Accounting 201 Slides

ACC201Assets and Liabilities

Long Lived Assets Depreciation Methods

Straight Line (SL): Simply divide asset price minus salvage value by number of years of useful life

Accelerated schedules result in moving tax payments back in time. This creates value due to time value of money

Sum of Year’s Digit (SOYD)If useful life is N years, add total of the years, say TFirst year fraction to be depreciated = N/TSecond year fraction to be depreciated = (N-1)/T

…Last year fraction to be depreciated = 1/TSOYD is an accelerated depreciation scheduleFor example, suppose the life of the asset is N = 4 years.

Then the fractions are:first year 4/10second year 3/10third year 2/10fourth year 1/10

Multiply above fractions by (Initial BV – Salvage Val) to obtain DepreciationAt the end of 4th year remaining BV will be reduced to Salvage Val

Double DecliningDepreciate at Twice the Straight Line of Total Remaining Undepreciated PriceStop when depreciated amount reaches Price –

Salvage Value. For the last year the amount is what makes total depreciation equal to Price – Salvage Value

Example: A firm has machinery that cost $60,000,000 and has an estimated useful life of 4 years. The salvage value will be $12,000,000. Find the depreciation under the above three methods

SL: $60M - $12M = $12M4

SOYD: First year fraction is 4/10, and Depreciation = ($60M - $12M)*4/10=$19.2MSecond year fraction is 3/10, and Depreciation =

($60M - $12M)*3/10=$14.4Metc.DD: First Year is double of SL (without salvage value) = $60M * 2 / 4 = $30MRemaining Balance = $60M - $30M = $30M

Second Year is double of SL of remaining balance= $30M * 2 / 4 = $15MRemaining Balance = $30M - $15M = $15MSecond Year is double of SL of remaining balance

= $30M * 2 / 4 = $15MRemaining Balance = $30M - $15M = $15MThird Year is double of SL of remaining balance= $15M * 2 / 4 = $7.5M

But value left to be depreciated is < $7.5M as: Price – Salvage Value = $48M If $7.5M was depreciated then total value depreciated would add to:

$30M + $15M + $7.5M = $52.5M > $48MMaximum depreciation possible for year 3= remaining value = depreciation for year 3 = $48M - $45M = $3M

Year 4 depreciation is $0All numbers $MYear S/L SOYD DD1 12 19.2 302 12 14.4 153 12 9.6 34 12 4.8 0

Units of ProductionIf a machinery has a useful life of N units, and during an accounting period it is used for M units, then the depreciation will be (M/N)*Price

DepletionIf a natural resource can produce N units, and during an accounting period M units have been produced, then the depreciation will be (M/N)*Price

For example, an oil well, or a iron ore mine

Sinking Fund DepreciationNot allowed in the USIRR = Cash Flowt – Depret

Book Valuet-1

Effect of the following on NI, Equity, Assets, ROA, ROE, Taxes and Turnover in the early years of the asset:A) Straight Line Versus Accelerated MethodsB) Depreciable Life

C) Salvage value Early Years S/L AccelNI G LEquity G LAssets G LROA G LROE G LSales/Assets L G

Taxes G LCash Flows L G

ImpairmentRemaining Book Value (Carrying Amount) of asset = Purchase Price – Accumulated DepreciationIf the value of the asset as measured by expected future

cash flows from its use and disposal is less than carrying value, then the firm should recognize Impairment. This is the Recoverability TestThis could happen due to increased costs, decreased demand for product,

changes in government regulations etc. Management has discretion in recognizing Impairment4 criteria for impairment (lack of recoverability of carrying amount):

A) Book Value greater than discounted value of cash flowsB) Increased costsC) Adverse future outlookD) Worsening business environment

Under US GAAP, once Impairment is recognized it cannot be reversedNot so for IASAmount of Impairment should be counted as a loss in the Income Statement

Impairment has no impact on the Cash Flow statementImpact of Impairment on Equity, NI, ROE, ROA, D/E, Depreciation etc present and subsequent years

