Chapter 6

REPORTING OPERATING INCOME

 Income statement is primary source of information about company performance.

o How profitable has the company been recently?
o How did it achieve that profitability?
o Will the current profitability level persist?
 When analyzing a company’s income statement, it is important to distinguish operating activities from
nonoperating activities and recurring activities from nonrecurring activities.
 Operating activities
o Primary transactions
o Purchase of goods from suppliers, employment of personnel, conversion of materials into
finish products, promotion and distribution of goods, sale of goods and services to customers,
and post-sale customer support.
o OA are reported in income statement under items such as sales, COGS, and selling, general,
and administrative expenses.
 Nonoperating activities
o Financial borrowing and securities investment activities of a company.
o Interest income and expenses, dividend revenues, gains and losses on sales of securities.

Revenue Recognition
 Revenue recognition refers to the timing and amount of revenue reported by the company.
o An entity should recognize revenue to depict the transfer of goods or services to customers
in an amount that reflects the consideration to which the entity expects to be entitled in
exchange for those goods and services.
o To accomplish this, it is a five-step process by companies:
1. Identify contract with customer
2. Identify performance obligations in contract
 How many distinct goods and services (i.e. deliverables)
 If entity regularly sells good or service separately, then it can be distinct
o Product warranty not separate if warranty terms are set to assure
customer product will perform as promised
o Separate example: frequent flyer miles separate from scheduled flight
3. Determine transaction price
4. Allocate transaction price
5. Recognize revenue when or as entity satisfies performance obligation
 In many instances, sole performance obligation is to deliver product or service to customer.
 In a consignment, a consigner delivers a product to a consignee, but retains ownership until the
consignee sells the product to the ultimate customer.
Revenue Recognition Subsequent to Customer Purchase
 Paying for good or service prior to delivery, a company must recognize a contract liability. The
company has an obligation to transfer goods or services to a customer. This is referred to as unearned
revenue or deferred revenue.

 Revenue recognition complication arises when agreement with a customer requires that two or more
products or services are sold under the same agreement for one lump sum. Ex: software and customer
support.
 In this case, the company must allocate the total consideration to the separate performance
obligations based on their stand-alone selling price (estimated, if necessary). Revenue allocated to the
performance obligations that have not yet been fulfilled (such as maintenance and customer support)
must be deferred, with revenue recognized as those performance obligations are fulfilled in future
periods.

REPORTING ACCOUNTS RECEIVABLE
 When companies sell to other companies, they usually do not expect cash upon delivery as is common
with retail customers. Instead, they offer credit terms, and the resulting sales are called credit sales or
sales on account.
 Accounts receivable are reported on the balance sheet of the seller at net realizable value, which is
the net amount seller expects to collect.
 Receivables are classified into three types:
1. Current or noncurrent
2. Trade or nontrade
3. Accounts receivable or notes receivables

Determining the Allowance for Uncollectible Accounts

 Allowance for doubtful (uncollectible) accounts
o a contra-asset account that nets against the total receivables presented on the balance sheet
to reflect only the amounts expected to be paid. The allowance for doubtful accounts is only
an estimate of the amount of accounts receivable which are expected to not be collectible.

 Amount of expected uncollectible accounts is usually estimated based on an aging analysis.

Reporting the Allowance for Uncollectible Accounts

 Uncollectible accounts are ESTIMATED and recorded as follows as bad debts expense. The allowance
for uncollectible accounts is a contra-asset account. It reduces accounts receivable.
 Example:
Recording Write-offs of Uncollectible Accounts
If $500 is to be written off:
 To summarize:
o The main balance sheet and income statement effects occur when the provision is made to the
allowance for uncollectible accounts.
o AR is reduced and that reduction is reflected in the income statement as bad debts expense.
o The net income reduction yields a corresponding equity reduction.
o Importantly, the main financial statement effects are at the point of ESTIMATION, not upon
the event of write-off.
Footnote Disclosures and Interpretations
 The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the
accounts receivable balance. We determine the allowance based on known trouble accounts, historical
experience, and other currently available evidence.
 Cookie jar reserve
o an accounting practice in which a company takes a quantity of large reserves from an
economically successful year and incurs them against losses from less successful years
EARNINGS MANAGEMENT

