Chapter 6: Reporting and analyzing inventory

Classifying/Determining inventory
Merchandising Company:
one classificationMerchandise inventory
Manufacturing Company:
three classificationsRaw Materials
Work In Progress
Finished Goods
*Both are reported under Current Assets
Physical inventory is taken for two reasons:
Perpetual System
1)Check accuracy of inventory records
2)Determine amount of inventory lost due to
wasted raw materials, shoplifting, or employee
theft
Periodic System
1)Determine the inventory on hand
2)Determine the cost of goods sold for the
period
*involves counting, weighting, or measuring each
kind of inventory on hand
*is taken when the business is closed or is slow;
taken at the END of the accounting period
Determining ownership of goods:
- Goods in transit
purchased goods not yet received
sold goods not yet delivered
*Goods in transit: included in inventory of the
company with legal title to the goods (legal title is
determined by terms of sale)

Inventory Costing
cost includes all expenditures necessary to
acquire goods and pace them in a condition
ready for sale
unit costs are applied to quantities to determine
the total cost of the inventory and the cost of
goods sold using the following costing methods:
(3)
- specific identification
**actual physical flow costing method in which
items still in inventory are specifically costed to
arrive at the total cost of the ending inventory.
practice is rare
most companies make (cost flow) assumptions
about which units were sold
Cost Flow Assumption does not need to be
consistent with the physical movement of
goods
(Beginning Inventory + Purchases) Ending
Inventory = Cost of Goods Sold
- first-in, first-out (FIFO)
**Cost of the earliest goods purchased are the
first to be recognized in determining cost of
goods sold
**Often parallels actual physical flow of
merchandise
**Companies determine the cost of the ending
inventory by taking the unit cost of the most
recent purchase and working backward until all
units of inventory have been costed

- last-in, first-out (LIFO)

**Costs of the latest goods purchased are the
first to be recognized in determining cost of
goods sold
**Seldom coincides with actual physical flow of
merchandise
**Exceptions include goods stored in piles (ex:
coal or hay)

- average cost (con: need to calculate new

average every time inventory is added)
**allocates cost of goods available for sale on
the basis of weighted-average unit cost incurred

**applies weighted-average unit cost to the

units on hand to determine cost of the ending
inventory

in a period of inflation, the cost flow method

that results in the lowest income taxes is the
LIFO METHOD
if a company uses LIFO for tax purposed to
reduce its tax bills, they will also have to report
lower net income in financial statements
Using Cost Flow Methods Consistently
Method should be used consistentlyenhances
comparability
Lower-of-Cost-or-Market

 When the value of inventory is lower than its

cost:
- companies can write down the inventory to
its market value in the period in which the
price decline occurs
- market value = replacement cost
- example of conservatism
**Choose whichever costs less

Analysis of Inventory
Inventory management is a critical task
1)High inventory levels storage costs, interest
costs (on funds tied up in inventory), and costs
associated with the obsolescences of technical
goods or shifts in fashion
2)Low inventory levels may lead to lost sales
Inventory Turnover Ratio = Cost of Goods Sold /
Average inventory
Days in inventory = 365 / Inventory Turnover Ratio
Companies using LIFO are required to report the
difference btwn inventory reported using LIFO
and FIFO (aka LIFO reserve)
Example:

Inventory Errors and Income Statement effects:

effects cost of goods sold and net income in two

periods
error in ending inventory of current period
reverse effect on net income of the next
accounting period

 over two years, total net income will be correct

b/c errors offset each other
Balance sheet effects:

CHAPTER 8: Reporting and analyzing receivables

Types of Receivables
Amounts due from individuals and companies
that are expected to be collected in cash
- accounts receivable: amounts customers owe
on account that result from the sale of goods
and services
- notes receivable: written promise (formal
instrument) for amount to be received (aka
trade receivables)
- other receivables: nontrade receivables
(interest, loans to officers, advances to
employees, income taxes refundable)
Accounts of Receivable ( is a current asset)
Two accounting issues:
1)recognizing accounts receivable
- service organizationrecords a receivable
when it performs service on account
- merchandiserrecords accounts receivable at
the point of sale of merchandise on account
2)valuing accounts receivable

