comparisrison
onss are
are made
made bete
beteenen compa
compani
nies.
es. *h*here
ere often
often are
are econ
economi
omicc
reasons for different depreciation methods and assumptions" hich can be
obscured in a simple restatement of results. 5or e&ample" Campbell uses
straight-line depreciation for plant and e%uipment another company may use
an accelera
acceleratedted method
method such
such as dou
double-decl
ble-declinin
ining-bal
g-balanc
ance.
e. *he selectio
selection
n of
differ
differen
entt metho
methodsds may
may refle
reflect
ct fund
fundame
ament
ntal
al differ
differen
ence
cess in mana
manage
gemen
mentt
philosophy and action toard capital financing and maintenance. Also" ith
capital intensive companies" profit margins may not reflect the higher costs
that may be e&pended to replace e&isting plant assets.
,peci
,pecific
ficall
ally
y" all
all thre
three
e of these
these meas
measur
ureses for Campb
Campbell
ell reve
reveal
al no mar!e
mar!edd
chan
change
gess from
from 8ear
ear 1F to 8ear 11. ,till"
,till" a mo
more
re compl
complete
ete analy
analysis
sis of this
this
con$ect
con$ecture
ure ould
ould involv
involve
e compari
comparison
sons
s of Campbel
Campbell=s
l=s measure
measuress ith those
those
from competitors.
4-22
E&ercise 4-11 1F minutes/
9alance sheet assets are2 c " d in

in some cases/" e" g " h" i " j " m" p" q
E&ercise 4-1 1F minutes/
Ending inventory under 5I5' ould be GH@.? million S1D1J1DT.
7ross profit ould be higher by the amount of the increase in the )I5' reserve"
or <H.@ million - <4.@ million L D million.
4-23
3R'9)E#,
3roblem 4-1 ?F minutes/
a. 0nde
0nderr the 5I5'
5I5' metho
method d of acco
accoun
untin
ting
g for inven
inventor
tories
ies"" cost
cost of goo
goods
ds sold
sold
reflects the cost of inventories purchased earlier less recent costs/. 6uring
periods of rising costs" operating margins are higher under 5I5' because
sales at current prices are matched ith older" loer cost inventory. 6uring
periods of declining
declining costs" operating margins are compressed because older"
higher cost inventories are matched ith current" loer priced sales. #ore
specifically" in the case of A9EO Corp. e estimate the folloing impacts2
1/ 6uring the period 8ear D through 8ear G" according to E&hibit I" cost per
pound produced
produced declined from ?4 cents to ?1 cents to H cents. *he use of
5I5' compresses A9EO(s margins because higher cost" older inventory is
being e&pensed.
/ 6uring
6uring the period 8ear
8ear G through 8ear
8ear H" according to E&hibit I" unit costs
ere rising. +amely" unit costs rose from H cents in 8ear G to ?D cents and
?H cents in 8ear < and 8ear H" respectively. *he use of 5I5' ould increase
A9EO(s operating margins during this period as older" loer cost inventory
is being e&pensed first.
b. Accord
According
ing to E&hibit
E&hibit I" prices and costs
costs are e&pected
e&pected to decline
decline in 8ea
8earr 1F. In
contrast" for 8ear 11" prices and presumably costs/ are e&pected to increase.
Conse%uently" adopting )I5' at in 8ear 11" prior to the pro$ected rise in prices
ould produce ta& savings" increased cash flos" and a better matching of
costs and revenues on the income statement. *his supports a
recommendation to adopt )I5' in 8ear 11.
3roblem 4- 1D minutes/
a. 8ear H retained earnings ad$ustment for )I5' to 5I5' change2

)I5' Reserve
Reserve & 1- *a&
*a& rate/ L
DF"FFF/ & 1 - .?D/ L ?"DFF increase
b. 8ear H net income ad$ustment for )I5' to 5I5' change for both 8ears < and H2
Chan
Changege in
in )I5
)I5'' Rese
Reserv
rve
e & 1-
1- *a
*a& rate/
rate/ L
S 4@"FFF/ - DF"FFF/ T & 1 - .?D/ L "@FF increase
c. *he primary
primary analy
analysis
sis ob$ectiv
ob$ective
e hen ma!ing
ma!ing a )I5' to 5I5' restate
restatemen
mentt is to
1/ achi
achiev
eve
e better
better comp
compara
arabil
bility
ity bete
beteen
en firms
firms usin
usingg differ
differen
entt inve
invent
ntory
ory
methods" and / obtain better measures" using more recent costs" of the
value of inventory on the balance sheet.
4-24
3roblem 4-? ?F minutes/
a. Ending
Ending Inve
Invento
ntory
ry Ad$us
Ad$usted
ted from )I5'
)I5' to 5I5'2
5I5'2
At :an.
:an. H"
H" 1HH
1HHH2
H2 L )I5'
)I5' Inv
Inven
ento
tory
ry J )I5'
)I5' Res
Reser
erv
ve
L 1H"@<@ J @"HFF
L 4@"D<@
At :an.
:an. ?F"
?F" 1HH
1HH<2
<2 L )I5'
)I5' Inv
Inven
ento
tory
ry J )I5'
)I5' Res
Reser
erv
ve
L 41"1D4 J D"1FF
L @@"D4
b. +et Incom
Income
e as Ad$us
Ad$usted
ted from
from )I5' to 5I5'
5I5'22
8ear
8ear ended
ended :an. H" 1HHH2 L )I5' Income
Income J After-*a
After-*a&
& Change in
in )I5' Reserv
Reserve e
L ?1"1<D J S @"HFF U D"1FF/ & 1 - .?G/ T
L ?"?1H
c. *he primary
primary analy
analysis
sis ob$ectiv
ob$ective
e hen ma!ing
ma!ing a )I5' to 5I5' restate
restatemen
mentt is to
1/ achi
achiev
eve
e better
better comp
compara
arabil
bility
ity bete
beteen
en firms
firms usin
usingg differ
differen
entt inve
invent
ntory
ory
methods" and / obtain better measures" using more recent costs" of the
value of inventory on the balance sheet.
3roblem 4-4 D minutes/
a. Reconstruction
Reconstruction of
of *ransactio
*ransactions
ns using *-A
*-Account
ccount Analysis2
Analysis2
ropert!" lant # $q%ipment &gross'

S1@1AT 9eg. "G?4.H
S1<@
S1<@TT Add
ddit
itio
ions
ns ?G1.
?G1.11 1D@.
1D@.G
G Reti
Retire
reme
ment
ntsK
sKsa
sale
les
s S1<@
S1<@TT
S1<@
S1<@TT Ac%ui
c%uire
red
d asse
assets
ts 4.G
4.G ?.1
?.1 Rate
Rate varia
arianc
ncee S1<@
S1<@TT
S1@1AT End. "H1.H
(cc%m%lated )epreciation
1"F1G. 9eg S1@T
1H4.D 6epreciation S1<@T
S1<GT RetirementKsale @H.D
S1<GT *ranslation Ad$. 1F.G
1"1?1.D End S1@T
b. *he reconstru
reconstructio
ction
n of transac
transactio
tions
ns throug
throughh *-acco
*-accoun
untt analysi
analysis
s enables
enables the
financial statement reader to e&amine the economic substance behind the
accounting disclosures and to better interpret the changes in !ey accounts.
4-25
3roblem 4-D DD minutes/
,oftare 6evelopment Costs2
Current 0namortized 9al. U 3rior 0namortized 9al. J Current Amortization E&pense

