LDP 2.2 Interpreting Quality and Consistency of BS and IS

Question 1

Examples of Valuation Allowance Accounts

Answer 1

1) allowance for doubtful accounts, with its associated bad-debt expense;
2) liability for future warranty payments, with its associated warranty expense;
3) allowance for obsolete inventory, with its associated COGS expense.

Question 2

Two estimation techniques for bad debt

Answer 2

1) The first is percentage-of-sales. This technique uses historical data to determine the relationship between bad debts and credit sales. The resulting percentage is then applied to the current period’s sales revenues to arrive at the appropriate current-period bad-debt expense.
2) The second technique is aging the accounts, which applies percentages based on the relationship of bad debts to the age of receivables at the balance sheet measurement date. Older receivables are assigned a higher loss percentage, and bad-debt expense is recognized accordingly.

Question 3

Four methods of inventory valuation that are permitted by GAAP.

Answer 3

1) Specific Identification
2) Average Cost
3) FIFO
4) LIFO

Question 4

Misc Notes

Answer 4

• Balance sheet items usually begin with cash, the most liquid asset, and descend to the least liquid, non-current assets. This arrangement is useful because the most liquid assets are the most readily available to repay loans.
• Current assets are assets expected to be converted to cash in the normal course of business or to be collectible within one year.
• Under GAAP, companies are required to use the allowance method to account for bad-debt expense.
• A company that uses the allowance method does not expense, or write off, uncollectible accounts when the losses actually happen.

Question 5

Four factors to consider to assess asset quality

Answer 5

1) restrictions on the use of the asset
2) net realizable value of the asset
3) the company’s ability to operate without the asset
4) time required to convert the asset to cash.

Question 6

How are the securities classified (under SFAS 115)?

Answer 6

1) held-to-maturity securities
- debt securities the company has the intent and ability to hold to maturity
- shown at amortized cost on the balance sheet
- with any realized gains and losses taken into income when sold

2) trading securities
- which the company intends to sell in the short term
- must be reported at fair value
- both realized and unrealized gains and losses must be taken into current period income

3) available-for-sale securities
- which the company classifies neither as held-to-maturity or as trading
- must also be recorded at fair value
- realized gains and losses must be taken into current period income and unrealized gains and losses must be included in Other Comprehensive Income (owner’s equity).

Question 7

Causes of Deferred tax assets

Answer 7

• represent tax deductions that a company expects to realize value from in the future.
  Causes:
  1) most common is due to loss carryforward
  2) temporary difference between when an expense is recognized by GAAP for financial reporting purposes vs. IRS allows it as a deduction (ie. warranty costs, some litigation exp.)
  3) when revenues may be recognized (ie. prepaid rental income, service contract revenue)

Question 8

Commitments

Answer 8

Commitments, such as orders to purchase fixed assets, usually have a known, specific amount and a definite due date, but are not yet direct liabilities because some other party has to do something, such as deliver or install equipment, before the company is actually obligated to pay.

Another example is operating leases

Question 9

Contingency

Answer 9

• an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss.
• most common are corporate guarantees and from lawsuits in progress

Question 10

Three types of contingencies

Answer 10

1) Take-or-pay contracts - the purchaser of goods agrees to pay specified fixed or minimum amounts periodically in exchange for products, even if delivery is not taken (ie. grower contract)
2) Litigation
3) Guarantees

Question 11

General Partnership

Answer 11

• a separate legal entity, but is usually disbanded on the death of a partner
• each partner is fully liable for the obligations of the partnership
• taxed individually on their share of business profits

Question 12

Limited liability partnership

Answer 12

• Partners are liable for debts of partnership that existed prior to registration but not for new debts incurred since registration
• single taxation applies, so partners are taxed individually on their share of business profits.

Question 13

Limited liability company

Answer 13

• members have no personal liability even though they manage the company
• Personal guarantees are needed to make members liable for LLC debts
• members are taxed individually on their share of the profits

Question 14

Limited partnership

Answer 14

• general partner manages the business and limited partners contribute capital but are not active in the business.
• Limited partners are liable for partnership obligations only to the extent of their investment.
• the lenders must take special steps in structuring and documenting the loan, such as obtaining guarantee agreements from limited partners
• partners are taxed individually

Question 15

Joint ventures

Answer 15

• taxed individually

Question 16

Corporation

Answer 16

• owners’ potential for loss is limited to the amount of their investment
• They are not personally liable for obligations of the corporation
• Regular corporations are double-taxed on corporate income and dividends
• subchapter S corporations do not pay taxes; their owners are taxed individually on their shares of the profits