Financial Analysis Exam 2

Inventory & Securities

Current Assets

Assets expected to be converted into cash within the operating cycle or 1 year (whichever is longer)

Cash - What to consider?

Liquidity - how easy is it to turn into cash?

Marketable securities not as liquid —> have to go through broker first

How much is equity and is it subject to declines in value?

How much is unavailable? Cash can be restricted due to bond covenants

Receivables - What to consider?

Collection risk

Is the allowance for bad debt (% we expect not to collect) sufficient?

Is the allowance for returns sufficient?

Securitization (Factoring) - A/R sold to a 3rd party to collect cash immediately, makes A/R look low

Prepaid Expenses

Current assets

Typically low, includes subscriptions, rent, insurance

Inventory Calculations

Beginning Inventory + Purchases = Goods Available for Sale

Goods Available for Sale = Ending Inventory + COGS

Methods for Inventory

Affects allocation between Ending Inventory and COGS, for both unit and cost

Major issue in accounting for consistency

What happens when prices are rising (LIFO, FIFO)?

Under LIFO, IS: COGS higher, NI lower, taxes lower (preferred!)

Under LIFO, BS: Ending Inventory lower

FIFO will be the opposite of all this

Why do firms use LIFO?

In inflationary times, it takes less taxes

IRS says if you use LIFO to report taxes, you must use it to report accounting

Only delays taxes for certain years, eventually you will have to pay all of it

Which is better for economic reality (LIFO vs. FIFO)?

FIFO is better during inflation

LIFO underestimates inventory on the balance sheet and does a poor job of recognizing economics, but it does show gross profit = economic profit

LIFO to FIFO conversion

LIFO Inventory + LIFO Reserve = FIFO Inventory

Long-Term Assets

PP&E + Intangible Assets

Fundamental Issue for LTA

Determining the cost and depreciating that cost over the useful life of the asset

• Affects BS (PP&E, Intangibles)

• Affects NI (Depreciation, Amortization expense)

How to report operational assets on BS?

Historical cost - Accumulated depreciation (BV)

If impaired, write down to reflect lower FMV, writing up assets is NOT allowed

Which expenditures are included in historical cost?

Costs necessary to acquire the asset (purchase price) and make it ready for use (ex. shipping, insurance, taxes, labor, transportation, etc.)

Will current value or BS line item be worth more (PP&E, Intangibles)?

CURRENT VALUE ALWAYS!

Net PP&E and Intangibles on the balance sheet never represent the value that we could get if we sold it because it is based on historical cost (minus depreciation)

Also because of conservatism and that depreciation is not part of valuation

What is included in historical cost for self-constructed assets?

Interest, because firms have to finance big construction projects with loans

Capitalized costs

Costs included in the asset account

Capitalization vs. Expense

Capitalized - placed on balance sheet

• Depreciated over useful life of asset

• Used when asset has useful life of over 1 year

Expensed - immediately reduce NI

Total effect on NI is the same regardless of whether you capitalize or expense, it just changes the timing of NI reductions

Depreciation

Distributes cost, less salvage, over the estimated life of the unit in a systematic manner. It is allocation, NOT valuation!

Intangibles

Have no physical substance, convey certain legal and economic rights, uncertainty associated with future benefits

VERY conservative, difficult to value

Is R&D expensed or capitalized?

Expensed because there is no guarantee that research will produce fruits

Identifiable Intangibles

We know our rights, we know we control it, we have had a transaction to suggest value

Patents, copyrights, trademarks, franchises, licenses

CAN PUT ON BOOKS

Unidentifiable Intangibles

Goodwill - happens when we purchase another business for more than the FV of its net assets

Synergies, customer lists, etc.

How to record intangibles acquired externally?

Capitalize (cost + ready for use) purchase cost and other related costs (ex. legal fees)

How to record intangibles developed internally?

If identifiable then capitalize (EXCEPT R&D), if unidentifiable then expense

As a result, companies do not capitalize much due to non-capitalized R&D

What if a patent is developed internally?

Capitalize filing & legal costs

R&D expensed

How to find intangible values if not recorded?

Letter to shareholders, transactions of other companies, footnotes, news stories, analyst reports

How does inventory affect SHE?

When converting to FIFO, additional NI gets dumped into RE

Debt Securities

Buying the bonds of another company

Have a specified maturity date when debt is paid off

Depends on what you plan to do with the investment

Equity Securities

Buying stock in another company

Represent an ownership interest, can vote and is based on control

Can securities have attributes of both (equity + debt)?

Yes, preferred stock!

Has payments in terms of dividends, yet don’t have control

Management chooses how to classify this

No Significant Influence (Equity)

<20% control

FV method:

Recognized on BS at FV (marked to FMV at EOY)

Unrealized holding gains/losses recognized in NI

Realized gains/losses recognized in NI
Cash dividends recognized as revenue

Significant Influence, But Not Control (Equity)

20-50%

Equity Method:

Recognize on BS at “adjusted value” (recognizing our portion of the earnings)

Unrealized holding gains/losses not recognized

Realized gains/losses are recognized

Cash dividends reduce investment in the investee

Control (Equity)

>50%

Consolidation Method:

Consolidated on the BS and IS (reporting all info as if it was part of your own)

Unrealized holding gains/losses not recognized

Realized gains/losses sometimes recognized (specific rules)

Cash dividends not recognized (getting cash from selves)

Held-to-Maturity

Company has intent/ability to hold to maturity

Goes on BS at amortized cost (PV of future cash flows discounted at MR)

Goes on IS as interest revenue + discount/premium amortization

Sale recognized as realized gain/loss on IS

Change in FV not recognized

Trading (Debt)

Bought and held for sale in the near term to generate income on price differences

Are current assets!

Goes on BS at FV

Goes on IS as interest revenue + discount/premium amortization

Sale recognized as realized gain/loss

Change in FV recognized as unrealized gain/loss

Available-for-Sale (Debt)

Everything that is not trading or held-to-maturity

Goes on BS at FV

Goes on IS as interest revenue + discount/premium amortization

Sale recognized as realized gain/loss

Change in FV (unrealized gain/loss) goes in AOCI, skipping IS

Why did GAAP change how equity investments used to be recorded?

Companies would sell passive investments (treated like AFS) to recognize realized gains in bad years —> earnings management

Other issues for Debt Securities

If there is a permanent decline in value, write it down to a new cost basis and include the loss in income as a realized loss

If MV cannot be determined, use the cost method (what we paid for goes on the books)

Current vs. Non-Current Asset Classification

Trading = current assets

AFS, HTM = could be either… are we selling within the year? when is it maturing?

Equity method securities = noncurrent

Classification in Statement of Cash Flows

Trading = Operating activity, could be investing if a huge company is using excess cash for it

AFS, HTM = Investing activity

Analyzing Investment Securities

Separate operating from investing and financing (if investment is not the core business)

• Remove gains/losses from investments including dividends, interest income, realized/unrealized gains/losses from NI and AOCI

• Remove non-operating assets

Analyze distortions

• Difference between realized and unrealized gains/losses

• Inconsistent definition of equity securities

• Classification based on intent