 Overly optimistic or pessimistic estimates

 Channel stuffing
o When a company uses its market power over customers or distributors to induce them to
purchase more goods than necessary to meet their normal needs. OR the seller may offer price
reductions to encourage buyers to stock up on products. Occurs immediately before end of
accounting period and boosts revenue.
 Strategic timing and disclosure of transactions and nonrecurring gains and losses
o Income smoothing: asset with less than market value, choose when to sell asset to recognize
gain and maintain improvements in net income
o Big bath: recording a nonrecurring loss in a period of already depressed income
 Mischaracterizing transactions at arm’s length
o Arm’s length: transfer of inventories or other assets to related entities typically are not
recorded until later arm’s length sales occur.
 Sales disguised as being sold
Chapter 7

COGS is important for three reasons:

1. cost of goods sold is often the largest single expense in a company's income statement, and inventory
may be one of the largest assets in the balance sheet.
2. in order to effectively manage operations and resources, management needs accurate and timely
information about inventory quantities and costs.
3. alternative methods of accounting for inventory and cost of goods sold can distort interpretations of
margins and turnovers unless the information in the financial statement footnotes is used.

Expense Recognition Principles

 Also important to recognize expenses correctly. Expenses are recognized when assets are diminished
or liabilities increased. Expense recognition can be generally divided into three approaches:
o Direct association
 Any cost that can be directly associated with a specific source of revenue should be
recognized as an expense at the same time that the related revenue is recognized. For
a merchandising company (a retailer or a wholesaler), an example of direct association
is recognizing cost of goods sold and sales revenue when the product is delivered to
the customer. The cost of acquiring the inventory is recorded in the inventory asset
account where it remains until the item is sold. At that point, the inventory cost is
removed from the inventory asset and transferred to expenses.
o Immediate recognition
 Many period costs are necessary for generating revenues and income but cannot be
directly associated with specific revenues. Some costs can be associated with all of the
revenues of an accounting period, but not with any specific sales transaction that
occurred during that period. Examples include most administrative and marketing
costs. These costs are recognized as expenses in the period when the costs are
incurred.
o Systematic allocation
 Costs that benefit more than one accounting period and cannot be associated with
specific revenues or assigned to a specific period must be allocated across all of the
periods benefitted. Most common example is depreciation expense. When asset is
purchased, it is capitalized in asset account. The asset cost is then converted into an
expense over course of depreciation formula.

Reporting Inventory Costs in the Financial Statements

When inventory is purchased or produced, it is capitalized and carried on the balance sheet as
an asset until it is sold, at which time its cost is transferred from the balance sheet to the income
statement as an expense (cost of goods sold). Cost of goods sold (COGS) is then subtracted from
sales revenue to yield gross profit.
 Gross Profit = Sale Revenue – COGS
Example:
Inventory and the Cost of Acquisition

In general, a company should recognize all inventories to which it holds legal title, and that inventory should be
recognized at the cost of acquiring the inventory. On occasion, that means that the company will recognize
items in inventory that are not on its premises. For instance, if a company purchases inventory from a supplier
on an "FOB shipping point" basis, meaning that the purchasing company receives title to the goods as soon as
they are shipped by the supplier, the purchasing company should recognize the inventory as soon as it
receives notice that the goods have been shipped.

A similar situation occurs when a company ships its own products to a customer, but has not yet fulfilled the
requirements for recognizing revenue on the shipment. In this case, the cost of the products remains in the
selling company's inventory account until revenue (and cost of goods sold) can be recognized.

Inventory is reported in the balance sheet at its cost, including any cost to acquire, transport, and prepare
goods for sale. In some cases, determining the cost of inventory requires accounting for various incentives that
suppliers offer to purchase more or to pay promptly. If a company qualifies for a supplier's volume discount or
rebate, it should immediately recognize the effective reduction in the cost of inventory and cost of goods sold.
Or, if the company purchases inventory on credit, suppliers often grant cash discounts to buyers if payment is
made within a specified time period. Cash discounts are usually established as part of the credit terms and
stated as a percentage of the purchase price. For example, credit terms of 1/10, n/30 (one-ten, net-thirty)
indicate that a 1 % cash discount is allowed if the payment is made within 10 days.

