Accounting Reporting and Analyzing Operating Assets Essay Example

Accounting: Reporting and Analyzing Operating Assets Paper Module 6 Reporting and Analyzing Operating Assets QUESTIONS Q6-1. When a company increases its allowance for uncollectible accounts, it also records bad debt expense in the income statement. If a company overestimates the allowance account, bad debt expense is too high and net income is understated. As well, accounts receivable (net of the allowance account) and total assets are both understated on the balance sheet. In future periods, the company will not need to add as much to its allowance account since it is already overestimated (or, it can reverse the excess existing allowance balance). As a result, future net income will be higher. On the other hand, if a company underestimates its allowance account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense as accounts are written off. Q6-2. If inventory costs are stable, the per unit dollar cost of inventories (beginning or ending) tends to be approximately the same under different inventory costing methods and the choice of method does not materially affect net income. To see this, remember that FIFO profits include holding gains on inventories. If the inflation rate is low (or inventories turn quickly), there will be less holding gains (inflationary profit) in inventory. Q6-3. FIFO holding gains occur when the costs of earlier inventory p are matched against current selling prices. Holding gains on inventories increase with an increase in the inflation rate and a decrease in the inventory turnover rate. Conversely, if the inflation rate is low or inventories turn quickly, there will be fewer holding gains (inflationary profit) in inventory. We will write a custom essay sample on Accounting: Reporting and Analyzing Operating Assets specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Accounting: Reporting and Analyzing Operating Assets specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Accounting: Reporting and Analyzing Operating Assets specifically for you FOR ONLY $16.38 $13.9/page Hire Writer Q6-4. If inventory costs are rising, (a) Last-in, first-out yields the lowest ending inventory (b) Last-in, first-out yields the lowest net income, (c) First-in, first-out yields the highest ending inventory, (d) First-in, first-out yields the highest net income, (e) Last in, first-out yields the highest cash flow because taxes are lowest. Q6-5. When costs are consistently rising, LIFO inventory costing method yields a significant tax benefit because LIFO increases COGS which reduces pretax income and taxes payable. Q6-6. Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule. When the replacement cost for inventory falls below its (FIFO or LIFO) historical cost, the inventory must be written down to its replacement cost (market value). The rationale is that, if market value has dropped, the inventory cost overstates the future economic benefit of selling the inventory. Q6-7. As an asset is used up, its cost is removed from the balance sheet and transferred to the income statement as expense. Capitalization of costs onto the balance sheet and subsequent removal as expense is the essence of accrual accounting. If a depreciable asset is immediately expensed upon purchase, profit would be too low in the year of purchase and too high in later years as revenues earned by the asset are not matched with a corresponding cost. The proper matching of expenses and revenues is essential for proper income measurement. Q6-8. When a company revises its estimate of an assets useful life or its salvage value, depreciation expense must be recalculated. One way is to depreciate the current undepreciated cost of the asset (original cost – accumulated depreciation) using the revised assumptions of remaining useful life and salvage value. Q6-9. PPE is considered to be impaired when the sum of the asset’s undiscounted expected future cash flows is less than its current net book value. An impairment loss is calculated as the difference between the assets net book value and its current fair value. Q6-10. The primary benefit of accelerated depreciation relates to tax reporting – higher depreciation deductions in the early years of the asset’s life reduce taxable income and income taxes. This increases cash flow that can be invested to yield additional cash inflows (e. g. , an interest-free loan that can be used to generate additional income). Companies generally prefer to receive cash inflows sooner rather than later in order to maximize this investment potential. Q6-11. The gain or loss on the sale of a PPE asset is calculated as the difference between the sales proceeds and the assets net book value. Sales proceeds in excess of net book values create gains; sales proceeds less than net book values cause losses. Factors that affect the size of