FFF
FFF22 1<
1< L ?1
?1 - F
F J G
FF12 D L G - ?1 J H
FF2 G L  - G J 1
FF?
FF?22 
 L ?1
?1 - 
 J 1?
1?
FF4
FF422 @
@ L 4
4 - ?1
?1 J 1D
1D
FFD
FFD22 1@
1@ L 4?
4? - 4
4 J 1D
1D
FF@2 G L ?@ - 4? J 14
b. ,oftare developm
developmentent costs typically
typically arguably/
arguably/ lead
lead to more direct
direct products.
products.
*he succ
success
ess or failu
failure
re of soft
softar
are
e deve
develo
lopme
pment
nt effor
efforts
ts is deter
determi
mine
ned
d by
heth
hetherer func
functio
tioni
ning
ng soft
softarare
e is ulti
ultimat
mately
ely produ
produce
ced
d that
that can
can be sold
sold to
customers.
customers. When salable
salable softare is reasonably
reasonably e&pected
e&pected to be developed"
developed"
the cost of the softare development can be capitalized and amortized to the
presumed benefit periods. *he product that results from other RQ6 efforts is
often less identifiable. Indeed" many RQ6 efforts fail. #oreover" many RQ6
efforts
efforts are only ind
indirec
irectly
tly related to future
future products
products.. *his has resulte
resulted
d in
7AA3 re%uirements that e&pense RQ6 costs in the periods hen incurred.
*hat is" RQ6 costs are not capitalized and allocated against future revenues
generated by any products developed from those efforts.
c. A revie
revie of the data suggests
suggests a one-year
one-year lag beteen
beteen RQ6 e&pendi
e&penditure
tures
s and
additi
additiona
onall inco
income.
me. ,peci
,pecific
ficall
ally
y" inco
income
me appea
appears
rs to incr
increas
easee in the
the year
year
folloing substantial
substantial RQ6 efforts and to decline in the year folloing reduced
RQ6
RQ6 effor
efforts.
ts. Also"
lso" this
this analy
analysi
siss shou
should
ld use
use inco
income
me before RQ6 e&penses
hen assessing the impact of RQ6 on income.
&*000s' 1HHH FFF FF1 FF FF? FF4 FFD FF@

RQ6 4FF 4H1 1@ 1 ?DD 41H 4F1 4DD
Income
3re- G1 <D< @F4 41< 41F DFF D@< @?4
RQ6
d. All else e%ual"

e%ual" if *rima&
*rima& invests
invests more in softare
softare development
development in a given year"
year"
net income ill be higher because the company can capitalize many softare
development costs. In contrast" e&penditures for other RQ6 pro$ects must be
e&pensed in the year hen incurred. 'f course" this response ignores the
economic implications for hich e re%uire additional information to $udge
the relative successes of these e&penditures.
4-26
3roblem 4-Dcontinued
e. Ratio Implications of Alternative Accounting

Accounting *reatments for RQ6
RQ6 and ,oftare2
S+ote, Ansers disregard income ta& conse%uences.T
&-ear 2006' +et income Return on Assets Return on

E%uity
1/ 1<@"FFF a .F4Fb .FDGc
/ <G"DF d .FDFe .F@@f
a2 +et income JAdd bac! amortized costs UActual softare development e&penditures L 1GH J 14 U G.
b2 Revised income col. 1/K *otal assets UCapitalized softare development costs/ L 1<@ K 4"@DF U ?@/.
c2 Revised income col. 1/K *otal e%uity UCapitalized softare development costs/ L 1<@ K ?"?1 U ?@/.
d2 +et income
income J Add
Add bac!
bac! e&pensed
e&pensed RQ6 - Amortizatio
Amortization n L 1GH J 4DD U 1K4/
1K4/ U ?DDK4/
?DDK4/ U 41HK4/
41HK4/ U
4F1K4/
L 1GH J 4DD - ?4@.GD L <G.D
e2 Revised income col.1/K*otal assets J0namortized RQ6/ L<G.DK 4"@DF J4DD J?FF.GD JFH.DF J
<<.GD/
L<G.D K D"GF4
f2 Revi
Revise
sed
d inco
income
me col
col.1
.1/K
/K*
*ootal
tal e%ui
%uity J0na
J0namo
mort
rtiized
zed RQ6/
RQ6/ L<
L<G.G.D
D K ?"
?"?1
?1 J4D
J4DD
D J?F
J?FF.
F.GD
GD J
FH.DF J<<.GD/
L<G.D K 4"?@@
f. Cash flo from

from operations
operations are
are unaffected
unaffected by
by the capitalizing
capitalizing versus
versus e&pensing
e&pensing
issu
issue.
e. Boe
Boev ver"
er" cash
cash flo
flo from
from op
oper
erat
atio
ions
ns is affe
affect
cted
ed by the
the deci
decisi
sion
on
regarding the %uantity of softare development and other RQ6 efforts that ill
be carried out in a given year.
3roblem 4-@ 4D minutes/
,*RAI7B*-)I+E
& * 0 0 0 s' -$(. 1 -$(. 2 -$(. / -$(.  -$(. 5
Earnings before ta&es
Q depreciation2. . .  1 " D F F .F   "F F F .F   " D F F .F  ? " F F F .F  ? "D F F .F
a/ 6e
6epreciation.......... FF.F/ FF.F/ FF.F/ FF.F/ FF.F/
+et 9efore *a&es...  1 " ? F F .F  1 "< F F .F   " ? F F .F   "< F F .F  ? "? F F .F
b/ Income *a&es........ @DF.F/ HFF.F/ 1"1DF.F/ 1"4FF.F/ 1"@DF .F/
c/ +et Income............  @D @ D F .F  HF H F F .F  1 " 1 D F .F  1 "4 F F . F  1 "@ D F .F
6epreciation.......... FF.F FF .F FF.F FF.F FF.F
d/ Cash 5lo..............  <DF.F  1 "1 F F .F  1 " ? D F .F  1 "@ F F . F  1 "< D F .F
4-27
,0#-'5-*BE- 8EAR,(-6I7I*,
&*0 0 0 s ' -$(. 1 -$(. 2 -$(. / -$(.  -$(. 5
Q depreciation ........  1 " D F F .F   "F F F .F   " D F F .F  ? "F F F .F  ? "D F F .F
a/ 6epreciation............. ?@?.@/ ?G.?/ HF.H/ D4.D/ 1<./
+et 9efore *a&es. . . . .  1 " 1 ? @ .4  1 "@ G  .G   "  F H .1   " G 4 D .D  ? " < 1 . <
b/ Income *a&es........... D@<./  < ? @ .4 /  1 "1 F 4 .@ /  1 "? G  .< / 1"@4F .H /
c/ +et Income...............  D@ D @ < .  <? < ? @ .?  1 " 1 F 4 .D  1 "? G  .G  1 " @ 4 F .H
6epreciation............. ?@?.@ ?G .? HF.H D4.D 1<.
d/ Cash 5lo.................  H?1.<  1 " 1 @ ? .@  1 " ? H D .4  1 " @  G .  1 " < D H .1
+ote2 Vs. ,traigh

