module 6 solutions

Module 6

Reporting and Analyzing Operating Assets

DISCUSSION QUESTIONS

Q6-1. When a company increases its allowance for uncollectible accounts, it also records bad debt expense in the income statement. If a company overestimates the allowance account, bad debt expense is too high and net income is understated. As well, accounts receivable (net of the allowance account) and total assets are both understated on the balance sheet. In future periods, the company will not need to add as much to its allowance account since it is already overestimated (or, it can reverse the excess existing allowance balance). As a result, future net income will be higher.

On the other hand, if a company underestimates its allowance account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense as accounts are written off.

Q6-2. If inventory costs are stable, the per unit dollar cost of inventories (beginning or ending) tends to be approximately the same under different inventory costing methods and the choice of method does not materially affect net income. To see this, remember that FIFO profits include holding gains on inventories. If the inflation rate is low (or inventories turn quickly), there will be less holding gains (inflationary profit) in inventory.

©Cambridge Business Publishers, 2013Solutions Manual, Module 6 6-1

Q6-3. FIFO holding gains occur when the costs of earlier purchased inventory are matched against current selling prices. Holding gains on inventories increase with an increase in the inflation rate and a decrease in the inventory turnover rate. Conversely, if the inflation rate is low or inventories turn quickly, there will be fewer holding gains (inflationary profit) in inventory.

Q6-4. If inventory costs are rising, (a) Last-in, first-out yields the lowest ending inventory (b) Last-in, first-out yields the lowest net income, (c) First-in, first-out yields the highest ending inventory, (d) First-in, first-out yields the highest net income, (e) Last in, first-out yields the highest cash flow because taxes are lowest.

Q6-5. When costs are consistently rising, LIFO inventory costing method yields a significant tax benefit because LIFO increases COGS which reduces pretax income and taxes payable.

Q6-6. Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule. When the replacement cost for inventory falls below its (FIFO or LIFO) historical cost, the inventory must be written down to its replacement cost (market value). The rationale is that, if market value has dropped, the inventory cost overstates the future economic benefit of selling the inventory.

Q6-7. As an asset is used up, its cost is removed from the balance sheet and transferred to the income statement as expense. Capitalization of costs onto the balance sheet and subsequent removal as expense is the essence of accrual accounting. If a depreciable asset is immediately expensed upon purchase, profit would be too low in the year of purchase and too high in later years as revenues earned by the asset are not matched with a corresponding cost. The proper matching of expenses and revenues is essential for proper income measurement.

Q6-8. When a company revises its estimate of an asset's useful life or its salvage value, depreciation expense must be recalculated. One way is to depreciate the current undepreciated cost of the asset (original cost – accumulated depreciation) using the revised assumptions of remaining useful life and salvage value.

©Cambridge Business Publishers, 2013Financial & Managerial Accounting for MBAs, 3rd Edition6-2

Q6-9. PPE is considered to be impaired when the sum of the asset’s undiscounted expected future cash flows is less than its current net book value. An impairment loss is calculated as the difference between the asset's net book value and its current fair value.

Q6-10. The primary benefit of accelerated depreciation relates to tax reporting – higher depreciation deductions in the early years of the asset’s life reduce taxable income and income taxes. This increases cash flow that can be invested to yield additional cash inflows (e.g., an "interest-free loan" that can be used to generate additional income). Companies generally prefer to receive cash inflows sooner rather than later in order to maximize this investment potential.

Q6-11. The gain or loss on the sale of a PPE asset is calculated as the difference between the sales proceeds and the asset's net book value. Sales proceeds in excess of net book values create gains; sales proceeds less than net book values cause losses. Factors that affect the size of the gain or loss include the amount of sales proceeds (the selling price) and depreciation assumptions. Because accumulated depreciation at the time of the asset’s sale affects the net book value, the depreciation rate and salvage values used to compute depreciation expense affect the gain or loss.


MINI EXERCISES

M 6-12 (10 minutes)

a. To bring the allowance from $500 to the desired balance of $2,100, the company will need to increase the allowance account by $1,600, resulting in bad debts expense of that same amount.

b. The net amount of Accounts Receivable reported in current assets is calculated as follows: $98,000 $2,100 = $95,900.

M 6-13 (15 minutes)

a. Credit losses are incurred in the process of generating sales revenue. Specific losses may not be known until many months after the sale. We set up an allowance for uncollectible accounts so that the expense of uncollectible accounts falls in the same accounting period as the sale. As well, the allowance ensures that we report accounts receivable at their estimated realizable value at the end of the accounting period. If we did not have an allowance, our net income and assets would be overstated and that could place you and all the directors in a risky position.

b. The balance sheet presentation shows the gross amount of accounts receivable, the allowance amount, and the difference between the two, the estimated net realizable value. The balance sheet, thus, reports the net amount that we expect to collect. That is the amount that is the most relevant to financial statement users and to the board of directors as they assess the company’s financial performance.

c. Accrual accounting requires that expenses (credit losses) be recorded in the income statement as incurred and not as paid. This dictates the use of the allowance method. Recognition of expense only upon the write-off of the account would delay the reporting of likely losses and, thereby, reduce the informativeness of the income statement. Accountants believe that providing more timely information justifies the use of estimates that may not be perfectly precise.


