Chapter 6

Question 1

costs capitalized vs costs not capitalized

Answer 1

costs capitalized go on the assets of the B/S and on the expenses of I/S

costs not capitalized don’t do on asset part of B/S, they end up on expenses on I/S

Question 2

what’s the flow of inventory expenditures on I/S and B/S

Answer 2

inventory expenditures follow the costs capitalized line

cost of inventory is added to the B/S as an asset (capitalized) when it’s purchased or manufactured

inventory cost is transferred from the balance sheet to the income statement as a cost of goods sold when sold, the COGS is deducted from sales to yield gross profit

Question 3

what are the 3 components of manufacturing costs

Answer 3

cost of
direct (raw) materials
used in the product, cost of
direct
labor
to manufacture the product, and
manufacturing overhead
. Direct materials cost is relatively easy to compute.
Design specifications list the components of each product, and their purchase costs are readily determined. The direct
labor cost per unit of inventory depends on how long each unit takes to construct and the wages and salaries paid for
employees who work on that product. Overhead costs are also capitalized into inventory. These include all manufactur-
ing costs other than direct materials and direct labor, such as utilities, supervisory personnel, repairs and depreciation on
manufacturing PP&E, and other related costs.

Question 4

what’s the inventory cost flows to financial statements

Answer 4

beginning inventory + inventory acquired = cost of goods available for sale = ending inventory + COGS

Question 5

what’s FIFO?

Answer 5

The FIFO inventory costing method transfers costs from inventory in the order that they were ini-
tially recorded. That is, FIFO assumes that the first costs recorded in inventory (first-in) are the first
costs transferred from inventory (first-out).

Question 6

what’s LIFO

Answer 6

The LIFO inventory costing method transfers the most recent inventory costs from the balance
sheet to COGS. That is, the LIFO method assumes that the most recent inventory purchases (last-
in) are the first costs transferred from inventory (first-out).

Question 7

what’s average cost

Answer 7

The average cost method computes the cost of goods sold as an average of the cost to purchase
or manufacture all of the inventories that were available for sale during the period.

Question 8

where is the average cost method commonly used

Answer 8

The average cost method is commonly adopted when inventory purchases and sales are continuous
during the year. This method is especially common for retail companies that stock (and constantly
restock) nonseasonal items and for manufacturing companies that use commodities (or commod-
itized items) as raw materials. Technological advances such as bar codes, scanners, and RFIDs have
enabled continuous inventory tracking, tracing, and counting. Enterprise resource planning (ERP)
systems interface with these inventory management systems, and, together, these advances reduce
the costs associated with inventory costing, prompting more firms to adopt the average cost method.

Question 9

is the inventory costing method related to the actual flow of inventory?

Answer 9

inventory costing method a company chooses to prepare
its income statement is independent of the actual flow of inventory.

Question 10

whats the income statement effects of inventory costing

Answer 10

in an inflationary environment, FIFO yields higher gross
profit than do LIFO or average cost methods.

Question 11

what’s the balance sheet effects of inventory cost methods

Answer 11

In
periods of rising costs, LIFO inventories are markedly lower than under FIFO. As a result, balance
sheets using LIFO do not accurately represent the cost that a company would incur to replace its current investment in inventories. A second issue is that financial statement users cannot compare LIFO
and FIFO inventory numbers across firms as the balance sheet and income statement numbers are
not equivalent. Thus, U.S. GAAP requires that firms choosing LIFO also report (in their notes) the
equivalent FIFO inventory amounts.

Question 12

what’s LIFO reserve

Answer 12

the difference between FIFO and LIFE inventories

FIFO inventory = LIFO inventory + LIFE reserve

Question 13

what’s the cash flow effects of inventory cost method

Answer 13

When inventory costs rise, the LIFO method yields lower net income. Assuming that companies
and investors prefer higher net income, one wonders why any company would use LIFO. The
answer is taxes. Unlike most other accounting method choices, inventory costing methods affect
taxable income. (U.S. IRS is the only taxing authority in the world to allow LIFO; LIFO is not
permitted under IFRS.) Using LIFO increases COGS, which reduces taxable income and taxes
paid. The net result is a real cash savings. Companies weigh the cash flow effect against the
financial reporting effect when selecting among LIFO, FIFO, and average cost.

Question 14

could companies strategically use FIFO for financial reporting (and present high net income
to investors) and LIFO for tax purposes (and pay as little tax as possible)?