- current asset
- valuation (net realizable value)
uncollectible accounts receivable
- sales on account raise the possibility of
accounts not being collected
- seller records losses that result from extending
credit as bad debts expense
Methods of accounting for ucollectible accounts:
direct write-of
**not allowed for financial accounting purposes
but ok for IRS
- theoretically undesireable:
poor matching (record but no collecting)
receivable not stated at net realizable value
not acceptable for financial reporting
allowance method
- losses are estimated:
better matching
receivable stated at net realizable value
REQUIRED BY GAAP
*Accounts receivable: add on blance sheet
*allowance for doubtful accounts: minus on balance
sheet
Allowance method for uncollectible accounts
1)companies estimate uncollectible accounts
receivable
2)Debit bad debts expense and Credit
allowance for doubtful accounts (contraasset account)
3)Companies DEBIT allowance for doubtful
accounts and CREDIT accounts receivable at

the time the specific account is written of as

uncollectible
Estimating Allowance: under the percentage of
receivables basis, management establishes a
percentage relationship between the amount of
receivables and
expected losses
from uncollectible
accounts

Aging the accounts receivable: customer balances

are classified by the length of time they have been
unpaid
Notes Receivable (asset, but current or not depends
on term)
Companies may grant credit in exchange for a
promissory notea written promise to pay a
specified amount of money on demand or at a
definite time.
Promissory notes may be used:

- when individuals/companies lend or borrow

money
- when amount of transaction and credit period
exceed normal limits
- in settlement of accounts receivable
*To the PAYEE, the promissory note is a NOTE
RECEIVABLE
*To the MAKER, the promissory note is a NOTE
PAYABLE
Maturity date can be expressed in terms of Months or
Days
Interest = Face Value of Note x Annual Interest Rate
x Time (years)
*When counting days, omit the date the note is
issued but include due date
Valuing Notes Receivable:
report short-term notes receivable at their cash
(net) realizable value
estimation of cash realizable value and recording
bad debt expense and related allowance are
similar to accounts receivable
Disposing Notes Receivable
notes may be held to their maturity date
maker may default and payee must make an
adjustment to the account
holder speeds up conversion to cash by selling
the note

*Honor of Notes Receivablenote is honored

when maker pays it in full at maturity date
*Dishonor of Notes Receivablenote is not paid
in full at maturity; no longer negotiable
Managing receivables: 5 steps
1)deermine who to extend credit
- if credit policy is too tightyou will lose sales
- if too loosemay sell to customer who will
pay either very late or not at all
*important to check references on potential
new customers as well as their financial
health
2)establish payment period
- companies should determine a required
payment period and communicate that policy
to customers
- payment period should be consistent with
competitors
3)monitor collections
- companies should prepare an A.R. aging
schedule at least monthly
*this helps managers estimate timing of
future cash inflows and provides info about
collection experience of the company and
identifies problem accounts
4)evaluate liquidity of receivables
accounts receivable turnover = net credit sales /
avg net A.R.
average collection period = 365 / A.R. turnover

5)accelerate cash receipts from receivables when

necessary

Statement Presentation of Receivables

Evaluating Liquidity of Receivables:
accounts receivable turnover:
- assess liquidity of receivables
- measure number of times, on avg, a company
collects receivables during the period
average collection period:
- used to assess effectiveness of credit and
collection policies
- collection period should not exceed credit
term period
Accerlerating Cash Receipts:
3 reasons for sale of receivables:
- size
- companies may sell receivables b/c they may
be the only reasonable source of cash
- billing and collection are often timeconsuming and costly
CHAPTER 10: Reporting and analyzing liabilities
Current Liabilities (needed for statement of cash
flows)
Two key features:
1)
company expects to pay debt from existing
current assets or through creation of other
current liabilities

