Chapter 4
Chapter 4
Analyzing Investing Activities
Analyzing Investing Activities
REVIEW
REVIEW
Assets are the
Assets are the driving forces of profitability for a company. Adriving forces of profitability for a company. Assets produce revenues ssets produce revenues thatthat compensate or!ers" repay lenders" reard oners" and fund groth. Current assets are compensate or!ers" repay lenders" reard oners" and fund groth. Current assets are res
resourources ces or or claclaims ims to to resresouources rces readreadily ily conconververtibtible le to to cashcash. . #a#a$or $or curcurrenrent t assassetsets inc
includlude e cascash h and and cascash h e%ue%uivivalealentsnts" " marmar!et!etablable e secusecuritritiesies" " recereceivaivablebles" s" derderivaivativtivee financial instruments" inventories" and prepaid e&penses. 'ur analysis of current assets financial instruments" inventories" and prepaid e&penses. 'ur analysis of current assets provides us insights into a company(s li%uidity. )i%uidity is the length of time until assets provides us insights into a company(s li%uidity. )i%uidity is the length of time until assets ar
are e coconvnverterted ed to to cacashsh. . It It is is an an inindidicacatotor r of of a a cocompmpanany(y(s s ababililitity y to to memeet et fifinanancnciaiall obli
obligatigationsons. . *he *he less li%uiless li%uid d a a compacompanyny" " the the loeloer r is its is its finafinanciancial l fle&fle&ibilibility to ity to purspursueue promising investment opportunities and the greater its ris! of failure. +oncurrent assets promising investment opportunities and the greater its ris! of failure. +oncurrent assets are resources or claims to resources e&pected to benefit more than the current period. are resources or claims to resources e&pected to benefit more than the current period. #a$o
#a$or r noncnoncurrenurrent t assetassets s incinclude lude proppropertyerty" " planplant" t" e%uie%uipmenpment" t" intaintangibngibles" les" inveinvestmestments"nts" and deferred charges. 'ur analysis of noncurrent assets provides us insights into a and deferred charges. 'ur analysis of noncurrent assets provides us insights into a com
companpany(y(s s sosolvelvency ncy and and opeoperatrationional al capcapacitacityy. . ,ol,olvenvency cy referefers rs to to the the abiabilility ty of of aa company to meets its long-term and current/ obligations. 'perational capacity is the company to meets its long-term and current/ obligations. 'perational capacity is the ability o
ability of a company to generate future profits. f a company to generate future profits. *his chapter shos ho e use financia*his chapter shos ho e use financiall state
statements ments to to better better assess assess li%li%uiduidityity" " solsolvencyvency" " and and operaoperationtional al capacity using capacity using assetasset values" and to critically evaluate a company(s financial performance and prospects. *he values" and to critically evaluate a company(s financial performance and prospects. *he ac
accocoununtiting ng prpracactiticeces s unundederlrlyiying ng ththe e memeasasururememenent t anand d rerepoportrtining g of of cucurrrrenent t anandd noncurrent assets are described. We discuss the accounting for these assets and its noncurrent assets are described. We discuss the accounting for these assets and its implications for analysis of financial statements. ,pecial attention is given to various implications for analysis of financial statements. ,pecial attention is given to various analytical ad$ustments helping us better understand current and
'0*)I+E
'0*)I+E
,ection 12
,ection 12 Current AssCurrent Assetsets •
• Cash and Cash E%uivalentsCash and Cash E%uivalents
Analyzing Cash and Cash E%uivalents Analyzing Cash and Cash E%uivalents • • ReceivablesReceivables Valuation of Receivables Valuation of Receivables Analyzing Receivables Analyzing Receivables •
• 3repaid E&penses3repaid E&penses •
• InventoriesInventories
Inventory Accounting and Valuation Inventory Accounting and Valuation Analyzing Inventories
Analyzing Inventories
,ection 2
,ection 2 +oncurrent As+oncurrent Assetssets •
• Introduction to )ong-)ived AssetsIntroduction to )ong-)ived Assets Accounting for )ong-)ived Assets Accounting for )ong-)ived Assets Capitalizin
Capitalizing versus E&pensing2 g versus E&pensing2 5inancial ,tatement and Ratio 5inancial ,tatement and Ratio EffectsEffects •
• 3lant Assets and +atural Resources3lant Assets and +atural Resources
Valuing 3lant Assets and +atural Resources Valuing 3lant Assets and +atural Resources 6epreciation and 6epletion
6epreciation and 6epletion •
• Intangible AssetsIntangible Assets
Accounting for Intangibles Accounting for Intangibles Analyzing Intangibles Analyzing Intangibles 7oodill
7oodill
0nrecorded Intangibles and
A+A)
A+A)8
8,I,
,I, '9:EC
'9:EC*IVE,
*IVE,
•
• 6efine current assets and their relevance 6efine current assets and their relevance for analysis.for analysis.
•
• E&plain cash management E&plain cash management and its implicationand its implications for analysis.s for analysis.
•
• AnalyAnalyze receivables" alloances ze receivables" alloances for bad debts" for bad debts" and securitization.and securitization.
•
• Interpret the effects Interpret the effects of alternative inventory methods under varying businessof alternative inventory methods under varying business conditions.
conditions. •
• E&plain the concept E&plain the concept of long-lived assets and its implicationof long-lived assets and its implications for analysis.s for analysis.
•
• Interpret valuation and cost allocation of plant assets and natural resources.Interpret valuation and cost allocation of plant assets and natural resources.
•
• 6escribe and analyze 6escribe and analyze intangiblintangible assets and e assets and their disclosures.their disclosures.
•
;0E,*I'+,
;0E,*I'+,
1.
1. a.a. +o+o. . WhWhen en ananalalyzyzining g cacashsh" " ththe e momost list li%u%uid of id of cucurrrrenent t asassesetsts" " ththe e ananalalysyst t isis inter
interested in ested in the the availavailabilability of ity of cash cash in meeting the in meeting the compacompany(s obligany(s obligationtions. As. A restr
restrictiiction on undeunder r compecompensatinsating ng balanbalance ce arrangarrangementements s does" at does" at orsorst" t" remoremoveve these cash balances from immediate availability as means of payment. Indeed" these cash balances from immediate availability as means of payment. Indeed" use of such balances can have repercussions for the company that can affect its use of such balances can have repercussions for the company that can affect its future access to ban! credit.
future access to ban! credit. b.
b. *h*he e ananalalyyst st shshouould ld e&e&clcludude e cacash sh rereststririctcted ed unundeder r cocompmpenensasatiting ng babalalancncee agreements from current assets. ,EC Accounting ,eries Release 14< re%uires agreements from current assets. ,EC Accounting ,eries Release 14< re%uires that a company that has borroed money from a ban! segregate on its balance that a company that has borroed money from a ban! segregate on its balance sheet any cash sub$ect to ithdraal or usage restrictions under compensating sheet any cash sub$ect to ithdraal or usage restrictions under compensating balan
balance ce agreemagreements ith the ents ith the lendlending ban!. ing ban!. *hese *hese re%ure%uiremeirements may" as nts may" as is oftenis often the case in such situations" move companies and their ban!er to alter the form of the case in such situations" move companies and their ban!er to alter the form of their contractual agreements hile retaining their substance. *he analyst must be their contractual agreements hile retaining their substance. *he analyst must be ever alert to such attempts to distort analysis measurements by presentations ever alert to such attempts to distort analysis measurements by presentations h
hosose e foform rm is is nonot t a a trtrue ue rereflflecectition on of of ththeieir r susubsbstatancnce. e. 'n'ne e memeasasurure e of of aa company=s vuln
company=s vulnerability in this area is the erability in this area is the ratio of restricted cash ratio of restricted cash to total cash.to total cash. .
