451 test 2

What is the preferred direction for accounts receivable turnover?

Higher, because the company is collecting faster.

What is the preferred direction for days sales outstanding?

Shorter, because cash comes in sooner.

What is the preferred direction for inventory turnover?

Higher, because inventory sells faster and there is less obsolescence risk. ★ Inventory turnover is lower under FIFO than under LIFO

What is the preferred direction for days inventory outstanding?

Shorter, because there are fewer days to sell.

What is the preferred direction for property, plant, and equipment turnover?

Higher, because there are more sales per dollar of assets.

What is the preferred direction for accounts payable turnover?

Lower, because paying slowly is free financing from suppliers.

★ A firm is "leaning on the trade" more when it has lower APT and higher DPO. Leaning on suppliers for financing

What is the preferred direction for days payable outstanding?

Longer, for the same reason: paying slowly is free financing from suppliers

What effect does the ADA provision have on the balance sheet and net operating assets?

Reported accounts receivable down, net operating assets down.

What effect does the ADA provision have on income and net operating profit after tax?

Bad debt expense up, net operating profit before tax down.

What is JE for ADA provision?

Debit Bad Debt Expense, credit Allowance for Doubtful Accounts.

What effect does an accounts receivable write-off have on the balance sheet and net operating assets?

No change

What effect does an accounts receivable write-off have on income and net operating profit after tax?

No change

What is the key point of an accounts receivable write-off?

Debit Allowance for Doubtful Accounts, credit Gross Accounts Receivable.

What effect does underestimating the ADA have on the balance sheet and net operating assets?

Net operating assets higher.

What effect does underestimating the ADA have on income and net operating profit after tax?

Current income higher, future income lower.

What is the key point of underestimating the ADA?

Income shifts from the future to the current period.

What effect does overestimating the ADA have on the balance sheet and net operating assets

Net operating assets lower.

What effect does overestimating the ADA have on income and net operating profit after tax?

Current income lower, future income higher

What is the key point of overestimating the ADA?

: Cookie jar (income is saved for later periods).

What effect does an inventory write-down have on the balance sheet and net operating assets?

Inventory, net operating assets, and equity down.

What effect does an inventory write-down have on income and net operating profit after tax?

Cost of goods sold up now, down later.

What is the key point of an inventory write-down?

Debit Cost of Goods Sold, credit Inventory. . If the cost on the books is more than what you could sell it for, you must write it down.

What effect does a LIFO liquidation have on the balance sheet and net operating assets?

The LIFO reserve shrinks

What effect does a LIFO liquidation have on income and net operating profit after tax?

Cost of goods sold lower, gross profit higher.

What is the key point of a LIFO liquidation?

It is not sustainable, A LIFO liquidation happens when units sold > units purchased, so the company digs into old, cheap inventory layers that built up over the years, opposite of the LIFO effect

What effect does an asset impairment have on the balance sheet and net operating assets?

Property, plant, and equipment and net operating assets down.

What effect does an asset impairment have on income and net operating profit after tax

Operating expense up, net operating profit after tax down

What is the key point of an asset impairment

Debit Impairment Loss, credit Property, Plant, and Equipment

What effect does a valuation allowance have on the balance sheet and net operating assets?

Deferred tax asset, net operating assets, and equity down

What effect does a valuation allowance have on income and net operating profit after tax?

Tax expense up, net operating profit after tax and net income down

: What is the key point of a valuation allowance

It reverses if realization becomes likely, •     

If it is ★ "more likely than not" (more than 50% chance) that some or all of the DTA will not be realized, the company must record a ★ Valuation Allowance (VA), a contra-asset.

Reported DTA = Gross DTA − VA

Dr. Tax Expense, Cr. Valuation Allowance.

What effect does underestimating warranty have on the balance sheet and net operating assets?

Liability lower, net operating assets higher

What effect does underestimating warranty have on income and net operating profit after tax?

Expense lower, net operating profit after tax and net income higher

What is the key point of underestimating warranty

Debit Warranty Expense, credit Warranty Liability.

What effect does a bond repurchase gain have on the balance sheet and net operating assets

Bond liability removed

What effect does a bond repurchase gain have on income and net operating profit after tax

A gain is recorded

What is the key point of a bond repurchase gain

It is accounting only, not economic

the gain or loss reflects ★ changes in market interest rates between issuance and repurchase. If rates went up, the bond is worth less on the market, so buying it back costs less than book value, and the company records a gain.

What effect does a stock buyback have on the balance sheet and net operating assets

Equity down

What effect does a stock buyback have on income and net operating profit after tax

No effect on net income

What is the key point of a stock buyback

Treasury stock is contra-equity.

Stock buybacks affect EPS and the debt-to-equity ratio. Why (my explanation of direction): fewer shares outstanding means earnings are divided among fewer shares, so EPS goes up. Equity shrinks, so debt-to-equity goes up

What is the key point of a cash dividend

It is not an expense

What effect does equity method vs. consolidation have on the balance sheet and net operating assets?