Inventory Reporting by Manufacturing Firms

*Note merchandisers only have 1 inventory account; manufacturer typically has 3 below
 Raw materials inventory
 o Cost of parts and materials purchased from suppliers for use in production process. When raw
materials used, cost of materials used is transferred from raw materials inventory into the
work-in-process inventory account.
 Work in process inventory
o Cost of inventory of partially completed goods. WIP includes the materials used in production
of product, plus labor and overhead. When production process is completed, the COGP is
transferred from WIP to finished goods account.
 Finished goods inventory
o Cost of stock of completed product ready for delivery to customers. When finished goods are
sold, COGS is debited and finished goods inventory credited.

INVENTORY COSTING METHODS

 Cost of inventory (beginning) + costs of current period purchases of inventory (ON THE BALANCE
SHEET) = total cost of goods (inventory) available for sale
 Then, total cost of goods available either ends up in COGS (REPORTED ON IS) or carried forward as
inventory to start the next period (ON THE ENDING BALANCE SHEET)
 If the beginning inventory plus all inventory purchased or manufactured during the period is sold,
then COGS is equal to the cost of the goods available for sale. However, when inventory remains at
the end of a period, companies must identify the cost of those inventories that have been sold and
the cost of those inventories that remain.

 Most companies wanted to keep cost of inventory management low, while minimizing spoiling, waste,
etc.
 The accounting for inventory and COGS does not have to follow the physical flow of units of inventory
so companies may also use a cost flow assumption that does not conform to the actual movement of
product through the firm.
o Example: grocery chains use last-in, first-out to account for inventory costs, but that doesn’t
mean they put newest product out to sell while keep the older produce back in storage.
 Example:
o
First-In, First-Out (FIFO)

 The first-in, first-out (FIFO) inventory costing method transfers costs from inventory in the order that
they were initially recorded. That is, FIFO assumes that the first costs recorded in inventory (first-in)
are the first costs transferred from inventory (first-out) to cost of goods sold.
 Conversely, the cots of the last units purchased are costs that remain in inventory at year-end.
o Use FIFO in the above 7.6:
Last-In, First-Out (LIFO)

 The last-in, first-out (LIFO) inventory costing method transfers to COGS the most recent costs
recorded in inventory. We assume that most recent costs recorded in inventory (last-in) are first costs
transferred from inventory (first-out).
 Conversely, costs of first units purchased are costs remain in inventory at year-end.
o Use Butler example from above:
  LIFO layers are kept separately. Meaning, ending inventory in 2019 consist of 2018 pre-layer of 250
units at $100 each, plus a 2019 layer of 100 units at $180 each.
 When unit sales exceed purchases, the first costs carried to COGS are those purchased in current year
and then working down to oldest layers. One aspect of this flow assumption is that reported LIFO
inventory values can be significantly lower than the current cost of acquiring the same inventory.

Inventory Costing and Price Changes

 LIFO and FIFO are historical cost methods. Differences exist when costs of inventory change over time.
LIFO puts more recent costs into COGS expense, so LIFO cost of goods sold is higher than FIFO COGS
and therefore gross profit is lower, when costs of inventory rising over time.
 LIFO = gross profit lower
Average Cost (AC)

 The average cost (AC) method computes the 2018 COGS as an average of the cost to purchase all the
inventories available for sale during the period, as follows:

Lower of Cost or Net Realizable Value

 Companies required to write down carrying amount of inventories, IF reported cost exceeds the net
realizable value.
1. This process is called lower of cost or net realizable value (LCNRV).
 2. Should the net realizable value be less than reported cost, the inventories must be written
down from cost to net realizable value, resulting the following effects:
 Inventory book value is written down to current net realizable value, reducing total
assets.
 Inventory write-down is reflected as an expense (part of cost of goods sold) on the
income statement, reducing current period gross profit, income, and equity.
3. Inventory write-down can shift income from one period to another.
4. Example:

 Inventory is $6,500
1. Copper Wire = 200*$10 = $2,000
2. Wood Panel = 500*$8 = $4,500

FINANCIAL STATEMENT EFFECTS AND DISCLOSURE

 Standards require financial statement disclosure of:
1. Composition of the inventory (in the balance sheet or a separate schedule in the notes).
2. Significant or unusual inventory financing arrangements.
 3. Inventory costing methods employed (which can differ for different types of inventory).