,traight-)i
t-)ineC
neCash
ash flo larger
larger +et Income
Income smaller
smaller 6epreci
6epreciatio
ation
n
larger
6'09)E-6EC)I+I+7-9A)A+CE
&*0 0 0 s ' -$(. 1 -$(. 2 -$(. / -$(.  -$(. 5
Q depreciation2. . .  1 " D F F .F   "F F F .F   " D F F .F  ? " F F F .F  ? "D F F .F
a/ 6e
6epreciation.......... 4FF.F/ ?F.F/ D@.F/ F4.</ 1@?.</
+et 9efore *a&es...  1 " 1 F F .F  1 "@ < F .F   "  4 4 .F   "G H D .  ? "? ? @ .
b/ Income *a&es........ DDF.F/ <4F.F/ 1"1.F/ 1"?HG.@/ 1"@@< .1/
c/ +e
+et Income............  DD D D F .F  <4 < 4 F .F  1 " 1   .F  1 " ? H G .@  1 "@ @ < .1
6epreciation.......... 4FF.F ?F .F D@.F F4.< 1@?.<
d/ Cash 5lo..............  HDF.F  1 "1 @ F .F  1 " ? G < .F  1 "@ F  . 4  1 "< ? 1 .H
+ote2 Cash flo higher

higher than straight line"
line" loer than ,.8.
,.8.6. e&cept 8ear
8ear 1/.
+et income loer than straight line" higher than ,.8.6. e&cept 8ear 1/.
6epreciation higher than straight line" loer than ,.8.6. e&cept 8ear 1/.
e&cept year D/
C5A adapted/
4-28
3roblem 4-G ?F minutes/
,*RAI7B*-)I+E
9eginn
9eginning
ing 6eprec
6epreciat
iation
ion +et
+et income
income +et incom
income e
8ear
8ear boo! value e&pense before ta&es after ta&es R'A
1 ?FF"FFF @F"FFF 4F"FFF ?F"FFF 1F
 4F"FFF @F"FFF 4F"FFF ?F"FFF 1.D
? 1<F"FFF @F"FFF 4F"FFF ?F"FFF 1@.@G
4 1F"FFF @F"FFF 4F"FFF ?F"FFF D
D  @F"FFF @F"FFF 4F"FFF ?F"FFF DF
,0#-'5-*BE- 8EAR,=-6I7I*,
9eginn
9eginning
ing 6eprec
6epreciat
iation
ion +et
+et income
income +et incom
income e
8ear
8ear boo! value e&pense before ta&es after ta&es R'A
1 ?FF"FFF 1FF"FFF F F F
 FF"FFF <F"FFF F"FFF 1D"FFF G.D
? 1F"FFF @F"FFF 4F"FFF ?F"FFF D
4  @F"FFF 4F"FFF @F"FFF 4D"FFF GD
D  F"FFF F"FFF <F"FFF @F"FFF ?FF
3roblem 4-< 4D minutes/
a. *he e&pen
e&penditditur
ures
es that
that shou
should
ld be capita
capitaliz
lized
ed h
hen
en e%uipme
e%uipment
nt is ac%ui
ac%uired
red
include the invoice price of the e%uipment net of discounts/" all incidental
outlays relating to its purchase or preparation for use" any insurance during
transit" freight" duties" onership search costs" onership registration costs"
installation
installation fees" and brea!-in costs. All available discounts" hether ta!en or
not" should be deducted from the capitalizable cost of the e%uipment.
b. 1/ When
When the mar!et
mar!et value
value of the e%uipme
e%uipmentnt is not determin
determinabl
ablee by reference
reference
to a similar cash purchase" the capitalizable cost of e%uipment purchased
ith bonds that have an established mar!et price should be the mar!et
value of the bonds.
/ When the mar!et
mar!et value of the e%uipment is not determinable by reference
reference
to a similar cash purchase" and the common stoc! used in the e&change
does
do es no
nott have
have an establ
establis
ished
hed mar!
mar!et
et price
price"" the
the capita
capitaliz
lizab
able
le cost
cost of
e%uipment should be the e%uipment(s estimated fair value if that is more
clearl
clearly
y evid
evident
ent than
than the
the fair
fair valu
value
e of the
the common
common stoc!.
stoc!. Inde
Indepen
pende
dent
nt
appraisals may be used to determine the fair values of the assets involved.
?/ When
When thethe mar!e
mar!ett valu
valuee of e%ui
e%uipm
pment
ent ac%u
ac%uire
iredd is no
nott determ
determin inab
able
le by
reference to a similar cash purchase" the capitalizable cost of e%uipment
purcha
purchased
sed by e&chan
e&changing
ging dissimil
dissimilar
ar e%uipme
e%uipment nt having
having a determin
determinabl
able
e
mar!e
mar!ett valu
value
e shou
shouldld be the
the mar!e
mar!ett valu
valuee of the
the dissim
dissimil
ilar
ar e%ui
e%uipme
pment
nt
e&changed.
4-29
c. *he factors that determine

determine hether
hether e&penditu
e&penditures
res toard property
property"" plant" and
e%uipment already in use should be capitalized are as follos2
• E&penditures are relatively large in amount
• *hey are nonrecurring in nature
• *hey e&tend the useful life of the property" plant" and e%uipment
• *hey increase the usefulness for e&ample" %uantity or %uality of goods
produced/ of the property" plant" and e%uipment
d. *he net boo!