2)company will pay the debt within one year or

operating cycle
**include (notes) payables, accounts payable,
unearned revenues, and accrued liabilities (taxes
(always current), salaraies/wages, interest)
Notes Payable (2 year = long term; within 1 year =
current)
written promissory note
usually require the borrower to pay interest
those due within one year of balance sheet date
are usually classified as current liabilities
Sales Tax Payable
sales taxes are expressed as a stated
percentage of the sales price
selling company collects tax from customer and
remits the collections to the states department
of revenue
Unearned Revenue
revenues that are received BEFORE the company
delivers goods or services
company DEBITS CASH and CREDITS CURRENT
LIABILITY ACCOUNT (unearned revenue)
when company earns the revenue, it debits the
unearned revenue and credits a revenue
Current Maturities of long-term debt
portion of long-term debt that comes due in the
current year
no adjusting entry required
Payroll/-Taxes Payable

 the term payroll pertains to both salaries

(managerial, administrative, and sales personnel
monthly or yearly rate) and wages (store
clerks, factory employees, and manual laborers
rate per hour)
determining payroll involves computing 1) gross
earnings 2) payroll deductions and 3) net pay
empoyer payroll taxes:
-payroll tax expense results from three taxes
that governmental agencies levy on employers
FICA tax, Federal unemployment tax, state
unemployment tax
Bonds: Long-Term liabilities
Bonds: form of interest-bearing notes payable
issued by corporations, universities, and govnmt
agencies
Sold in small denominations (usually $1k or
muliples of)
When corporations issue bonds, theyre
borrowing money; the person who bus the bonds
(bondholder) is investing in bonds.
investors buy bonds
Types of bonds: 1) Secured 2) Unsecured 3)
Convertible 4) Callable
Issuing Procedures:
Bond certificate: issued to the investor; provides
name of company issuing bonds, face value,
maturity date, and contractual (stated) interest
rate
Face value: principal due at maturity

 Maturity date: date final payment is due

Contractual interest rate: rate to determine cash
interest paid, generally semiannually (aka stated
rate)
Determining Market Value of Bonds
the current market price (present value) of a
bond is a function of three factors:
1)the dollar amounts to be received
2)length of time until amounts are received
3)market rate of interest (rate of interest
investors demand for loaning funds to a
corporation)
**discounting the future amounts: process of finding
present value
Accounting for Bond Issues
A corporation records bon transactions when it
issues or retires (buys back) bonds
when bondholders convert bonds into common
stock
Bonds may be issued at:
face value (par)
below face value (discount) (% is higher than
contract)
above face value (premium) (% is lower than
contract)
**Bond prices are quoted as a percentage of face
value
Issuing bonds at a discount:
Ex: Long-term liabilities

Bonds payable
$100,000
Less: Discount on bonds payable
2,000
$98,000
Sale of bonds below face value: cause total cost
of borrowing to be more than the bond interest
paid
Reason: borrower is required to pay the bon
discount at the maturity date; thus, bond
discount is considered to be an increase in cost
of borrowing
Discount on bonds payable = contra account

Issuing bonds at a premium:

Ex: Long-term liabilities
Bonds payable
$100,000
Add: premium on bonds payable
2,000
$102,000
sale of bonds above face value: causes total cost
of borrowing to be less than bond interest paid
Reason: borrower s not require to pay the bond
premium at the maturity date of the bonds; thus,

bond premium is considered to be a reduction in

the cost of borrowing

Accounting for Bond Redemptions

Redeeming bonds at maturity:
When a company retires bonds before maturity,
it is necessary to:
- eliminate the carrying value of bonds at
redemption date
--carrying value of bonds is the face value of
the bonds less unamortized bond discount or
plus unamortized bond premium at the
redemption date
- record the cash paid
- recognize the gain or loss on redemption
**SO when bonds are redeemed before
maturity, the gain or loss on redemption is the
difference between the cash paid and the
carrying value of the bonds

 when bonds are converted into common stock,

the carrying value of the bonds is transferred to
paid-in capital accounts
bond price goes up and down like stocks
(stocks based on if theyre making money)
(bond based on interest rate)
- if interest rate increases, bonds value
decreases
- if interest rate decreases, bonds value
increases
(inverse relationship)
Financial Statement Presentation/Analysis