M 6-14 (20 minutes)

a. ($ millions) 2010 2009

Accounts receivable (net)....................................$6,539 $5,197

Allowance for uncollectible accounts................ 246 121

Gross accounts receivable..................................$6,785 $5,318

Percentage of uncollectible accounts to gross accounts receivable...........................

3.63%($246 / $6,785)

2.28%($121 / $5,318)

b.($ millions) 2010 2009

Accounts receivable (net)....................................$ 6,539 $ 5,197

Total assets...........................................................$95,289 $66,714

Percentage of A/R to Total assets......................6.9%

= ($6,539 / $95,289)

7.8%

= ($5,197 / $66,714)

The level of receivables to total assets has declined during the year, which could signal some efficiencies and perhaps an increase in the quality of the receivables. We would like to calculate A/R turnover and days to collect to confirm that the company is managing the receivables and that they are of high quality.

However, the allowance for uncollectible accounts as a percentage of gross accounts receivable has increased. The increase might indicate that the quality of the accounts receivable has deteriorated as a result of the recessionary economy in 2010. It could also reflect the fact that the company is selling to a less creditworthy class of customers, or the company’s management of accounts receivable has declined. However, it might also indicate that the 2010 allowance account is too high. This would result in lower reported profits in the current year and higher profits in future years when the allowance for uncollectible accounts is decreased.


M 6-15 (20 minutes)

a. Accounts Receivable Turnover

for 2010

Procter & Gamble...........................$78,938 / [($5,335+$5,836) / 2] = 14.13

Colgate-Palmolive...........................$15,564 / [($1,610+$1,626) / 2] = 9.62

b. P&G turns its accounts receivable much faster than Colgate-Palmolive. Differences can arise due to variations in the product mix of competitors, the types of customers they sell to, their willingness to offer discounts for early payment, and their relative bargaining strength vis-à-vis the companies or individuals owing them money. Both of these companies sell a significant amount of their product to Wal-Mart. P&G is a sizable company, and may have greater bargaining power with Wal-Mart than does the smaller Colgate-Palmolive.

M 6-16 (20 minutes)

a. FIFO cost of goods sold = 1,000 @ $100 + 700 @ $150 = $205,000FIFO ending inventories = $400,000 - $205,000 = $195,000

b. LIFO cost of goods sold = 1,700 @ $150 = $255,000LIFO ending inventories = $400,000 - $255,000 = $145,000

c. AC cost of goods sold = 1,700 @ $400,000 / 3,000 = $226,667AC ending inventories = $400,000 – $226,667 = $173,333


M 6-17 (10 minutes)

a. FIFO cost of goods sold = 400 @ $10 + 200 @ $12 = $6,400FIFO ending inventories = $12,400 - $6,400 = $6,000

b. LIFO cost of goods sold = 600 @ $12 = $7,200LIFO ending inventories = $12,400 - $7,200 = $5,200

c. AC cost of goods sold = 600 @ $12,400 / 1,100 = $6,764AC ending inventories = $12,400 – $6,764 = $5,636

M 6-18 (20 minutes)

a. Inventory Turnover rates for 2010

ANF................................................ $1,257 / [ ($386 + $311) / 2 ] = 3.61

TJX................................................ $16,040 / [($2,765+$2,532) /2] = 6.06

b. TJX’s inventory turnover rate is higher than ANF’s. TJX concentrates on the value-priced end of the clothing spectrum. Thus, it realizes a lower profit margin that must be offset with higher turnover to yield an acceptable return on net operating assets (see discussion of profitability and turnover in Module 4).

c. Inventory turnover improves as the volume of goods sold increases relative to the dollar value of goods available for sale. Retailers must balance the cost savings from inventory reductions against the marketing implications of lower inventory levels. Companies can lower inventory levels by reducing the depth and breadth of product lines carried (such as not carrying every style, size and color), eliminating slow-moving product lines, working with suppliers to arrange for delivery when needed, and marking down goods for sale at the end of product seasons.


M 6-19 (15 minutes)

a. Straight-line: ($18,000 - $1,500) / 5 years = $3,300 for both years

b. Double-declining-balance: Twice straight-line rate = 2 × 1/5 = 40%1st year: $18,000 × 0.40 = $7,200 2nd year: ($18,000 - $7,200) × 0.40 = $4,320

Notice that, over the first two years, the company reports $6,600 ($3,300 x 2) of depreciation expense under the straight-line method and $11,520 ($7,200 + $4,320) of depreciation expense under the double-declining balance method.

M 6-20 (15 minutes)

a. Straight-line depreciation

2011: ($145,800 - $5,400) × (8/36) = $31,200

2012: ($145,800 - $5,400) × (12/36) = $46,800

b. Double-declining-balance depreciationTwice straight-line rate = 2/3 = 66⅔%

2011: ($145,800 × 66⅔% ) × (8/12) = $64,800

2012: ($145,800 - $64,800) × 66⅔% = $54,000


M 6-21 (15 minutes)

a. PPE turnover for 2010

Intel Corporation..........................$43,623 / [($17,899+$17,225) /2] = 2.48

Texas Instruments.......................$13,966 / [($3,680 + $3,158) / 2] = 4.08

Texas Instruments turns over its PPE more quickly than does Intel.

b. PPE turnover increases with sales volume relative to the dollar amount of PPE on the balance sheet. The PPE turnover is often very difficult to improve because doing so typically requires creative thinking. Many companies are off-loading the manufacturing process in whole or in part to others in the supply chain. This is productive so long as the benefits realized by the reduction of manufacturing assets more than offset the higher cost of the goods that are now purchased rather than manufactured. Another approach is to utilize long-term operating assets in partnership with another firm, say in a joint venture.