Financial Statement Effects of Inventory Costing

FIFO cost of goods sold = LIFO cost of goods sold - Change in the LIFO reserve

Income Statement Effects

 The income differences between inventory methods are a function of two factors:
1. Speed and direction of inventory cost changes
 For Butler Company, inventory costs have increased from $100 per unit to $180 per
unit in a two-year period. If costs increased more slowly, the difference between LIFO
and FIFO would decrease. And, if costs decreased, the differences would reverse: FIFO
cost of goods sold would be greater than LIFO cost of goods sold.
2. Length of time inventory is held by the company
 If Butler Company were able to operate with zero inventory, the three inventory
methods would yield the same COGS. But if inventory held for a long time, the
differences would increase.
Effects of Changing Costs
  When cost of products changes, management changes prices for these products. If costs are declining,
competitive pressures are likely to push down the prices customers are willing to pay. If costs are
increasing, the company will try to increase prices to recover at least some of the greater cost. When
costs fluctuate (for example, for a commodity), management may act to cause its prices to fluctuate in
an effort to maintain its target profit margin.
 If costs and prices are rising, then FIFO reports a higher gross margin, because costs of older inventory
are being matched against current selling prices. For tax purposes, the company would prefer LIFO
because it would decrease gross profit and decrease taxable income.
 Ex:

Balance Sheet Effects

 Balance sheets using LIFO do not accurately represent the cost that a company would incur to replace
its current investment in inventories.
o In rising costs, LIFO yields ending inventories that are lower than FIFO.
 For the purposes of analysis, the value of the LIFO reserve can be viewed as an unrealized holding gain
a gain resulting from holding inventory as prices are rising. That is, there is a holding gain due to rising
inventory costs that has not been recorded in the financial statements.
 Companies using FIFO tend not to have large unrealized inventory holding gains.
 FIFO costing tends to approximate current value in the balance sheet.
 However, if prices fall, companies using FIFO are more likely to adjust inventory values to the lower of
cost or net realizable value.
Cash Flow Effects

 Increased gross profit using FIFO results in higher pretax income and higher taxes payable. Use of LIFO
in an inflationary environments results in lower tax liability.
Adjusting the Balance Sheet to FIFO

 LIFO reserve can be used to adjust balance sheet and income statement to achieve comparability
between companies that use different costing methods.
Adjusting the Income Statement to FIFO

 To adjust income statement from LIFO to FIFO, we use the change in the LIFO reserve.

ANALYZING FINANCIAL STATEMENTS

See pg. 345-350 (Home Depot) example.

Some formulas/topics:

APPENDIX 7A: LIFO Liquidation

 When companies use LIFO inventory costing, the most recent costs of purchasing inventory are
transferred to cost of goods sold, while older costs remain in ending inventory. Each time inventory is
purchased at a different price, a new layer (also called a LIFO layer) is added to the inventory balance.
 As long as a year 's purchases equal or exceed the quantity sold, older cost layers remain in inventory.
 On the other hand, when quantity sold exceeds the quantity purchased, inventory costs from these
older cost layers are transferred to COGS. This is known as LIFO Liquidation.
 Because these older costs are usually much lower than current replacement costs, LIFO liquidation
normally yields a boost to current gross profit as these older costs are matched against current
revenues.
 Ex:
Analysis Implications
 LIFO liquidation boosts gross profit when older, lower costs are matched against revenues based on
current sales prices. This increase in gross profit is transitory.
 Once an old LIFO layer is liquidated, it can only be replaced at current prices.
Chapter 8 – Long Term Assets
Tangible assets are assets that have physical substance. They are frequently included in the balance sheet as property, plant,
and equipment, and include land, buildings, machinery, fixtures, and equipment.