boo! valu
value
e at the date of the
the sale
sale cost
cost of the prope
property
rty"" plant"
plant" and
e%uipment less the accumulated depreciation/ should be removed from the
accounts. *he e&cess of cash from the sale over the net boo! value removed
is accounted for as a gain on the sale" hile the e&cess of net boo! value
removed over cash from the sale is accounted for as a loss on the sale.
e. Cons
Consid ider
erat
atio
ions
ns in anal
analyz
yzin
ing
g prop
proper
erty
ty"" plan
plant"
t" and
and e%ui
e%uipm
pmen
entt incl
includ
ude2
e2 1/
1/
recognit
recognition
ion that
that boo! values
values are at historic
historical
al cost"
cost" / need
need for sufficien
sufficientt
capacity
capacity to meet
meet anticipa
anticipated
ted demand"
demand" ?/ need
need for ritedo
ritedons
ns of impaired
impaired
assets" 4/ assess effects of changes in price levels" D/ identify use of assets
unde
un derr op
opera
eratin
ting
g lease
lease arra
arrang
ngem
emen
ents"
ts" and
and @/
@/ revie
revie
 for e&ist
e&isten
ence
ce of idle
idle
facilities.
3roblem 4-H 4F minutes/
a. Assumi
Assumingng a D-year
D-year useful
useful life for 9ellagio"
9ellagio" annual
annual deprecia
depreciation
tion ould
ould be @4
million. *hus" net income ould be2
8ear
8ear 12 1F.D/
1F.D/ million DF
DF - @4 depreciation
depreciation J ?.D
?.D ta& benefit/
benefit/
8ear
8ear 2 4.D million
million GF
GF - @4 depreciation
depreciation U 1.D
1.D ta& e&pense/
e&pense/
8ear
8ear ?2 <.D
<.D million GD
GD U @4 depreciation
depreciation U .GD ta& e&pense/
e&pense/
+et assets total 1"D?@ million" 1"4G million" and 1"4F< million in FF1" FF"
and FF?" respectively. Accordingly" return on assets is -F.@<" F.?1" and
F.DH for FF1" FF" and FF?" respectively.
b. Assumi
ssuming
ng a 1D-ye
1D-year
ar usefu
usefull life
life for 9ella
9ellagio
gio"" annu
annual
al depre
deprecia
ciatio
tion
n ou
ouldld be
1F@.@G million. *hus" net income ould be2
FF12 4.D/ million DF - 1F@.@G depreciation J 14.1G ta& benefit/
FF2 G.D/ million GF - 1F@.@G depreciation J H.1G ta& benefit/
FF?2 ?.GD/ million GD U 1F@.@G depreciation J G.H ta& benefit/
+et assets total 1"4H? million" 1"?<G million" and 1"<F million in FF1" FF"
and FF? respectively. Accordingly"
Accordingly" return on assets is -.<D" -1.H<" and
-1.<@ for FF1" FF" and FF?" respectively.
4-30
c. Assuming
Assuming a 1F-year
1F-year useful life
life for 9ellagio"
9ellagio" annual
annual depreciation
depreciation ould be 1@F
million. *hus" net income ould be2
FF12 <.D/ million DF - 1@F depreciation J G.D ta& benefit/
FF2 @G.D/ million GF - 1@F depreciation J .D ta& benefit/
FF?2 @?.GD/ million GD U 1@F depreciation J 1.D ta& benefit/
+et assets total 1"44F million" 1"<F million" and 1"1F million in FF1" FF"
and FF?" respectively. Accordingly"
Accordingly" return on assets is -D.G?" -D.G" and
-D.@H for FF1" FF" and FF?" respectively.
d. Assumi
ssumingng a 1-yea
1-yearr usef
useful
ul life
life for 9ellagi
9ellagio"
o" depre
deprecia
ciatio
tion
n ou
ould
ld be 1"@F
1"@FF
F
million in FF1. *hus" net income ould be2
FF12 1"1@.D/ million DF - 1"@FF depreciation J ?<G.D ta& benefit/
FF2 D.D million GF - 1G.D ta& e&pense/
FF?2 D@.D million GD U 1<.GD ta& e&pense/
*he net assets are ritten don to zero. *hus" return on assets is infinite for
FF1" FF" and FF?.
3roblem 4-1F ?F minutes/
a. A compa
company
ny may ish to cons
constru
truct
ct its o
on n fi&ed
fi&ed assets
assets rath
rather
er than
than ac%ui
ac%uire
re
them from outsiders to utilize idle facilities andKor personnel. In some cases"
fi&ed assets may be self-constructed to effect an e&pected cost saving. In
other cases" the re%uirements
re%uirements for the asset demand special !noledge"
!noledge" s!ills"
and talents not readily available outside the company. Also" the company may
ant to !eep the manufacturing process for a particular product as a trade
secret.
b. Costs
Costs that should
should be capitali
capitalized
zed for a self-con
self-constr
structe
ucted
d fi&ed asset include
include all
direct and indirect material and labor costs identifiable ith the construction.
All direct overhead costs identifiable ith the asset being constructed
constructed should
also be capitalized. E&amples of cost elements hich should be capitalized
during
during the constru
constructio
ction
n period
period include
include charge
charges s for licenses
licenses"" permits"
permits" fees"
fees"
depreciation
depreciation of e%uipment
e%uipment used in the construction"
construction" ta&es" insurance"
insurance" interest
on boborr
rro
oin
ings
gs"" and
and othe
otherr simi
simila
larr char
charge
ges
s rela
relate
tedd to the
the asse
assett bein
being
g
constructed.
4-31
c. 1/ *he increas

increasee in overhe
overhead
ad caused
caused by the
the self-constru
self-constructio
ctionn of fi&ed assets
assets
should be capitalized. *hese costs ould not have been incurred if the
assets
assets had not been
been constru
constructed
cted.. *hi
*hiss proposit
proposition
ion holds
holds regardl
regardless
ess of
hether or not the plant is operating at full capacity. It is improper to
increase the cost of finished goods ith costs that ere not incurred in
their manufacture and that ould not have been incurred if fi&ed assets
had
had nonott been
been prod
produc
uced
ed.. Boe
Boeve
verr" if the
the tota
totall cons
constr
truc
ucti
tion
on cost
costs
s on
self-constructed fi&ed assets ere substantially in e&cess of their business
and economic usefulness" the e&cess cost is not capitalized but instead is
recorded as a loss.
/ It is clear
clear that
that the
the capit
capitali
alize
zedd costs
costs of self-co
self-cons
nstru
tructe
cted
d asset
assets
s shou
should
ld
inclu
include
de a prop
proport
ortion
ionate
ate share
share of overh
overhead
ead on the
the same
same basis
basis as that
that
applied to goods manufactured for sale hen the plant is operating at full
capa
capaci
city
ty at the
the time
time the
the fi&e
fi&ed
d asse
assett is cons
constr
truc
ucte
ted.
d. 0nd
0nder thes
thesee
circumstances costs of finished goods produced should not be increased
for overhead for goods for hich production as foregone. *he activity
replacing the production of goods for sale should be charged ith the
related overhead.
When idle plant capacity is used for the construction of a fi&ed asset"
opinion varies as to the propriety of capitalizing a share of general factory
ove
overhe
rhead allallocat
ocated
ed on the the same basiasis as that appl
applie
ied
d to go good
odss
manufactured for sale. *he arguments to allocate overhead maintain that
cons
constru
tructe
ctedd fi&ed
fi&ed asset
assetss shoul
should
d be accor
accorded
ded the
the same
same treatm
treatmen
entt as
inve
invent
ntor
ory
y" ne
ne produ
products
cts"" or $oint
$oint prod
product
ucts.
s. It is maint
maintain
ained
ed that
that this
this
proce
procedu
dure
re is neces
necessa
sary
ry"" or speci
special
al favor
favors
s or e&emp
e&emptio
tions
ns from
from un
undeder-
r-
costing of fi&ed assets ill cause a conse%uent over-costing of inventory
assets.
*hose argu
*hose arguining
g again
againstst alloca
allocatin
ting
g over
overhehead
ad to fi&ed
fi&ed assets
assets hher
eree the
the
assets
assets areare cons
constru
truct
cted
ed h hen
en idle
idle capaci
capacityty e&ists
e&ists maint
maintain
ain that"
that" since
since
normal prod roduction
tion iilll not be affec ffectted or oveoverhea
rhead
d increased
ased""
capita
capitali
lizat
zatio
ionn il
illl resu
result
lt in incre
increas
ased
ed repo
reporte
rted
d inco
income
me for
for the
the perio
period
d
resulting from construction rather than production of goods for sale. It is
also
also somet
sometimeimes s maint
maintain
ained
ed that
that the full
full cost
cost of the
the cons
constr
truc
ucted
ted asset
asset
should not include overhead that ould be incurred in the absence of such
construction.
4-32
d. *he
*he HF"
HF"FF
FFF F cost
cost by hich
hich the init initia
iall mach
machininee e&ce
e&ceededed
ed the
the cost
cost of the
the
subse
subse%u%uenentt machi
machine ness shou
should ld be capita
capitaliz
lized
ed.. Witho
Without
ut %u
%uest
estion
ion there
there are
are
substantial future benefits e&pected from the use of this machine. 9ecause
future periods ill benefit from the e&tra outlays re%uired to develop the initial
machi
machinene"" all deve
develo
lopme
pmentnt costs
costs shou
should ld be capita
capitaliz
lized
ed and
and subs
subse%
e%ue
uentl
ntly
y
asso
associciat
ated
ed ith
ith the
the rela
relate
tedd rev
revenue
enue prodproduc
uceded by thethe sale
sale of prod
produc
ucts
ts
manuf
manufactactur
ured
ed.. If" ho
hoev
everer"" it can
can be deterdetermi
minened
d that
that the
the e&cess
e&cess cost
cost of
producing the first machine as the result of inefficiencies or failure hich did
not contribute to the machine(s successful development" these costs should
be recognized as an e&traordinary loss. ,ubse%uent periods should not be
burdened ith charges arising from costs that are not e&pected to yield future
benefits. Capitalizing the e&cess costs as a cost of the initial machine can be
$ustified under the general rules of asset valuation.
valuation. *hat is" an asset ac%uired
should be charged ith all costs incurredincurred in obtaining the asset and placing it
in service.
AIC3A Adapte
Adapted/
d/
4-33
3roblem 4-11 DF minutes/
a. Intang
Intangible
ible assets
assets represe
represent
nt rights
rights or claims
claims to future
future benefits
benefits.. An intangib
intangible
le
asset is usually defined as a noncurrent asset having no physical e&istence
ith a high degree of uncertainty regarding future benefitsits value being
dependent on the rights that possession confers upon the oner.
b. 1/ A dolla
dollarr to be receiv
received
ed in the futu
future
re is orth
orth less
less than
than a do
dolla
llarr recei
receive
ved
d
today because of an interest or discount factoroften referred to as the
time value of money. *he discounted value of the e&pected 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.
/ If the royalty