SFAS 143 SFAS 143 concerns future liabilities that may happen due costs of future disposal of assets. Mostly environmental cleanup costs

For example, a copper mine would require cleanup after its useful life has expired This expense is recognized when the asset is bought. It is referred to as Asset Retirement Obligation (ARO)

Firms must recognize the ARO liability in the period the asset was acquiredThe liability equals the market value, and if that is not available the present value of cash flows that will

be required to extinguish the liabilityAn asset equal to the initial liability is added to the Balance Sheet, and depreciated over the life of the asset

The result is an increase in both assets and liabilities. This will affect financial ratios, for example return on assets will decline, debt equity ratio will increase, etc Each accounting period the ARO is grown using an

interest rate. You grow the ARO to reflect increasing costs (inflation) with time. The accretion expense will be an expense on the Income Statement (even though there are no cash flows associated with AROs)

Lower NI due to accretion expense and also larger depreciation (assets larger)D/E is lowerTurnover is lowerROA and ROE are lowerInterest Coverage is lower

InventoriesThere are 3 forms of costing for inventories: FIFO (First In First Out)LIFO (Last In First Out)Average

Remember, the above are not methods for inventory valuation, but for costing. Valuation may be done by LCM (Lower of Cost or Market)

1) LIFO (Last In First Out) Latest items (last in) of inventory are assumed to be sold first

2) FIFO (First In First Out) Oldest items (first in) of inventory are assumed to be sold first

3) Average Cost Inventory is valued at average cost. The costs and values lie in the range between LIFO and FIFO

The usual situation is inflation, increasing prices with time, rather than decreasing prices (deflation)

[LIFO Diagram]

LIFO: As the COGS are recent, it more accurately reflects current production costs. However the inventory is likely undervalued due to the old prices, leading to total assets being

undervalued. Result is more accurate Income Statement but less accurate B/S

US firms prefer to use LIFO due to it producing lower taxes

FIFO: As older items (which were produced during a time of lower prices) exit first, this gives a higher value for Inventory (remaining items in inventory) and lower COGS

Lower COGS => Lower Costs => Higher EBIT => Higher NI & Higher TaxesHigher Inventory => Higher Total AssetsAlso the remaining items in inventory show the price of production more accurately

than the other methods, and therefore possibly show the price at which they can be sold more accuratelyResult is less accurate Income Statement but more accurate B/S

Example: Suppose a firm over a year (the accounting period) has the following inventory transactions:Beginning Inventory: 20 Units @ $100 per unit = $2,000

Purchases during the year:March 15: 10 units @ $120 per unit = $1,200July 21: 30 units @ $150 per unit = $4,500November 15: 25 units @ $160 per unit = $3,200

The firm sells 60 units during the year

LIFOCOGS = 25*$160 + 30*$150 + 5*$120 = $9,100

LIFOEnd-Inventory = 20*$100 + 5*$120 = $2,600

FIFOCOGS = 20*$100 + 10*$120 + 30*$150 = $7,700

FIFOEnd-Inventory = 25*$160 = $4,000Note that sum of COGs and Inventory are same in both methods ($11,700), as indeed

they both add up to total cost of all units sold and remainingActual flow of physical units in and out of the inventory has nothing to do with the accounting method used

The above are Inventory Costing, not Valuation methodsLower of cost or market (LCM) value is taken as Inventory value

Cost of Goods Sold + Ending Value of Inventory = Beginning Value of Inventory + Goods Purchased Think of Inventory in a box

The amount that exits is COGS and the amount that enters is Goods PurchasedIn above example:Goods Purchased = 10*$120 + 30*$150 + 25*$160 = $9,700

Begin Value of Inventory = 20*$100 = $2,000

FIFOCOGS + FIFOEnd-Inventory = $9,700 + $2,000 = $11,700And same for LIFO

LIFOCOGS + LIFOEnd-Inventory = $9,100 + $2,600 = $11,700

Comparison of impact on Inventory, Earnings, Taxes, Cash Flows and B/S due to three different methods in an inflationary environment:

FIFO LIFOInventory G LEarnings G L

Taxes G LCash Flows L GB/S Assets G L

COGS L GProfitability G L

Liquidity L GCOGS/Avg

InvenL G

Inven/Sales G LInven/Assets G L

GAAP: Inventory is valued at the lower of cost or market price (LCM) Increases in value of inventory are ignored, whereas losses need to be accounted for (holding period loss)

Increases will result in greater value when the goods are actually sold rather than just sitting in inventoryFor comparing firms can do a FIFO to LIFO conversion, or vice versa

LIFOReserve = FIFOInventory – LIFOInventory

COGSFIFO = COGSLIFO – LIFOReserve-End + LIFOReserve-Beg

If we wish to be conservative

in estimating COGSLIFO then an rough adjustment is:

COGSLIFO = COGSFIFO + Higher Value of Beginning FIFO

Inv due to Inflation that is

BeginFIFO-Inventory

*Inflation rate

When a firm using LIFO sells more than it purchases (declining units in Inventory) the older cheaper units will be sold, inflating profits (as cost of production understated)

This is dipping into the LIFO reserve, also known as “LIFO Liquidation”LIFO reserve can also fall due to deflation

Difference between International Accounts Standards 2 and GAAPIAS2 says FIFO or Average Cost methods should be favored over LIFO

GAAP requires LCM writedowns to be made for items separately, whereas IAS allows aggregates for similar items

Example: ABC Ltd. reports the followingYear 2015 2016FIFO Invent 1,400 1,450LIFO Reserve 230 265

By LIFO basis accounting: COGS = 4,150; NI = 120; Tax rate = 40%; ROE = 6%1) ABC’s Turnover? Turnover is COGS divided by Average Inventory

FIFO Basis Turnover: 2*4,150/(1,400 + 1,450) = 2.9122LIFO inventory for 2015 = 1,400 – 230 = 1,170LIFO inventory for 2016 = 1,450 – 265 = 1,185

LIFO Basis Turnover: 2*4,150/(1,170 + 1,185) = 3.5244Income if ABC used FIFO basis?LIFO Reserve has increased by: 265 – 250 = 15

FIFO basis Income before Tax would increase by 15FIFO basis Income after Tax would be:120 + 15*(1 – 0.40) = 129 ROE on FIFO basis?

Both Equity and Income will changeAverage Equity by LIFO is:120/0.06 = 2,000 For FIFO basis we increase Equity by average tax adjusted LIFO Reserve:

2,000 + 0.5*(230 + 265)*(1 – 0.40) = 2,148.5FIFO basis ROE: 129/2,148.5 = 6.004%

TaxesFinancial statements are:1) Book (for reporting purposes)2) Tax (to compute taxes)

TerminologyPretax Income (book) is reported on I/SMore complete but cumbersome would be Income Before Income Tax for Financial Reporting.

Some authors prefer Book Income(Income) Tax Expense (book) is based on Pretax Income. It is reported in I/STaxable Income (tax) is the income on which taxes are computed

Taxes Payable (tax) is tax liability based on Taxable IncomeIncome Tax Paid is actual cash paid to the IRS during a year (book). This includes refunds or payments for prior years

Tax Expense can be broken down into: Taxes Payable (actual tax return liability) and Deferred Income Tax ExpenseEffective tax rate = Income tax expense

Pretax Income

Deferred Tax Assets increase when a timing difference results in: Taxable income > Pretax Income Leading to: Taxes Payable > Income Tax Expense

Warranties and Tax Loss Carryforwards are typical sources of Deferred Tax AssetsA firm is not allowed for tax purposes to recognize an expense due to warranties until it actually occurs. It

will however recognize the expense in its bookDeferred Tax Liabilities arise when:Income Tax Expense > Taxes Payable

Timing Difference can arise between Pretax Income and Taxable Income due to, for example S/L versus Accelerated Depreciation1) Temporary Difference goes away with time