the gain or loss include the amount of sales proceeds (the selling price) and depreciation assumptions. Because accumulated depreciation at the time of the asset’s sale affects the net book value, the depreciation rate and salvage values used to compute depreciation expense affect the gain or loss. MINI EXERCISES M 6-12 (10 minutes) a. To bring the allowance from $500 to the desired balance of $2,100, the company will need to increase the allowance account by $1,600, resulting in bad debt expense of that same amount. b. The net amount of Accounts Receivable reported in current assets is calculated as follows: $98,000 ( $2,100 = $95,900. M 6-13 (15 minutes) a. Credit losses are incurred in the process of generating sales revenue. Specific losses may not be known until many months after the sale. We set up an allowance for uncollectible accounts so that the expense of uncollectible accounts falls in the same accounting period as the sale. As well, the allowance ensures that we report accounts receivable at their estimated realizable value at the end of the accounting period. If we did not have an allowance, our net income and assets would be overstated and that could place you and all the directors in a risky position. b. The balance sheet presentation shows the gross amount of accounts receivable, the allowance amount, and the difference between the two, the estimated net realizable value. The balance sheet, thus, reports the net amount that we expect to collect. That is the amount that is the most relevant to financial statement users and to the board of directors as they assess the company’s financial performance. . The matching principle requires that expenses (credit losses) related to a given revenue be recorded in the same income statement. This dictates the use of the allowance method. Recognition of expense only upon the write-off of the account would delay the reporting of likely losses and, thereby, reduce the informativeness of the income statement. Accountants believe that providing more timely information justifies the use of estimat es that may not be perfectly precise. M 6-14 (20 minutes) a. ($ millions) |2007 |2006 | |Accounts receivable (net) |$5,197 |$3,869 | |Allowance for uncollectible accounts | 94 | 84 | |Gross accounts receivable |$5,291 |$3,953 | |Percentage of uncollectible accounts to gross accounts receivable |1. 78% |2. 2% | | |($94 / $5,291) |($84 / $3,953) | b. The reduction in the allowance for uncollectible accounts as a percentage of gross accounts receivable is substantial. The dip might indicate that the quality of the accounts receivable has improved; perhaps because the economy has improved, the company is selling to a more creditworthy class of customers, or the company’s management of accounts receivable has improved. However, it might also indicate that the 2007 allowance account is too low. This would result in higher reported profits in the current year and lower profits in future years when the allowance for uncollectible accounts is increased. M 6-15 (20 minutes) a. |Acco unts Receivable Turnover | | |for the current year | |Procter Gamble |$83,503 / [($6,761+$6,629) / 2] = 12. 47 | |Colgate-Palmolive |$13,790 / [($1,681+$1,523) / 2] = 8. 61 | b. P turns its accounts receivable much faster than Colgate-Palmolive. Differences can arise due to variations in the product mix of competitors, the types of customers they sell to, their willingness to offer discounts for early payment, and their relative bargaining strength vis-a-vis the companies or individuals owing them money. Both of these companies sell a significant amount of their product to Wal-Mart. P is a sizable company, and may have greater bargaining power with Wal-Mart than does the smaller Colgate-Palmolive. M 6-16 (20 minutes) a. FIFO cost of goods sold = 1,000 @ $100 + 700 @ $150 = $205,000 FIFO ending inventories = $400,000 $205,000 = $195,000 b. LIFO cost of goods sold = 1,700 @ $150 = $255,000 LIFO ending inventories = $400,000 $255,000 = $145,000 c. AC cost of goods sold = 1,700 @ $400,000 / 3,000 = $226,667 AC ending inventories = $400,000 – $226,667 = $173,333 M 6-17 (10 minutes) a. FIFO cost of goods sold = 400 @ $10 + 200 @ $12 = $6,400 FIFO ending inventories = $12,400 $6,400 = $6,000 b. LIFO cost of goods sold = 600 @ $12 = $7,200 LIFO ending inventories = $12,400 $7,200 = $5,200 c. AC cost of goods sold = 600 @ $12,400 / 1,100 = $6,764 AC ending inventories = $12,400 – $6,764 = $5,636 M 6-18 (20 minutes) a. | |Inventory Turnover rates for 2008 | |ANF |$1,238 / [ ($333 + $427) / 2 ] = 3. 26 | |TJX |$14,082 / [($2,737+$2,582) /2] = 5. 