royalty receipts
receipts are e&pected
e&pected to occur
occur at regula
regularr interva
intervals
ls 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 e&pected. 'n the
other hand"
hand" if receipts are e&pected to be irregular in amount" or if they are
to occur at irregular intervals" each e&pected future receipt ould have to
be multiplied by the present value of 1 for the number of periods of delay
e&pected.
In each case some interest rate discount factor/ per period must be
assumed and used. As an e&ample" if receipts of 1F"FFF are e&pected
each si& months over the ne&t 1F years and an < percent annual interest
rate is selected" the present value of the tenty 1F"FFF payments is e%ual
to 1F"FFF times the present value of an annuity of 1 for F periods at 4
percent. *ice as many periods as years" and half the annual interest rate
of < percent" are used because the payments are e&pected at semiannual
intervals. *hus the discounted present/ value of these receipts is 1?D"HF?
1F"FFF & 1?.DHF?/. 9ecause of the interest rate" this discounted value is
cons
considider
erab
ably
ly less
less than
than the
the tota
totall e&pe
e&pect
cted
ed coll
collec
ecti
tion
ons
s of FF
FF"F
"FFFFF..
Cont
Contininui
uing
ng the
the e&amp
e&ample"
le" if instea
insteadd it is e&pe
e&pecte
cted
d that
that 1F"F
1F"FFF
FF il
illl be
received si& months hence" F"FFF one year from no" and a terminal
payment of 1D"FFF is e&pected 1< months hence" the calculation is as
belo2
1F"FFF & present value of 1 at 4 for 1 period L 1F"FFF & .H@1D4
F"FFF & present value of 1 at 4 for  periods L F"FFF & .H4D@
1D"FFF & present value of 1 at 4 for ? periods L 1D"FFF & .<<HFF
Adding
Adding the results
results of these
these three
three calculation
calculations
s yields
yields a total
total of 41"441
41"441
rounded/" considerably less than the 4D"FFF total collections" again due
to the discount factor.
4-34
3roblem 4-11
4- 11continued
continued
c. *he basis of valuation

valuation for the patents
patents that is generally
generally accepted in accounting
accounting
is cost.
cost. Evide
Evidentl
ntly
y the
the carto
cartons
ns e
erere develo
developed
ped and
and the
the paten
patents
ts ob
obtai
tained
ned
dire
direct
ctly
ly by thethe clie
client
nt corp
corpor
orat
atio
ion.
n. *h
*her
eref
efor
ore"
e" thei
theirr cost
cost o
oululd
d incl
includ
ude
e
government and legal fees" and the costs of any models and draings. *he
proper initial valuation ould be the sum of these costs plus any other costs
incident to obtaining the to patents. *his is in accord ith the accounting
principle that the initial valuation of any asset generally includes virtually all
costs necessary to ac%uire and ma!e it ready for normal use. ,uch values are
ob$ectively determined and rest upon actual completed transactions rather
than upon estimates and future e&pectations.
d. 1/ Intang
Intangible
ible assets
assets represe
representnt rights
rights to future
future benefits.
benefits. *he ideal
ideal measure
measure of
the
the valu
value
e of intan
intangib
gible
le assets
assets is the
the disco
discoun
unted
ted prese
present
nt valu
value
e of thei
their
r
futu
future
re bene
benefit
fits.
s. 5o
5orr the
the Vandndiv
iver
er Corpo
Corporat
ratio
ion"
n" this
this ou
ouldld incl
includ
udee the
the
discounted value of e&pected net receipts from royalties as suggested by
the financial vice-president as ell as the discounted value of the e&pected
net receipt
receipts
s to be derive
derivedd from
from the Vandi
Vandiver
ver Corporatio
Corporation(s
n(s productio
production.
n.
'the
'therr valua
aluati
tion
on base
basess that
that hav
have been
been sugg
suggeseste
ted
d are
are curr
curren
entt cash
cash
e%uivalent or fair mar!et value.
/ *he amortization

amortization policy is implied in the definition
definition of intangible
intangible assets as
rights to future benefits. As the firm receives the benefits" the cost or other
value should be charged to e&pense or to inventory to provide a proper
matching of revenues and e&penses. 0nder the discounted value approach
the
the perio
periodic
dic amorti
amortiza
zatio
tion
n ou
ouldld be the
the decli
decline
ne du
durin
ring
g the
the year
year in the
the
present value of e&pected net receipts.
e. *he litigatio
litigationn can and probably
probably shoul
should d be mentioned
mentioned in notes
notes to the financial
financial
statements.
statements. ,ome indication of the e&pectations of legal counsel in respect to
the
the outco tcome cancan prop oper
erly
ly accomp
compa any the state tateme
men nts. It oou uld be
inappropriate
inappropriate to record a contingent asset reflecting the e&pected damages to
be recovered. Costs incurred to ,eptember ?F" 8ear 1" in connection ith the
litigation should be carried forard and charged to e&pense or to loss if the
cases are lost/ as royalties or damages/ are collected from the parties against
hom the litigation has been instituted hoever" the conventional treatment
ould
ou ld be to charg
chargee these
these costs
costs as ordin
ordinar
ary
y legal
legal e&pen
e&penses
ses.. If the
the final
final
outcome of the litigation is successful" the costs of prosecuting it should be
capita
capitalizlized.
ed. ,imil
,imilarl
arly
y" if the
the clien
clientt ere
ere the
the succ
success
essfu
full defen
defenda
dant
nt in an
infringement suit on these patents" the generally accepted accounting practice
oul
o uldd be to addadd the
the cost
costs
s of the
the lega
legall defe
defens
nsee to the
the 3ate
3atent
ntss acco
accoununt.
t.
6evelopments to the time that the statements are prepared and released can
be refl
reflececte
tedd in no
notetes
s to the
the stat
statem
emen
ents
ts as a po post-b
st-bal
alan
ance
ce shee
sheett or
or
subse%uent event/ disclosure.
AIC3A Adapte
Adapted/
d/
4-35
CA,E,
Case 4-1 ?F minutes/
a. *he main determin