Liquidity
ratios:
measure the
short-term
ability of a
company to
pay its maturing obligations and to meet unexpected
needs for cash
Solvency ratios: measure the ability of a company to
survive over a long period of time
Debt to Assets ratio = Total Liabilities / Total Assets
Times Interest Earned = Net Income + Interest Expense + Tax Expense
------------------------------------------------------------Interest Expense

Off-Balance-Sheet Financing
Contingencies
Leasing
- operating lease
- capital lease
Amortizing Bond Discount:

 to follow expense recognition principle,

companies allocate bond discount to expense in
each period in which the bonds are outstanding
bond discount / # of interest periods = bond discount
amortization
Example:

Amortizing Bond Premium:

Long-Term Notes Payable

may be secured by a mortgage that pledges title to
specific assets as security for a loan
typically, terms require the borrower to make
installment payments over the term of the loan.
Each payment consists of 1) interest on the unpaid
balance of the loan and 2) a reduction of loan principal
companies initially record mortgage notes payable at
face value

CHAPTER 12: Statement of cash flows

Statement of Cash Flows: Usefulness/Format
Usefulness of the Statement of Cash Flows:
Provides info to help assess:
- entitys ability to generate future cash flows
- ability to pay dividends and obligations
- reasons for the difference btwn net income and net
cash provided (used) by operating activities
- cash investing/financing transactions during the
period
Classifications: (3 types of activities)
operating: income statement items
investing: changes in investments & long-term assets
financing: changes in long-term liabilities and
stockholders equity

Significant Noncash Activities

1) direct issuance of common stock to purchase assets
2) conversion of bonds into common stock
3) direct issuance of debt to purchase assets
4) exchanges of plant assets
Companies report noncash activities in either a 1) separate
schedule (bottom of the statement) or 2) separate note to
the financial statement

Preparation of the Statement of Cash FlowsINDIRECT

METHOD Format: OIF (1) operating 2) investing 3) financing)
**operating activities have direct and indirect methods

Examples:

To prepare statement of cash flows, use 3 sources of info:

1) comparative balance sheets
2) current income statement,
3) additional info
Indirect and Direct methods:
Companies favor the indirect method b/c 1) easier and less
costly to prepare and 2) it focuses on differences btwn net
income and net cash flow from operating activities

Indirect Method:
Step 1: determine net cash provided/used by operating
activities by converting net income from accrual basis to
cash basis
common adjustments to Net Income (loss):
- add back noncash expenses (depreciation,
amortization, depletion expense)
- deduct gains and add losses
- changes in noncash current asset and current
liability accounts
example of cash flow from operating activity: payment of
cash to lenders for interest

 deprecation expensealthough depreciation expense

reduces net income, it doesnt reduce cash; company
must add it back to net income
loss on disposal of plant assetscompanies report as a
source of cash in the investing activities section the
actual amount of cash received from the sale
- any loss on sale is ADDED to net income in
operating section
- any gain on sale is DEDUCTED from net income in
op. section
changes to noncash current asset accountwhen the
Accounts Receivable balance DECREASES, cash receipt
are higher than revenue earned under accrual basis
- company adds to net income the amt of decrease in
A.R.
when the Inventory balance INCREASES, the cost of
merchandise purchased exceeds the cost of good
sold
- cost of goods sold does NOT reflect cash payments
made for merchandise; the company deducts from
net income this inventory increase
when the Prepaid Expense balance INCREASES, cash
paid for expenses is higher than expenses reported
on an accrual basis; the company DEDUCTS the
DECREASE from net income to arrive at net cash
provided by operating activities
- if Prepaid Expenses DECREASE, reported expenses
are higher than expenses paid
Changes to noncash current asset accountswhen
accounts payable INCREASES, the company received
more in goods than paid for. The increase is ADDED to
net income to determine net cash provided by
operating activities
- when Income Taxes Payable DECREASES, the net tax
expense reported on the income state was LESS than

the amt of taxes paid during the period; the DECREASE

is SUBTRACTED from net income to determine net cash
provided by operating activities
SUMMARY OF CONVERSION TO NET CASH PROVIDED BY
OPERATING ACTIVITIESINDIRECT METHOD:

STEP 2: Investing and Financing Activities

STEP 3: Net change in Cash
- compare net change in cash on Statement of Cash
Flows with change in cash account reported on
Balance Sheet to make sure amounts agree
Using cash flows to evaluate a company
Free Cash Flow = Cash Provided by Op. Activities Capital
Expenditures Cash Dividends
Free Cash Flow: describes the cash remaining from
operations after adjustment for capital expenditures and
dividends
Assessing Liquidity and Solvency:
liquidity: ability to pay obligations expected to become
due within the next year

Current Cash Debt Coverage = Net Cash from Op. Activities

-------------------------------------Avg Current Liabilities
**a value below 0.40 times is cause for additional
investigation
Solvency: ability of company to survive over long term
Cash Debit Coverage = Net Cash from Op. Activities
---------------------------------Avg Total Liabilities
**a ratio below 0.20 times is cause for additional
investigation
CHAPTER 13: Financial analysis: the big picture
Sustaiable Income
Sustainable incomeNet income adjusted for irregular items
**Irregular items are separately identified on income
statement
- discontinued operations
- extraordinary items
**irregular items are reported net of income taxes

Discontinued Operations:
disposal of a significant component of a business
income statement should report a gain (or loss) from
discontinued operations, net of tax
Extraordinary items: events and transactions that meet
two conditions1) unusual in nature and 2) infrequent in
occurrence
companies must consider the environment in which it
operates; amounts reported net of tax
Are these considered Extraordinary Items?
Effects of major natural casualties, if rare in the area
Effects of major natural casualties, not uncommon in
the area
Write-down of inventories or write-off of receivables
Expropriation (takeover) of property by a foreign
government
Losses attribute to labor strikes
Effects of a newly enacted law or regulation, such as
condemnation action
Gains or losses from sales of property, plant, and
equipment

Changes in Accounting Principle

principle used in current year is different from one used
in preceding year
ex: change from FIFO to avg cost
permissible when management can show new principle
is preferable
most changes are reported retroactively
Comprehensive Income
all changes in stockholders equity except those
resulting from
- investments by stockholders and distribution by
stockholders
certain gains and losses bypass net income and instead
are reported as direct adjustments to stockholders
equity
- ex: unrealized gain or loss on Available-for-sale
securities
**Accounting standards require companies to adjust most
investments in stocks and bonds up or down to their market
price at the end of each accounting period
to account for unrealized loss, if stock is classified as
- trading security unrealized gains/losses (income
statement)
- available for-sale security unrealized gains/losses
(Comprehensive income stockholders equity)
Format 1: Comprehensive IncomeCombined statement of
income and comprehensive income

Format 2: Comprehensive IncomeSeparate component of

Stockholders Equity

Format 3: Comprehensive IncomeComplete Income

Statement

Comparative Analysis
Analyzing financial statements involve:

 Comparison Bases
- intracompany
- intercompany
- industry averages

Basic Tools
- horizontal analysis
- vertical analysis
- ratio analysis

Horizontal analysis (aka trend analysis): technique for

evaluating a series of financial statement data over a
period of time
- purpose: to determine increase or decrease that has
taken place
- commonly applied to balance sheet and income
statement

**When using horizontal analysis, be sure to examine

both dollar amt changes and percentage changes

**In horizontal analysis, while the amt column is

additive (total = $99 mil), the percentage column is not
additive (9.9% is not a total)

 ex:

Vertical analysis (aka common-size analysis): technique

that expresses each financial statement item as a
percent of a base amount
- commonly applied to the balance sheet and income
statement

**These results indicate the company shifted toward

equity financing by relying less on debt and by
increasing the amt of retained earnings

**The increase in net income as a percentage of net

sales is due primarily to the decrease in interest
expense and income tax expense as a percentage of
sales

 -although Chicago cereals net sales are less than

General mills, vertical analysis eliminates the impact of
this size difference for our analysis
vertical analysis also enables a comparison of
companies of different sizes

Ratio Analysis
expresses the relationship among selected items of
financial statement data