Answer 14

The answer is No.
A “LIFO conformity rule” in the IRS tax code stipulates that if a company uses LIFO for its
tax filing, it must also adopt LIFO for financial reporting. This rule limits companies’ ability to
cherry-pick among accounting methods. Further, the LIFO reserve quantifies the difference that
LIFO creates

Question 15

why does inflation make companies switch from LIFO to FIFO

Answer 15

many companies re moving away from LIFO, for their inventory, as
inflation continues to pressure businesses’ earnings. . . One lever finance executives have to
combat the impact of inflation on earnings is to make an accounting-policy change: moving to
FIFO, instead of LIFO. Switching to FIFO can boost a company’s
profitability because older inventory acquired at a lower cost is used to value the cost of goods
sold on the income statement. Through FIFO, businesses can also better align their inventory
accounting across global operations, as the method is allowed under International Financial
Reporting Standards while LIFO isn’t… Businesses have been heading toward FIFO over LIFO for
years—particularly with the rise of tech companies, whose costs tend to fall over time—but such
activity appears to have accelerated amid a turbulent economy. . . On average, an estimated 55%
of companies in the S&P 500 used FIFO as their primary inventory method and 15% used LIFO,
according to
Credit Suisse Group AG
, citing annual reports from 2021 and 2022. The rest of the
companies used other options such as the average-cost method or a combination of methods,
Credit Suisse said. . . But a switch doesn’t come free, either. Leaving LIFO would necessitate
submitting a cash payment to the Internal Revenue Service over four years, a cost other firms
may view as justifying the benefits.

Question 16

whats reporting inventories are the lower cost or market and what are the following financial statement effects

Answer 16

Inventory book value is written down to current market value (net realizable value), reducing
inventory and 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.

Question 17

why are disclosures needed for LIFO reserve

Answer 17

companies that use LIFO must
report their LIFO reserve, and we can use these disclosures to adjust the LIFO numbers to their
FIFO equivalents. Once we convert CAT’s inventory and its total assets to FIFO

Question 18

what are the balance sheet adjustments for LIFO reserve

Answer 18

make three modifications and then recompute balance sheet totals
and subtotals (current assets, total assets, and total equity).

Increase inventories by the LIFO reserve.
■
Increase tax liabilities by the tax rate applied to the LIFO reserve.
■
Increase retained earnings for the difference.
As an example, to adjust CAT’s 2022 balance sheet, we would:
■
Increase inventories by $3,321 million.
■
Increase tax liabilities by $697.41 million ($3,321 million × 21%)
4
■
Increase retained earnings by the difference of $2,623.59 million (computed as
$3,321 million − $697.41 million).

Question 19

what are the income statement adjustments for LIFO reserve

Answer 19

we must adjust cost of goods sold from LIFO to FIFO.
Recall that: Cost of Goods Sold = Beginning Inventories + Purchases − Ending Inventories. To
determine FIFO COGS, we must use the
change
in the LIFO reserve as follows.

FIFO cogs = LIFO cogs change in LIFO reserve

Question 20

what’s LIFO liquidation

Answer 20

The increase in gross profit resulting from a reduction of inventory quantities in the presence
of rising costs

When companies reduce inventory levels, older inventory costs flow
to the income statement. These older LIFO costs are often markedly lower than current inventory
costs, assuming an inflationary environment. The net effect is that the LIFO cost of sales is lower
than the equivalent FIFO cost of sales (the reverse of the typical situation). The liquidation boosts
gross profit as older, lower costs are matched against current selling prices on the income statement.

Question 21

what’s gross profit margin

Answer 21

gross profit divided by sales

Question 22

what does a decrease in gross profit mean

Answer 22

it indicates that the company has less ability to pass on increased product cost
to customers or that the company is not effectively managing product costs

Question 23

what are some factors that affect GPM

Answer 23

Higher product and transportation costs.
Increases in commodity costs, particularly those
related to crude oil prices (which affects the cost of plastic and gasoline), and disruptions in the
supply chain significantly dampened gross profit margins.
●
Shrink.
This cost relates to the loss of inventory due to product obsolescence, damage, theft,
and a variety of other causes. Shrink is included in the cost of goods sold.
●
Investments in the supply chain network.
Supply chain disruptions during and after the pan-
demic had global impacts on sourcing and transport which increased product costs as compa-
nies sought to secure alternate supply sources and develop alternate transportation networks.
Follow-on efforts to streamline supply chains added more cost to COGS.
●
Higher selling prices.
Gross profit margin reflects the spread between the unit cost of a product
and its selling price. To the extent that companies are able, raising selling prices will increase
overall gross profit margin.
●
Product mix.
Each product sold carries its own gross profit margin. As the mix of products sold
changes toward higher gross margin products, the overall gross profit margin increases.