29 | b. TJX’s inventory turnover rate is higher than ANF’s. TJX concentrates on the value-priced end of the clothing spectrum. Thus, it realizes a lower profit margin that must be offset with higher turnover to yield an acceptable return on net operating assets (see discussion of profitability and turnover in Module 4). c. Inventory turnover improves as the volume of goods sold increases relative to the dollar value of goods available for sale. Retailers must balance the cost savings from inventory reductions against the marketing implications of lower inventory levels. Companies can lower inventory levels by reducing the depth and breadth of product lines carried (such as not carrying every style, size and color), eliminating slow-moving product lines, working with suppliers to arrange for delivery when needed, and marking down goods for sale at the end of product seasons. M 6-19 (15 minutes) a. Straight-line: ($18,000 $1,500) / 5 years = $3,300 for both 2009 and 2010 b. Double-declining-balance: Twice straight-line rate = 2 ? 1/5 = 40% 2009: $18,000 ? 0. 40 = $7,200 2010: ($18,000 $7,200) ? 0. 40 = $4,320 Notice that, over the first two years, the company reports $6,600 of depreciation expense under the straight-line method and $11,520 of depreciation expense under the double-declining balance method. M 6-20 (15 minutes) a. Straight-line depreciation 2009:($145,800 $5,400) ? (8/36) = $31,200 2010:($145,800 $5,400) ? (12/36) = $46,800 b. Double-declining-balance depreciation Preliminary computation: Twice straight-line rate = 2/3 = 66? % 2009:($145,800 ? 66? % ) ? (8/12) = $64,800 010:($145,800 $64,800) ? 66? % = $54,000 M 6-21 (15 minutes) a. | |PPE turnover for 2007 | |Intel Corp. |$38,334 / [($16,918+$17,602) /2] = 2. 22 | |Texas Instruments |$13,835 / [($3,609 + $3,950) / 2] = 3. 66 | Texas Instruments turns over its PPE more quickly than does Intel. b. PPE turnover increases with sales volume relative to the dollar amount of PPE on the balance sheet. The PPE turnover is often very difficult to improve because doing so typically requires creative thinking. Many companies are off-loading the manufacturing process in whole or in part to others in the supply chain. This is productive so long as the benefits realized by the reduction of manufacturing assets more than offset the higher cost of the goods that are now purchased rather than manufactured. Another approach is to utilize long-term operating assets in partnership with another firm, say in a joint venture. EXERCISES E 6-22 (20 minutes) a. 2009 bad debts expense computation $90,000 ( 1%=$ 900 20,000 ( 2%= 400 11,000 ( 5%= 550 6,000 ( 10%= 600 4,000 ( 25%= 1,000 $3,450 Less: Unused balance before adjustment 520 Bad debt expense for 2009$2,930 b. | |Balance Sheet |Income Statement | | |Transaction |Cash Asset | |Accounts receivable (net) |$13,420 |$10,873 | |Allowance for uncollectible accounts | 226 | 220 | |Gross accounts receivable |$13,646 |$11,093 | |Percentage of uncollectible accounts |1. 66% |1. 98% | |to gross accounts receivable |($226/$13,646) |($220/$11,093) | c. ($ mill ions) |2007 |2006 |2005 | |Bad debt expense |$32 |$37 |$17 | |Amounts actually written off |$29 |$48 |$76 | The provision (increase in the allowance account arising from bad debt expense recorded on the income statement) increased from 2005 following the high write-offs in that year. The receivables that the company wrote off have been declining. Over the three year period, HP accrued $86 million ($32 + $37 + $17) of bad debt expense and wrote off $153 million ($29 + $48 + $76) of uncollectible accounts receivable. d. The allowance for uncollectible accounts has decreased as a percentage of gross accounts receivable from 1. 98% in 2006 to 1. 66% in 2007 (see part b). One way to gauge the adequacy of the allowance account is to look at write-offs as a percentage of the allowance account at the beginning of the year. In 2006, this percentage is 21. 1% ($48/$227) and for 2007 it is 13. 2% ($29/$220). HP’s write-offs as a percentage of the allowance decreased from 2006 to 2007. This means that the bad debt expense is keeping up with actual accounts that go bad. Further insight might be gained by comparing HP’s allowance account to those of its peers. E6-25 (20 minutes) a. Aging schedule at December 31, 2009 Current ($304,000 ( 1%)$ 3,040 1–60 days past due ($44,000 ( 5%) 2,200 61–180 days past due ($18,000 ( 15%)2,700 Over 180 days past due ($9,000 ( 40%) 3,600 Amount required11,540 Allowance balance 4,200 2009 bad debts expense$ 7,340 . Current Assets Accounts receivable$375,000 Less allowance for uncollectible accounts (11,540) $363,460 E6-26 (30 minutes) a. YearSalesCollectionsAccounts Acc Recble. Written Off Balance 20 07$ 751,000$ 733,000$ 5,300 $12,700 2008 876,000 864,000 5,800 18,900 2009 972,000 938,000 6,500 46,400 Total$2,599,000$2,535,000 $17,600 Uncollectible Accounts Expense is: 2007$ 7,510 computed as 1% ( $751,000 2008 8,760 computed as 1% ( $876,000 2009 9,720 computed as 1% ( $972,000 2007–2009$25,990 computed as 1% ( $2,599,000 Allowance for Uncollectible Accounts is: 8,390, computed as $25,990 total provision for uncollectible accounts less $17,600 in total write-offs. b. The 1% rate appears to be too high. A 0. 