. a.a. *h*he e opopereratatining g cycyclcle e coconcncepept t is imis impoportrtanant t in the in the clclasassisifificacatition of on of asassesets ts anandd liabilities as either current or noncurrent. *he operating cycle encompasses the liabilities as either current or noncurrent. *he operating cycle encompasses the period of time from the commitment of cash for purchases until the collection of period of time from the commitment of cash for purchases until the collection of receivables resulting from the sale of goods or services. *he diagram near the receivables resulting from the sale of goods or services. *he diagram near the beginning of Chapter 4 illustrates this concept.
beginning of Chapter 4 illustrates this concept. b.
b. If the nIf the normal ormal collecollectioction intern interval of a receval of a receivabivables is loles is longer thnger than a year such as ian a year such as ithth long
longer er term installterm installment receivablment receivables/" then es/" then their inclustheir inclusion as ion as currencurrent t assets isassets is proper provided the operating cycle is e%ual to or greater than the obligation due proper provided the operating cycle is e%ual to or greater than the obligation due date for the receivables. ,imilarly" if inventories" by business need or custom" date for the receivables. ,imilarly" if inventories" by business need or custom" have to be !ept on average for more than 1 months" then this normal inventory have to be !ept on average for more than 1 months" then this normal inventory holding period becomes part of the operating cycle and such inventories are holding period becomes part of the operating cycle and such inventories are included among current assets.
included among current assets. c.
c. *he limi*he limitatatiotions of ns of the currthe current ratient ratio hico hich is h is comcomputputed from itemed from items defins defined ased as or!ing capital/ as a measure of short-term li%uidity are discussed in Chapter 11. or!ing capital/ as a measure of short-term li%uidity are discussed in Chapter 11. ,till" if e accept the proposition that it is useful to measure the current resources ,till" if e accept the proposition that it is useful to measure the current resources available to pay current obligations" then it is difficult to see ho e&tension of available to pay current obligations" then it is difficult to see ho e&tension of >current> from the customary 1 months to periods of ?@ months or longer can >current> from the customary 1 months to periods of ?@ months or longer can serve a useful purpose. *he operating cycle concept may help companies sho serve a useful purpose. *he operating cycle concept may help companies sho the !ind of positive current position that they otherise might not be able to sho" the !ind of positive current position that they otherise might not be able to sho" but this concept is of doubtful value or
but this concept is of doubtful value or validity frovalidity from the point of vie of m the point of vie of a financiala financial analyst that must assess
analyst that must assess a company=s short-term li%uiditya company=s short-term li%uidity.. d.
d. 1/ *o1/ *obaccbacco o InIndudustrstryy. *he . *he totobacbacco co lealeaf f musmust t go throgo througugh h an an agaginging" " curcuringing" " andand dry
drying ing proprocescess s e&tee&tendinding ng ovover er sevseveraeral l yeayears. rs. *hi*his s tobtobaccacco o ininvenventortory y grgreeneen leaves/" that may not be used in the production of a salable product for many leaves/" that may not be used in the production of a salable product for many yea
years" rs" is is claclassissifiefied d as as curcurrenrent t undunder er the the opeoperatrating ing cyccycle le conconcepcept. t. *hi*his s ououldld occur even if long-term loans classified among noncurrent liabilities/ ere ta!en occur even if long-term loans classified among noncurrent liabilities/ ere ta!en out to finance
/ )i%uor Industry. *he li%uor industry has an operating cycle e&tending beyond / )i%uor Industry. *he li%uor industry has an operating cycle e&tending beyond the customary 1 months. In this case" the holding of li%uor inventory for aging the customary 1 months. In this case" the holding of li%uor inventory for aging purposes over many years provides sufficient $ustification for inclusion of such purposes over many years provides sufficient $ustification for inclusion of such inventories among current assets.
inventories among current assets. ?/ Retailing Industry
?/ Retailing Industry. In retailing" the sale of . In retailing" the sale of >large tic!et> items on >large tic!et> items on the installmentthe installment plan can e&te
plan can e&tend the operating cycle nd the operating cycle to" for e&le" ?@ to" for e&le" ?@ months or longermonths or longer. A. As such"s such" these installment receivables are reported among current assets.
these installment receivables are reported among current assets. ?.
?. a. a. *h*he e tto o momost impst imporortantant t %u%uesestitionons s fafacicing the ng the fifinanancnciaial l ananalalysyst t iith resth respepect ct toto receivables are2 1/ Is the receivable genuine" due" and enforceable" and / Bas receivables are2 1/ Is the receivable genuine" due" and enforceable" and / Bas the
the proprobabbabiliility ty of of colcolleclectiotion n beebeen n proproperperly ly assassessessed ed WhWhilile e the the un%un%ualualifiifieded opinion of an independent auditor lends some assurance ith regard to these opinion of an independent auditor lends some assurance ith regard to these %ue
%uestistionons" s" the the finfinancancial ial anaanalyslyst t mumust st recrecognognize ize the the pospossibsibililitity y of of an an errerror or of of $udgment as ell
$udgment as ell as the lac! of complete independence.as the lac! of complete independence. b.
b. 6escr6escriptiiption of the receivabon of the receivables in the notes to finales in the notes to financiancial statemenl statements usualts usually do notly do not contain sufficient clues to allo a reliable $udgment as to hether a receivable is contain sufficient clues to allo a reliable $udgment as to hether a receivable is genuine" due" and enforceable. Conse%uently" !noledge of industry practices genuine" due" and enforceable. Conse%uently" !noledge of industry practices and supplementary sources of
and supplementary sources of informatioinformation must be used n must be used for additional assurance"for additional assurance" e.g.2
e.g.2 •
• In some industries" such as compact discs" toys" or boo!s" a substantial rightIn some industries" such as compact discs" toys" or boo!s" a substantial right of merchandise return e&ists and alloance must be made
of merchandise return e&ists and alloance must be made for this.for this. •
• #o#ost st proprovivisisionons s for for uncuncololleclectibtible le accaccounounts ts are are basbased ed on on paspast t e&pee&perieriencence although they should also ma!e alloances for current and emerging industry although they should also ma!e alloances for current and emerging industry conditions. In practice" the accountant is li!ely to attach more importance to conditions. In practice" the accountant is li!ely to attach more importance to the former than to the latter. *he analyst must" in such cases" use one=s on the former than to the latter. *he analyst must" in such cases" use one=s on $udgment and !noledge of industry conditions to assess the ade%uacy
$udgment and !noledge of industry conditions to assess the ade%uacy of theof the provisio
provision for n for uncollectibluncollectible ae accounts.ccounts. •
• Information that ould be helpful in assessing the general level of collectionInformation that ould be helpful in assessing the general level of collection ris!s ith receivables is not usually found in published financial statements. ris!s ith receivables is not usually found in published financial statements. ,uc
,uch h ininforformatmation ion cancan" " of of coucourse" rse" be be sousoughght t frofrom m the the cocompampany ny didirectrectlyly.. E&les of such information are2 1/ What is customer concentration What E&les of such information are2 1/ What is customer concentration What percent of total receivables is due from one or a fe ma$or customers Would percent of total receivables is due from one or a fe ma$or customers Would failure of any one customer have a material impact on the company(s financial failure of any one customer have a material impact on the company(s financial condition
condition / What / What is the is the age pattern of age pattern of the receivables the receivables ?/ What p?/ What proportionroportion of notes rece
of notes receivabivable represenle represent reneals of olt reneals of old notes d notes 4/ Bave all4/ Bave alloancoanceses been made for trade discounts" returns" or other credits to hich customers been made for trade discounts" returns" or other credits to hich customers are entitled
are entitled •
• *he analyst" in assessing current financial position and a company(s ability to*he analyst" in assessing current financial position and a company(s ability to meet its obligations currentlyas e&pressed by such measures as the current meet its obligations currentlyas e&pressed by such measures as the current ratiomust recognize the full impact of accounting conventions that relate to ratiomust recognize the full impact of accounting conventions that relate to classification of receivables as >current.> 5or e&le" the operating cycle classification of receivables as >current.> 5or e&le" the operating cycle concept allos the
concept allos the inclusioinclusion of installment receivables" hich may n of installment receivables" hich may not be not be fullyfully collectible for years. In balancing these against current obligations" alloance collectible for years. In balancing these against current obligations" alloance for such differences
for such differences in timing of cash flos should be made.in timing of cash flos should be made. 4.