determinants
ants of the valuation
valuation of feature
feature films" televisio
television
n programs"
programs"
and general release feature productions
productions by Columbia
Columbia 3ictures are 1/ the cost
of productions and / estimates on ho to allocate those costs over the
earnings-generating capacity of the films.
b. *he reasonab
reasonablene
leness
ss of the bases
bases of valua
valuation
tion depends
depends almost
almost entirely
entirely on the
reasonableness of the estimates of the e&piration of value of the inventory
costs. :udging from the second paragraph of the note" it appears that some of
the company(s estimates of the value of films ere overly optimistic and that
this prior optimism re%uired subse%uent
subse%uent and substantial
substantial ritedons. 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 ith suspicion
and caution.
c. An ununse
secu
cured
red lender
lender ou
ould
ld ant
ant to caref
careful
ully
ly asses
assess
s the
the valu
valuati
ation
on of film
film
inven
inventotorie
ries
s in the light
light of past
past e&peri
e&perien
ence
ce and
and of futu
future
re prospe
prospects
cts in the
the
industry. *his is particularly crucial here because inventories form such an
important part of total assets for Columbia 3ictures and other companies in
this
this ind
indus
ustry
try.. *h
*he
e analy
analyst
st ou
ould
ld a
ant
nt to !no
!no Colu
Columb
mbia=
ia=s
s e&peri
e&perien
ence
ce in
valuing its inventoryfrom available evidence in Columbia(s note this is not
reass
reassururin
ing.
g. *h
*hee analy
analyst
st o
ould
uld ant
ant to compa
comparere Colu
Columbi
mbia=a=s
s estim
estimati
ation
on
process ith that folloed by other companies in the industry" and also ould
ant to compare Columbia=s
Columbia=s estimates ith forecasted conditions and trends
in the industry.
4-36
Case 4- 4D minutes/
a. 1/ 5I5
5I5'
' allocate
allocates
s costs to sales
sales in in the order
order good goods s are purchpurchased ased22
,ales 1"FFF units & 1.GF/ ...................
............................
.................
.................
........................
...............  1"GFF
Cost of goods sold 1"FFF units & 1.FF" hich is
all beginning-year
beginning-year inventory/...
inventory/............
.................
.................
..................................
......................... 1"FFF/
+et income before ta&es.......................
ta&es.... ......................................
.....................................
......................
....  GFF
3rovision for federal income ta&es DF/...............................
DF/.............. ...................... ..... ?DF/
+et Income *ransferred
*ransferred to Retained Earnings......................
Earnings............... ............. ......  ?DF
/ )I5' allocates

allocates recent
recent cost to sales2
sales2
,ales 1"FFF units
units & 1.GF/ .................................................
.............................. ..........................
...........
....  1"GFF
Cost of goods sold 1"FFF units & 1.DF" hich are
the most recent
recent 1"FFF units ac%uired/.......................................
ac%uired/....................................... 1"DFF/
+et income before ta&es................
ta&es.........................
..................
..................
..................
.....................
............  FF
3rovision for federal income ta&es DF/...............................
DF/.............. ........................... 1FF/
+et Income *ransferred
*ransferred to Retained Earnings......................
Earnings............... ............. ......  1FF
b. 1/
1/ 5I5'2 9ala
alance ,he ,heet
A,,E*,
Cash..........
Cash...................
..................
..................
..................
..................
.................
.................
......................
.........................
............  FF
Invent
Inventory
ory 5I5'
5I5' method
method/.... /........
........
.......
.......
........
........
........
........
........
........
........
........
........
..........
.........
... 1"DFF
1"DFF
*otal
*otal Assets
Assets .................
..........................
..................
..................
......................................
.......................................
.......... 1"GFF
)IA9I)I*IE, A+6 E;0I*8
5ederal income ta&es payable.............
payable.....................
.................
.................................
........................  ?DF
*otal
*o tal e%uity ..................
...........................
..................
.................
.................
..................
..................
..................
..............
..... 1"?DF
*otal
*o tal )iabilities
)iabilitie s and E%uity.....................................
E%uity.................. ..................................
......................
......... 1"GFF
/ )I5
)I5'2
'2 9alance
9alance ,heet ,heet
A,,E*,
Cash..........
Cash...................
..................
..................
..................
..................
.................
.................
......................
.........................
............  FF
Invent
Inventory
ory )I5'
)I5' method
method/.... /........
........
.......
.......
........
........
........
........
........
........
........
........
........
..........
.........
... 1"FFF
1"FFF
*otal
*otal Assets........
Assets.................
..................
.................
.................
..................................
.........................................
................ 1"FF
)IA9I)I*IE, A+6 E;0I*8
5ederal income ta&es payable.............
payable.....................
.................
.................................
........................  1FF
*otal
*o tal e%uity ..................
...........................
..................
.................
.................
..................
..................
..................
..............
..... 1"1FF
*otal
*o tal )iabilities
)iabilitie s and E%uity.....................................
E%uity.................. ..................................
......................
......... 1"FF
4-37
Case 4-continued
c. 6uring a period of rising

rising costs"
costs" the )I5' method is more
more conservativ
conservative
e in profit
determination and in the evaluation of the financial position of a company
than the 5I5' method. )I5' 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 loer than
those under the 5I5' method. 3arts a/ and b/ of this case reveal this relation.
*hat is" under )I5'" income reported is 1FF after ta&es as compared to ?DF
under 5I5'. )i!eise" inventory is reported at 1"FFF under )I5' as opposed
to 1"DFF under 5I5'. Evidence of rising costs is that e&isting inventory is
valued at 1.FF per unit hile goods purchased during the year ran at 1.DF
per unit. *a& considerations also are important. As e can see from parts a/
and b/" the )I5' method produces
produces a ta& liability of 1FF" hereas ta&es under
the 5I5' method amount to ?DF. As long as inventory is maintained at a given
level or increases" )I5' produces an interest-free" perpetual loan from the
government. 'f course" should inventory be li%uidated" cost of goods sold ill
be very lo compared to sales" ith a resulting higher income ta& liability
ma!ing up for the prior deferrals/.
d. Compani
Companies es use a dollar pool
pool )I5' method
method to prevent
prevent li%uidati
li%uidation
on of lo-cos
lo -costt
)I5' inventory units. 0nder this method" groups of items are vieed as a
dollar pool" and if one item is sold" it may be replaced by ne items of the
same
same or greagreater
ter do
dolla
llarr valu
value"
e" and
and there
there is no li%ui
li%uidat
datio
ion
n of the pool.
pool. *h
*hee
problem for a company that prepares interim statements is to decide hether
li%uidated items in one %uarter ill be replaced before the end of the fiscal
year.
year. If the items are replaced" income ta&es allocated to profits of the current
current
%uarter ill be loer than if the items are not replaced.
C5A Adapted/
4-38
Case 4-? 4D minutes/
a. +et Inco
Income
me Comp
Comput
utati
ation
on22
5I5' )I5' Average cost
,ales 1"FFF & D/..........................
D/.......................... D"FFF D"FFF D"FFF
Cost of sales2
9eginning inventory...............
inventory........ ............ ....... F F F
Add2
Add2 3urchase
3urchases............................
s............................ ?"FF ?"FF ?"FF
)ess2 Ending inventory.............
inventory....... ......... ... 11"GFF/ H"1FF/ 1F"?1/
Cost of sales...................................
sales................................... 11"DFF 14"1FF 1"<<<
7ross profit....................
profit.....................................
................. 1?"DFF 1F"HFF 1"11
'perating
'perating e&penses.......................
e&penses....................... D"FFF D"FFF D"FFF
+et income.......................................  <"DFF  D"HFF  G"11
+et income per share..................... 4.D .HD ?.D@
+'*E,2
+'*E,2 1/ 5I5'
5I5' invent
inventory
ory comp
computa
utatio
tion
n is based
based on DFF units
units at 1D and ?FF at
14.
/ )I5' inventor
inventory
y computation
computation is based
based on 1FF units
units at 1F" ?FF units at
11" and 4FF units at 1.
?/
?/ Average
age cost
cost is obtabtained
ined by divdividi
iding ?"
?"F
FFF by 1"<F
1"<FF
F units
purchased" yielding an average unit price of 1.<H.
b. 5inanci
5inancial
al Ratio
Ratio Comput
Computatio
ations
ns
5I5'
)I5'
Average
Cost
1/ Current ratio .. .4G .?@ .41
/ 6ebt-to-e%uity ratio . @G.< G1.? @H.@
?/ Inventory turnover  .FF ?.1F .DF
4/ Return on total assets  H.< G.F <.?
D/ 7ross margin D4.F 4?.@ 4<.D
ratio.
@/ +et profit as percent of sales. ?4.F ?.@ <.D
c. LIFO $ffects. 0nde