Changes in product mix toward lower-margin products.
■
New products introduced at low prices to gain market share.
■
Increases in production costs.
■
Decrease in production volume (lower production volume spreads out manufacturing over-
head over a smaller number of units produced, thus increasing the cost per unit produced).
■
Increases in supply-chain costs (like procurement, transportation, technology, and insurance).
■
More generous sales discounts or sales returns policies.
■
Inventory obsolescence and/or overstocking.
■
Warranty costs.
■
General decline in economic activity.
■
New competitors in the market.
■
Regulation that inhibits sales or adds fees or taxes to products sold.

Question 24

where do improvements on GPM arise from?

Answer 24

better management of supply chains, production processes, or distribution networks.
Companies that succeed do so because of better performance on basic business processes.

Question 25

what are the 2 inventory ratios commonly calculated and why

Answer 25

inventory turnover and days inventory outstanding

A useful way to analyze inventory is to compare the income statement activity related to inventory
(COGS) to inventory levels on the balance sheet. This helps us assess inventory management and
provides insight into the company’s efficiency in generating sales.

Question 26

define inventory turnover

Answer 26

measures the number of times during the period that the company
sells its inventory and is computed as follows.

inventory turnover = COGS/average inventory

Question 27

define Days inventory Outstanding (DIO)

Answer 27

measures the days required to sell the average inventory available for sale

Days inventory outstanding = 365/inventory turnover

Question 28

why do DIO vary widely by industry

Answer 28

At the high
end, Capital goods, Household durables, Semiconductor, and Apparel compa-
nies build up inventory levels in advance of sales. At the low end are Trans-
portation, Oil and gas, and Utility companies whose inventory line item on the
balance sheet reflects relatively small amounts of fuel and other consumables
primarily for internal use and whose inventories are largely pre-sold.

Question 29

why did DIO increase due to pandemic

Answer 29

Supply chain disruptions.
The global economy suffered severe disruptions in the supply
chain during the pandemic as factories shut down and distribution networks were crippled. In
response, companies stockpiled inventories in attempts to ensure adequate supply.
■
Decrease in demand.
Believing that consumer spending would rebound as the effects of the
pandemic subsided, many companies stocked up on inventories to meet expected demand.
When demand failed to materialize, companies were left with warehouses, stores, and fac-
tories full of inventory that could not be sold. Companies were forced to significantly mark
down prices to sell excess inventory, resulting in lower gross profit margins.
Overall, analysis of days inventory outstanding is important for at least two reasons.

Question 30

why is analysis of DIO important?

Answer 30

1. Inventory quality.
   The ratios can be compared over time and across competitors. Fewer days
   is viewed favorably, because it implies that products are salable, preferably without undue
   discounting (we would compare profit margins to assess discounting). Conversely, more days
   implies that inventory is on the shelves for a longer period of time, perhaps from excessive
   purchases or production, missed fashion trends or technological advances, increased compe-
   tition, and so forth. Our conclusions about higher or lower days inventory outstanding must
   consider alternative explanations including the following. ●
   Product mix can include more (or less) higher margin inventories that sell more slowly.
   This can occur from business acquisitions that consolidate different types of inventory.
   ●
   A company can change promotion policies. Increased, effective advertising is likely to
   decrease days inventory outstanding. Advertising expense is in SG&A, not COGS. This
   means additional advertising cost is in operating expenses, but the benefit is in gross
   profit and fewer days.
   ●
   A company can realize improvements in manufacturing efficiency and lower investments
   in direct materials and work-in-process inventories. Such improvements reduce inventory
   and, consequently, decrease days inventory outstanding. Although a good sign, it does
   not yield any information about the desirability of a company’s product line.
2. Asset utilization.
   Companies strive to optimize their inventory investment. Carrying too
   much inventory is expensive, and too little inventory risks stock-outs and lost sales (current
   and future). Companies can make the following operational changes to optimize inventory.
   ●
   Improved manufacturing processes can eliminate bottlenecks and the consequent buildup
   of work-in-process inventories.
   ●
   Just-in-time (JIT) deliveries from suppliers, which provide raw materials to the production
   line when needed, can reduce the level of raw materials and associated holding costs.
   ●
   Demand-pull production, in which raw materials are released into the production
   process when final goods are demanded by customers instead of producing for estimated
   demand, can reduce inventory levels.
   Harley-Davidson
   , for example, does not
   manufacture a motorcycle until it receives the customer’s order; thus, Harley produces
   for actual, rather than estimated, demand.

Question 31

why is reducing inventory seen as good

Answer 31

Reducing inventories reduces inventory carrying costs, thus improving profitability and
increasing cash flows. The reduction in inventory is reflected as an operating cash inflow in the
statement of cash flows.