8% rate would have provided $20,792, which still exceeds the $17,600 total write-off by $3,192. Moreover, this smaller allowance seems large enough to provide an adequate margin for future write-offs. E6-27 (30 minutes) Units Cost Beginning Inventory 1,000$ 20,000 Purchases:#1 1,800 39,600 #2 800 20,800 #31,200 34,800 Goods available for sale4,800$115,200 Units in ending inventory = 4,800 – 2,800 = 2,000 a. First-in, first-out UnitsCostTotal 1,[emailprotected] $29=$34,800 [emailprotected] $26= 20,800 Ending Inventory2,000$55,600 Cost of goods available for sale$115,200 Less: Ending inventory 55,600 Cost of goods sold$ 59,600 | | |Balance Sheet |Income Statement | | |Transaction |Cash Asset |+ | | |Transaction |Cash Asset |+ | | |Transaction |Cash Asset + | |2006 |[pic] |[pic] |[pic] | |2007 |[pic] |[pic] |[pic] | b. Intel has improved its receivables, inventory, and PPE turnover rates. Receivable turnover rates can be improved by monitoring more closely the quality of credit customers, implementing better collection procedures, and offering discounts as an incentive for early payment. Inventory turnover rates can be improved by weeding out slow-moving product lines, by reducing the depth and breadth of products carried, by implementing just-in-time deliveries, reducing work-in-process inventories through better manufacturing techniques, and by reducing finished goods inventories by producing to demand. PPE turns can be improved by off-loading manufacturing to other companies in the supply chain and acquiring long-term operating assets in partnership with other companies, say in a joint venture. E6-37 (15 minutes) a. Annual straight-line depreciation is: $20,000 per year Computations: ($225,000 $25,000) / 10 years b. As of July 1, 2009, Ziebart would have used the equipment for four complete years, from July 1, 2005, through July 1, 2009. Thus, its net book value at July 1, 2009, would be: $145,000. Computations: $225,000 cost less $80,000 accumulated depreciation, the latter computed as $20,000 x 4 years. c. An asset is impaired if it meets the following condition: Sum of (undiscounted expected cash flows ; Net book value of asset For this equipment: $125,000 ; $145,000 This implies that â€Å"yes,† the equipment is impaired at July 1, 2009. This is because the equipment will not generate sufficient expected cash flows to cover the current net book value. d. From part c we know that the equipment is impaired. The impairment loss is computed as the equipments net book value minus its current fair value; computations follow: Impairment loss=Net book value of asset – Fair value of asset $55,000= $145,000 ( $90,000 PROBLEMS P6-38 (30 minutes) a. Best Buy (a retailer) reports a much higher receivables turnover rate than do the manufacturers, Caterpillar and Harley-Davidson. The likely reason for this is that retail sales are usually via cash, check, or credit cards (which are like cash for the retailers). Recall that the turnover ratio includes credit sales, but, because most firms do not report credit sales, we are forced to use total sales when we calculate the turnover ratio. Manufacturers, on the other hand, usually sell to retailers on credit and the accounts are not collected for a much longer period of time. CAT and HOG both have finance subsidiaries that provide loan and lease financing. The longer term of these receivables reduces turnover rates. b. Harley-Davidson’s relatively higher inventory turnover rate, compared with Caterpillar, most likely reflects the fact that demand is high for Harley-Davidson’s products and the motorcycles are sold before production begins, thus minimizing finished goods inventories. CAT, on the other hand, builds a relatively smaller number of high cost machines that likely take a much longer period of time to manufacture. Oracle is a software development and service company and does not carry inventories of products for sale. c. Carnival, the cruise ship line, is capital-intensive. Microsoft, on the other hand, requires relatively few PPE assets to support its operations. Microsoft’s RD costs are expensed under GAAP rather than capitalized as PPE. Thus, Microsoft’s PPE turnover is much higher than Carnival’s. d. The relative asset turnover rates reported generally conform to our expectations across industries. Those industries that sell on credit, rather than using credit cards, or that normally stock inventories for production and sale, or that require substantial investment in long-term assets yield much lower receivable, inventory, and PPE turnover rates respectively. These lower turnover rates must be accompanied by higher profit margins and/or higher financial leverage to yield a satisfactory return on net operating assets. Generally, we expect the following: Industry |Receivables |Inventory |PPE | | |Turnover |Turnover |Turnover | |Retailing |^ |^ |^ | |Manufacturing |v |v |v | P 6-39 (30 minutes) a. ,b. |($ 000s) |2007 |2006 |2005 | |Accounts receivable (net) |$602,650 |$566,607 |$518,625 | |Allowance for uncollectible acco unts | 25,830 | 18,801 | 18,401 | |Gross accounts receivable |$628,480 |$585,408 |$537,026 | |Percentage of uncollectible accounts to gross |4. 