Financial Ratio Classifications

Liquidity: measures short-term ability of company to
pay its maturing obligations and to meet unexpected
needs for cash
Solvency: measures ability of company to survive over
a long period of time
Profitability: measures income or operating success of a
company for a given period of time

Quality of Earnings
a company that has high quality of earnings provides
full and transparent info that will not confuse or mislead
users of the financial statements

Alternative Accounting Methods

variations among companies in the application of GAAP
may hamper comparability and reduce quality of
earnings (FIFO vs LIFO)

Pro Forma Income

usually excludes items that are unusual or nonrecurring
some companies have abused the flexibility that pro
forma numbers allow to put their companies in a more
favorable light

 Alternative Accounting Methods

some managers have felt pressure to continually
increase earnings
abuses include:
- improper recognition of revenue (channel stuffing)
- improper capitalization of operating expenses
(WorldCom)
- failure to report all liabilities (Enron)

Price-Earnings Ratio
reflects investors assessment of a companys future
earnings
- P-E ratio will be higher if investors think earnings will
increase substantially in the future
- P-E ratio will be lower when there is belief that a
company has poor-quality earnings

Ex: Comprehensive income Vertical analysis

Quality of earnings Pro forma income

Solvency ratio Extraordinary items

1. Measures the ability of the company to survive over a

long period of time.
2. Usually excludes items that a company thinks are
unusual or non-recurring.
3. Includes all changes in stockholders equity during a
period except those resulting from investments by
stockholders and distributions to stockholders.

4. Indicates the level of full and transparent information

provided to users of the financial statements.
5. Describes events and transactions that are unusual in
nature and infrequent in occurrence.
6. Expresses each item within a financial statement as a
percent of a base amount.

Anayzing financial staements involves:

Characteristics: liquidity, profitability, solvency
Comparison bases: intra company, industry averages,
intercompany

Liquidity Ratios
short-term creditors such as bankers and suppliers are
particularly interested in assessing liquidity
ratios include: current ratio, current cash debt
coverage, accounts receivables turnover, avg collection
period, inventory turnover, and days in inventory

* current ratio: expresses the relationship of current

assets to current liabilities

*current cash debt coverage: b/c it uses cash provided

by operating activities, it may provide a better
representation of liquidity

*accounts receivables turnover: measures the number

of times, on avg, a company collects receivables during
the period

*average collection period: converts the receivable

turnover ratio into das

*Inventory turnover: measures the number of times avg

inventory was sold during the period

 *days in inventory: measures the avg number of days

inventory is held

Solvency Ratios
debt-paying ability
- debt to assets ratio
- times interest earned
- cash debt coverage
free cash flow provides info about solvency and ability
to pay additional dividends or invest in capital
expenditures

*debt to assets ratio: indicates the degree of financial

leveraging; provides some indication of companys
ability to withstand losses

*times interest earned: aka interest coverage; indicates

companys ability to meet interest payments as they
come due

*cash debt coverage: indicates a companys ability to

repay its liabilities from cash generated from operating
activities w/o having to liquidate the assets used in its
operations

*free cash flow: Ability to pay dividends or expand

operations. Calculate the ratio for Chicago.

Profitability Ratios

*return on common stockholders equity (ROE): Shows

how many dollars of net income the company earned
for each dollar invested by the owners.

*return on assets: Measures the overall profitability of

assets in terms of the income earned on each dollar
invested in assets.

*profit margin: Or rate of return on sales, is a measure

of the percentage of each dollar of sales that results in
net income.

*asset turnover: Measures how efficiently a company

uses its assets to generate sales.

You can analyze the combined effects of profit margin

and asset turnover on return on assets for Chicago as
shown

*gross profit rate: Indicates a companys ability to

maintain an adequate selling price above its cost of
goods sold.
- As an industry becomes more competitive, this ratio
declines.

*earnings per share: A measure of the net income

earned on each share of common stock.
- EPS is not compared between companies because of
the wide variations in the number shares outstanding
among companies.

*price-earnings (P-E) ratio: Reflects investors

assessments of a companys future earnings.
*payout ratio: Measures the percentage of earnings
distributed in the form of cash dividends.
- This ratio should be calculated over a longer period of
time to evaluate any trends.