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UC / Accounting / ACCT 8089 / How is ar receivable information evaluated?

How is ar receivable information evaluated?

How is ar receivable information evaluated?


Coverage: Receivables, inventories, long-term assets, lease

How is ar receivable information evaluated?

Format: Multiple-choice questions (8) + Short-answer question (4) 

A combination of concepts, calculations and analysis, focusing more on financial statement analysis skills. 

Exam 2 focuses on how different methods/estimates/errors affect financial statements (B/S, I/S). You should be able to understand and solve problems related to the following issues:

1. Receivables:

(1) Understand how receivables are related to bad debt expense, sales returns, and sales discounts and their effects on financial statements. How does the estimation of bad debt expense affect B/S and I/S? Accounts Receivables

Influence B/S

Influence I/S

① Uncollectible

Allowance for uncollectible ↓A/R

Bad debt expense ↓ I/S

② Returns

Allowance of sales return ↓A/R

Sales return

Decrease net sales revenue ↓ I/S

③ Cash discounts

If cash paid < A/R ↓Assets

Sales discount

Decrease net sales revenue ↓ I/S

What is the difference between perpetual recording and periodic recording?

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Net sales= sales revenues - sales discount - sales returns- sales rebate

(2) How to evaluate AR receivable information?

2.1 What are the implications for AR growth > sales growth?

It is a red flag when receivables grow faster than sales. Like the firm has changed its financial reporting policy – accelerated revenue recognition.

2.2 How to calculate AR related ratios, e.g. allowance-to-AR ratios, AR turnover ratio, average days of AR collection; what are their implications?

Receivables turnover ratio = Net sales/Average accounts receivable

▪ an indication of a company’s efficiency in collecting receivables.

▪ The higher the ratio, the shorter the average time between sales and cash collection.

▪ Gross receivables are more precise in measuring how much credits in total provided to promote sales, while net value can be used when gross values are not available.

Average collection period = 365/ Receivables turnover ratio

▪ Estimation on average collection period; How long to collect A/R to convert into cash.

allowance-to-AR ratios

the estimates of % (of sales / of ARs) to decide the balance of allowance or bad debt

We can measure “allowance for uncollectible to gross receivables” to understand the estimate % of uncollectible

What do fifo and lifo stand for in financial statements?

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Receivable quality: If receivable turnover slows, it indicates the reason could be deterioration in collectability.Don't forget about the age old question of What are causes of pneumothorax?
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(3) When financing with receivables, how financial statements and related ratios are different for the sales scenario vs. for the collateral borrowing scenario?

Sales scenario:

collateral borrowing scenario

Receivables removed from balance sheet Gain or loss recognized in income

Cash ↑ A/R↓ No liability

Receivables stay on balance sheet

Loan shown as balance sheet liability.

No gain or loss recognized in income

No change on A/R; increase Liability

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2. Inventories:

(1) How are the perpetual inventory system and the periodic inventory system different? Two accounting systems are used to record transactions involving inventory:

Perpetual Inventory System

Periodic Inventory System

The inventory account is continuously updated as purchases and sales are made.

The inventory account is adjusted at the end of a reporting cycle.

keeps a running (or “perpetual”) record of the amount of inventory on hand.

Record of Cost of goods sold: must be determined by physically counting the goods on hand at the end of the period.

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(2) Quantities & costs included in inventory: especially understand what is absorption cost and how absorption costs distort financial statements.

Absorption costing of inventory (required by GAAP)

1. Fixed production costs: Manufacturing rentals and depreciation; Property taxes 2. Variable production costs: Raw materials; Direct labor; Variable overhead, like electricity

(3) Understand how different cost flow assumptions affect financial statements.

3.1 cost flow assumption:

First-in, First-out (FIFO)

Last-in, First-out (LIFO)

▪ Matches low (older) costs with current (higher) sales.

▪ Inventory is valued at approximate replacement cost.

▪ Results in higher taxable income.

▪ Matches high (newer) costs with current (higher) sales.

▪ Inventory is valued based on low (older) cost basis.

▪ Results in lower taxable income.

(4) Understand how to use LIFO reserve to cover financial statements from LIFO to FIFO to compare different companies; in addition, what is LIFO liquidation and how does LIFO liquidation distort financial statements.