Question 32

what’s accounts payable turnover

Answer 32

measures the number of payment cycles in a year

accounts payable turnover = COGS/average accounts payable

Question 33

what’s days payable outstanding

Answer 33

the average length of time a company takes to pay its suppliers

DPO = 365/accounts payable turnover

Question 34

pros and cons on delayed payments

Answer 34

Delaying payment to suppliers allows the purchasing company to increase its available cash
(in other words, reduce its necessary level of cash). However, excessive delays (called “leaning on
the trade”) can damage supplier relationships. Remember, the purchaser’s days payable outstand-
ing is the seller’s days sales outstanding in accounts receivable—this means as the purchaser gains
cash from delaying payment, the seller loses an equal amount. As such, if delays become exces-
sive, sellers might increase product cost or even choose to not sell to the purchaser. In managing
the days accounts payable outstanding, companies must take care to maximize available cash
while minimizing supply-chain disruption.

Question 35

what’s the cash conversion cycle

Answer 35

CCC = DIO + DSO - DPO

aim is to minimize the time to complete a cycle

Question 36

how can companies get supply chair optimization

Answer 36

minimize the time it takes to get the right amount go product from the distribution venter to the store shelves - needs accurate estimates of customer demand for products and an efficient logistics network

Question 37

what’s the change in cash

Answer 37

a change in cash = change in DIO x (cogs/365)

Question 38

what happens when PP&E is acquired

Answer 38

it is recorded at cost on the balance sheet. This is called
capitaliza-
tion
, which explains why
expenditures
for PP&E are called CAPEX. The amount capitalized on
the balance sheet includes all costs to put the assets into service. This includes the cost of the
PP&E as well as transportation, duties, tax, and necessary costs to install and test the assets.

Question 39

how might companies acquire PP&E

Answer 39

purchase them or companies often enter into long-term equipment leases
to increase operational flexibility or to take advantage of attractive financing terms. If the lease
terms extend beyond a year, the equipment is capitalized just like other tangible assets. These
lease assets are included in the company’s balance sheet even though the company does not
legally own the assets. The rationale is that the company operates the assets as if it did own them.
Leased assets typically show up on the balance sheet either as part of the PP&E line item or as a
separate line item called right-of-use (ROU) assets.

Question 40

how to determine depreciation expense

Answer 40

1. Useful life
   —period of time over which the asset is expected to generate measurable benefits.
2. Salvage value
   —amount expected for the asset when disposed of at the end of its useful life.
3. Depreciation method
   —estimate of how the asset is used up over its useful life.

, the company can determine a depreciation rate that approximates how
the asset is used up over its life. The company uses that rate to systematically decrease the asset’s
balance sheet value (called the carrying value) such that, at the end of its useful life, the asset’s
carrying value equals its salvage value. When the asset is sold, the difference between the sales
proceeds and its book value is recorded as a gain or loss on sale in the income statement

Question 41

what’s straight line depreciation

Answer 41

depreciation the asset the same amount each year

Question 42

define accumulated depreciation

Answer 42

sum of all depreciation expense that has been recorded to date.

Question 43

define asset net book value (carrying value)

Answer 43

is cost less accumulated depreciation.

Although
the word
value
is used here, it does not refer to market value. Depreciation is a cost allocation
concept (transfer of costs from the balance sheet to the income statement), not a valuation concept.

Question 44

define accelerated depreciation

Answer 44

record more depreciation in the early years of an asset’s useful
life (hence the term
accelerated
) and less depreciation in later years.

Question 45

define units of production depreciation

Answer 45

records depreciation according to asset use. Specifically, the
depreciation base is cost less salvage value, and the depreciation rate is the units produced and sold
during the year compared with the total expected units to be produced and sold.

common for oil and gas, timber and coal

Question 46

define modified accelerated cost recovery system (MACRS)

Answer 46

an accelerated method, is required
by the U.S. IRS to calculate taxable income.

Question 47

why are R&D costs not capitalized (with the exception of facilities and equipment that have alternative uses)

Answer 47

■
Whether any tangible projects or services will be developed is often uncertain while the R&D
is ongoing. Indeed, many R&D efforts fail to produce any benefits whatsoever.
■
Even for R&D programs that look promising, the timing of future products and services is
uncertain.
■
Salaries for R&D personnel are no different than for other personnel whose salaries and
wages are expensed when incurred.

It is generally acknowledged that R&D costs, especially development costs associated with
clearly defined products for which a workable prototype has been proven, do create future benefits
and have the characteristics of assets. However, the measurement uncertainty argument prevails
and R&D costs are not capitalized under GAAP and, with the exception of general-use R&D
PP&E assets, they are expensed when incurred.