LIFO $ffects 0nderr cond
conditi
ition
ons
s of fluctu
fluctuati
ating
ng inve
invent
ntory
ory costs
costs"" the
the )I5'
)I5'
inventory method ill have a smoothing effect on income. #oreover" the )I5'
method results" in times of cost increases" in an unrealistically lo reported
inventory figure. *his" in turn" ill loer the current ratio of a company and at
the same time tend to increase its inventory turnover ratio. *he )I5' method
also affords management an opportunity to manipulate profits by alloing
inventory to be depleted in poor years" thus draing on the lo cost base
4-39
pool.. FIFO $ffects

pool $ffects. *h
*hee use
use of 5I5'
5I5' in the valua
valuatio
tion
n of inve
invent
ntor
ories
ies il
illl
generally result in a higher inventory on the balance sheet and a loer cost of
goods
goo ds sold
sold than
than un
unde
derr )I5'
)I5' resu
resulti
lting.
ng. *h
*his
is ou
ould
ld resu
result
lt in a high
higher
er net
net
income. (verage ost $ffects. *he average cost method smoothes out cost
fluctuations by using a eighted average cost in the valuation of inventories
and cost of goods sold. *he resulting net income ill be close to an average
of the net income under )I5' and 5I5'.
4-40
Case 4-4 4D minutes/
a. 1"D1<.D
1"D1<.D S?@T - 1"G<
1"G<.F
.F S4DT
S4DT L 4F.D.
4F.D.
b. Campbell
Campbell ,oup
,oup sells to retailers"
retailers" li!e grocery
grocery stores.
stores. +ote
+ote 1? reports
reports that
the company has established an alloance for uncollectible accounts of
1@.? million as of the end of the year. *his amount represents ?.4 of
gross accounts receivable from trade creditors see +ote 1?/.
c. *h
*hee compa
company ny employ
employs s )I5'
)I5' inveinventntor
oryy costin
costing.g. Inve
Invento
ntorie
ries
s are
are ritte
ritten n
don to the loer of cost or mar!et.
d. Invent
Inventory
ory turnov
turnoverer L 4FHD.D
4FHD.D million
million KGF@.G
KGF@.G million
million J<1H.<
J<1H.< million/K
million/K L
D.?G times. Companies can improve the inventory turnover rate by reducing
ra
ra mater
material
ials
s on handhand ith
ith $ust-
$ust-in
in-ti
-time
me deliv
deliveri
eries/
es/"" or!-i
or!-in- n-pr
proce
ocessss
inventories by improved manufacturing processes/" and finished goods
inventories by producing to order rather than to demand forecasts/.
e. *he )I5' reserv
reserve e is <H.@ million
million +ote 14/. 14/. *he cumulativ
cumulative e ta& savings
savings are
<H.@ million & ?D L ?1.4 million.
f. Bad it used
used 5I5' invento
inventoryry costing
costing"" gross profit
profit ould
ould have been
been higher
higher by
the increase in the )I5' reserve" or <H.@ million - <4.@ million L D million.
*he pre-ta& profit ould have been @@G.4 million J D million L @G.4
million.
g. 33E
33E repres
represenents
ts 1"GH
1"GHF.F.4
4 millio
million n K 4"14
4"14H.F
H.F millio
millionn L 4?
4? of total
total asset
assets. s.
Campb
Campbellell ,oup
,oup usesuses strai
straigh
ght-l
t-lin
inee deprec
deprecia iatio
tion
n +ote
+ote 1/. Accumu
ccumulat lated
ed
depreciation is 1"1?1.D million K "H1.H million - D@.? million - ?G.@
mill
millio
ion/
n/ L 44.@44.@ of totatotall gros
gross s long
long-t-te
erm depr
deprec
ecia
iabl
ble
e asse
assets ts.. *h
*hee
accumulated depreciation to gross depreciable assets yields information
about
about the
the perce
percenta
ntage
ge that
that these
these asset
assetss have
have been
been Muse
Mused d up
up.N.N As this
this
percent
percentage
age increas
increases"
es" the company
company ill have have to e&pend
e&pend more
more cash on
repairs and upgrades.
h. Intangible
Intangible assets
assets arise from
from ac%uisitions.
ac%uisitions. *hey *hey represent
represent the portion of of the
purc
pu rcha
hase
se pric
pricee for
for ac%u
ac%uirired
ed comp
compan anie
ies
s that
that has
has been
been allo
allocacate
ted d to
intangible assets.
4-41
Case 4-D 4D minutes/
a. 6epre
6eprecia
ciatio
tion
n is a syst
system
em hose
hose pu purpo
rpose
se is to allocate
allocate the cost of tangib
tangible
le
capital assets" less salvage" over their useful lives in a systematic and rational
manner
manner.. 0nder
0nder 7A7AAA3" deprecia
depreciation
tion is a process
process of cost allocatio
allocation"
n" not of
valuation" through hich the productive effort cost/ is to be matched ith
produ
producti
ctive
ve accom
accompli
plish
shme
ment
nt reve
revenu
nue/.
e/. *h
*his
is proce
process
ss is found
founded
ed on the
the
matchin
matching g princip
principle.
le. 6eprecia
6epreciation
tion"" therefo
therefore"
re" is mainly
mainly concer
concerned
ned ith the
timing of the e&piration of the cost of tangible fi&ed assets.
b. *he propose
proposed d deprec
depreciaiatio
tion
n metho
method d is"
is" of cours
course" e" syste
systemat
matic
ic.. Whet
Whethe
herr it is
ratio
rationa
nall in terms of costcost alloca
allocatio
tion
n depend
depends s on the facts
facts of the
the case.
case. It
produces an increasing depreciation charge" hich is usually not $ustifiable in
terms
terms of thethe bene
benefit
fits
s deriv
derived
ed from
from the use of an asset. asset. *h
*hisis is beca
becaususee
manuf
manufact
actur
urer
ers
s typic
typicall
ally
y prefer
prefer to use
use their
their ne
ne e%uie%uipm
pmen
entt as mumuchch as
possible and their old e%uipment only as needed" such as to meet production
%uotas during periods of pea! demand. As a general rule" benefits decline
ith age. Assuming that the actual operations including
including e%uipment
e%uipment usage/ of
each year are identical" then maintenance and repair costs are li!ely to be
higher in the later years of usage than in the earlier years. *his means the
proposed method ould match loer depreciation ith loer repair charges
in the early years" hile it ould match higher depreciation ith higher repair
charges in the later years. Boever" reported net income in the early years
ould be much higher than reported net income in the later years of the
asset=s life. *his is an unreasonable and undesirable variation during periods
of identical operation. 'n the other hand" if the e&pected level of operations
including e%uipment usage/ in the early years of the asset=s life is e&pected to
be lo relative to that of later years" then the pattern of depreciation charges
of the
the propos
proposeded metho
method d appro&
appro&ima
imatel
tely
y paral
parallel
lels
s e&pect
e&pected
ed bene
benefit
fits
s and
and
revenues/. In this admittedly unusual case" the method may be vieed as
reasonab
reasonable.le. Although
lthough"" the uniunits-of-p
ts-of-prod
roducti
uction
on depreci
depreciation
ation method
method is the
more usual method selected to fit this case.
c. 1/ 6epreci
6epreciatio
ationn charges
charges neither
neither recover
recover nor create
create cash.
cash. Revenue-p
Revenue-produ
roducing
cing
activiti
activities
es are the sources
sources of cash
cash from operation
operations.
s. If revenu
revenues
es e&ceed
e&ceed
out-of-poc!et costs during a period" then cash is available to cover other
than
than out-o t-of-p
f-poc!e
oc!ett costs.
sts. Boeev
ver" if rev
revenues do not e&ce &ceed
out-of-poc!et costs" then no cash is made available no matter ho much"
or little" depreciation is charged.
4-42
/ 6epre
6eprecia
ciatio
tion
n can
can affect
affect cash
cash in at least
least to ays.ays. 5irst
5irst"" depr
depreci
eciati
ation
on
char
charge
gess affe
affect
ct repo
reportrted
ed inco
incomeme and"
and" henc
hence" e" can
can affe
affect
ct mana
manage geri
rial
al
deci
decisi
sion
onss such
such as thos thosee rega
regard
rdin
ing
g pric
pricin
ing"
g" prod
produc
uctt sele
select
ctio
ion"
n" and
and
divide
dividend
nds.
s. 5o
5orr e&ampl
e&ample" e" the
the propo
proposed
sed metho
method d ou
ould
ld resu
result
lt initi
initiall
ally
y in
higher reported income than ould the straight-line method. Conse%uently"
shareholders
shareholders might demand higher higher dividends in the earlier years than they
ould
ou ld other
otheris
isee e&pect
e&pect.. *h*hee strai
straigh
ght-li
t-line
ne metho
method" d" by yield
yieldin
ing
g a loer
loer
reported income during the early years of asset life and by reducing the
amou
amountnt of po pote
tent
ntia
iall div
dividen
idendsds in earl
earlyy year
years s as comp
compar ared
ed ith
ith the
the
prop
propos
osed
ed meth
methodod"" coul
could d enco
encou urag
rage earlearlie
ierr rein
reinv
vestm
estmenentt in othe
other r
profit-earning assets to meet increasing demand.
,econd" depreciation charges affect reported ta&able income. *his means

