Fourth Edition

Peter D. Easton Mary Lea McAnally Greg Sommers Xiao-Jun Zhang

MODULE 6

Asset Recognition
and Operating Assets

©Cambridge Business Publishers, 2015

 Learning Objective 1

Describe accounting for accounts

receivable and the importance of the
allowance for uncollectible accounts
in determining profit.

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 Accounts Receivable

 When companies sell to other companies, they

offer credit terms, which are called sales on
credit (or credit sales or sales on account).
 Accounts receivable are reported on the balance
sheet of the seller at net realizable value, which
is the net amount the seller expects to collect.

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 Cisco Systems, Inc.
Current Assets

Note: Cisco’s Accounts Receivable are

reported net of a $207 million allowance
for uncollectible accounts.

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 Allowance for Uncollectible Accounts

 The amount of expected uncollectible accounts

is usually computed based on an aging analysis.
 Each customer’s account balance is categorized
by the number of days or months the underlying
invoices have remained outstanding.
 Based on prior experience or on other available
statistics, bad debts percentages are applied to
each of these categorized amounts, with larger
percentages being applied to older accounts.

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 Aging Analysis Example

 GAAP requires companies to disclose the

amount of the allowance for uncollectible
accounts, either on the face of the balance
sheet or in the notes.
 Companies are also required to disclose their
accounting policies with respect to receivables.
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 Reporting Accounts Receivable

Given a
 gross balance of $100,000 and
 estimated uncollectible accounts of $2,900,
 accounts receivable will be reported as follows:

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 Bad Debt Expense

 Bad Debt Expense is equal to the increase in the allowance

for uncollectible accounts.
 In our previous example,
 if the estimated amount of credit losses is $2,900, and
 a previous balance of $2,200 existed in the allowance for
uncollectible accounts,
 the company would record a bad debt expense of $700.
 and,
 If the allowance for uncollectible accounts has a balance of
$1,000,
 bad debt expense would be $1,900.

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 Write-Off or Uncollectible Accounts

 The write-off of an uncollectible account does

not affect income. The amount written-off is
reflected as a reduction of the account receivable
balance and the allowance for uncollectible
accounts:

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 Income Shifting

 By underestimating the provision, expense is

reduced in the income statement, thus
increasing current period income.
 In one or more future periods, when write-offs
occur for which the company should have
provisioned earlier, it must then increase the
provision to make up for the underestimated
provision for the earlier period.
 This reduces income in one or more subsequent
periods. Income has, thus, been shifted
(borrowed) from a future period into the current
period.
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 Receivables Turnover Rate and
Days Sales in Receivables
 The accounts receivables turnover (ART) rate is defined
as

 The accounts receivable turnover rate reveals how many

times receivables have turned (been collected) during the
period.
 More turns indicate that receivables are being collected
quickly.

 A companion ratio is the Average Collection Period:

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 Example
 Suppose that
 sales are $1,000
 ending accounts receivable are $230
 average accounts receivable are $200.
$1,000
Receivable Turnover = $200
 5 times

(uses average balance)

$230
 84 days
Average Collection period =  $1,000 
 365 

(uses ending balance)

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 Insights from
Accounts Receivable Turnover

1. If turnover slows, the reason could be deterioration in

collectability. However, there are at least three
alternative explanations:
 A seller can extend its credit terms.
 A seller can take on longer-paying customers.
 The seller can increase the allowance provision.
2. Asset utilization Asset turnover is often viewed as an
important dimension of financial performance, both
by managers for internal performance goals, as well as
by the market in evaluating investment choices.

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 Receivable Turnover Rates
for Selected Companies

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 Average Collection Period
for Selected Industries

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 Learning Objective 2

Explain accounting for inventories and

assess the effects on the balance sheet
and income statement from different
inventory costing methods.

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 Inventories

 Inventory costs either are reported on the

balance sheet or they are transferred to the
income statement as an expense (cost of goods
sold) to match against sales revenues.
 The process for which costs are removed from
the balance sheet is important.