Intangible assets, such as trademarks and patents, do not have physical substance, but provide the owner with specific rights
and privileges.

PROPERTY, PLANT, AND EQUIPMENT (PPE)

Outlays to acquire PPE are called capital expenditures. Expenditures that are recorded as an asset must possess each of the
following two characteristics:

1. The asset is owned or controlled by the company.

2. The asset is expected to provide future benefits.

All normal costs incurred to acquire an asset and prepare it for use should be capitalized and reported on the balance sheet.
Companies can only capitalize costs that are directly linked to future benefits. The costs capitalized a an asset can be no
greater than the expected future benefits to be derived from use of the asset.

Routine repairs and maintenance costs are necessary to realize the full potential benefits of ownership of the asset and
should be treated as expenses of the period in which the maintenance is performed. However, if the cost can be considered
an improvement or betterment of the asset, the cost should be capitalized. An improvement or betterment is an outlay that
either enhances the usefulness of the asset or extends the asset's useful life beyond the original expectation.

Depreciation
We rely on systematic allocation to assign a portion of the asset’s cost to each period benefitted. Allocation of cost is
depreciation.

Useful life. The useful life is the period of time over which the asset is expected to provide economic benefits to the company.
The useful life is not the same as the physical life of the asset. An asset may or may not provide economic benefits to the
company for its entire physical life. This useful life should not exceed the period of time that the company intends to use the
asset. For example, if a company has a policy of replacing automobiles every two years, the useful life should be set at no longer
than two years, even if the automobiles physically last three years or more.

Residual (or salvage) value. The residual value is the expected realizable value of the asset at the end of its useful life.

Straight-Line Method Under the straight-line (SL) method, depreciation expense is recorded evenly over the useful life
of the asset. That is, the same amount of depreciation expense is recorded each year. The depreciation rate is equal to one
divided by the useful life.
Asset Sales and Impairments

Gain or loss on asset sale = Proceeds from sale - Book value of asset sold.

Asset Impairments Property, plant, and equipment assets are reported at their net book values (original cost less
accumulated depreciation). This is the case even if fair values of these assets increase subsequent to acquisition.

Typically, fair value is the current price for which an asset could be sold on the open market. Book value usually represents
the actual price that the owner paid for the asset. The two prices may or may not match, depending on the type of asset. The
difference between the book value and fair value is a potential profit or loss. There is no way to know which you'll have
until you sell the asset. Book value is asset’s original cost minus AD and impairment.

Impairment of PPE assets is determined by comparing the sum of expected future (undiscounted) cash flows from the asset
with its net book value. If these expected cash flows are greater than net book value, no impairment is deemed to exist.
However, if the sum of expected cash flows is less than net book value, the asset is deemed impaired and it is written down
to its current fair value (generally, the discounted present value of those expected cash flows).

INTANGIBLE ASSETS

Research and Development Costs

 Immediate recognition as an expense
Patents
Copyrights
Trademarks
Franchise Rights

• Capitalize if the expenditure was external

• Include on the balance sheet as an asset
• Examples:
• Intangibles acquired from a third party
• Filing fees associated with registering intangibles for exclusive use
• Goodwill
• Expense if the expenditure was internal
• Include on the income statement as expense in the current period
• Examples:
• R&D
• Advertising
• Internally developed intangibles
Amortization and Impairment of Identifiable Intangible Assets

When intangible assets are acquired and capitalized, a determination must be made as to whether the asset has a definite
life. Examples of intangible assets with definite lives include patents and franchise rights. An intangible asset with a
definite life must be amortized over the expected useful life of the asset. Amortization is the systematic allocation of the
cost of an intangible asset to the periods benefited, similar to depreciation of tangible assets.