EXERCISES

E 6-22 (20 minutes)

a. Bad debts expense computation $90,000 1% = $ 900

20,000 2% = 400 11,000 5% = 550 6,000 10% = 600 4,000 25% = 1,000

Total required balance in allowance $3,450Less: Unused balance before adjustment (520)Bad debt expense for the year $2,930

b. Balance Sheet Income Statement

TransactionCash Asset

+Noncash Assets

=Liabil-ities

+Contrib. Capital

+EarnedCapital

Rev-enues

–Expen-

ses=

NetIncome

BDE 2,930 AU 2,930

Record bad debts expense

-2,930Allowance for Uncollectible

Accounts

=-2,930

Retained Earnings

–+2,930

Bad Debt Expense

= -2,930

c. Accounts receivable, net = $131,000 - $3,450 = $127,550

Reported in the balance sheet as follows:Accounts receivable, net of allowance of $3,450 ....................... $127,550


E 6-23 (30 minutes)

The ending balance of Penman’s accounts receivable and allowance accounts are as follows.

Accounts receivable $138,100Less allowance for uncollectible accounts 10,384 $127,716

Computations Accounts Allowance forReceivable Uncollectible Accounts

Beginning balance...................................$ 122,000 $ 7,900Sales.......................................................... 1,173,000Collections...............................................(1,150,000)Write-offs*................................................ (6,900) (6,900)Bad debts expense**..............................._________ 9,384Ending balance.........................................$ 138,100 $ 10,384

* Write offs = $3,600 + $2,400 + $900 = $6,900** Bad debts expense = $1,173,000 0.8% = $9,384


E 6-24 (25 minutes)

a, b.($ millions) 2010 2009

Accounts receivable (net)....................................$18,481 $16,537

Allowance for uncollectible accounts................ 525 629

Gross accounts receivable..................................$19,006 $17,166


2.76%($525/$19,006)

3.66%($629/$17,166)

c.($ millions) 2010 2009 2008

Bad debts expense............................................... $80 $282 $226

Amounts actually written off...............................$191 $206 $144

The provision (increase in the allowance account arising from bad debts expense recorded on the income statement) decreased from 2009 following the high write-offs in that year. Over the three-year period, HPQ accrued $588 million ($226 + $282 + $80) of bad debt expense and wrote off $541 million ($144 + $206 + $191) of uncollectible accounts receivable. The difference between the expense and the write-offs is small. Thus, it appears that HP is accurately accruing for anticipated credit losses.

d. The allowance for uncollectible accounts has decreased as a percentage of gross accounts receivable from 3.66% in 2009 to 2.76% in 2010 (see part b). One way to gauge the adequacy of the allowance account is to look at write-offs as a percentage of the allowance account at the beginning of the year. In 2009, this percentage is 37% ($206/$553) and for 2010 it is 30% ($191/$629). HPQ’s write-offs as a percentage of the allowance decreased from 2009 to 2010. By this measure as well, it appears that HP is accurately accruing for anticipated credit losses. Further insight might be gained by comparing HPQ’s allowance account to those of its peers.


E6-25 (20 minutes)

a. Aging schedule at December 31

Current ($304,000 1%)......................................................... $ 3,0401–60 days past due ($44,000 5%)................................... 2,20061–180 days past due ($18,000 15%)................................. 2,700Over 180 days past due ($9,000 40%)................................ 3,600Amount required...................................................................... 11,540

Allowance balance ................................................................. 4,200 Bad debts expense.................................................................. $ 7,340

b. Current Assets

Accounts receivable $375,000Less allowance for uncollectible accounts (11,540) $363,460

E6-26 (30 minutes)

a.Year Sales Collections Accounts Acc Recble.

Written Off Balance2009 $ 751,000 $ 733,000 $ 5,300 $12,7002010 876,000 864,000 5,800 18,9002011 972,000 938,000 6,500 46,400Total $2,599,000 $2,535,000 $17,600

Uncollectible Accounts Expense is:2009 $ 7,510 computed as 1% $751,0002010 8,760 computed as 1% $876,0002011 9,720 computed as 1% $972,0002009–2011 $25,990 computed as 1% $2,599,000

Allowance for Uncollectible Accounts is:$8,390, computed as $25,990 total provision for uncollectible accounts less $17,600 in total write-offs.

b. The 1% rate appears to be too high. A 0.8% rate would have provided $20,792, which still exceeds the $17,600 total write-off by $3,192. Moreover, this smaller allowance seems large enough to provide an adequate margin for future write-offs.