4.1 COGS_FIFO = Beg Inv _FIFO + Purchase – End Inv_FIFO

= (Beg Inv_LIFO + Beg LIFO Reserve)+ Purchase – (End Inv_LIFO + End LIFO Reserve) = ( Beg Inv_LIFO + Purchase – End Inv_LIFO) – (End LIFO reserve - Beg LIFO reserve) = COGS_LIFO – chg in LIFO reserve 

4.2 LIFO liquidation: When a LIFO firm liquidates old LIFO layers, the net income number under LIFO can be seriously distorted. Old LIFO layers that are liquidated are “matched” against sales dollars that are stated at higher current prices.

(5) How to apply the “lower cost or market” principle; when and how to write-down inventories? Understand how do different choices affect evaluation of permanent earnings.

5.1 The lower of cost or market method can be applied to: Individual inventory items; Classes of inventory; The inventory is a whole.

5.2 when inventory has salability impaired, such as Deterioration, Obsolescence, and Changes in price levels, Losses are recognized in the period the value of inventory declines below its cost. ✔ If inventory write-downs are commonplace for a company, losses usually are included in cost of goods sold (permanent)

✔ If a write-down is substantial and unusual, GAAP requires that the loss be expressly disclosed (temporary)

Misclassification about common price effect to inventory write-downs can inflate permanent income.

(6) How errors in inventories may affect multiple year financial statements?

2015 overstated

2016 Understated

(7) How to evaluate inventories information?

2016 understated

- How to calculate inventory related ratios, e.g. inventory turnover ratio, average days of inventory outstanding); what are the implications?

Inventory turnover ratio = COGS/Average inventory

The more frequently a business can sell, or turn over, its inventory, the lower its investment in inventory must be for a given level of sales

Average days in inventory = 365/ Inventory turnover ratio

indicates the number of days it normally takes to sell inventory

Inventory quality: high inventory turnover indicates goods are superior sales force or a successful advertising campaign; while low inventory turnover might indicate obsolete items or poor marketing and sales efforts.

3. Long-term assets:

(1) How to capitalize or expense initial expense and subsequent expense related to PPE and intangible assets.

⬥ GAAP capitalizes costs incurred after the asset has been placed in use if the expenditure: ■ Extends the asset’s useful life 

■ Increases its productive capacity (e.g. attainable production units)

■ Increases its production efficiency (e.g., fewer raw materials)

■ Increases the asset’s other economic benefits 

⬥ If there is no increase in economic benefits (or future service potential), the expenditure is charged to income as an expense.

⬥ GAAP requires virtually all R&D expenditures to be expensed as incurred.

Impact of Misapplication of Asset Capitalization Rules:

If management choose to capitalize sth. that should be expensed:

Effect: lower expense ???? higher income ???? higher retained earnings; ???? higher assets

(2) Understand how to allocate expense over the useful life of long-term assets (PPE, intangible assets, natural resources) and how different methods affect financial statements.

▪ Total depreciation expenses will be the same;

▪ When choose accelerated method to recognize depreciation expense, income is lower in earlier years and therefore income tax is deferred.

▪ Firms can use straight line method for financial reporting while use accelerated method for tax. No conformity rule.

(3) What is impairment on long-term assets? How to decide whether to recognize impairment and how much impairment to recognize? What are the effects on financial statements?

Impairment loss= Book value- fair value

Effects on financial statements

(4) How to report assets sold or assets held for sale – what are the effects on financial statements?

⬥ When firms actively try to sell assets they own, the asset groups should be classified on the balance sheet as “held for sale”.

⬥ When assets are held for sale, they are reported at the lower of book value or net realizable value (fair market value minus costs to sell).

⬥ Impairment Loss = Net book value – Net realizable value; when gains are indicated, no recognition!

(5) What to evaluate PPE information

- How to calculate PPE related ratios, e.g. PPE turnover ratio, average useful life, percent used up); what are their implications?

Measure the effectiveness of using Long-term assets

Anticipate high capital expenditure in the near future.

4. Lease

Compare the difference between capital lease and operating lease in accounting, what are the impacts on financial statements and ratios.

Capital lease summary

⬥ For firms with operating lease, the new requirement indicates:

Higher assets and liabilities on the B/S, total expense the same/similar

Higher debt-to-equity; lower ROA

⬥ Compare previous operating lease with capitalized lease

Higher assets and liabilities on the B/S, total expense the same/similar

Higher debt-to-equity; lower ROA

⬥ Compare new operating lease with capitalized lease

Same liability

Different assets: higher assets in earlier years

Different expense: lower expense in earlier years

Differences between Operating and Capital Leases

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