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 Manufacturing Costs

 Raw materials cost is relatively easy to compute.

Design specifications list the components of each
product, and their purchase costs are readily
determined.
 Labor cost in a unit of inventory is based on how
long each unit takes to build and the rates for
each labor class working on that product.
 Overhead costs include the manufacturing plant
depreciation, utilities, plant supervisory
personnel, and so forth.

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 Cost of Goods Sold

 When inventories are used up in production or

are sold, their cost is transferred from the
balance sheet to the income statement as cost of
goods sold (COGS).
 COGS is then matched against sales revenue to
yield gross profit:

Sales revenue
- COGS
Gross profit
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 The Cost of Goods Sold Computation

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 Inventory Costing Methods

 First-In, First-Out (FIFO) – This method assumes

that the first units purchased are the first units
sold.
 Last-In, First-Out (LIFO) – The LIFO inventory
costing method assumes that the last units
purchased are the first to be sold.
 Average cost – The average cost method
assumes that the units are sold without regard to
the order in which they are purchased. Instead, it
computes COGS and ending inventories as a
simple weighted average.
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 FIFO Inventory Costing

FIFO Inventory Costing:

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 LIFO Inventory Costing

LIFO Inventory Costing:

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 Lower of Cost or Market

 Companies must write down the carrying amount of

inventories on the balance sheet if the reported cost
exceeds market value.
 This process is called reporting inventories at the lower
of cost or market and creates the following financial
statement effects:
 Inventory book value is written down to current market
value (replacement cost); reducing inventory and total
assets.
 Inventory write-down is reflected as an expense on the
income statement.

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 LCM Illustration

 To illustrate,
 assume that a company has inventory on its balance
sheet at a cost of $27,000.
 Management learns that the inventory’s
replacement cost is $23,000 and writes inventories
down to a balance of $23,000.
 The following financial statement effects template
shows the adjustment.

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 Inventory Costing Effects
on Income Statement

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 FIFO’s “Phantom Profits”

Assume a FIFO inventory costing method:

Beginning Inventory: 35 units @ $1.20
Purchase of 20 units @ $1.35
Ending Inventory: 10 units
45 units were sold at a price of $2.75/unit
Gross profit is computed as follows:
Sales (45 x $2.75) $123.75
FIFO COGS (35 @ $1.20 + 10 @ $1.35) 55.50
Gross Profit $ 68.25

Q: What portion of the gross profit is “economic” and what

portion is the “holding gain”?

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 FIFO’s “Phantom Profits”
Solution:
Economic Profit: 45 units x ($2.75-$1.35) $63.00
Holding Gain: 35 units x ($1.35-$1.20) 5.25
$68.25

Phantom profit consists of both economic profit and

holding gain.
 Economic profit is the number of units sold multiplied by the difference
between the sales price and the replacement cost of the inventories.
 Holding gain is the increase in replacement cost since the inventories
were acquired, which equals the number of units on hand at the start
of the period multiplied by the difference between the current
replacement cost and the original acquisition cost.
 This is typically approximated by the LIFO reserve (the difference
between LIFO and FIFO inventories).
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 Inventory Costing Effects
on Cash Flows
 One reason frequently cited for using LIFO is the
reduced tax liability in periods of rising prices.
 Companies using LIFO are required to disclose
the amount at which inventories would have
been reported had it used FIFO.
 The difference between these two amounts is
called the LIFO reserve.

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 CAT’s LIFO Reserve

 The use of LIFO has reduced the carrying amount

of 2012 inventories by $2,750 million.
 This difference, referred to as the LIFO reserve, is
the amount that must be added to LIFO
inventories to adjust them to their FIFO value.

