PTD3 Flashcards
Bosco Corp. Financial Statements Footnote
The following commonly used ratios . A 365-day fiscal year is assumed where needed.
Ratio/Measure Value Ratio/Measure Value
Liquidity ratios: Activity ratios:
Inventory turnover 7.40
Accounts receivable turnover 9.50
Accounts payable turnover 7.80
Determine Operating Cycle
Determine Cash Conversion Cycle
88 OP
41 CASH
The length of operating cycle (Bosco) is 87.74 days, rounded to 88.
The operating cycle is defined as the average period of time between the acquisition of inventory until the collection of cash from the sale of that inventory. The shorter the operating cycle, the shorter the time the business has its funds tied up in its primary business process and the more quickly it will recognize the results of that process. The operating cycle is calculated as: Number of days’ supply in inventory + Number of days’ sales in accounts receivable.
The number of days’ supply in inventory is determined by dividing the inventory turnover rate into the number of days in the firm’s fiscal period. For Bosco, that calculation is:
365 days (given)/7.40 times (given) = 49.32 days.
The number of days’ sales in accounts receivable is determined by dividing the accounts receivable turnover into the number of days in the firm’s fiscal period. For Bosco, that calculation is 365 days (given)/9.50 times (given) = 38.42 days.
Thus, the length of Bosco’s operating cycle would be:
Number of days’ supply in inventory 49.32 days
Number of days’ sales in account receivable 38.42 days
Days in operating clycle 87.74 days
Length of Cash Conversion Cycle
The length of cash conversion cycle (Bosco) is 40.95 days, rounded to 41.
The cash conversion cycle is defined as the average period of time between when cash is paid to suppliers of inventory until the collection of cash from the sale of that inventory. Notice that, unlike the operating cycle, which measures from the acquisition (not payment for) inventory until cash is collected from the sale of that inventory, the cash conversion cycle measures from the payment for inventory until cash is collected from the sale of that inventory. It measures from the time cash is paid until related cash is received. The difference is the period during which the obligation for the payment of inventory is an account payable. Thus, the cash conversion cycle is calculated as: Number of days’ supply in inventory + Number of days’ sales in accounts receivable – Number of days’ purchases in accounts payable. If the operating cycle is known, the cash conversion cycle also can be computed as: Number of days in operating cycle – Number of days’ sales in account payable.
As computed above:
Number of days’ supply in inventory 49.32 days
Number of days’ sales in account receivable 38.42 days
The number of days’ purchases in accounts payable is determined by dividing the accounts payable turnover rate into the number of days in the firm’s fiscal period. For Bosco, that calculation is:
365 days (given)/7.80 times (given) = 46.79 days.
Therefore, Bosco’s cash conversion cycle is:
Number of days’ supply in inventory 49.32 days
Number of days’ sales in account receivable 38.42 days
Subtotal – Operating cycle 87.74 days
Less: Number of days’ purchases in account payable −46.79 days
Days in cash conversion cycle 40.95 days
DEFINE Operating Cycle
DEFINE Cash Conversion Cycle
Determine Operating Cycle
Number of days’ supply in inventory + Number of days’ sales in accounts receivable
Determine Cash Conversion Cycle
Number of days’ supply in inventory + Number of days’ sales in accounts receivable − Number of days’ purchases in accounts payable
DO EACH OF THE BELOW AFFECT THE OPERATING CYCLE AND THE CASH CONVERSION CYCLE?
1 Extend its credit terms to customers from 30 days to 40 days (i.e., offer 2/10, n/40)
2 Implement a lockbox system that would result in accounts receivable being collected 2 days sooner
3 Stretch (delay) payments on its trade accounts payable Arrange with inventory suppliers to make smaller, more frequent deliveries of inventory
4 Identify and eliminate very slow-moving inventory items
1 Action Operating Cycle Cash Conversion Cycle
2 Extend its credit terms to customers from 30 days to 40 days (i.e., offer 2/10, n/40)
No
No
3 Implement a lockbox system that would result in accounts receivable being collected 2 days sooner
Yes
Yes
4 Stretch (delay) payments on its trade accounts payable
No
Yes
5 Arrange with inventory suppliers to make smaller, more frequent deliveries of inventory
Yes
Yes
6 Identify and eliminate very slow-moving inventory items
Yes
Yes
With the passage of the Sarbanes-Oxley Act in 2002, the Securities and Exchange Commission (SEC) asked the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) to develop additional guidance to companies on the role and membership of audit committees so as to improve the effectiveness and independence of audit committees in response to an inquiry from a senior manager of a company that is considering going public, write a memo discussing the expanded role of a company’s audit committee in light of the provisions of the Sarbanes-Oxley Act.