4. a.a. 5a5actctooriring ng oor r sesecucuririttizizaattioion n oof f rerececeivivabableles s rerefeferrs s to to ththe pe praractcticice oe of f sesellllining g aallll or a portion of a c
b.
b. WhWhen en rereceiceivavablbles es arare e sosold ld iith recoth recourursese" " ththe e ththirird d papartrty y pupurcrchahaser ser of of ththee re
receiceivavablbles es retretaiains ns ththe e ririghght t to to cocollllecect t frfrom om ththe e cocompmpanany y ththat at sosold ld ththee receivable if the receivable proves uncollectible. When receivables are sold receivable if the receivable proves uncollectible. When receivables are sold ithout recourse" the purchaser of the
ithout recourse" the purchaser of the receivables assumes the collection ris!.receivables assumes the collection ris!. c.
c. WheWhen receivn receivablables are es are solsold ith recd ith recourourse" the balanse" the balance ce shsheet repoeet reports the cashrts the cash receiv
received from the sale of the receivabled from the sale of the receivable. e. BoeBoeverver" the balan" the balance sheet may or ce sheet may or ma
may y nonot t rerepoport rt ththe e cocontntiningegent nt liliababililitity y to to ththe e rereceiceivavablbles es pupurcrchahaser ser fofor r unco
uncollectllectiblible e receivreceivables purchased ables purchased ith recourseith recoursethis depends this depends on on hoho assumes the ris! of
assumes the ris! of onership.onership. D.
D. a.a. 5e5e ususefeful genul genereralalizizatatioions abons about the effeut the effect ct of difof diffeferiring metng methohods of ds of ininveventntororyy valuation on financial analysis can be
valuation on financial analysis can be made. 8emade. 8et" e provide some t" e provide some guidance.guidance. •
• In the case of )I5'" e !no that under conditions of fluctuating price levels"In the case of )I5'" e !no that under conditions of fluctuating price levels" it ill have a smoothing effect on
it ill have a smoothing effect on income. #oreover" tincome. #oreover" the )I5' method yields" inhe )I5' method yields" in times of price inflation" an unrealistically lo inventory amount. *his" in turn" times of price inflation" an unrealistically lo inventory amount. *his" in turn" loers the current ratio and tends to increase the inventory turnover ratio. We loers the current ratio and tends to increase the inventory turnover ratio. We als
also o !no!no thathat t the the )I)I5' 5' metmethod hod affaffordords s manmanageagemenment t an an oppopportortununity toity to manipulate profits by alloing inventory to be depleted in poor years" thus manipulate profits by alloing inventory to be depleted in poor years" thus draing on the lo cost pool to inflate income. A $udgment on all of these draing on the lo cost pool to inflate income. A $udgment on all of these co
consnse%e%ueuencences s can can ononly ly be be mamade de on on ththe e babasisis s of of an an asassesessssmement nt of of alalll surrounding circumstances. 5or e&le" a slight change in a current ratio of surrounding circumstances. 5or e&le" a slight change in a current ratio of 421 may be of no significance" hereas the same change in a ratio of 1.D21 may 421 may be of no significance" hereas the same change in a ratio of 1.D21 may be of far greater importance.
be of far greater importance. •
• *he use *he use of 5I5' for the of 5I5' for the valuation of inventories ill valuation of inventories ill generally result in a higher generally result in a higher inventory on the balance sheet and a loer cost of goods sold and higher inventory on the balance sheet and a loer cost of goods sold and higher income/ in comparison to
income/ in comparison to )I5'.)I5'. •
• *he average cost method smoothes out cost fluctuations by using a eighted*he average cost method smoothes out cost fluctuations by using a eighted average cost in valuing inventories and in pricing cost of goods sold. *he average cost in valuing inventories and in pricing cost of goods sold. *he resulting net income ill be close to an average of the net income under )I5' resulting net income ill be close to an average of the net income under )I5' and 5I5'.
and 5I5'. •
• *he >loer-of-cost-or-mar!et> principle of inventory accounting has additional*he >loer-of-cost-or-mar!et> principle of inventory accounting has additional implications for the analyst. In times of rising prices it tends to undervalue implications for the analyst. In times of rising prices it tends to undervalue inventories regardless of the cost method used. *his" in turn" ill depress the inventories regardless of the cost method used. *his" in turn" ill depress the current ratio belo its true level since the other current assets as ell as current ratio belo its true level since the other current assets as ell as current liabilities/ are not valued on a consistent basis ith the methods used current liabilities/ are not valued on a consistent basis ith the methods used in valuing inventories.
in valuing inventories. b.
b. In pracIn practice e can find idtice e can find ide variate variations iions in the !indn the !inds of costs thas of costs that are includt are included ined in inventory
inventory. 3ractice . 3ractice varies particularly ith respect varies particularly ith respect to the to the inclusioinclusion or n or e&clusion of e&clusion of 1
1/ / vavaririouous s clclasasseses s of of ovovererhehead ad cocoststs" s" / / frfreieighght-it-in" n" anand d ??/ / gegeneneraral l anandd administrative costs. *his variety in practices can have a significant effect on administrative costs. *his variety in practices can have a significant effect on comparability across companies.
comparability across companies. @.