Amortization

Impairment
Some transferable intangible assets, such as some trademarks, have indefinite lives. For these assets, the expected useful
life extends far enough into the future that it is impossible for management to estimate a useful life. An intangible asset
with an indefinite life should not be amortized until the useful life of the asset can be specified. That is, no expense is
recorded until management can reasonably estimate the useful life of the asset.
Goodwill

Goodwill is an intangible asset that is recorded only when one company acquires another company.
Goodwill is defined as the excess of the purchase price paid for a company over the fair value of its identifiable net assets
(assets minus the liabilities assumed). The identifiable net assets include any identifiable intangible assets acquired in the
purchase. Therefore, goodwill can neither be linked to any identifiable source, nor can it be sold or separated from the
company. It represents the value of the acquired company above and beyond the specific identifiable assets
listed on the balance sheet.

Chapter 9 Reporting and Analyzing Liabilities

LONG-TERM LIABILITIES

Installment Loans
Companies can borrow small amounts of long-term debt from banks, insurance companies, or other
financial institutions. These liabilities are often designed as installment loans and may be secured
by specific assets called collateral.

Present Value= Payment X Present Value Factor

Bonds
Generally, the entire face amount (principal) of the bond or note is repaid at maturity and interest payments are made
(usually semiannually) in the interim.

Pricing of Bonds

Coupon (contract or stated) rate The coupon rate of interest is stated in the bond contract. It
is used to compute the dollar amount of (semiannual) interest payments that are paid to bondholders
during the life of the bond issue.
Market (yield) rate The market rate is the interest rate that investors expect to earn on the
investment for this debt security. This rate is used to price the bond issue.

The bond price equals the present value of the expected cash flows to the bondholder. Specifically,
bondholders normally expect to receive two different cash flows:
1. Periodic interest payments (usually semiannual) during the bond's life. These cash flows are
typically in the form of equal payments at periodic intervals, called an annuity.
2. Single payment of the face (principal) amount of the bond at maturity.

Bonds Issued at Par When a bond is issued at par, its coupon rate is identical to the market
rate. Under this condition, a $1 ,000 bond sells for $1 ,000 in the market. To illustrate bond pricing,
assume that investors wish to value a bond issue with a face amount of $100,000, a 6% annual
coupon rate with interest payable semiannually (3% semiannual rate), and a maturity of 4 years.3
Bonds Issued at a Discount As a second illustration, assume that market conditions are
such that investors demand an 8% annual yield (4% semiannual) for the 6% coupon bond, while all
other details remain the same.
Bonds Issued at a Premium As a third illustration, assume that investors in the bond
market demand a 4% annual yield (2% semiannual) for the 6% coupon bonds, while all other details
remain the same.
Effective Cost of Debt

When a bond sells for par, the cost to the issuing company is the cash interest paid. In our first illustration
where the bond is issued at par, the effective cost of the bond is the 6% interest paid by the issuer.
When a bond sells at a discount, the issuer's effective cost consists of two parts: (1) the cash
interest paid and (2) the discount incurred. The discount, which is the difference between par and the
lower issue price, is a cost that must eventually be reflected in the issuer's income statement as an expense. This fact means
that the effective cost of a discount bond is greater than if the bond had sold
at par. A discount is a cost and, like any other cost, must eventually be transferred from the balance
sheet to the income statement as an expense. In the previous section's discount example, the economic
substance is that the bond issuer has not borrowed $100,000 at 6%, but rather $93,267 at 8%.

Reporting of Bond Financing

Bonds Issued at a Discount

Effects of Discount and Premium Amortization

The Fair Value Option

Thus far, we have described the reporting of liabilities at historical cost. This means that all financial
statement relationships are established on the date that the liability is created and do not subsequently
change. For example, the interest rate used to value a bond is the market rate of interest
on the date that the bond is issued and the reported value of the bond is the face value plus the
unamortized premium or minus the unamortized discount. Yet, once issued, bonds can be traded in
secondary markets. Market interest rates fluctuate and, as a consequence, the market value of a bond
is likely to change after the bond is issued.

Effects of Bond Repurchase

Gain or loss on bond repurchase = Book value of the bond - Repurchase payment

The book (carrying) value of the bond is the net amount reported on the balance sheet. If the issuer
pays more to retire the bonds than the amount carried on its balance sheet, a loss is reported on its
income statement, usually called loss on bond retirement. The issuer reports a gain on bond retirement
if the repurchase price is less than the book value of the bond.