Leverage understated. (debt)

• the investee's debt never appears on the investor's balance sheet, so total debt looks smaller.

What effect does equity method vs. consolidation have on income and net operating profit after tax?

Net operating profit margin overstated

•      equity income is included in NOPAT (it is operating), but the investee's sales are not in the denominator. So the profit is counted without the sales that produced it.

What is the key point of equity method vs. consolidation?

Return on equity is unchanged

net income attributable to the investor and equity attributable to the investor are the same under both methods (1,560 and 12,200 in the example).

What effect does the operating lease under ASC 842 have on the balance sheet and net operating assets?

: Net operating assets, net nonoperating obligations, and leverage up (debt)

What effect does the operating lease under ASC 842 have on income and net operating profit after tax?

Net operating asset turnover and return on net operating assets down.

What is the key point of the operating lease under ASC 842?

The lease asset is operating, and the lease liability is nonoperating

What effect does a finance vs. operating lease have on income and net operating profit after tax?

Early expense is higher under a finance lease

What is the key point of finance vs. operating leases?

Cash flow from operations is higher under a finance lease.

What effect does an underfunded pension liability have on the balance sheet and net operating assets?

Net operating assets lower (it is an operating liability).

What effect does an underfunded pension liability have on income and net operating profit after tax?

Only service cost hits net operating profit before tax.

What is the key point of an underfunded pension liability?

It needs future cash funding

In rising prices, what does FIFO do?

Lower cost of goods sold, higher profit, higher taxes, higher inventory, lower turnover.

In rising prices, what does LIFO do?

Higher cost of goods sold, lower profit, lower taxes, lower inventory, higher turnover.

How is the balance sheet affected by an investment under 20% (fair value)?

The investment is reported at fair value.

How is the income statement affected by an investment under 20% (fair value)?

dividends received increase pretax income, and ★ unrealized gains and losses from fair value changes directly affect net income during the holding period.

How is the income statement affected by a 20 to 50% investment (equity method)?

Equity income hits net income. Dividends do not.

How is the balance sheet affected by an investment over 50% (consolidation)?

: Assets and liabilities are combined, and noncontrolling interest is shown.

How is the income statement affected by an investment over 50% (consolidation)?

Sales and expenses are combined, and net income is split with noncontrolling interest.

How is the balance sheet affected by a 20 to 50% investment (equity method)?

Reported at cost plus equity income minus dividends. It is not affected by fair value changes.

how does income shift ADA is under or over estimated?

Underestimate ADA = income shifts from future to current. Overestimate = current to future

what is lifo reserve

•  a contra-asset account that reduces inventory. Its ending balance equals the ★ difference in ending inventory between FIFO and LIFO. It captures the ★ cumulative LIFO effect since the company adopted LIFO.

What is lifo charge

the ★ difference in COGS:(current year change in LIFO reserve) LIFO COGS − FIFO COGS. It is the effect for just the current period. The ★ change in the LIFO reserve equals the LIFO charge for the year

LIFO reserve adjusting entry to reduce inventory

Dr. lifo charge

Cr. lifo reserve

Average useful life why it matters (asset cost/Dep. exp)

a longer assumed life means less depreciation expense each year, which makes income look higher.

Asset impairment test

1.     Test: is the sum of ★ undiscounted expected future cash flows less than the asset's net book value?

2.     If no: no impairment, do nothing.

If yes: the asset is impaired. Write it down to ★ fair value, which is often the sum of ★ discounted expected cash flows.

Asset impairment effects

★ lower NOPAT (the loss is an operating expense) and ★ lower NOA (the asset is smaller).

Why it is a manager-discretion item: the cash flow forecasts are the manager's own estimates, and nobody likes announcing a big loss. Managers have an incentive and the room to delay recognizing impairments

Discounted bonds

carrying value increases and interest expense keeps rising

cash dividend effects on RE and income, and BS

no effect on either, BS: Cash down

stock dividend effects on RE and contributed capital

reduce retained earnings but increase contributed capital. No cash leaves the company. It is just a move from one equity account to another, so total equity does not change

How much is RE ruduced by by a less than 20% stock dividend and a more than 20% stock dividend.

Less than 20% Market Value

More than 20% Par value

Examples shown in the Statement of Comprehensive Income:

•      Pension remeasurements: gains or losses when actuarial assumptions change in a defined benefit pension plan.

•      Derivative fair value changes: unrealized gains or losses on derivatives.

Pro-forma consolidation - what does it do

1.     Reverse out the equity method. Balance sheet: remove the Equity Method Investment account and take the same amount out of total equity. Income statement: remove Equity Income and take the same amount out of net income.

2.     Apply consolidation. Combine the investor's and investee's balance sheets and income statements.

3.     Allocate noncontrolling interest proportionally where appropriate.

Non-controlling interest is:

NCI = outsider % × investee equity (balance sheet) and × investee NI (income statement).