11% |3. 21% |3. 3% | |accounts receivable |($25,830/$628,480) |($18,801/$585,408) |($18,401/$537,026) | c. |($ 000s) |2007 |2006 |2005 | |Bad debts expense (titled provision for |$15,436 |$6,057 |$1,326 | |uncollectible accounts) | | | | d. The allowance for uncollectible accounts has increased as a percentage of gross accounts receivable from 3. 43% in 2005 to 4. 11% in 2007 (see part b solution). The allowance is increasing appropriately because write-offs of uncollectible accounts are also increasing. e. In 2006, the allowance for uncollectible accounts was 3. 21% of gross accounts receivable. Applying that percentage to the 2007 gross accounts receivable of $628,480 yields an allowance of $20,174 which is $5,656 lower than the $25,830 reported in the allowance account for 2007. Thus, maintaining the allowance account at the 2006 level would have increased 2007 profit (before tax) by $5,656 (all $ 000s). f. Since 2005, Grainger has increased its allowance for uncollectible accounts as a percentage of gross receivables by increasing the addition (provision) to the allowance account. This increase in the provision corresponds to an increase in write-offs since 2005. | |2007 |2006 |2005 | |Write-offs |$8,755 |$5,660 |$6,380 | Grainger currently has an allowance account of $25,830, nearly three times the level of current year write-offs. It appears, therefore, that the reserve is more than adequate. P6-40 (40 minutes) ($ in thousands, consistent with Intuit’s financial statements) a. Gross receivables as of 2008 are $127,230 + $15,636 = $142,866. Gross receivables as of 2007 are $131,691 + $15,248 = $146,939. b. Estimated uncollectible accounts as a percentage of gross accounts receivable are: 10. 9%, computed as ($15,636 / $142,866) in 2008 10. 4%, computed as ($15,248 / $146,939) in 2007 The 2008 allowance for uncollectible accounts increased slightly as a percentage of gross accounts receivable – the allowance increased despite a decrease in gross accounts receivable. This could be because there is greater uncertainty about the collectability of receivables in general, or one or more large accounts are in arrears. c. The receivables turnover rate is [pic] Average collection period (days sales in accounts receivable) is: $142,866 / ($3,071,000 / 365) = 16. 98 days Intuit’s sales to consumers are primarily via on-line purchases using credit cards for payment. Its average collection period for receivables will, therefore, be low for this portion of its business. Service revenues are likely on account, and the collection period is likely to be longer for this segment of Intuit’s business. Its overall average collection period for accounts receivable is an average of these lines of business. d. Intuit’s allowance seems high – over 10% in both 2007 and 2008. To assess this, we would compare Intuit’s ratios to the allowances of Intuit’s competitors. It could be that the industry suffered an economic downturn in 2007 and 2008 and customers are having difficulty paying. P6-40—continued e. Intuit’s allowance for uncollectible accounts is increased by the provision (â€Å"additions charged to expense†) and is decreased by write-offs of accounts receivable (â€Å"deductions†). Over the three-year period covered by the table, Intuit has increased its allowance account by a cumulative amount of $38,234 ($14,269 + $14,743 + $9,222). It has written off a cumulative total of $37,565 ($13,881 + $11,027 + $12,657). The allowance account has, therefore, increased by $669 ($38,234 $37,565), from $14,967 to $15,636. The increase charged to expense has slightly exceeded its write-offs. As mentioned above, this increase might be due to customers’ weakening credit quality. It might also be the case that Intuit is conservative and is intentionally depressing its current profit. An inflated allowance can be used to absorb future receivable write-offs with no impact on future profit, or can be reversed in a future year to provide an immediate reduction in expense and consequent increase in profit. Either way, if the allowance account is inflated, the effect is to shift profit from the current period into one or more future periods. This does not appear to be the case for Intuit since the additions to the allowance account have nearly mirrored write-offs of accounts receivable. P6-41 (45 minutes) ($ millions) a. Dow uses LIFO inventory costing for 34% of inventories at December 31, 2007. As of 2007, the LIFO inventory reserve is $1,511 million. Thus, cumulatively, pretax income has been reduced by $1,511 million because Dow uses LIFO. Assuming a tax rate of 35%, Dow has saved taxes of $528. 