2.2 Measuring and Reporting Financial Performance

Accrued Expense

• also known as accrued liabilities, refers to an expense that recognized on books before it has been paid. They are incurred in the current period without being paid until the next period

• common examples include wage, interest, and utilities expenses

• these accrued expenses accumulated (accrue) over time, so should be recognized as expenses on income statement

• at the time, accrued expenses represent a company’s obligation to make future cash payments, they should also show on a company’s balance sheet as current liabilities

Prepaid Expense

• the future expenses that has been paid in advance

• it is not adequate to recognize it as an expense as related revenue has not occurred when the payment is prepaid (violating matching principle)

• because pre-payment represents a future right, can be seen as a type of asset under firm’s control. It is thus recognized as asset on the balance sheet

• common examples include rent, insurance, and advertising

Depreciation

the process of allocating the cost of buildings and equipment over their productive using systematic and rational method

Depreciation Expense

• When fixed assets are expected to provide economic benefits beyond one accounting period

• according to matching principle, expense should be matched to periods when it generates revenue

• the amount of depreciation recorded during each period is reported on the income statement as Depreciation Expense

3 Pieces of Information to Calculate Depreciation Expenses

1. Estimated useful life

2. Estimated residual (or salvage) value at the end of the assets’ useful life

3. Depreciation method

2 Methods to Calculate Depreciation

• Straight-line method: evenly allocate the expenses over its useful life

• Reducing-balance method: higher depreciation to be recognized in early years

Straight-Line Depreciation Method

Straight-line depreciation method allocates equal amount of depreciation expense each period over its useful life of the asset. It is chosen if the asset is expected to provide benefits evenly over time. It is the most comment method

Straight-Line Formula

(Cost - Residual) x 1/Useful Life = Depreciation Expense

Reducing-Balancing Method

• an accelerated depreciation method that allows higher depreciation to be recognized in early years

• some certain assets produce more revenue in early lives because they are more efficient than in later years, managers should choose accelerated depreciation which allows higher depreciation to be recognized in early years

• this is consistent with matching principle that expenses and revenues should be matched

• the most common rate is 200% and when 200% rate is used, it is also referred to as double-declining balance method

Reducing-Balancing Method Formula

(Cost - Accumulated Depreciation) x 2/Useful Life = Depreciation Expense

Impact of Alternative Depreciation Methods

• accelerated depreciation methods report higher depreciation and therefore, lower net income during early years of an asset’s life. As the age of the asset increase, this effect reverses

• differences in depreciation methods rather than real economic differences can cause significant variation in reported net incomes

• managers determine which depreciation method provides the best matching of revenues and expenses

• financial analysts are particularly interested in changes in accounting estimates because they can have a large impact on a company’s before-tax operating income

Flow of Inventory Costs (Merchandising)

In merchandising (wholesale and retailers), the flow of inventory costs is relatively simple. When merchandise is purchased, the merchandise inventory account is increased. When goods are sold, cost of goods sold is removed from the raw materials inventory and added to the work in process inventory

Flow of Inventory Costs (Manufacturing)

1. Raw materials (also called direct materials) must be purchased

2. When they are used, the cost of these materials is removed from the raw materials inventory and added to the work-in-process inventory

3. Two other components of manufacturing cost, direct labor and factory overhead, also are added to the work-in-process inventory when they are used

   1. Direct Labor Cost represents the earnings of employees who work directly on the products being manufactured

   2. Factory Overhead Costs include all other manufacturing costs

      1. When the goods are ready for sale, the related amounts in work-in-process inventory are transferred to finished goods inventory

      2. When the finished goods are sold, cost of goods sold increases and finished goods inventory decreases

3 Stages of Inventory Cost Flows

1. The first involves purchasing and/or production activities

2. In the second stage, these activities result in additions to inventory accounts on the balance sheet

3. In the third stage, inventory items are sold and the amounts become cost of goods sold expense on the income statement

Cost of Goods Sold Equation

Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold

Calculating Costs of Goods Sold

1. Each accounting period starts with stock of inventory called beginning inventory (BI)

2. During the accounting period, new purchases (P) are added to inventory.

3. The sum of the two amounts is the goods available for sale during that period. What remains unsold at the end of the period becomes ending inventory inventory (EI) on balance sheet.