@. a.a. *h*he e alallolocacatition of oon of oveverhrhead coead coststs to all us to all uninits of prts of prododucuctition muon must be dost be done on ane on a rational basis designed to get
rational basis designed to get the best athe best appro&imation of actual cost. Boever" thisppro&imation of actual cost. Boever" this is far from easy. *he greatest difficulty stems from the fact that a good part of is far from easy. *he greatest difficulty stems from the fact that a good part of overhead is fi&ed costs" i.e." costs that do not vary ith production but vary overhead is fi&ed costs" i.e." costs that do not vary ith production but vary mos
mostly ith the tly ith the laplapse se of of timtime. e. E&amE&lples es are are renrent t paypaymenments ts and and ththe e facfactortoryy manager(s salary. *hus" assuming only a single product is produced" fi&ed costs manager(s salary. *hus" assuming only a single product is produced" fi&ed costs are 1FF"FFF" and 1F"FFF units are produced" then each unit ill absorb 1F of are 1FF"FFF" and 1F"FFF units are produced" then each unit ill absorb 1F of fi&ed costs. Boever" if D"FFF units are
produced" each
produced" each unit ill abunit ill absorb F sorb F of fi&ed costs. *his shos that level of actof fi&ed costs. *his shos that level of activityivity is an important determinant of unit costide fluctuations in output can yield is an important determinant of unit costide fluctuations in output can yield ide fluctuations in unit cost.
ide fluctuations in unit cost. b.
b. *o al*o allocate fi&ed costs to units" an assumptilocate fi&ed costs to units" an assumption inition initially mually must be made as to host be made as to ho many units the company e&pects to produce. *his determines over ho many many units the company e&pects to produce. *his determines over ho many units the overhead costs is allocated. *hat calculation re%uires estimates of sales units the overhead costs is allocated. *hat calculation re%uires estimates of sales and related production. *o the e&tent
and related production. *o the e&tent that actual production differs from estimatedthat actual production differs from estimated pro
producductiotion" n" ovoverherhead ead coscosts ts ilill l be be eiteither her ovoveraperapplplied ied or or undunderaerapplppliedied. . *ha*hatt means that production and inventory are charged ith more than total overhead means that production and inventory are charged ith more than total overhead costs or ith an
costs or ith an insufficinsufficient amount of overhead ient amount of overhead costs.costs. G.
G. *he ma$or ob*he ma$or ob$ectiv$ective of the )I5e of the )I5' method o' method of invenf inventory accotory accountiunting is to cng is to charge cost oharge cost of f goods sold ith the most recent costs incurred. When the price level is stable" the goods sold ith the most recent costs incurred. When the price level is stable" the results under either the 5I5' or the )I5' method ill be the same. When price levels results under either the 5I5' or the )I5' method ill be the same. When price levels change" the use of these different methods can yield significantly different financial change" the use of these different methods can yield significantly different financial results. 'ne of the primary aims of )I5' is to obtain a better matching of costs and results. 'ne of the primary aims of )I5' is to obtain a better matching of costs and revenues in times of inflation. 0nder the )I5' method" the income statement is given revenues in times of inflation. 0nder the )I5' method" the income statement is given priority over the balance sheet. *his means that hile a matching of more current priority over the balance sheet. *his means that hile a matching of more current cos
costs ts itith h revrevenuenues es occoccurs urs in in timtimes es of of prprice ice infinflatlatioion n dedeflaflatitionon/" /" the the invinvenentortoryy carrying amounts in the balance sheet ill be unrealistically lo high/. +ote that use carrying amounts in the balance sheet ill be unrealistically lo high/. +ote that use of the )I5' method is encouraged by its acceptance for ta& purposes. *he ta& la of the )I5' method is encouraged by its acceptance for ta& purposes. *he ta& la stipulates that its use for ta& purposes ma!es mandatory its adoption for financial stipulates that its use for ta& purposes ma!es mandatory its adoption for financial reporting.
reporting. <.
<. In most In most annual reports" iannual reports" insufficiennsufficient informat information is tion is given to algiven to allo the lo the analyst to coanalyst to convertnvert inventories accounted for under one method to a figure reflecting a different method inventories accounted for under one method to a figure reflecting a different method of inventory accounting. #ost analysts ant such information to better compare the of inventory accounting. #ost analysts ant such information to better compare the financial statements of companies that use different inventory accounting methods. financial statements of companies that use different inventory accounting methods. Con
Conververtinting g an an ininvenventortory y figfigure ure frofrom m one methoone method d to to anoanothether r is is madmade e eveeven n mormoree difficult by the use of different methods for various components of inventory. ,till" difficult by the use of different methods for various components of inventory. ,till" analysts must" in most cases" ma!e an overall assessment of the impact of different analysts must" in most cases" ma!e an overall assessment of the impact of different inventory methods on the comparability of inventory figures. ,uch an assessment inventory methods on the comparability of inventory figures. ,uch an assessment should be based on a thorough understanding of the inventory methods in use and should be based on a thorough understanding of the inventory methods in use and the
the effeffect ect thethey y are are li!li!ely to ely to havhave e on on invinvententory valuory values. *he es. *he didiffefferenrences ces thathat t ariarisese beteen informed appro&imations and e&act figures using additional data generally beteen informed appro&imations and e&act figures using additional data generally are not
are not materially differenmaterially different.t. *o be
*o be mosmost t useusefuful" l" didisclsclososureures s of of ininvenventortory y metmethodhods s musmust t givgive" e" in in addadditiition on toto methods used" an identification of the inventory components in amounts/ here methods used" an identification of the inventory components in amounts/ here such methods are used. #ore important" disclosure of the dollar difference beteen such methods are used. #ore important" disclosure of the dollar difference beteen the method in use and the method most prevalent in the industry ould be very the method in use and the method most prevalent in the industry ould be very useful.
useful. H.
H. a.a. CoCostst" " dedefifinened gened generaralllly as y as ththe e prpricice e papaid or conid or consisidederaratition gion giveven to n to acac%u%uirire e anan asset" is the
asset" is the primary basis in accounting for primary basis in accounting for inventorieinventories. As applied to inventories"s. As applied to inventories" cost generally means the sum of the applicable e&penditures and charges directly cost generally means the sum of the applicable e&penditures and charges directly or indirectly incurred in bringing an article to its e&isting condition and location. or indirectly incurred in bringing an article to its e&isting condition and location. *hese applicable e&penditures and
*hese applicable e&penditures and charges include all ac%uisition and productioncharges include all ac%uisition and production co
coststssbubut t ththey ey e&e&clcludude e sesellllining g e&e&pepensnses es anand d gegeneneraral l anand d adadmimininiststraratitiveve e&penses not clearly related
b.
b. #ar!e#ar!et" as appliet" as applied to the valuad to the valuationtions of invens of inventoritories" means thes" means the current bid pe current bid price atrice at the balance sheet date for the inventory in the volume for hich it is usually the balance sheet date for the inventory in the volume for hich it is usually purchased in. *he term is applicable to inventories of purchased goods and to purchased in. *he term is applicable to inventories of purchased goods and to manufactured goods involving materials" labor" and overhead/. #ore generally" manufactured goods involving materials" labor" and overhead/. #ore generally" mar!et means current replacement costalthough" it must not e&ceed the net mar!et means current replacement costalthough" it must not e&ceed the net realizable value estimated selling price less predicted costs of completion and realizable value estimated selling price less predicted costs of completion and disposal/ and must not be less than net realizable value reduced by an alloance disposal/ and must not be less than net realizable value reduced by an alloance for a normal profit margin.
for a normal profit margin. c.