Question 48

when does R&D costs get capitalized

Answer 48

R&D includes costs associated with property and buildings to be used as research facilities

R&D facilities and equip-
ment
are not immediately expensed. If they are
general-use
in nature (such as a general research
laboratory that can be used for many types of activities), the costs are capitalized on the balance
sheet and depreciated over their useful life like other depreciable assets.

Only those R&D facilities
and equipment that are purchased specifically for a single R&D project, and have
no alternative
use
, are expensed immediately in the income statement (an unusual situation)

Question 49

what’s the gain or loss of the sale of a tangible asset

Answer 49

gain or loss on asset sale = proceed from sale - net book value of asset sold

An asset’s net book value is its acquisition cost less accumulated depreciation. When an asset is
sold, its acquisition cost and related accumulated depreciation are both removed from the balance
sheet, and any gain or loss is reported in income from continuing operations.

gains and
losses are usually
transitory operating
income components. Financial statements do not typically
report gains and losses from tangible asset sales because, if the gain or loss is small (immaterial),
companies include the item in selling, general and administrative expenses.

Question 50

how does a transitory gain or loss complicate analysis

Answer 50

1. The gain (loss) will increase (decrease) income in the year of sale, and
2. The gain or loss reflects estimation error, not errors in GAAP, in financial statements.

Question 51

how to handle gain and losses in analysis

Answer 51

1. Do nothing. Accept that prior period income statements, and balance sheets, are likely overestimated
   or underestimated due to these gains and losses.
2. Adjust prior periods’ reports by allocating the gain or loss over the time period of the misestimated
   depreciation and income.

Question 52

what’s impairment of PP&E assets?

Answer 52

Impairment
of PP&E assets is determined by comparing
the asset’s net book value to the sum of the asset’s
expected
future (undiscounted) cash flows. If
the sum of expected cash flow is greater than net book value, there is no impairment. However,
if the sum of the expected cash flow is less than net book value, the asset is deemed impaired
and it is written down to its current fair value (generally, the present value of those expected
cash flows)

companies must write off the impaired cost and recognize losses on those assets if the market values of PP&E assets decrease

Question 53

what is corporate restructuring

Answer 53

designed to turn a company around and are frequently initiated in response to
poor performance, mounting debt, and shareholder pressure. A restructuring can involve eliminat-
ing business segments, selling major assets, downsizing the workforce, and reconfiguring debt.
Ultimately, the goal of a restructuring is to positively impact a company’s long-term financial
performance. But in the short term, restructurings usually have large negative impacts on the
company’s income statement.

Question 54

what costs are in restructuring

Answer 54

1. Employee severance or relocation costs.
2. Asset write-downs.
3. Other restructuring costs.

Question 55

how does a company report of employee severance or relocation costs

Answer 55

represents accrued (estimated) costs to terminate or relo-
cate employees as part of a restructuring program. To accrue those expenses, the company must:
■
Estimate total costs of terminating or relocating selected employees; these costs might include
severance pay (typically a number of weeks of pay based on the employee’s tenure with the
company), outplacement costs, and relocation or retraining costs for remaining employees.
■
Report
total
estimated costs as an expense (and a liability) in the period the restructuring
program is announced. Subsequent payments to employees reduce the restructuring accrual
(the liability).

Question 56

how does a company report of asset write down in restructuring

Answer 56

Restructuring activities usually involve closure or relocation of manufacturing or administrative facilities. This can require the write-down of assets
whose fair value is less than book value. For example, restructurings can necessitate the write-
down of long-term assets (such as plant assets or goodwill) and of inventories.

Question 57

how does a company report other restructuring costs

Answer 57

includes costs of vacating duplicative facilities, fees to terminate
contracts (such as lease agreements and service contracts), and other exit costs (such as legal
and asset-appraisal fees). Companies estimate and accrue these costs and reduce the restructur-
ing liability as those costs are paid in cash.
For a company to use the term
restructuring
in the income statement and to accrue restructur-
ing liabilities, the company is required to have a formal restructuring plan that is approved by its
board of directors. Also, a company must identify the relevant employees and notify them of its
plan. In each subsequent year, the company must disclose in its notes the original amount of the
restructuring liability (accrual), how much of that liability is settled in the current period (such
as employee payments), how much of the original liability has been reversed because of original
cost overestimation, any new accruals for unforeseen costs, and the current balance of the liability.
This creates more transparent financial statements, which allow readers to see, in hindsight, if the
initial restructuring accrual was overstated (requiring subsequent reversal) or understated (requir-
ing subsequent additions to the restructuring accrual).