they affect directly the amount of income ta&es payable in the year of
deduction. 0sing the proposed method for ta& purposes ould reduce the
total ta& bill over the life of the assets 1/ if the ta& rates ere increased in
future years or / if the business ere doing poorly no but ere to do
sign
signif
ific
ican
antl
tly
y bett
better
er in the
the futu
future
re.. *h
*hee firs
firstt cond
condititio
ion
n is popoli
liti
tica
call and
and
speculative"
speculative" but the second condition
condition may be applicable to *o *oro
ro in vie of
its recent
recent origin
origin and its rapid
rapid e&pansi
e&pansionon progra
program.m. Conse%u
Conse%uententlyly"" more
funds might be available for reinvestment in fi&ed assets in years of larger
deductions
deductions if the business remains
remains profitable. If *o *oro
ro is not profitable no"
it ould not benefit from higher deductions no and should consider an
increasing charge method for ta& purposes" such as the one proposed. If
*oro is profi
profitab
table
le no
no"
" the
the presid
presiden
entt shou
should ld reco
reconsnside
iderr his
his prop
proposa
osall
because it ill delay the availability of cash that must be paid to cover
ta&e
ta&es.
s. Also
lso the
the pro
propo
pose
sedd met
metho
hod d coul
couldd resu
result
lt in loe
loerr esti
estima mate
ted
d
production costs in earlier years" hich could lead to underpricing of the
product.
AIC3A Adapte
Adapted/
d/
4-43

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Chapter 04 - Analyzing Investing Activities

,ection 2 +oncurrent Assets

• 6efine current assets and their relevance for analysis.

• E&plain cash management and its implications

• Interpret the effects of alternative inventory methods under varying business

• E&plain the concept of long-lived assets and its implications

• 6escribe and analyze intangible

?/ Retailing Industry.

produced" each unit ill absorb

G. *he ma$or ob$ectiv

<. In most annual reports" insufficien

1F. )I5' tends to yield loer

14. *here are a number of measures relating to plant

*he average total life span of

*he average age of

*he average remaining life of

*he above ratios are helpful

1G. Bard assets

b. When a company ac%uires

1H. In valuing property"

F. a. *he basic approach

Regardless of the amount incurred in the ac%uisition or internal development of an

. *here are a number

/ 6eferred e&penses.

?. a. 'ne categor

E&ercise 4-1 1 minutes/

E&ercise 4- 1D minutes/

E&ercise 4-? 1D minutes/

a. i/ *he avera

E&ercise 4-4 1 minutes/

b. Cost of goods sold is usually

E&ercise 4-D D minutes/

Revenues @"FD.< 1 1?/ @"FD.< 11?/

b. *he primary analysis

E&ercise 4-@ 1F minutes/

E&ercise 4-G F minutes/

E&ercise 4-< D minutes/

used should be reasonable and should be applied consistently from period to

E&ercise 4-H F minutes/

E&ercise 4-1F F minutes/

E&ercise 4-11 1F minutes/

9alance sheet assets are2 c " d in

E&ercise 4-1 1F minutes/

Ending inventory under 5I5' ould be GH@.? million S1D1J1DT.

3roblem 4- 1D minutes/

a. 8ear H retained earnings ad$ustment for )I5' to 5I5' change2

3roblem 4-? ?F minutes/

3roblem 4-4 D minutes/

ropert!" lant # $q%ipment &gross'

3roblem 4-D DD minutes/

,oftare 6evelopment Costs2

Current 0namortized 9al. U 3rior 0namortized 9al. J Current Amortization E&pense

&*000s' 1HHH FFF FF1 FF FF? FF4 FFD FF@

d. All else e%ual"

e. Ratio Implications of Alternative Accounting

&-ear 2006' +et income Return on Assets Return on

f. Cash flo from

3roblem 4-@ 4D minutes/

+ote2 Vs. ,traigh

+ote2 Cash flo higher

3roblem 4-G ?F minutes/

3roblem 4-< 4D minutes/

c. *he factors that determine