E6-27 (30 minutes)

Units CostBeginning Inventory 1,000 $ 20,000Purchases: #1 1,800 39,600

#2 800 20,800#3 1,200 34,800

Goods available for sale 4,800 $115,200

Units in ending inventory = 4,800 – 2,800 = 2,000

a. First-in, first-outUnits Cost Total1,200 @ $29 = $34,800 800 @ $26 = 20,800

Ending Inventory 2,000 $55,600

Cost of goods available for sale $115,200Less: Ending inventory 55,600 Cost of goods sold $ 59,600

Balance Sheet Income Statement


+Noncash Assets

=Liabil-ities

+Contrib. Capital

+EarnedCapital

Rev-enues

–Expen-

ses=

NetIncome

COGS 59,600 INV 59,600

Record FIFO cost of goods sold

-59,600Inventory

=-59,600RetainedEarnings

–

+59,600Cost of Goods

Sold

=-59,600

b. Last-in, first-outUnits Cost Total

1,000 @ $20 = $20,000 1,000 @ $22 = 22,000

Ending inventory 2,000 $42,000

Cost of goods available for sale $115,200Less: Ending inventory 42,000Cost of goods sold $ 73,200


E6-27 (concluded)

c. Average cost

$115,200 / 4,800 = $24 average unit cost2,000 × $24 = $48,000 ending inventory$115,200 - $48,000 = $67,200 cost of goods sold (or 2,800 × $24)

d. 1. In most circumstances, the first-in, first-out method most closely reflects the physical flow of inventory. First-in, first-out physical flow is critical when inventory is perishable or in situations in which the earliest items acquired are moved out first because of risk of deterioration or obsolescence such as technology products and retail items.

2. Last-in, first-out yields the highest cost of goods sold expense during periods of rising unit costs, which in turn, results in the lowest taxable income and the lowest income tax.

3. The first-in, first-out method results in the lowest cost of goods sold, and the largest amount of income, in periods of rising prices. Of course, this assumes that prices will continue to rise as they have in the past. Companies cannot change inventory costing methods without justification, and the change may be restricted by tax laws as well.


E6-28 (25 minutes)

a. GE’s 2010 balance sheet reports $11,460, which is the LIFO inventory value.

b. GE’s 2010 balance sheet would have reported $11,864, which is the FIFO inventory value.

c. Cumulative pretax income (until the end of fiscal 2010) has been reduced by $404 million ($11,864 million - $11,460 million) since GE adopted LIFO inventory costing. This is because LIFO matches more “current” inventory costs against current selling prices, thus avoiding the recognition of holding gains that would have resulted had FIFO inventory costing been used.

d. Pretax income has been reduced by $404 million (see part c). Assuming a 35% tax rate, taxes have been reduced by $404 × 0.35 = $141.4 million. GE’s cumulative taxes have been decreased from the use of LIFO inventory costing.

e. For 2010 only, the LIFO reserve decreased by $125 million ($529 million - $404 million). 2010 pretax income is $125 million higher, relative to what it would have been with the FIFO method, thus increasing taxes by $43.75 million ($125 million × 0.35). In fiscal 2010, the use of LIFO inventory costing did not save taxes for GE. The taxes were saved in prior years.


E6-29 (25 minutes)

Units Cost TotalBeginning inventory 100 @ $46 = $ 4,600Purchases: Purchase #1 650 @ 42 = 27,300

Purchase #2 550 @ 38 = 20,900Purchase #3 200 @ 36 = 7,200

Cost of goods available for sale 1,500 $60,000

a. First-in, first-out

Units Cost Total 200 @ $36 = $ 7,200 150 @ 38 = 5,700

Ending inventory.......................... 350 $12,900

Cost of goods available for sale. $60,000Less: Ending inventory............... 12,900 Cost of goods sold....................... $47,100

b. Average cost

Cost of Goods Available for Sale/Total Units Available for Sale= $60,000 / 1,500 = $40 Average Unit Cost

Ending Inventory = 350 units × $40 = $14,000

Cost of goods available for sale $60,000Less: Ending inventory 14,000 Cost of goods sold $46,000

c. Last-in, first-out

Units Cost Total 100 @ $46 = $ 4,600

250 @ 42 = 10,500 Ending inventory........................ 350 $15,100

Cost of goods available for sale $60,000Less: Ending inventory.............. 15,100 Cost of goods sold..................... $44,900


E6-30 (25 minutes)

a. Deere reports $3,063 million for inventories on its 2010 balance sheet. (Its 2009 inventories are $2,397 million.)

b. Had Deere used the FIFO method, its 2010 balance sheet would have reported $4,461 million as inventories. (Its 2009 inventories would have been $3,764 million.)

c. Pretax income (until the end of fiscal 2010) has been decreased by $1,398 million cumulatively since Deere adopted LIFO inventory costing ($4,461 million - $3,063 million). This decline occurs because costs have been rising and Deere has matched current (higher) inventory costs against current selling prices.

d. Cumulative pretax income has been decreased by $1,398 million (see part c). Assuming a 35% tax rate, cumulative taxes were lower by $489.3 million ($1,398 × 0.35) as compared to the taxes that Deere would have paid had it used the FIFO system. (As of 2009, its cumulative taxes were lower by $478.45 million, computed as $1,367 × 0.35.)

e. During 2010, the LIFO reserve increased by $31 million ($1,398 million - $1,367 million). This reduced taxable income by that amount (as compared to the taxable income that Deere would have reported had it used the FIFO system). Assuming a tax rate of 35%, Deere saved taxes of $10.85 million ($31 million × 0.35) in 2010 because it used the LIFO costing method.