c. *h*he e uususual al babasisis s fofor r cacarrrryiying ng foforrarard d ininvevenntotory ry to to ththe e nene&t &t pepeririod od is is cocostst.. 6eparture from cost is re%uired"
6eparture from cost is re%uired" hoever" hoever" hen the utility of the goods included inhen the utility of the goods included in inventory is less than their cost. *his loss in utility should be recognized as a inventory is less than their cost. *his loss in utility should be recognized as a lossloss of
of ththe e cucurrrrenent t peperrioiod" d" ththe e pepeririod od in in hhicich h it it ococcucurrrreded. . 5u5urtrthehermrmorore" e" ththee subse%uent period should be charged for goods at an
subse%uent period should be charged for goods at an amount that measures their amount that measures their e&pe
e&pected cted concontritributbutioion n to to thathat t perperiodiod. . In In othother er orordsds" " the the subsubse%se%uenuent t perperiodiod should be charged for inventory at prices no higher than those that ould have should be charged for inventory at prices no higher than those that ould have been paid if the inventory had been obtained at the beginning of that period. been paid if the inventory had been obtained at the beginning of that period. B
Bisistotoriricacallllyy" " ththe e loloerer-o-of-f-cocostst-o-or-r-mamar!r!et et rurule le ararosose e frfrom om ththe e accaccouountntiningg convention of providing for all losses and anticipating no profitsconservatism./ convention of providing for all losses and anticipating no profitsconservatism./ In accordance ith the foregoing reasoning the rule of >cost or mar!et" hichever In accordance ith the foregoing reasoning the rule of >cost or mar!et" hichever is
is loloeer> r> mamay y be be apapplplieied d to to eaceach h ititem em in in ththe e ininveventntororyy" " to to ththe e tototatal l of of ththee components of each ma$or category" or to the total of the inventory" hichever components of each ma$or category" or to the total of the inventory" hichever most clearly reflects the economic reality. *he )C# rule is usually applied to each most clearly reflects the economic reality. *he )C# rule is usually applied to each item" but if individual inv
item" but if individual inventory items enter into the entory items enter into the same category same category or categories of or categories of finished product" alternative procedures are
finished product" alternative procedures are suitable.suitable. d.
d. AArgrgumumenents ts agagaiainsnst t ususe e of of ththe e loloeer-r-oof-f-cocostst-o-or-r-mamar!r!et et memeththod od of of vavaluluiningg inventories include2
inventories include2
1/ *he method re%uires the reporting of estimated losses all or a portion of the 1/ *he method re%uires the reporting of estimated losses all or a portion of the e&cess of actual cost over replacement cost/ as income charges even though the e&cess of actual cost over replacement cost/ as income charges even though the losses have not been sustained to date and may never be sustained. 0nder a losses have not been sustained to date and may never be sustained. 0nder a consistent criterion of realization" a drop in selling price belo cost is no more a consistent criterion of realization" a drop in selling price belo cost is no more a sustained loss than a rise above cost is a
sustained loss than a rise above cost is a realized gain.realized gain.
/ A price shrin!age is brought into the income statement before the loss has / A price shrin!age is brought into the income statement before the loss has be
been en susuststaiainened d ththrorougugh h sasalele. . 5u5urtrthehermrmorore" e" if if ththe e chchararge ge fofor r ththe e ininveventntororyy ri
rite-te-dodon n is not is not madmade e to to a a spespeciacial l losloss s accaccounount" t" the cost the cost figfigure for ure for googoodsds actually sold is inflated by the amount of the estimated shrin!age in price of the actually sold is inflated by the amount of the estimated shrin!age in price of the unsold goods. *he title >Cost of 7
unsold goods. *he title >Cost of 7oods ,old> therefore becomes oods ,old> therefore becomes a misnomer.a misnomer. ?/ *he
?/ *he method is inconsismethod is inconsistent in application in a given year because tent in application in a given year because it recognizesit recognizes the propriety of implied price reductions but gives no recognition in the accounts the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of price advances.
or financial statements to the effect of price advances.
4/ *he method is inconsistent in application in one year as opposed to another 4/ *he method is inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost at one year-end and at because the inventory of a company may be valued at cost at one year-end and at mar!et at the ne&t year-end.
mar!et at the ne&t year-end. D/
D/ *he *he loerloer-of--of-cost-cost-or-maor-mar!et r!et methmethod od valuvalues es invinventorentory y in the in the balabalance nce sheetsheet conservatively. Its effect on the income statement" hoever" may be the opposite. conservatively. Its effect on the income statement" hoever" may be the opposite. Alth
Although the income statement ough the income statement for the year for the year in hich the unsustained loss is ta!enin hich the unsustained loss is ta!en is reported conservat
is reported conservativelivelyy" the " the net net incoincome me for the for the subssubse%uene%uent t perioperiod d may bemay be distorted if the e&pected reductions in sales prices do not materialize.
@/ In the application of the loer of cost or mar!et rule" a prospective >normal @/ In the application of the loer of cost or mar!et rule" a prospective >normal prof
profit> is it> is used in used in deterdeterminimining inventong inventory ry valuvalues es in certain in certain cases. ,ince cases. ,ince normnormalal pro
profit is fit is an an estestimaimated ted figfigure based ure based upupon on paspast t e&pee&perieriences and nces and migmight ht nonot t bebe attained in the
attained in the
future/" it is not ob$ective in nature and presents an opportunity for manipulation future/" it is not ob$ective in nature and presents an opportunity for manipulation of the results of
of the results of operations.operations. 1F.
1F. )I5' tends to yield loe)I5' tends to yield loer reported earninr reported earnings hen prices rise as compared to gs hen prices rise as compared to 5I55I5'.'. *he folloing illustration highlights these effects2
*he folloing illustration highlights these effects2 3
3eerriiood d 00nniitts s iin n IInnvveennttoorryy CoCosst t ppeer r 00nniitt **oottaal l CCoosstt 3 3eerriiood d 11 D D D D DD 3 3eerriiood d D D 11F F DDFF 3 3eerriiood d ?? D D 11D D GGDD
0nder )I5'" if 1F units are sold" then cost of goods sold is 1D" computed as D & 0nder )I5'" if 1F units are sold" then cost of goods sold is 1D" computed as D & 1D/ J D & 1
1D/ J D & 1F/. AlF/. Also" the )I5' inso" the )I5' inventory value is ventory value is D" computed as D & D. D" computed as D & D. If units If units areare sold for
sold for F" then gross proF" then gross profit is fit is GD" computed as 1F & F/ - 1D. GD" computed as 1F & F/ - 1D. 0nder 5I50nder 5I5'" if 1F'" if 1F units are sold" then cost of goods sold is GD" computed as D & D/ J D & 1F/. 7ross units are sold" then cost of goods sold is GD" computed as D & D/ J D & 1F/. 7ross pro
profifit t ouould be ld be 1D1D" " comcompuputed as ted as FF FF - - GD. InvenGD. Inventortory y ouould be ld be valvalued at ued at GD"GD" computed as D & 1Dinflating the balance sheet. *his shos that 5I5' tends to computed as D & 1Dinflating the balance sheet. *his shos that 5I5' tends to increase income and ta&es
increase income and ta&es in inflatioin inflationary periods.nary periods. 11
11. . IncIncreareases ses in in ra ra matmaterierials can" als can" in in certcertain instaain instancences" s" be be a a pospositiitive ve sigsign n thathat t thethe compa
company is ny is buibuildilding invenng inventorietories to s to meet e&pected demand. meet e&pected demand. BoeBoeverver" increas" increases ines in both ra materials and or!-in-process inventories" can reflect inefficient operations both ra materials and or!-in-process inventories" can reflect inefficient operations that have sloed productio
that have sloed production. n. Increases in finiIncreases in finished goods can reflect the buildshed goods can reflect the building of ing of arehoused inventory to meet large demand or it can represent the stoc! piling of arehoused inventory to meet large demand or it can represent the stoc! piling of fin
finishished gooded goods s thathat t are not in are not in gregreat demanat demand. d. *he cruci*he crucial part of al part of anaanalylysis is tosis is to interpret these changes in the
interpret these changes in the conte&t of current conte&t of current and pro$ected industry conditions.and pro$ected industry conditions. 1.