2) Permanent Difference (for example due to Municipal Bond interest payments) persists through timeIncome Tax Expense = Income Taxes (actually payable or paid) + Change in Deferred Tax Liability

Example: Suppose Income Tax Expense = $5M and Taxes Payable = $4MDebit: Income Tax Expense for $5MCredit Income Tax Payable for $4M

And Credit Deferred Tax Liability for $1MDeferral Method now replaced by the Liability Method for calculating Deferred Tax LiabilityIn the Deferral Method:

1) Income Tax Expense was calculated from Pretax Income and tax rates2) Deferred Tax Liability was calculated This is problematic if future tax rates change

In the Liability Method: 1) Future taxes are estimated to compute the Deferred Tax Liability2) Income Tax expense is computed

Example of Deferred Tax Liability: Suppose a firm depreciates an asset it purchased for $12,000 over 3 years using S/LAsset lasts 4 years and produces revenues of $8,000 every year. Tax rate is 34%

Tax CalculationDepre Taxable

IncomeTaxes Payable

Yr 1 4,000 4,000 1,360Yr 2 4,000 4,000 1,360Yr 3 4,000 4,000 1,360Yr 4 0 8,000 2,720

Reporting

Dep Pretax Inc

Tax Exp

Def Tax Liab

Yr 1 3K 5K 1.7K 340Yr 2 3K 5K 1.7K 680Yr 3 3K 5K 1.7K 1,020Yr 4 3K 5K 1.7K 0

Example of Deferred Tax Asset: Warranty ExpensesSuppose a firm has revenues of $20M for two years from selling a product. It will only incur a warranty expense of $2M during year 2. Suppose tax rate is 34%

Tax CalculationWarr Exp

Taxable Income

Taxes Payable

Yr 1 0 20M 6.8MYr 2 2M 18M 6.12M

Reporting

Warr Exp

Pretax Income

Tax Expense

Yr 1 1M 19M 6.46MYr 2 1M 19M 6.46M

Deferred Tax Asset for Yr 1 = $6.8M - $6.46M = $0.54MYr2 the DTA reverses

Changes in Tax RatesLiability Method: Revalue all existing DTAs and DTLs using the tax rates that will be applicable when the DTAs or DTLs reverse

A Tax Increase => DTL increase. For example, consider DepreciationFor tax purposes machinery is depreciated faster than for accounting purposes. This means that in later years the firm will not be able to

shelter income using depreciationThis would imply that an increase in tax rates in the later years would increase income tax in those years, thus today DTL will increase

If DTL > DTA and increase in tax rates => increase in Income Tax expense => decrease in NI and Equity If DTL > DTA and decrease in tax rates => decrease in Income Tax expense => increase in NI and Equity

Example of an increase in tax rates, say from 30% to 45%. Now taxes have increased by 50%, that is (45% - 30%)/30% = 50%A firm has a DTL of $10,000

Its DTL will increase to $10,000*(1 + 0.50) = $15,000Change (increase) in DTL = $5,000Suppose its DTA is $4,000Its DTA will increase from $4,000 to $6,000

Change (increase) in DTA = $2,000Change in Income Tax Exp = Change in DTL – Change in DTA = $5,000 - $2,000 = $3,000

Are DTLs liability or equity?If high probability of reversal then liability, otherwise equity

What is the value of a DTL? It is the undiscounted value for accounting purposesIn real terms you should discount it and find the present value

For example, there is a DTL that you expect to reverse in 5 years for $1,000. It has an accounting value of $1,000 but a present value of $712.99 at a discount rate of 7%

If you are analyzing the firm, treat the difference ($287.01) as equity

A firm should decrease DTL and increase Equity if it concludes that a DTL will not be reversed in the future.This could happen if capital expenditures are growing. Increase in Equity would

decrease ratios like ROE and book D/E.Similarly if it is believed that a DTA will not be reversed, then DTA should be decreased, accompanied by a corresponding decrease to Equity.