4. The portion of goods available for sale that is sold becomes cost of goods sold on the income statement. The ending inventory for one accounting period then becomes the beginning inventory for the next period.

5. The relationship between these various inventory amounts are brought together in the cost of goods sold equation

Inventory Cost Methods

• when inventory costs have changed during an accounting period, which inventory costs are treated as sold or remaining in inventory can turn profits into losses and cause companies to pay or save millions in taxes

• the 4 inventory costing methods are alternative ways to assign the total dollar amount of goods available for sale between (1) ending inventory and (2) cost of goods sold. The Specific Identification method identifies individual items that remain inventory or are sold. The remaining three methods assume that the inventory costs follow a certain flow

Four Generally Accepted Inventory Costing Methods

1. Specific Identification

2. First-in, first-out (FIFO)

3. Last-in, first-out (LIFO)

4. Average cost

Cost Flow Assumptions

• the choice of an inventory costing method is not based on the physical flows of goods on and off the shelves

Specific Identification Method

• the cost of each item is individually identified and recorded as cost of goods sold

• this method requires keeping up-to-date track of the purchase and sell of each item in inventory

• this method is impractical when large quantities are stocked. It is suitable when dealing with items such as houses, or fine jewelry

First-In, First-Out (FIFO) Method

• this method assumes that the earliest goods purchased are the first goods sold, and the last goods purchased are left in the inventory

• under FIFO, cost of goods sold and ending inventory are computed as if the flows in and out of the FIFO inventory bin commence with the first goods purchased for the inventory

• FIFO allocates the oldest unit costs to cost of goods sold and the newest unit costs to ending inventory

• Accepted by the US GAAP & the IFRS

Last-In, First-Out (LIFO) Method

• this method assumes that the most recently purchased goods (the last ones in) are sold first and the oldest units are left in the ending inventory

• LIFO allocates the newest unit costs to cost of foods sold and the oldest unit costs to ending inventory

• Accepted only by the US GAAP

Average Cost Method (Weighted Average Cost Method)

• this method uses the weighted average unit cost of goods available for sale for both cost of goods sold and ending inventory

• when using the weighted average, we assign the average cost of the goods available for sale to cost of goods sold. The average cost is determined by dividing the cost of goods available for sale by the number of units available of sale

• Accepted by the US GAAP & the IFRS

Effects of Inventory Costing Methods on the Financial Statement

• the method that gives the highest ending inventory amount also gives the lowest cost of goods sold, and the highest gross profit, income tax expense and net income amounts, and vice versa.

Effects of LIFO & FIFO Methods on the Financial Statement

When unit costs are rising, LIFO produces lower net income and a lower inventory valuation than FIFO. Even in inflammatory times, some companies cost decline. When unit costs are declining, LIFO produced high net income and higher inventory valuation that FIFO.

Two Factors that Determine Accounting Method Choice

• Net Income Effects: managers prefer to report higher earnings for their companies

• Income Tax Effects: managers prefer to pay the least amount of taxes possible

Accounting rules require companies to apply their accounting methods on a consistent basis over time. A change in method is allowed only if the change will improve the measurement of financial results and financial position

Any conflict between the two motives is usually resolved by choosing one accounting method for external financial statements, and a different method for preparing tax returns

The LIFO Conformity Rule

this rule states that if LIFO is used to compute taxable income, it must also be used to calculate inventory and cost of goods sold for financial statements

LIFO and Conflicts Between Managers’ and Owners’ Interests (A Question of Ethics)

Company managers may have an incentive to select a method that is not consistent with the owner's objectives, if their compensation is tied to the profits. This is engaging in questionable ethical behavior