9 million ($1,511 million ? 35%), cumulatively. During 2007, the LIFO reserve increased by $419 million ($1,511 million $1,092 million), saving the company $146. 65 million ($419 million ? 35%) in taxes. This tax saving increased operating cash flow by that same amount. b. The inventory turnover rate for 2007 is 7. 17 (computed as[pic]). The average inventory days outstanding for 2007 is 54. 16 ($6,885 / [$46,400/ 365 days]). DOW is a manufacturer, thus, it requires a certain level of raw materials and continually maintains inventories in production and awaiting delivery. The average inventory days outstanding does not appear excessive. We could usefully compare both of these ratios to those of other manufacturers in the same industry as DOW to make a more informed comparison. c. Since the overall cost of its inventories has been increasing, DOW’s reduction of inventory quantities resulted in the matching of lower-cost inventories against higher current selling prices. This increased its income by $321 million in 2007, $97 million in 2006, and $110 million in 2005. This reduction in inventory quantities is called LIFO liquidation. P6-42 (15 minutes) a. Average useful life= Depreciable asset cost / Depreciation expense = ($15,597,801 $494,021 $1,121,328) / $1,072,855 = 13. 03 years Note: We eliminate land and construction in progress from the computation because land is never depreciated and construction in progress represents assets that are not in service yet and are consequently not yet â€Å"depreciable†). The footnote indicates that buildings have estimated useful lives ranging from 10-50 years ( 27-year average) and Equipment from 3-20 years (11-year average). Thus, the estimate of 13. 0 years rests between these two reported values. b. Percent used up= Accumulated depreciation/ Depreciable asset cost = $8,079,652 / ($15,597,801 $494,021 $1,121,328) = 57. 8% (Note: We eliminate land and construction in progress from the computation because land is never depreciated and construction in progress represents assets that are not in service yet and are consequently not â€Å"depreciable†). Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% depreciated, on average. Abbott Labs 57. 8% is slightly higher than this level, but not high enough to cause concern that it will need markedly higher capital expenditures in the near future to replace aging assets. P6-43 (45 minutes) $ millions a. PPE turnover for 2007 is: $8,897 / [($2,871 + $2,669) / 2] = 3. 21. This turnover is lower than the 5. 03 median for all publicly traded companies. This indicates that Rohm and Haas is more capital intensive than the median publicly traded company. Rohm and Haas’ balance sheet does not reflect all of its operating assets. For example, under generally accepted accounting principles, the company must expense most, if not all, of its RD expenditures. Substantial RD costs not reflected on the balance sheet would yield understated PPE assets and thus, an overstated PPE turnover rate – the sales resulting from the RD investments are included in the numerator of PPE turnover but the RD related assets are excluded from the denominator. b. Rohm and Haas’ average asset life, assuming straight-line depreciation, can be estimated as Depreciable asset cost / Depreciation expense ($8,779 $146*- $352* $271*) / $412 = 19. 44 years *Note: We eliminate land from the computation because land is never depreciated. We eliminate construction in progress and capitalized interest because these represent assets that the company is building (and the interest paid on the construction loans). These assets are not yet in service and are consequently not yet depreciable. c. As of 2007, the company’s plant assets were approximately 73. 8% â€Å"used up,† which is computed as follows: Accumulated depreciation / Depreciable asset cost $5,908 / ($8,779 $146*- $352* $271*) = 73. 76% *Note: We eliminate land from the computation because land is never depreciated. We eliminate construction in progress and capitalized interest because these represent assets that the company is building (and the interest paid on the construction loans). These assets are not yet in service and are consequently not depreciated. If plant assets are replaced at a constant rate, we would expect those assets to be about 50% â€Å"used up,† on average. A substantially higher percentage â€Å"used up† indicates that the assets are closer to the end of their useful lives and will require replacement (and usually higher maintenance costs near the end of their useful lives). Such a situation would negatively impact future cash flows. Rohm Haas’ depreciable assets appear to be substantially â€Å"used up† based on this analysis. P6-43—continued