Type your communication in the response area below.
The Enron-era scandals convinced Congress that something was amiss in U.S. corporate governance. Therefore, many of the reforms contained in the Sarbanes-Oxley Act of 2002 (SOX) were aimed at improving that governance, despite the fact that this is an area of the law traditionally relegated to the states. One of the most significant of these changes is that Congress mandated a major alteration in the operation and responsibilities of the audit committees of public companies.
SOX requires public companies to create audit committees composed entirely of independent directors who are not officers of the company and do not have other significant ties to the firm. In addition, the audit committees should contain at least one “financial expert” who has the experience and knowledge necessary to evaluate the financial statements. SOX makes four changes that render these audit committees powerful and influential.
Almost all of the Enron-era scandals involved huge accounting frauds. There was evidence that CEOs and CFOs of major companies frequently pressured audit firms into accepting inappropriate treatments of various transactions and structures. Arguably, they had leverage to do this because officers hired, fired, and compensated outside auditors. Therefore, SOX first requires that auditors be selected, evaluated, and terminated by the independent directors composing the audit committee.
Second, because conflicts of interest arise when supposedly independent auditors also provide consulting services to their audit clients, SOX prohibits auditors from performing most consulting services for public company audit clients. Those that are permitted, such as tax services, must be disclosed to, and preapproved by, the audit committee.
Third, because several Enron-era scandals involved situations where boards of directors were not informed of disputes that company officers had with external auditors regarding the appropriateness of certain accounting treatments, SOX requires that the outside auditors report to the audit committee regarding (a) all critical accounting policies and practices to be used; (b) all alternative treatments discussed with management and their ramifications; and (c) other material communications between the auditor and management, such as a schedule of unadjusted differences.
Fourth, remembering the role that Sherron Watkins played in disclosing the Enron frauds, Congress instructed in SOX that audit committees are to create procedures for receiving, retaining, and treating complaints about accounting procedures and internal controls and for protecting the confidentiality of these whistleblowers.
In summary, Congress used SOX to refashion the audit committee of public companies and gave these committees substantial authority to guard the integrity of the financial statements issued by these companies.
Thank you,
Future CPA
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Economic Value Added (EVA(R)) is a relatively new metric, while residual income (RI) has been around for many years. The division manager, Jim Cole, has heard that residual income is helpful in preventing the diluted hurdle rate problem but does not know what the diluted hurdle rate problem is or how EVA(R) and RI differ. In an effort to help Jim understand the issues involved, write a memo to Jim that explains how EVA(R) is both similar to and different from residual income, defining EVA(R) and RI in the process. Also, explain the diluted hurdle rate problem by using an example, and explain how using EVA (R) or RI solves the problem.
Economic value added is defined as net operating profit after taxes, less the weighted average cost of capital multiplied by total assets minus current liabilities. Economic value added is a specific form of residual income. Residual income is defined as income less required return on investment multiplied by the investment base. Consequently, economic value added defines the elements of residual income more precisely.
Here is an example to explain the diluted hurdle rate problem. A manager with incentive compensation based on return on investment has four assets with an average return of 28%. The manager has idle cash to invest in a project that is expected to achieve a return of 25%. The company has a hurdle rate (which can be defined as the required minimum return target) of 20%. Given these circumstances, the manager will be unwilling to invest in a project earning any amount less than the current 28% because it would dilute or reduce the current average return on the total.
This conclusion is bad for the company since the cash will remain unused. Since both residual income and economic value added are expressed in dollars, any increase in income from an acceptable investment will increase the manager’s potential compensation. Therefore, comparison between investments is not influenced by returns previously earned on prior investments.
Thank you,
Future CPA
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