1. *he *he obobserservatvation is ion is corcorrect rect in poinin pointinting g out that out that an an anaanalylyst st musmust t subsub$ec$ect t the the datdataa regard
regarding an ing an entientity(s deprecty(s depreciatioiation policin policies to es to criticritical analyscal analysis and is and scrutscrutinyiny. . *he*he compa
company ny can can chooschoose e amonamong g severaseveral l acceptabacceptable le but vastly differebut vastly different nt depredepreciatiociationn methods.
methods. *he reasons a particular *he reasons a particular choices/ is choices/ is made by the company made by the company and the effectand the effect on
on rerepoportrted ed dedeprprececiaiatition on e&e&pepensnse e anand d accaccumumululatated ed dedeprprecieciatatioion n shshouould ld bebe assessed.
assessed.
1?. In the absence of more precise data" an analyst is better off ad$usting depreciation 1?. In the absence of more precise data" an analyst is better off ad$usting depreciation
charges on the
charges on the basis of hisKher estimates and assumptionbasis of hisKher estimates and assumptions than not ad$usting them ats than not ad$usting them at all.
all. AnalAnalyses such as those dyses such as those described in the chapter can help to escribed in the chapter can help to create a more usefulcreate a more useful estimate of periodic depreciation e&pense and
14.
14. *here are a number of measures relating to plan*here are a number of measures relating to plant assets that are useful in t assets that are useful in comparingcomparing depreciation policies over time as
depreciation policies over time as ell as for intercompany comparisons.ell as for intercompany comparisons. *he
*he average total life spanaverage total life span of plant and e%uipment can be appro&imated as2 of plant and e%uipment can be appro&imated as2 7ross
7ross 3lant 3lant and and E%uipment E%uipment Current Current 8e8ear ar 6epreciation 6epreciation E&pense.E&pense. *he
*he average ageaverage age of plant and e%uipment can be computed as2 of plant and e%uipment can be computed as2 Accumulated
Accumulated 6epreciation 6epreciation Current Current 8e8ear ar 6epreciation 6epreciation E&pense.E&pense. *he
*he average remaining lifeaverage remaining life of plant and e%uipment is computed as2 of plant and e%uipment is computed as2 +et
+et 6epreciated 6epreciated 3lant 3lant and and E%uipment E%uipment Current Current 8e8ear ar 6epreciation6epreciation E&pense.
E&pense. Also
Also" draing on the " draing on the above relations" e can above relations" e can compute2compute2
Average *otal )ife ,pan L Average Age J Average Remaining )ife. Average *otal )ife ,pan L Average Age J Average Remaining )ife. *he
*he above ratios are above ratios are helphelpful in ful in assesassessing a sing a compcompany(s depreciaany(s depreciation poliction policies andies and assumptions over time. *he ratios can be computed on a historical cost basis as ell assumptions over time. *he ratios can be computed on a historical cost basis as ell as on a current cost basis.
as on a current cost basis.
1D. 'ne of the more common solutions applied by analysts to the analysis of goodill is 1D. 'ne of the more common solutions applied by analysts to the analysis of goodill is to simply ignore it. *hat is" they ignore the asset shon on the balance sheet. As for to simply ignore it. *hat is" they ignore the asset shon on the balance sheet. As for the income statement" under current accounting standards" goodill is no longer the income statement" under current accounting standards" goodill is no longer amo
amortrtizeized" d" but but is is subsub$ec$ected ted to to an an impimpairairmenment t testest t annannualually ly and and ririttetten n dodon n if if re%uired. 'ften" hoever" the rite-don e&pense is treated ith s!epticism and is re%uired. 'ften" hoever" the rite-don e&pense is treated ith s!epticism and is fre
fre%ue%uentntly ly ignignoreored. d. 9y 9y ignignorioring ng googoodidillll" " anaanalylysts sts igignornore e ininvesvestmetmentnts s of of ververyy substantial resources in hat may often be
substantial resources in hat may often be a company(s most important and valuablea company(s most important and valuable ass
asset. et. IgIgnornorining g the the impimpact act of of googoodidill on ll on repreportorted ed incincome ome is is no no solsolutiution on to to thethe analysis of this comple& item. Even considering the limited information available" an analysis of this comple& item. Even considering the limited information available" an ana
analyslyst t is is betbetter ter off off evaevalualuatinting g the the accoaccountunting ing nunumbembers rs for for googoodidill ll ratrather her thathann dismissing them altogether.
dismissing them altogether.
7oodill is measured by the e&cess of cost over the fair mar!et value of tangible net 7oodill is measured by the e&cess of cost over the fair mar!et value of tangible net assets ac%uired in a transaction accounted for as a purchase. It is the e&cess of the assets ac%uired in a transaction accounted for as a purchase. It is the e&cess of the purchase price over the fair value of all the tangible assets ac%uired" arrived at by purchase price over the fair value of all the tangible assets ac%uired" arrived at by carefully ascertaining the value of such assetsat least in theory. *he analyst must carefully ascertaining the value of such assetsat least in theory. *he analyst must be alert to the ma!eup and the method of valuation of 7oodill as ell as to the be alert to the ma!eup and the method of valuation of 7oodill as ell as to the method of its ultimate disposition. 'ne ay of disposing of the 7oodill account" method of its ultimate disposition. 'ne ay of disposing of the 7oodill account" fre%uently preferred by management" is to
fre%uently preferred by management" is to rite it off at a rite it off at a time hen it ould have thetime hen it ould have the le
leasast t imimpapact ct on on ththe e mamar!r!et(et(s s asassesessssmement nt of of ththe e cocompmpanany(y(s s peperfrforormanmancece. . ffor or e&le" in a period of
e&le" in a period of losses or reduced earnings/.losses or reduced earnings/.
1@. Costs are capitalized as assets hen these e&penditures are e&pected to bring the 1@. Costs are capitalized as assets hen these e&penditures are e&pected to bring the entity value beyond the current year. If the value associated ith the e&penditure ill entity value beyond the current year. If the value associated ith the e&penditure ill be used up in the current period" the e&penditure is e&pensed.
be used up in the current period" the e&penditure is e&pensed. 1G.
1G. Bard assetBard assets are s are assets sucassets such as h as the factory and machinthe factory and machineryterythey are hey are tangitangible andble and iden
identifitifiableable. . ,oft asset,oft assets are assets such as softares are assets such as softare" research and develo" research and developmenpmentt efforts" and intellectual capitalthey are
1<.