d. Plant assets are deemed to be impaired if the undiscounted expected future cash flows from those assets are not sufficient to recover their net book value. That is, the sum of the undiscounted future cash flows is less than the net book value. If impaired, the plant assets are written down to their fair value, which is typically, the discounted value of the future expected cash flows. An asset impairment charge (such as Rohm and Haas’ $24 million charge in 2007) reduces net income, but has no effect on current period cash flows because an impairment charge is a noncash expense. Moreover, the impairment charge is not deductible for tax purposes until the asset is disposed of, that is, until the loss is realized. Since asset impairment charges are nonrecurring, we would be justified in treating them as transitory (operating) items for analysis purposes. MANAGEMENT APPLICATIONS MA6-44 (30 minutes) Reducing operating assets is an important means of increasing RNOA. Most companies focus first on reducing receivables and inventories. This is the low-hanging fruit that can lead to quick results. Some possible actions include the following: a. Reducing receivables through: 1. Better underwriting of credit quality 2. Better controls to identify delinquencies, automated dunning notices, better collection procedures 3. Increased attention to accuracy in invoicing b. Reducing inventories through: 1. Use of less costly components (of equal quality) and production with lower wage rates 2. Elimination of product features not valued by customers 3. Outsourcing to reduce product cost 4. Just-in-time deliveries of raw materials 5. Elimination of manufacturing bottlenecks to reduce work-in-process inventories 6. Producing to order rather than to estimated demand to reduce finished goods inventories c. Reducing PPE assets is much more difficult. The benefits, however, can be substantial. Some suggestions are the following: 1. Sale of unused and unnecessary assets 2. Acquisition of production and administrative assets in partnership with other companies for greater throughput 3. Acquisition of finished or semifinished goods (sub-components) from suppliers to reduce manufacturing assets MA6-45 (40 minutes) a. It is instructive to think about the parties that are affected by ethical issues. It is often a much longer list than first thought. Some possibilities include: 1. Management of the company 2. Other employees 3. The company’s external auditors 4. Shortsellers who anticipated a stock price drop 5. Future shareholders who purchase artificially inflated stock 6. Suppliers that grant credit based on inflated earnings and employees of those companies 7. The company’s lenders that grant credit based on inflated earnings b. Reducing the provision results in an allowance for uncollectible accounts that is too low. Net receivables will, therefore, be overstated. Additionally, profit is overstated because bad debt expense is too low. c. In a future period, the allowance account will have to be increased in order to absorb actual (higher) credit losses. At that time, bad debt expense will increase, thus lowering future profits. The increase in the allowance account will also reduce net accounts receivable. d. To assess the level of the allowance, the auditors will assess the credit quality of the companies’ customers. To justify a smaller allowance, management might contend that overall credit quality has improved, perhaps referring to a business upturn or a shift in the customer mix toward a less risky class of customer. MA6-45—continued. . Outsiders can use two ratios to potentially detect this sort of earnings management. First, the accounts receivable turnover (or days sales in accounts receivables) is usually computed based on net accounts receivable. The lower (understated) allowance for uncollectible accounts will overstat e net accounts receivable. This will yield a lower receivables turnover rate (and a larger days to collect ratio). Thus, while the declining turnover may appear unhealthy, analysts want to consider how the allowance affects the ratio. To that point, analysts usually also recompute both receivable ratios on the gross accounts receivable rather than net. This will show if turnover is really declining or if it’s a by-product of earnings management via the allowance account. Second, the allowance for uncollectible accounts as a percentage of gross accounts receivable will decrease from prior periods. f. Cheating begets cheating. Once senior management condones activities like this, the moral compass of the company suffers greatly. Employees begin to feel that it is OK to fudge numbers and might pad expense reports, recognize sales inappropriately in order to obtain bonuses or otherwise steal from the company, lower work output, and a host of other actions that are not in the best interest of the company.