E6-31 (20 minutes)

a. Straight line:($80,000 - $5,000) / 5 years = $15,000 per year



+Noncash Assets

=Liabil-ities

+Contrib. Capital

+EarnedCapital

Rev-enues

–Expen-

ses=

NetIncome

COGS 15,000 AD 15,000 Record

$15,000 depreciation as part of COGS*

-15,000Accumulated Depreciation


–

+15,000Cost of Goods Sold*

=-15,000

* Because the equipment is used exclusively in the manufacturing process, the depreciation is more accurately recorded as part of cost of goods sold and not as depreciation expense.

b. Double-declining-balance: Twice straight-line rate = 2 × (100%/5) = 40%

Year Book Value × Rate Depreciation Expense

1 $80,000 × 0.40 = $32,0002 ($80,000 - $32,000) × 0.40 = 19,2003 ($80,000 - $51,200) × 0.40 = 11,5204 ($80,000 - $62,720) × 0.40 = 6,912

5 5,368**

Total $75,000

**The calculated depreciation expense of $4,147 [($80,000 - $69,632) × 0.40] is not enough to result in the $5,000 salvage value. Therefore, we adjust the depreciation in year 5 to $5,368 so that the total depreciation expense is $75,000. This is called a “plug.”



+Noncash Assets

=Liabil-ities

+Contrib. Capital

+EarnedCapital

Rev-enues

–Expen-

ses=

NetIncome

COGS 32,000 AD 32,000 Record

$32,000 depreciation as part of COGS*

-32,000Accumulated Depreciation


–

+32,000Cost of Goods Sold*

=-32,000


E6-32 (25 minutes)

a. 1. Cumulative depreciation expense to date of sale:[($800,000 - $80,000) / 10 years] × 6 years = $432,000

2. Net book value of the plane at date of sale:$800,000 - $432,000 = $368,000

b. 1. There is no gain or loss if the cash proceeds are equal to the plane’s net book value at the disposal date.

2. Loss on sale of: $195,000 - $368,000 = $173,000

3. Gain on sale of: $600,000 - $368,000 = $232,000

E6-33 (20 minutes)

a. Straight-line

2011 and 2012 ($218,700 - $23,400) / 6 years = $32,550

b. Double-declining-balanceTwice straight-line rate = 2 × (100% / 6) = 33⅓%

2011 $218,700 × 33⅓% = $72,900

2012 ($218,700 - $ 72,900) × 33⅓% = $48,600


E6-34 (20 minutes)

a. Depreciation expense to date of sale is [($27,200 - $2,000) / 6] per year × 3 years =$12,600.The net book value of the van is, therefore, $27,200 - $12,600=$14,600.

b. 1. There is no gain or loss if the cash proceeds are equal to the net book value.

2. $400 gain ($15,000 - $14,600)

3. $2,600 loss ($12,000 - $14,600)

E6-35 (15 minutes)

$ millions

a. Average useful life = Depreciable asset cost / Depreciation expense = ($8,579 - $113 - $478) / $540

= 14.8 years

Note: We eliminate land and construction in progress from the numerator because land is never depreciated and construction in progress represents assets that are not in service yet and are, consequently, not yet depreciable. The footnote indicates that buildings have estimated average useful lives of 23 years, machinery and equipment of 11 years, dies, etc of 7 years, and all other of 5 years.

b. Percent used up = Accumulated depreciation/ Depreciable asset cost = $4,856 / ($8,579 - $113 - $478)

= 60.8%

Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% “used up,” on average. Deere’s 60.8% is higher than this average. The implication is that Deere will require higher capital expenditures in the near future to replace aging assets.


E6-36 (25 minutes)

a.

Receivable turnover rate Inventory turnover rate PPE turnover rate

2010

2009

b. While its receivables and inventory turns have decreased slightly, Intel’s PPE turnover rate has increased. Receivable turnover rates can be improved by monitoring more closely the quality of credit customers, implementing better collection procedures, and offering discounts as an incentive for early payment. Inventory turnover rates can be improved by weeding out slow-moving product lines, by reducing the depth and breadth of products carried, by implementing just-in-time deliveries, reducing work-in-process inventories through better manufacturing techniques, and by reducing finished goods inventories by producing to demand. PPE turns can be improved by off-loading manufacturing to other companies in the supply chain and acquiring long-term operating assets in partnership with other companies, say in a joint venture.


E6-37 (15 minutes)

a. Annual straight-line depreciation is: $20,000 per year

Computations: ($225,000 - $25,000) / 10 years

b. As of the end of the fourth year, the net book value of the equipment would be: $145,000.

Computations: $225,000 cost less $80,000 accumulated depreciation, the latter computed as $20,000 x 4 years.

c. An asset is impaired if it meets the following condition:Sum of undiscounted expected cash flows < Net book value of asset

For this equipment: $125,000 < $145,000

This implies that “yes,” the equipment is impaired at the end of the fourth year. This is because the equipment will not generate sufficient expected cash flows to cover the current net book value.

d. From part c we know that the equipment is impaired. The impairment loss is computed as the equipment's net book value minus its current fair value; computations follow:

Impairment loss = Net book value of asset – Fair value of asset $55,000 = $145,000 $90,000


