Week 2 - Tangible assets Flashcards
IAS 2 - Inventories
- Important measurement
- Why do we care?
- What are assets?
- Lower of cost and net realisable value (NRV)
- Inventories are intrinsically related to COGS, one of the most significant expenses in I/S
- ie. inventory system captures info about economic reality, past mistakes…
- COGS is a MATCH to REVENUE to reflect economic reality for stakeholders
» COGS = purchases - (ending inv - beginning inv) - Assets = deliver VALUE in the future
- IAS 2 applies to all inventories, except financial instruments, work in progress from contracts, biological assets [IAS 41]
IAS 2 - Inventories
2 systems of tracking inventory
- PERPETUAL system
- tracks units sold directly
- more ACCURATE, more timely, potentially more costly
- mainly for HETEROGENEOUS products (eg. small group of 5 nuclear reactors) - PERIODIC system
- infers Units sold = beginning units + production - ending units
» rmb that we are reporting VALUE instead of quantity, hence can be different from reality
- harder to detect inventory shrinkage, theft, spoilage and fraud
- uses LIFO vs FIFO
*LIFO & FIFO is only relevant for periodic system!
IAS 2 - Inventories
FIFO (first-in-first-out) vs LIFO (last-in-first-out)
FIFO
1. ‘conveyor belt’
2. COGS measured using PAST prices, ENDING INV valued using CURRENT prices
3. with RISING PRICES,
- expenses are lower
- balance sheet value of inventory is higher
LIFO
1. ‘cookie jar’
2. COGS measured using CURRENT prices, ENDING INV valued using PAST prices
3. with RISING PRICES,
- expenses are higher
- balance sheet value of inventory is lower
*does NOT represent economic reality very well b/c COGS = what we are paying now vs Inventory = what we have been paying
IAS 2 - Inventories
FIFO vs LIFO in a normal environment (rising prices, stable/growing inventories)
- FIFO measures assets better
- FIFO overreports earnings (old prices for COGS) but reports more realistically assets - LIFO measures income better
- LIFO underreports assets (old prices for inventory) but reports more realistically COGS - This results in deferment of TAX PAYMENTS as well
*debt investors favour assets, equity investors favour earnings (different INCENTIVES for choosing one method over another!)
4. Ceteris paribus: both will result in the same outcomes
IAS 2 - Inventories
5 reasons for choosing FIFO vs LIFO
- TAX EFFECTS
- Agency conflicts
- optimal compensation using acct. changes
- covenants - Other reasons
- size of firms (political costs); very high profits may draw scrutiny for large firms
- significant bookkeeping costs
IAS 2 - Inventories
In our current inflationary times, would a manager rather report using FIFO or LIFO?
FIFO b/c want to understate expenses and report higher profits.
IAS 16 - PP&E
2 criteria for recognising an asset as PP&E
- Repairs & maintenance are charged to IS (lowers profitability), unless classifies as an asset {hence mgmt has the leeway to choose
- If it is probable that it can generate FUTURE ECONOMIC BENEFITS for the entity {gives biz flexibility to define what counts as PPE}
- the COST of the item can be RELIABLY MEASURED
- PP&E is expected to be used during > 1 period
IAS 16 - PP&E
3 components of depreciation up to management’s discretion
- Useful life
- Salvage value
- Dep. method
- straight-line, reducing balance (or double-declining),
- sum-of-the-year digits, usage
IAS 16 - PP&E
2 options of valuing PP&E
-
COST MODEL
- initially at cost (purchase price + any costs directly attributable to bring asset to necessary condition)
- subsequent measurement of repairs/maintenance, DEPRECIATION
» hence value cannot be adjusted upwards -
REVALUATION MODEL
- FAIR VALUE - (ACC DEP + IMPAIRMENT LOSSES)
» can adjust value UPWARDS/DOWNWARDS
- no cherry picking: all assets of the same class = same model
eg. football clubs for value of players -> show large assets so can take larger loans to make purchases
IAS 16 - PP&E
How to treat Initial & Subsequent Revaluation?
Initial revaluation
1. Increases to OCI (don’t show in earnings but on balance sheet as revaluation surplus)
2. Decreases to P&L
Subsequent revaluation
1. Increases to P&L (offsets previous impairment losses, excess to OCI)
2. Decreases to OCI (offsets previous revaluation surplus, excess to P&L)
IAS 16 - PP&E
Formula for Impairments
Impairment loss = Carrying amount - Recoverable amount
- No assets carried at more than recoverable amount = max[FV – costs to sell, value in use]
- Value in use = PV of future cash flows
IAS 41 Cannabis case - 3 takeaways
-
IAS 41 recommends the use of FAIR VALUES by companies with BIOLOGICAL ASSETS in their inventory.
- These companies are using “ESTIMATES” that could lead to DISTORTIONS in the income statement. This
is not to say that IAS 41 is not adequate but rather to highlight that there is ROOM FOR ABUSE.
» Theoretically, a brand-new commercial production facility that has sown a new crop, taken it through the flowering stage, and not sold a single gram of cannabis could have total revenues of zero and reported net income of millions. - Unsophisticated investors who engage in arbitrary ratio analysis for selecting stocks and who are
not aware of the “NOISE” in profitability measures of cannabis (biological) stocks, could make
DISTORTED INVESTMENT DECISIONS. - OTHER METRICS might become more important when it comes at valuing firms with biological assets:
revenue, quality of management team and potential for scalability among others
Delta Air Lines case - 2 main reasons for changing the useful life & residual values for depreciation
- To reduce annual dep. expenses & to report HIGHER INCOME
- due to Intense competition and deregulation in the airline industry - ECONOMIC CHANGES in asset useful lives
eg. improvements in construction technology, materials used, planned uses, etc.
Delta Air Lines case - FRESH START ACCOUNTING
- An acct. method involving the resetting and REVALUATION of ASSET & LIABILITIES to FAIR VALUE at time of reorganisation
- also includes app. of NEW ACCT. STANDARDS
- creation of NEW EQUITY BASE
- extensive DISCLOSURE REQ.S - Typically when a co. goes through a significant financial restructuring/REORGANISATION
eg. as part of bankruptcy proceedings and M&A - More accurate representation of a company’s financial position following a sig. financial overhaul
Case study: Waste Management
DEPRECIATION FRAUD
1. Deferred current expenses into the future to inflate earnings
- extended estimated USEFUL LIVES of their garbage trucks & increased trucks’ SALVAGE VALUES
- restated fin. stt.s from 1992 to 1996
2. Overstated earnings by $1.7bn
Arthur Andersen was their auditor