Question 58

how to analyze employee severance or relocation costs and other costs

Answer 58

Com-
panies are allowed to record costs relating to employee separation or relocation that are
incre-
mental
and that do not benefit future periods. Similarly, other accrued costs must be related to the
restructuring and not to expenses that would otherwise have been incurred in the future. Thus,
accrual of these costs is treated like other liability accruals. We must, however, be aware of over-
or understated costs and their effect on current and future profitability. Disclosure rules require
a reconciliation of this restructuring accrual in future years (see the preceding Business Insight
on Pfizer’s restructuring). A reconciliation reveals either overstatements or understatements:
overstatements are followed by a reversal of the restructuring liability, and understatements are
followed by further accruals. Should a company develop a reputation for recurring reversals or
understatements, its management loses credibility.

Question 59

how to analyze asset write downs

Answer 59

Asset write-downs accelerate (or catch up) the deprecia-
tion process to reflect asset impairment. Impairment implies the loss of cash-generating capabil-
ity and, likely, occurs over several years. Thus, prior periods’ profits were arguably not as high
as reported, and the current period’s profit is not as low. This measurement error is difficult to
estimate and, thus, many analysts do not adjust balance sheets and income statements for write-
downs. At a minimum, however, we must recognize the qualitative implications of restructuring
costs for the profitability of recent prior periods and the current period.

Question 60

what’s PP&E turnover

Answer 60

determining their productivity/utilization of PP&E

PP&E turnover (PPET) = sales/average PP&E (net)

Question 61

why would you want a higher PP&E turnover

Answer 61

Higher PP&E turnover is preferable to lower. A higher PP&E turnover implies a lower capital
investment for a given level of sales. Higher turnover, therefore, increases profitability because
the company avoids asset carrying costs and because the freed-up assets can generate operating
cash flow.
PP&E turnover is lower for capital-intensive manufacturing companies than it is for compa-
nies in service or knowledge-based industries. To this point, consider the following chart of PP&E
turnover for selected industries

from low to high: utilities -> oil, gas, and consumable fuels -> transportation -> chemicals -> consumer discretionary and consume staples -> pharmaceuticals -> biotechnology -> capital goods

Question 62

what’s something to keep in mind for PP&E turnover with leased equipment

Answer 62

PP&E turnover can be overstated if a company has large amounts of leased equipment that is
not
included in the PP&E line item reported on the balance sheet. In that case, we should adjust
PP&E and PP&E turnover to include leased equipment

Question 63

define average useful life of PP&E

Answer 63

average useful life = average depreciable asset cost / depreciation expense

Question 64

what to compute depreciable assets excluding which items

Answer 64

■
Land of $8,719 million, which is never depreciated.
■
Construction-in-progress of $1,297 million, which is not depreciated until the assets under
construction are completed and placed into service, which is when the company begins to
use the assets.

Question 65

what’s PP&E percent used up

Answer 65

estimate the proportion of a company’s depreciable assets that have already been
transferred to the income statement. This ratio reflects the percent of depreciable assets that are
no longer productive

percent used up = accumulated depreciation / depreciable asset cost

Question 66

what’s a general rule for ratios

Answer 66

As a
general rule
for ratios, we use year-end values for both the numerator and denominator
when both are balance sheet numbers; we typically use average balance sheet numbers when a
ratio includes an income statement number

Question 67

how to record acquisition of intangible asset

Answer 67

any of these assets possess enormous value.
In an acquisition, and after the purchase price is allocated to the assets and liabilities that are
reported on the target company’s balance sheet, any excess is allocated to the acquired intangible
assets. Each intangible asset must be identified, valued, and assigned a useful life, just like for
PP&E. Identifying and valuing these intangible assets can be challenging. Consider the value of a
brand name. In theory a brand name’s value is simply the present value of all future cash flows that
the company expects to realize by owning that brand name

they are not often
reported on the acquired company’s balance sheet. Although intangibles are likely to yield future
benefits, it is difficult to reliably measure those benefits.

Question 68

how can intangible assets explain part of wide disparity in company’s market value vs book value in SE

Answer 68

The patent’s economic benefit is valued by the market and reflected in the
company’s share price.

Question 69

how to acquire intangible assets

Answer 69

Most acquired intangible assets arise from
contractual or legal rights
. Other acquired intangible
assets that are not based on contractual or legal rights are recognized if they are
separable
from
the acquired entity—meaning that they could plausibly be sold separately from the company that
owns them.