PROBLEMS

P6-38 (30 minutes)

a. Best Buy (a retailer) reports a much higher receivables turnover rate than does the manufacturer, Caterpillar. The likely reason for this is that retail sales are usually via cash, check, or credit cards (which are like cash for the retailers). Recall that the turnover ratio includes credit sales, but, because most firms do not report credit sales, we are forced to use total sales when we calculate the turnover ratio. Using total sales instead of credit sales overstates the turnover ratio. Manufacturers, on the other hand, usually sell to retailers on credit and the accounts are not collected for a much longer period of time. CAT has a finance subsidiary that provides loan and lease financing. The longer term of these receivables reduces turnover rates. Walmart, on the other hand, is primarily cash-and-carry, hence its high turnover rate for accounts receivable.

b. Dell’s relatively higher inventory turnover rate, compared with Caterpillar, most likely reflects the fact that Dell builds to order, not in anticipation of demand. That is, raw materials are not acquired until needed in the production process and components are built by sub-contractors. Both of these techniques reduce the amount of work-in-process inventories that Dell must carry. In addition, Dell does not generally inventory finished products since production commences once the order is placed by its customers. CAT, on the other hand, builds a relatively smaller number of high-cost machines that likely take a much longer period of time to manufacture. It, therefore, carries high levels of raw materials, work-in-process and finished goods inventories.

c. Caterpillar and Verizon are relatively capital intensive. Caterpillar requires significant investment in manufacturing facilities and equipment and Verizon in telecommunications facilities and equipment. This capital investment typically results in a lower PPE turnover rate.


P6-38 (continued)

d. The relative asset turnover rates reported generally conform to our expectations across industries. Those industries that sell on credit, rather than using credit cards, or that normally stock inventories for production and sale, or that require substantial investment in long-term assets yield much lower receivable, inventory, and PPE turnover rates respectively. These lower turnover rates must be accompanied by higher profit margins and/or higher financial leverage to yield a satisfactory return on net operating assets. Generally, we expect the following:

Industry ReceivablesTurnover

Inventory Turnover

PPE Turnover

Retailing.................. ↑ ↑ ↑

Manufacturing........ ↓ ↓ ↓


P 6-39 (30 minutes)

a. b.

($ 000s) 2010 2009 2008

Accounts receivable (net)....................$762,895 $624,910 $589,416

Allowance for uncollectible accounts..............................................

24,552 25,850 26,481

Gross accounts receivable..................$787,447 $650,760 $615,897


3.12%

($24,552/$787,447)3.97%

($25,850/$650,760)

4.30%

($26,481/$615,897)

c.($ 000s) 2010 2009 2008

Bad debts expense (titled provision for uncollectible accounts)............................................

$6,718$10,748 $12,924

d. The allowance for uncollectible accounts has decreased as a percentage of gross accounts receivable from 4.30% in 2008 to 3.12% in 2010 (see part b above for details). The allowance is decreasing appropriately because write-offs of uncollectible accounts are also decreasing.

e. In 2008, the allowance for uncollectible accounts was 4.30% of gross accounts receivable. Applying that percentage to the 2010 gross accounts receivable of $787,447 yields an allowance of $33,860 which is $9,308 higher than the $24,552 reported in the allowance account for 2010. Thus, maintaining the allowance account at the 2008 percentage level would have decreased 2010 profit (before tax) by $9,308 (all $ 000s).

f. Since 2008, Grainger has decreased its allowance for uncollectible accounts as a percentage of gross receivables by decreasing the addition (provision) to the allowance account. This decrease in the provision corresponds to a decrease in write-offs since 2008.

2010 2009 2008Write-offs......................$8,302 $12,254 $11,501

Grainger currently has an allowance account of $24,552, nearly three times the level of current-year write-offs. It appears, therefore, that the reserve is more than adequate.


P6-40 (40 minutes)

($ in millions, consistent with Intuit’s financial statements)

a. Gross receivables as of 2010 are $135 + $22 = $157.Gross receivables as of 2009 are $135 + $16 = $151.

b. Estimated uncollectible accounts as a percentage of gross accounts receivable are:

14.0%, computed as ($22 / $157) in 201010.6%, computed as ($16 / $151) in 2009

The 2010 allowance for uncollectible accounts increased significantly as a percentage of gross accounts receivable. This could be because there is greater uncertainty about the collectability of receivables in general, or one or more large accounts are in arrears.

c. The receivables turnover rate is

Average collection period (days sales in accounts receivable) is:$157 / ($3,455 / 365) = 16.59 days

Intuit’s sales to consumers are primarily via online purchases using credit cards for payment. Its average collection period for receivables will, therefore, be low for this portion of its business. Service revenues are likely on account, and the collection period is likely to be longer for this segment of Intuit’s business. Its overall average collection period for accounts receivable is an average of these lines of business.

d. Intuit’s allowance seems high – over 10% in 2009 and increasing to 14.0% in 2010. To assess this, we would compare Intuit’s ratios to the allowances of Intuit’s competitors. The economy was slowly emerging from a significant downturn in 2010 and the high level of anticipated uncollectible accounts might reflect deterioration in the collectability of its receivables during that downturn.


P6-40 (concluded)

e. Intuit’s allowance for uncollectible accounts is increased by the provision (“additions charged to expense”) and is decreased by write-offs of accounts receivable (“deductions”). Over the three-year period covered by the table, Intuit has increased its allowance account by a cumulative amount of $52 ($23 + $14 + $15). It has written off a cumulative total of $45 ($17 + $14 + $14). The allowance account has, therefore, increased by $7 ($52 - $45), from $15 to $22. The increase charged to expense has slightly exceeded the account write-offs.