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 LIFO’s Cash Savings for CAT

 Use of LIFO reduced CAT’s inventories by $2,750

million, resulting in a cumulative increase in cost
of goods sold and a cumulative decrease in gross
profit and pretax profit of that same amount.
 Because CAT also uses LIFO for tax purposes, the
decrease in pretax profits reduced CAT’s
cumulative tax bill by about $963 million ($2,750
million X 35% assumed corporate tax rate).

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 Gross Profit Analysis

 Gross profit ratio = gross profit ÷ sales.

 A decline in this ratio is usually cause for concern
since it indicates that the company has less
ability to mark up the cost of its products into
selling prices.

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 Cisco’s Gross Profit Margin

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 Possible Causes for a
Decline in Gross Profit Ratio
 Some possible reasons for a decline in Gross
Profit Ratio:
 Product line is stale.
 New competitors enter the market.
 General decline in economic activity.
 Inventory is overstocked.
 Manufacturing costs have increased.
 Changes in product mix.

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 Inventory Turnover Rates
for Selected Companies

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 Average Inventory Days
for Selected Companies

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 Learning Objective 3

Describe accounting for property,

plant and equipment and explain the
impacts on profit and cash flows from
depreciation methods, disposals
and impairments.

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 Long-Term Assets

 Long-term assets mainly consist of property,

plant, and equipment (PPE).
 These assets often make up the largest asset
amounts, and
 Future expenses arising from these long-term
assets often make up the larger expense
amounts—typically reflected in depreciation
expense and asset write-downs.

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 Depreciation Factors and Process

Depreciation requires the following estimates:

1. Useful life – period of time over which the
asset is expected to generate cash inflows
2. Salvage value – Expected disposal amount for
the asset at the end of its useful life
3. Depreciation rate – an estimate of how the
asset will be used up over its useful life

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 Variance in Depreciation

 A company can depreciate different assets using

different depreciation rates (and different useful
lives).
 The using up of an asset generally relates to
physical or technological obsolescence.

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 Depreciation Methods

 All depreciation methods have the following

general formula:

 Depreciation Methods:
1. Straight-line method
2. Accelerated Methods (Double-declining-balance
method)

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 Straight-Line Method

 Straight-line method: Under the straight-line (SL)

method, depreciation expense is recognized
evenly over the estimated useful life of the asset.
 Consider the following example:
An asset (machine) with the following details:
 cost of $100,000
 salvage value of $10,000
 useful life of 5 years

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 Straight-Line Depreciation Example

 For the straight-line method, we use our

illustrative asset to assign the following amounts
to the depreciation formula:

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 Double-Declining-Balance Method

 Double-declining-balance method – For the

double-declining-balance (DDB) method, we use
our illustrative asset to assign the following
amounts to the depreciation formula:

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 Double-Declining-Balance Method

 The asset is reported on the balance sheet as

follows:

 In the second year, $24,000 ($60,000  40%) of

depreciation expense is recorded in the income
statement and the NBV of the asset on the
balance sheet follows:

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 DDB Depreciation Schedule

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 Comparison of Depreciation Methods

INSIGHT:
All depreciation methods leave the same salvage value.
Total depreciation over asset life is identical for all
methods.
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 Asset Sales

Alcoa’s sale of land:

Alcoa carries the sale of the hydroelectric project on its balance

sheet at $277 million, computed as $597 million cash from the sale
less the $320 million realized gain on sale.
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 Asset Impairments

 Impairment of plant assets other than goodwill is

determined by comparing the sum of the expected
future (undiscounted) cash flows generated by the asset
with its net book value.
 Companies must recognize a loss if the asset is deemed
to be impaired.

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 Potential Problems
with Asset Write-Downs

 Asset write-downs present two potential

problems:
1. Insufficient write-down
2. Writing down more than is necessary

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 Analysis Implications

 PPE Turnover: analysis of the productivity of

long-term assets

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 PPE Turnover
for Selected Companies

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 PPE Turnover
for Selected Industries

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 Analysis of Useful Life
and Percent Used Up

 Estimated useful life =

 Percent used up =

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The End