Question 70

what are the 5 categories of intangible assets

Answer 70

■
Marketing-Related Intangible Assets
●
Trademarks, trade names, service marks, certification marks
●
Trade dress (unique color, shape, package design)
●
Newspaper mastheads
●
Noncompetition agreements
●
Internet domain names
■
Customer-Related Intangible Assets
●
Customer lists*
●
Order or production backlog
●
Customer contracts and related customer relationships
●
Noncontractual customer relationships*
■
Artistic-Related Intangible Assets
●
Plays, operas, ballets
●
Books, magazines, newspapers, literary works
●
Musical works, compositions, song lyrics, jingles
●
Pictures, photographs
●
Audiovisual material, films, videos, TV programs

■
Technology-Based Intangible Assets
●
Unpatented technology*
●
Patented technology
●
Computer software and mask works
●
Databases, including title plants*
●
Trade secrets, secret formulas, processes, recipes
■
Contract-Based Intangible Assets
●
Licensing, royalty, franchise agreements
●
Advertising, construction, management, or supply contracts
●
Lease agreements (whether investee is lessee or lessor)
●
Construction permits
●
Operating and broadcast rights
●
Service contracts, mortgage servicing contracts
●
Employment contracts
●
Use rights such as drilling, water, air, timber, routes

Question 71

are In process research and development depreciated

Answer 71

IPR&D assets are not amortized
initially but are tested for impairment annually. Should the project reach technological feasibility,
AMD will reclassify the IPR&D asset as a finite-life intangible asset and begin to amortize the
asset over its estimated useful life.

Question 72

how is the value of goodwill computed

Answer 72

it is computed
as a residual amount—the amount of the purchase price remaining unallocated after all other assets
and liabilities are identified and valued. Consequently,
if a company overpays for an acquired com-
pany, that overpayment is reflected in goodwill.

Question 73

what are the valuation models for intangible assets

Answer 73

Relief from Royalty Method (RRM)
This method presumes that the company could have
paid royalties to license the use of the intangible asset in question but instead avoided the
royalties by acquiring the asset. The value of the asset is the present value of the avoided roy-
alty payments, net of any applicable tax. RRM is often used to value intangible assets such as
brand names, trademarks, licensed computer software, and in-progress R&D.
■
Multiperiod Excess Earnings Method
This method measures the intangible asset’s antici-
pated earnings that are in excess of an expected return on the asset. The method is similar to
the Residual Operating Income (ROPI) model that we discuss in Module 14. The multiperiod
excess earnings model is frequently utilized when acquiring a business that is a stand-alone
entity or an asset with an identifiable income statement and balance sheet.
■
With and Without Method (WWM)
This method estimates the value of the business
enterprise with and without the asset in question. That is, it compares the value of the enter-
prise assuming the company did not own the asset to the scenario where the company did own
it. The WWM is often used to value noncompete agreements.
■
Real Option Pricing
This approach applies to intangible assets that currently do not gener-
ate cash flows but that have the potential to do so in the future. This method follows that used
to value options in general and works when there exists some future contingent event that will
resolve the underlying “intrinsic” value of the asset. The method is often used for intangibles
such as undeveloped patents and undeveloped natural resources, where future information
about the underlying value (of the project or natural resource, for example) determines the
intangible asset’s value.
■
Replacement Cost Method Less Obsolescence
This method values the asset at the cost
that would be incurred to replace it. This method often works well for software, databases,
and manufacturing processes.

Question 74

how to account for goodwill

Answer 74

Although goodwill is different from other intangible assets, it still must meet the conceptual
definition of an asset if it is to be included on the balance sheet: the goodwill asset must continue
to provide future economic benefits to the company. To that end, goodwill must be evaluated
annually for impairment (i.e., loss of future benefits), and if it is found to be impaired, it must be
written down just like any other impaired asset.
Goodwill is not amortized because it is considered to have an “indefinite,” or
infinite
, life. As
a practical matter, goodwill is not likely to last forever, but its useful life cannot be reasonably esti-
mated at acquisition. Thus, goodwill is not amortized. The same holds true for any indefinite-lived
asset, including land and other indefinite-lived intangible assets such as trademarks, trade names,
and perpetually renewable licenses. Importantly, all indefinite-lived assets (tangible and intangible)
must be evaluated for impairment, at least annually. Companies also must conduct their annual
evaluation at the same time each year to prevent companies from “gaming” the impairment evalu-
ation by conducting it in the first quarter one year and then the fourth quarter in the following year.
From a practical perspective, the goodwill impairment test is straightforward. Companies esti-
mate the fair value of each subsidiary that has goodwill on its balance sheet. It then compares the
estimated fair value of the subsidiary to its carrying value on the parent company’s balance sheet. If a subsidiary’s fair value is less than its carrying value (as adjusted for any other impairments),
the subsidiary’s goodwill is impaired. As such, a goodwill impairment test is a test of whether the
value of the entire subsidiary is impaired.

Goodwill can only be written down to zero. After that point, any fur-
ther decline in the fair value of the subsidiary is not reflected in the company’s income statement
unless that subsidiary is sold.