As mentioned above, this increase might be due to customers’ weakening credit quality. It might also be the case that Intuit is conservative and is intentionally depressing its current profit. An inflated allowance can be used to absorb future receivable write-offs with no impact on future profit, or can be reversed in a future year to provide an immediate reduction in expense and consequent increase in profit. Either way, if the allowance account is inflated, the effect is to shift profit from the current period into one or more future periods. This does not appear to be the case for Intuit since the additions to the allowance account have nearly mirrored write-offs of accounts receivable.


P6-41 (45 minutes)

($ millions)

a. Dow uses LIFO inventory costing for 29% of inventories at December 31, 2010. As of 2010, the LIFO inventory reserve is $1,003 million. Thus, cumulatively, pretax income has been reduced by $1,003 million because Dow uses LIFO. Assuming a tax rate of 35%, Dow has saved taxes of $351.05 million ($1,003 million × 35%), cumulatively. During 2010, the LIFO reserve increased by $185 million ($1,003 million - $818 million), saving the company $64.75 million ($185 million × 35%) in taxes in 2010. This tax saving increased operating cash flow by that same amount.

b. The inventory turnover for 2010 is 6.57 (computed as ).

The average inventory days outstanding for 2010 is 56.50 ($7,087 / [$45,780/ 365 days]). DOW is a manufacturer, thus, it requires a certain level of raw materials and continually maintains finished goods inventory awaiting delivery. The average inventory days outstanding does not appear excessive.

We could usefully compare both of these ratios to those of other manufacturers in the same industry as DOW to make a more informed comparison.

c. Since the overall cost of certain inventories increased during 2009 and 2010, DOW’s reduction of those inventory quantities resulted in the matching of lower-cost inventories against higher current selling prices. This increased its income by $84 million in 2009 and $159 million in 2010. This reduction in inventory quantities is called LIFO liquidation. In 2008, however, inventory costs had fallen and the reduction of inventory quantities in that year had the opposite effect; that is, the reduction in quantities reduced income by $45 million in that year. As this example clearly demonstrates, it is not always the case that LIFO liquidations result in profit increases.


P6-42 (15 minutes)

a. Average useful life = Depreciable asset cost / Depreciation expense = ($17,374,302 - $648,988 - $577,460) / $1,207,450

= 13.37 years

Note: We eliminate land and construction in progress from the computation because land is never depreciated and construction in progress represents assets that are not in service yet and are consequently not yet “depreciable”.The footnote indicates that buildings have estimated useful lives ranging from 10-50 years (27-year average) and Equipment from 3-20 years (11-year average). Thus, the estimate of 13.37 years rests between these two reported values.

b. Percent used up = Accumulated depreciation/ Depreciable asset cost= $9,403,346 / ($17,374,302 - $648,988 - $577,460)

= 58.2%

Note: We eliminate land and construction in progress from the computation because land is never depreciated and construction in progress represents assets that are not in service yet and are consequently not yet “depreciable”.Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% depreciated, on average. Abbott Labs 58.2% is slightly higher than this level, but not high enough to cause concern that it will need markedly higher capital expenditures in the near future to replace aging assets.


P6-43 (45 minutes)

$ millionsa. PPE turnover for 2007 is: $8,897 / [($2,871 + $2,669) / 2] = 3.21.

This turnover is lower than the 5.03 median for all publicly traded companies. This indicates that Rohm and Haas is more capital intensive than the median publicly traded company.

b. Rohm and Haas’ average asset life, assuming straight-line depreciation, can be estimated asDepreciable asset cost / Depreciation expense($8,779 - $146- $352 - $271) / $412 = 19.44 years

Note: We eliminate land from the computation because land is never depreciated. We eliminate construction in progress and capitalized interest because these represent assets that the company is building (and the interest paid on the construction loans). These assets are not yet in service and are consequently not yet depreciable.

c. As of 2007, the company’s plant assets were approximately 73.8% “used up,” which is computed as follows:

Accumulated depreciation / Depreciable asset cost$5,908 / ($8,779 - $146- $352 - $271) = 73.76%

Note: We eliminate land from the computation because land is never depreciated. We eliminate construction in progress and capitalized interest because these represent assets that the company is building (and the interest paid on the construction loans). These assets are not yet in service and are consequently not depreciated. If plant assets are replaced at a constant rate, we would expect those assets to be about 50% “used up,” on average. A substantially higher percentage “used up” indicates that the assets are closer to the end of their useful lives and will require replacement (and usually higher maintenance costs near the end of their useful lives). Such a situation would negatively impact future cash flows. Rohm & Haas’ depreciable assets appear to be substantially “used up” based on this analysis.


P6-43 (concluded)

d. Plant assets are deemed to be impaired if the undiscounted expected future cash flows from those assets are not sufficient to recover their net book value. That is, the sum of the undiscounted future cash flows is less than the net book value. If impaired, the plant assets are written down to their fair value, which is typically the discounted value of the future expected cash flows.

An asset impairment charge (such as Rohm and Haas’ $24 million charge in 2007) reduces net income, but has no effect on current-period cash flows because an impairment charge is a noncash expense. Moreover, the impairment charge is not deductible for tax purposes until the asset is disposed of, that is, until the loss is realized.

Since asset impairment charges are nonrecurring, we would be justified in treating them as transitory. This is an operating item for analysis purposes because the writeoff relates to operating assets.