1<. a.a. 7eneral7enerally accely accepted accoupted accountinnting pring principlciples re%ues re%uire that nire that naturaatural resol resources aurces astinsting/g/ ass
assets ets be be stastated ted at at hihistostorirical cal coscost t plplus us coscosts ts of of disdiscovcoveryery" " e&pe&plorloratiation" on" andand development. *his means the
development. *his means the large cost outlays that large cost outlays that occur folloing the discoveryoccur folloing the discovery of
of natnaturaural l resresouources rces are are nonot t gigiven ven accoaccountunting recogning recognitiition on as as parpart t of of natnaturaurall resource assets. Rather" they generally are e&pensed as incurred. Conse%uently" resource assets. Rather" they generally are e&pensed as incurred. Conse%uently" rel
relatiationons s sucsuch h as as incincome to ome to assassets ets are are didistostorterted d by by a a faifailulure re to to capcapitaitalizlize e allall relevant costs and by the
relevant costs and by the related implicatiorelated implications to current and future ns to current and future earnings.earnings. b.
b. When a company ac%uWhen a company ac%uires natuires natural resoural resources from anorces from another entitther entityy" thi" this cost is mores cost is more li!ely to reflect the entire fair value of these resources. In such a situation the li!ely to reflect the entire fair value of these resources. In such a situation the relat
relation beteen the cost ion beteen the cost of the of the assets and the assets and the revenrevenues" e&penses" and incomeues" e&penses" and income they generate is li!ely to be
they generate is li!ely to be more economically sensibmore economically sensible.le. 1H.
1H. In valuing propertyIn valuing property" plant and e%uipment" and in reporting it in conventional financial" plant and e%uipment" and in reporting it in conventional financial statements" accountants emphasize the ob$ectivity of historical cost. *hey also sho statements" accountants emphasize the ob$ectivity of historical cost. *hey also sho an emphasis on conservatism ith an accounting for the number of dollars originally an emphasis on conservatism ith an accounting for the number of dollars originally invested in the assets. *he emphasis is not overly focused on the ob$ectives of those invested in the assets. *he emphasis is not overly focused on the ob$ectives of those that analyze and depend on financial statements for business decisions. *hey are that analyze and depend on financial statements for business decisions. *hey are content to proclaim that >a balance sheet does not purport to reflect and could not content to proclaim that >a balance sheet does not purport to reflect and could not usefully reflect the value of the enterprise.> 5rom the user=s perspective" historical usefully reflect the value of the enterprise.> 5rom the user=s perspective" historical cos
costs ts popossessess ss sevseveraeral l lilimimitattationions. s. *he*hey y are are not not relrelevaevant nt to to %ue%uestistionons s of of curcurrenrentt replacement costs or of future needs. *hey are not directly comparable to similar replacement costs or of future needs. *hey are not directly comparable to similar data in
data in otheother r compcompaniesanies( ( reporreports. *hey ts. *hey do not do not enablenable e users to users to measurmeasure e oppoopportunrtunityity costs of disposal" nor of the alternative uses of funds. *hey do not provide a valid costs of disposal" nor of the alternative uses of funds. *hey do not provide a valid yardstic! against hich to measure return. Also" in times of changing price levels" yardstic! against hich to measure return. Also" in times of changing price levels" th
they ey rereppreresesent nt an an ooddd d cocongnglolomemerratatiioon n oof f a a vvararieiety ty oof f pupurcrchahasising ng ppooeer r disbursements.
disbursements. F.
F. a.a. *he basic app*he basic approach in accouroach in accountinnting for ideng for identifitifiable inable intangitangibles obles other than gother than goodiodill/ll/ is
is to to recrecord ord at at hishistortoricaical l coscost t and and subsubse%se%uenuently amorttly amortizize e thathat t coscost t to to benbenefiefitt periods. If assets other than cash are given in e&change for the intangible" the periods. If assets other than cash are given in e&change for the intangible" the intangible must be recorded at the fair mar!et value of the consideration given. intangible must be recorded at the fair mar!et value of the consideration given. +o
+otictice e thathat t if if a a comcompanpany y spespends maternds material and ial and lablabor or in the in the conconstrstructuction of ion of aa >tangible> asset" such as a machine" these costs are capitalized and recorded as >tangible> asset" such as a machine" these costs are capitalized and recorded as an asset that is depreciated over its estimated useful life. 'n the other hand" if a an asset that is depreciated over its estimated useful life. 'n the other hand" if a company spends a great amount of resources advertising a product or training a company spends a great amount of resources advertising a product or training a sales force
sales force to to sell and sell and serviservice ce ithithich is ich is one process one process for creating goodilfor creating goodillilitt usually cannot capitalize such costs. *his is even hen such costs may be as" or usually cannot capitalize such costs. *his is even hen such costs may be as" or mor
more" e" benbenefieficiacial l to to the the comcompanpany(y(s s futfuture ure opeoperatrationions s thathan n are are any any >ta>tangngiblible>e> assets. *he reason for this inconsistency in accounting for these to classes of assets. *he reason for this inconsistency in accounting for these to classes of assets e&tends to several basic accounting conventions such as conservatism. assets e&tends to several basic accounting conventions such as conservatism. *hese conventions" draing on the level of certainty in future returns" casts more *hese conventions" draing on the level of certainty in future returns" casts more doubt on the future realizations of benefits from intangibles such as advertising doubt on the future realizations of benefits from intangibles such as advertising or training/ than realizations from tangible" >hard> assets.
or training/ than realizations from tangible" >hard> assets. b.
b. 7ood7oodill ill is an impois an importanrtant intangt intangible assible asset. ,tilet. ,till" it reprl" it represents the onlesents the only case herey case here the valuation of the asset is restricted to its cost of ac%uisition from a third party. the valuation of the asset is restricted to its cost of ac%uisition from a third party. #oreover
#oreover" any costs of defending a " any costs of defending a patent" copyright" or trademar! patent" copyright" or trademar! or similar/ areor similar/ are properly included as part of the cost of intangible assets. *his e&tends to other properly included as part of the cost of intangible assets. *his e&tends to other intangibles such as leases" leasehold improvements" special processes" licenses" intangibles such as leases" leasehold improvements" special processes" licenses" and franchi
and franchises. ses. In mar!ed contraIn mar!ed contrast" internst" internally devally developeeloped goodid goodill cannoll cannot bet be capitalized and carried as an asset.
c.
c. IdentIdentifiabifiable le intanintangiblegibless otother her thathan n gogoododilill/ l/ can can be be sepseparaarateltely y ideidentintifified ed andand given reasonably descriptive names such as patents" trademar!s" and franchises. given reasonably descriptive names such as patents" trademar!s" and franchises. Identifiab
Identifiable intangibles can be le intangibles can be developed internallydeveloped internally" ac%uired singly or as " ac%uired singly or as part of part of aa group of assets. *hey should be recorded at cost and amortized over their useful group of assets. *hey should be recorded at cost and amortized over their useful lives. Writ
lives. Write-don or complete e-don or complete rite-off at date rite-off at date of ac%uisition is not permitted.of ac%uisition is not permitted. Unidentifiable intangibles
Unidentifiable intangibles can be developed internally or purchased from others. can be developed internally or purchased from others. *hey cannot be ac%uired singlythey are inherently part of a group of assets or *hey cannot be ac%uired singlythey are inherently part of a group of assets or part of
part of an entire entityan entire entity. *he . *he e&cess of e&cess of cost of an cost of an ac%uiac%uired company or segment/red company or segment/ over the sum total of identifiable net assets is the most common unidentifiable over the sum total of identifiable net assets is the most common unidentifiable intangible assetthat of Mgoodill.N It is the residual amount in an ac%uisition intangible assetthat of Mgoodill.N It is the residual amount in an ac%uisition after the amount of tangible and identifiable intangibles are determined. 7oodill after the amount of tangible and identifiable intangibles are determined. 7oodill is no longer amortized" but is tested annually for impairment and ritten don if is no longer amortized" but is tested annually for impairment and ritten don if re%uired.
re%uired. d.
d. IdenIdentifitifiablable intangie intangibles are believed to have bles are believed to have limlimited usefited useful liveul lives. Accos. Accordinrdinglygly" they" they are amortized. 6epending on the type of intangible asset" its useful life may be are amortized. 6epending on the type of intangible asset" its useful life may be li
limimiteted d by by susuch ch fafactctorors s as as lelegagal" l" cocontntraractctuaual" l" reregugulalatitionons" s" dedemamand nd anandd com
competpetitiitionon" " liflife e e&pe&pectaectancincies es of of empemploloyeeyees" s" and and othother er econeconomiomic c and and socsociaiall factors. *he cost of each intangible should be amortized over its useful life ta!ing factors. *he cost of each intangible should be amortized over its useful life ta!ing into account all factors that determine its life. 7oodill is not amortized" but is into account all factors that determine its life. 7oodill is not amortized" but is tested annually for impairment and ritten don if re%uired.
tested annually for impairment and ritten don if re%uired. 1.