Question 75

How should we treat the write-down of goodwill or other intangible assets in our analysis of a
company?

Answer 75

First, an intangible asset write-down does
not
have cash flow effects. The write-down
is reflected in the income statement as an expense, which reduces net income and retained earn-
ings. The write-down also reduces the asset’s reported value on the balance sheet.
The write-down does have information effects, How the write-down is interpreted by the market
may rest with the reasons behind it and the way in which the write-down is communicated.

Question 76

how are good will write down seen as?

Answer 76

Goodwill impairments are, by definition, an acknowledgment that companies have made poor
investment decisions. Writing down goodwill allows companies to move on—often taking actions to
improve performance that would have been difficult without formally acknowledging the impairment.
And although many executives fear that any write-down announcement will automatically cause
their company’s share price to tumble, a negative reaction is by no means certain.

The lesson for companies that need to write down goodwill assets is to be as candid with inves-
tors as possible about the nature of the impairment and plans for the future. Abstract plans with
loosely defined goals may leave the problem unresolved in the minds of investors and could cause
the negative share-price reaction that companies wish to avoid. Executives should also record as
much of the impairment or restructuring charges as possible in a single announcement. Delivering
a lot of bad news all at once to investors tends to work better than spooning out smaller bits of bad
news over and over again.

Question 77

what are the 2 options when it comes to goodwill impairement

Answer 77

1. Remove the impairment charge from operating income and adjust tax expense to arrive at adjusted net income.
   This is a proper adjustment when the impairment arises from factors beyond management’s control, for example,
   due to decreased demand during a pandemic or when assets were seized during a violent conflict.
2. Adjust prior periods’ reports by allocating the impairment charge over a proper time period up to the year of
   the acquisition that created the goodwill. This approach would be warranted if management action or inaction
   created the impairment conditions.

Question 78

difference between inventory for IFRS and GAAP

Answer 78

1. IFRS does not permit use of the LIFO method.
2. IFRS permits companies to reverse inventory write-downs; GAAP does not. This means that
   if markets recover and inventory previously “impaired” regains some or all of its value, it can
   be revalued upwards. IFRS notes disclose this revaluation, if material, which permits us to
   recompute inventory and cost of sales amounts that are comparable to GAAP.

Question 79

difference between PP&E for IFRS and GAAP

Answer 79

1. GAAP requires the total cost of a tangible asset to be capitalized and depreciated over its use-
   ful life. Under IFRS, tangible assets are disaggregated into individual components and then
   each component is separately depreciated over its useful life. Thus, assets with components
   with vastly different useful lives can yield IFRS depreciation expense that is markedly differ-
   ent from that computed using GAAP.
2. Property, plant, and equipment can be revalued upward to fair market value under IFRS.
   The latter will cause IFRS book values of PP&E to be higher. Few companies have opted to
   revalue assets upwards but in some industries, such as real estate, the practice is common.
3. U.S. GAAP applies a two-step approach for determining impairments. Step 1: compare book
   value to
   undiscounted
   expected future cash flows; and Step 2: if book value is higher, measure
   impairment using
   discounted
   expected future cash flows. IFRS uses
   discounted
   expected future
   cash flows for both steps, which means IFRS uses one step. This results in more asset impair-
   ments under IFRS.
4. IFRS fair-value impairments for tangible assets can be reversed; that is, written back up after
   being written down. The notes to PP&E articulate such reversals.

Question 80

what’s the difference of R&D in IFRS vs GAAP

Answer 80

All R&D costs are expensed under GAAP whereas IFRS
allows development costs (but not research costs) to be capitalized as an intangible asset if all of
the following six criteria are met.
■
It is technically feasible to complete the asset.
■
The company intends to complete the asset and use or sell it.
■
The company is able to use or sell the asset.
■
The company can use the asset to create economic benefits or there is a profitable market for
the asset.
■
The company has adequate resources to complete the asset.
■
Costs related to the asset can be reliably measured.
For some companies and some industries these intangible assets are significant and the IFRS
financial statements can be markedly different.

Question 81

what’s the difference in restructuring between IFRS and GAAP

Answer 81

1. Under IFRS, restructuring expense is recognized when there is a plan for the restructuring
   and if the affected employees expect the plan to be implemented. Under GAAP, restructuring
   expense can be recognized earlier because the trigger is board approval of a plan.
2. Consistent with other IFRS accruals, a restructuring provision is recorded at its best estimate.
   This is usually the expected value or, in the case of a range of possible outcomes that are
   equally likely, the provision is recorded at the
   midpoint
   of the range. The GAAP estimate
   is at the most-likely outcome; and if there is a range of possible outcomes, the provision is
   recorded as the
   minimum
   amount of the range.