This would decrease Equity and increase ratios like ROE and book D/E.

Analysis of Financial Liabilities

Bond Features and TerminologyBonds issued at Par: 1) Book value = Par value2) Coupon Payments = Interest Expense

3) Money received by sale and repayment of Face at maturity goes to Cash Flows from Financing in Cash Flow Statement4) Interest payments are accounted for in Cash Flow from Operations

Premium Bonds: 1) Book Value = Par + Premium2) Premium amortized to zero at maturity3) Coupons are taken to consist of two parts: Interest

Expense + Premium AmortizationHence for a premium bond interest expense is less than coupon payment4) Interest Expense = Beginning BV x Rate of Discount at Issuance

Example for Premium Bond Bond Face value: $1,000,000Coupon Rate 9% per annum paid semi-annually6 years to maturityMarket rate of return = 7% per annum

Price of Bond = $1,096,633Suppose Bond sold for Cash, then Assets in the form of Cash increases by $1,096,633Liabilities in the form of Long Term Debt increases by $1,000,000 and a Premium of $96,633

Interest Expense for the first period will be: $1,096,633*0.035 = $38,382Premium Amortization = $1,000,000*0.045 - $38,382 = $6,618Premium post Amortization = $90,015

Cash Flow Statement has two entries:1) Cash Flows from Financing (CFF): $1,096,633 2) Cash Flows from Operations: $45,000

Book Value post amortiz (beginning of next period) = Long Term Debt + Premium post Amortiz = $1,000,000 + $90,015 = $1,090,015

Interest Expense for the second period will be: $1,090,015*0.035 = $38,151 (note, it is the rate of return when the bond was sold, rather than the rate of return at the second period)

Premium Amortization = $1,000,000*0.045 - $38,151 = $6,849Premium post Amortization = $83,166Cash Flow Statement will have a single entry ($45,000)

as Cash Flows from OperationsThe coupons of $45,000 will pay the interest and amortize the Premium down to ZERO over the 6 years as the 12 six-monthly coupons of $45,000 and the final

payment of $1,000,000 generates a return of 3.5% on the initial investment of $1,096,633 (see lectures on Time Value of Money)This will leave a Book Value of $1,000,000 which will be repaid at the end of the 6 yrs

Similarly for a discount bond, Interest Expense is more than coupon payments.For a discount bond:1) The B/S shows a Book Value equal to Par and a discount

2) The discount is also amortized to zero over the life of the bond

Example for Discount Bond Bond Face value: $1,000,000Coupon Rate 9%6 years to maturityMarket rate of return = 10%Price of Bond = $955,684

Suppose the Bond sold for Cash, then Assets in the form of Cash increases by $955,684Liabilities in the form of Long Term Debt increases by $1,000,000 and a Discount of $44,316

Interest Expense for the first period will be: $955,684*0.05 = $47,784Discount Amortization = $47,784 - $1,000,000*0.045 = $2,784Discount post Amortization = $41,532

Cash Flow Statement has two entries, one the $955,684 as Cash Flows from Financing (CFF) and the other ($45,000) as Cash Flows from OperationsBook Value post amortization (beginning of

next period) = Long Term Debt + Discount post Amortization = $1,000,000 + ($41,532) = $958,468Interest Expense for the second period will be: $958,468*0.05 = $47,923 (note, it is the rate of return

when the bond was sold, rather than the rate of return at the second period)Discount Amortization = $47,923 - $1,000,000*0.045 = $2,923Discount post Amortization = $38,609

Cash Flow Statement will have a single entry ($45,000) as Cash Flows from Operations

Zero Coupon is a discount bond with no coupons paid. Hence the Discount is not amortized, but rather paid off at maturityThe first period will show a CFF equal to the price for

which the Bond sells, but CFO will be zeroExample of Zero Coupon: On Jan 1 2010 XYZ Corp. issued a Zero Coupon bond due on Dec 31 2020. Face value of the bond is