1. 7ood7oodill is ofill is often a ten a sizasizable asset. It can be ble asset. It can be recordrecorded only upon the purchase of aned only upon the purchase of an ongoing business enterprise or segment. *he accounting conventions governing the ongoing business enterprise or segment. *he accounting conventions governing the record
recording of ing of goodgoodill mean that ill mean that only purchasonly purchased ed goodgoodilill is l is reporreported ted among theamong the reco
recorderded d assassets ets and and thathat t mormore e googoodidill li!ell li!ely ly e&ie&ist st off off the the balbalancance e shesheet. et. *h*hee description of hat is being paid for in such a transaction varies and this adds to the description of hat is being paid for in such a transaction varies and this adds to the unc
uncertertainainty ty sursurrouroundnding ing thithis s assasset. et. ,om,ome e refrefer er to to an an abiabilility ty to to attattract ract and and !eep!eep satisfied customers" hile others point to %ualities inherent in an enterprise that is satisfied customers" hile others point to %ualities inherent in an enterprise that is ell organized and efficient in production" service" and sales. ,till others point out ell organized and efficient in production" service" and sales. ,till others point out that if there is value in goodill it must be reflected in earnings. *hat is" if there is that if there is value in goodill it must be reflected in earnings. *hat is" if there is value to goodill" then it should give rise to superior earnings ithin a reasonably value to goodill" then it should give rise to superior earnings ithin a reasonably short time after ac%uisition. If those earnings are not evidenced" then it is fair to short time after ac%uisition. If those earnings are not evidenced" then it is fair to assume that the investment in goodill is of no value regardless of hether it is assume that the investment in goodill is of no value regardless of hether it is reported on the balance sheet.
reported on the balance sheet.
Regardless of the amount incurred in the ac%uisition or internal development of an Regardless of the amount incurred in the ac%uisition or internal development of an intangible" the carrying amount of any asset is not to be carried at an amount in intangible" the carrying amount of any asset is not to be carried at an amount in e&cess
e&cess of of realirealizablzable e valuvalue e salesales s price or price or futufuture re utilutilityity/. /. AActual implectual implementamentation istion is another matter" and the analyst must be prepared to form $udgments on the amounts another matter" and the analyst must be prepared to form $udgments on the amounts reported for intangible assets.
reported for intangible assets. .
. *here are a *here are a numbnumber of categorieer of categories of deferred chargess of deferred charges. In each . In each case" the rationcase" the rationale for ale for deferral is that
deferral is that these outlays hold future utility benefits/ for the company.these outlays hold future utility benefits/ for the company. 1/ 9usiness development" e&pansion"
1/ 9usiness development" e&pansion" merger" and relocation costs.merger" and relocation costs. a.
a. 3re-op3re-operatinerating e&penseg e&penses" inits" initial stial start-uart-up costs" ap costs" and toolnd tooling coing costs.sts. b.
b. IniInitial otial operatiperating lossng losses or preoperes or preoperating e&penating e&penses of subsidses of subsidiariiaries.es. c.
c. #ov#oving" ing" planplant rearrat rearrangemenngement" and reit" and reinstanstallatllation coion costs.sts. d.
d. #er#erger or ager or ac%uc%uisiisitition e&on e&penpensesses.. e.
f.
/ 6eferred e&penses. / 6eferred e&penses.
a.
a. AdAdvertvertisinising g and and propromotimotional onal e&pensee&penses.s. b.
b. ImImpuputed ted inintetererestst.. c.
c. ,elling" ,elling" general general and and administraadministrative tive e&penses.e&penses. d.
d. 3ension 3ension plan plan costs.costs. e.
e. 3roperty 3roperty and and other other ta&es.ta&es. f.
f. Rental Rental and and leasing leasing costs.costs. g.
g. Vacation Vacation pay.pay. h.
h. ,easonal ,easonal groing groing and and pac!ing pac!ing e&penses.e&penses. ?/ Intangible costs.
?/ Intangible costs. a.
a. IntaIntangibngible dle drilrillinling ang and devd developelopment cment costsosts.. b.
b. ContContracts" fracts" filmilms" cops" copyrigyright mateht materialrials" art rs" art rightightss c.
c. CoCosts sts of of comcompuputer ter sosoftftareare 4/ 6ebt discount and e&penses. 4/ 6ebt discount and e&penses. D/ 5uture income ta& benefits. D/ 5uture income ta& benefits. @/ 'rganization costs.
@/ 'rganization costs. G/ Advance
G/ Advance royalties.royalties. ?.
?. a.a. 'ne cate'ne categorgory of assety of assets not recos not recorderded on the baland on the balance sheet is ince sheet is interternalnally crely createdated goo
goodidill. In ll. In ththis is casecase" " if if the the inintantangigiblble e is is ininterternalnally ly devdeveloelopedped" " ratrather her thathann purchased from an outside party" it cannot be capitalized and all costs must be purchased from an outside party" it cannot be capitalized and all costs must be e&pensed as incurred. *his means" to the e&tent an asset is created that can be e&pensed as incurred. *his means" to the e&tent an asset is created that can be sold or possesses earning poer/" prior income that is charged ith the e&pense sold or possesses earning poer/" prior income that is charged ith the e&pense of
of itits s dedevevelolopmpmenent t is is unundedersrstatateted d aand nd fufututure re inincocome me iill ll be be ovovererststatateded/./. +u
+umemerorous us inintantangigiblble e asassesets ts fifit t ththis is catcategegororyy. . AAnonothther er cacategtegorory y is is ththat at of of co
contntiningegent nt asassesetsts. . 0n0ndeder r ththe e prprininciciplple e of of coconsnservervatatisism" m" ththe e cocontntiningegentnt rightsKclai
rightsKclaims to resources ms to resources are not are not recognized due to recognized due to their uncertaintytheir uncertainty.. b.
b. *he analys*he analyst must realt must realize that repize that reported booorted boo! values are not sub! values are not substitstitutes foutes for mar!etr mar!et values. As ill
values. As illustrated by the ustrated by the accounting-based e%uity valuation model" unrecordedaccounting-based e%uity valuation model" unrecorded ass
assets ets mumust st eveeventuntuallally y be be rearealizlized ed in in the the forform m of of resresiduidual al incincome ome ababnornormalmal earnings/. If there is no above-normal income" then there is little value in any earnings/. If there is no above-normal income" then there is little value in any unrecorded assets.