IFRS APPLICATIONS

I6-44 (20 minutes)

a. Inventory Turnover for 2009

Volkswagen €91,608 / [ (€14,124 + €17,816) / 2 ] = 5.74

Daimler €65,567 / [ (€12,845 + €16,805) /2 ] = 4.42

Gross Profit Margin (%)

Volkswagen (€105,187 – €91,608) / €105,187 = 12.9%

Daimler (€78,924 – €65,567) / €78,924 = 16.9%

b. Both Daimler and Volkswagen manufacture and sell high-quality automobiles and both have luxury brands. However, Volkswagen also sells some value-priced vehicles compared to Daimler. Thus, Volkswagen realizes a lower level of profit on each vehicle sold. To achieve an acceptable return on net operating assets, Volkswagen must be more efficient with its assets. This explains why Volkswagen’s inventory turnover rate is higher than Daimler’s (5.74 compared to 4.42).

c. Inventory turnover improves when cost of goods sold are reduced for each car sold. The companies could try to find cheaper sources for materials, but given the importance of safety, Daimler and Volkswagen can likely not cut costs too drastically.

Inventory turnover also improves as the volume of automobiles sold increases relative to the dollar value of goods available for sale. Automobile manufacturers must balance the cost savings from inventory reductions against the marketing implications of lower inventory levels. The companies could maybe lower inventory levels by reducing the depth and breadth of car model designs (such as discontinuing certain styles and models), eliminating slow-moving cars, working with suppliers to arrange for delivery when needed (just in time inventory models), and marking down prices on cars for sale before introducing new models.


I6-45 (20 minutes)

(in NOK millions)

a. Average useful life = Depreciable asset cost / Depreciation expense

= (789,418 – 89,221 – (25% × 15,375)) / 46,596= 14.9 years

Note: We eliminate land (25% of land and buildings) and assets under development (i.e. construction in progress) from the numerator because land is never depreciated and assets that are still under development are not in service yet and are, consequently, not yet depreciable.

b. Percent used up = Accumulated depreciation/ Depreciable asset cost = 448,583 / (789,418 – 89,221 – (25% × 15,375))

= 64.4%

Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% “used up,” on average. Statoil’s 64.4% is higher than this average. The implication is that Statoil will require higher capital expenditures in the near future to replace aging assets.


I6-46 (25 minutes)

(in €millions)

a.

Receivable turnover Inventory turnover PPE turnover

2008

2009

b. Receivable, inventory, and PPE turnover rates have all weakened during 2009 as compared to 2008. Lower turnovers indicate that the company is less efficient in collecting its receivables and in selling its inventory. The decline in PPE turnover indicates that company is not generating as much revenue per euro of assets as in the prior year.

c. Receivable turnover rates can be improved by monitoring more closely the quality of credit customers, implementing better collection procedures, and offering discounts as an incentive for early payment. Inventory turnover rates can be improved by weeding out slow-moving product lines, by reducing the depth and breadth of products carried, by implementing just-in-time deliveries, reducing work-in-process inventories through better manufacturing techniques, and by reducing finished goods inventories by producing to demand. PPE turns can be improved by off-loading manufacturing to other companies in the supply chain and acquiring long-term operating assets in partnership with other companies, say in a joint venture.


I6-47 (25 minutes)

a. Gross receivables as of 2009 are €2,314 + €129 = €2,443.Gross receivables as of 2008 are €2,788 + €120 = €2,908.

b. Uncollectible accounts as a percentage of gross accounts receivable are:

2009: 5.3% (computed as €129 / €2,443)2008: 4.1% (computed as €120 / €2,908)

During 2009, gross trade receivables decreased. Yet the 2009 allowance for uncollectible accounts increased slightly in both euro terms and as a percentage of gross accounts receivable. This could be because there is greater uncertainty about the collectability of receivables in general, or one or more large accounts are in arrears.

c. Unilever’s allowance seems a bit low – under 5% in 2008 and just over 5% in 2009. To assess this, we would compare Unilever’s ratios to the allowances of Unilever’s competitors. It could be that the industry for fast moving consumer goods has done well throughout the economic downturn in 2008 and 2009 due to the discount nature of its products.

d. The receivables turnover is €39,823 / [(€ 2,443 + € 2,908) /2] = 14.9

Average collection period (days sales in accounts receivable) is:€2,443 / (€39,823 / 365) = 22.4 days


I6-48 (25 minutes)

a. Inventory turnover rate for 2009 is 2.55 calculated as: 33,937 / [( 13,371 + 13,226) / 2] ₹ ₹ ₹

Average inventory days outstanding for 2009: 365 / ( 33,937 / 13,371) = 143.8₹ ₹

Dr. Reddy’s is a pharmaceutical company, thus, it requires a significant level of raw materials and finished drugs and, as a result, the average inventory days outstanding is higher than for other consumer goods companies.

We could usefully compare both of these ratios to those of other companies in the same industry as Dr. Reddy’s to make a more informed comparison.

b. Like GAAP, IFRS allows for either FIFO or weighted average costing methods. However IFRS prohibits the uses of the LIFO inventory costing method.

c. In an inflationary environment, FIFO cost of goods sold yields higher gross profits than does LIFO. Thus, net income will be higher under FIFO rather than LIFO. Weighted average cost will be between LIFO and FIFO reported numbers.