$1,000,000 and rate of return is 6% compounded annually What will be the impact of the sale of the Zero Coupon on Interest Expense, and on CFO?We first find the price of the bond to be:

$1,000,000/1.0610 = $558,395The Interest Expense for year 1 will be:$558,395 * 0.06 = 33,504As nothing is paid to bond owner, for the 2nd year the

Book Value of the debt liability will increase to:558,395 + 33,504 = 591,899And the Interest Expense for the 2nd year will be:591,899 * 0.06 = 35,514

And so on till the 10th year when the Book Value will reach the maturity value of $1,000,000

If a Bond is paid off (retired) early, then the difference between the price paid by the firm (to retire the bond) and the book value of the bond is an “Extraordinary Loss” or “Extraordinary Gain”

An Extraordinary Gain is likely when interest rates are high, and therefore prices of Bonds issued earlier are lowSimilarly if market rates of return are low, then an Extraordinary Loss is likely

LeasesA Lessee leases an asset for use from a Lessor (asset owner). There are two types of accounting treatments for leases: Capital Lease and Operating Lease

In a Capital Lease the lease is treated as if the Lessee has purchased the assetHence the asset enters the left side of the B/S and the future payments to be made for the lease enter the right side of the B/S as a Liability

If the lease meets any one of the four following conditions, then it is treated as a Capital Lease:1) At the end of the lease the Lessee becomes the owner of the asset

2) The lease contract includes a “bargain purchase option”, that is the asset can be purchased by the Lessee at a lower price3) The PV of the payments to be made to the Lessor by the

Lessee exceeds 90% of Fair Market Value of the assetThe discount rate for finding the PV is the lower of the Lessee’s marginal rate of borrowing, and the rate in the lease contract

4) If the length of time for which the asset is leased is greater than 75% of the useful life of the asset

Example: An equipment with a market price (FMV) of $100,000 and useful life of 5 years is leased to a Lessee for a period of 4 yearsThe lease payments are $26,000 a year

The borrowing rate for the firm is 8%, and the rate implicit in the lease is 7%There is no provision for Lessee to purchase asset at the end of the lease term, nor any bargain purchase option

Is it a Capital Lease or an Operating Lease?1) and 2) not satisfied. The rate for discounting will be 7% (lower of 7% & 8%)At that rate the PV of the payments is $88,070. So PV

of payments to be made is only 88.07% of FMV < 90%So 3) is not satisfied4 years/5 years = 80% > 75%, 4) is satisfiedSo the lease should be treated as a Capital Lease

Suppose lease was OLThen no B/S impact$26,000 expense on IS and outflow for CFOSuppose lease was CL

Then an asset and a liability of $88,070 when the lease is entered intoFor the first period:Interest Expense = $88,070*7% = $6,165

Depreciation Expense = $88,070 / 4 years = $22,017Total Expenses = $22,017 + $6,165 = $28,182 > Lease Payment of $26,000So in the earlier years of the lease, use of CL rather than OL results in greater

expenses (lesser NI)Situation reverses in later yearsAt the beginning of the second year CL will be lower by: $26,000 - $6,165 = $19,835

So the CL at the beginning of second year will be:$88,070 - $19,835 = $68,235 The payment for the lease is divided into two parts in the CF Statement:

CFO has the IE of ($6,165) This gets smaller over the yearsCFF has the liability reduction of ($19,835) This gets larger over the yearsCFI will not change (CL reported as “non-cash

investment and financing activity”) The total CF for both (OL & CL) will be same at $26,000

For ratios like ROA, Asset Turnover etc, remember that CL increases Assets of the firmFor D/E, remember that CL increases Liabilities

Advantages and Disadvantages of OL and CLOL keeps risk with Lessor, lower leverage, higher NI in earlier yearsCL provides tax advantages, Comparisons of OL and CL

OL do not have any B/S impact, whereas CL doAssets higher under CLLiabilities higher under CLIn CL the asset is treated as being financed by a borrowing, so CFF lower