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Implementing ABC at Plastim

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In order to apply ABC to Plastim’s costing system, we follow the seven-step approach to costing and the three guidelines for refining costing systems (increasing direct-cost tracing, creating homogeneous indirect-cost pools, and identifying cost-allocation bases that have cause-and-effect relationships with costs in the cost pool). Exhibit 5-3 shows an overview of Plastim’s ABC system. Use this exhibit as a guide as you study the following steps, each of which is marked in Exhibit 5-3.<br />
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Step 1: Identify the Products That Are the Chosen Cost Objects. The cost objects are the 60,000 S3 and the 15,000 CL5 lenses that Plastim will produce in 2011. Plastim’s goal is to first calculate the total costs and then the per-unit cost of designing, manufacturing, and distributing these lenses. Step 2: Identify the Direct Costs of the Products. Plastim identifies as direct costs of the lenses: direct material costs, direct manufacturing labor costs, and mold cleaning and maintenance costs because these costs can be economically traced to a specific lens or mold. Exhibit 5-5 shows the direct and indirect costs for the S3 and CL5 lenses using the ABC system. The direct costs calculations appear on lines 6, 7, 8, and 9 of Exhibit 5-5. Plastim classifies all other costs as indirect costs, as we will see in Exhibit 5-4. Step 3: Select the Activities and Cost-Allocation Bases to Use for Allocating Indirect Costs to the Products. Following guidelines 2 and 3 for refining a costing system, Plastim identifies six activities—(a) design, (b) molding machine setups, (c) machine operations, (d) shipment setup, (e) distribution, and (f) administration—for allocating indirect costs to products. Exhibit 5-4, column 2, shows the cost hierarchy category, and column 4</div>
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shows the cost-allocation base and the budgeted quantity of the cost-allocation base for each activity described in column 1. Identifying the cost-allocation bases defines the number of activity pools into which costs must be grouped in an ABC system. For example, rather than define the design activities of product design, process design, and prototyping as separate activities, Plastim defines these three activities together as a combined “design” activity and forms a homogeneous design cost pool. Why? Because the same cost driver, the complexity of the mold, drives costs of each design activity. A second consideration for choosing a cost-allocation base is the availability of reliable data and measures. For example, in its ABC system, Plastim measures mold complexity in terms of the number of parts in the mold and the surface area of the mold (parts-square feet). If these data are difficult to obtain or measure, Plastim may be forced to use some other measure of complexity, such as the amount of material flowing through the mold that may only be weakly related to the cost of the design activity.<br />
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Step 4: Identify the Indirect Costs Associated with Each Cost-Allocation Base. In this step, Plastim assigns budgeted indirect costs for 2011 to activities (see Exhibit 5-4, column 3), to the extent possible, on the basis of a cause-and-effect relationship between the cost-allocation base for an activity and the cost. For example, all costs that have a cause-and-effect relationship to cubic feet of packages moved are assigned to the distribution cost pool. Of course, th strength of the cause-and-effect relationship between the cost-allocation base and the cost ofan activity varies across cost pools. For example, the cause-and-effect relationship between direct manufacturing labor-hours and administration activity costs is not as strong as the relationship between setup-hours and setup activity costs.<br />
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Some costs can be directly identified with a particular activity. For example, cost of materials used when designing products, salaries paid to design engineers, and depreciation of equipment used in the design department are directly identified with the design activity. Other costs need to be allocated across activities. For example, on the basis of interviews or time records, manufacturing engineers and supervisors estimate the time they will spend on design, molding machine setup, and machine operations. The time to be spent on these activities serves as a basis for allocating each manufacturing engineer’s and supervisor’s salary</div>
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costs to various activities. Still other costs are allocated to activity-cost pools using allocation bases that measure how these costs support different activities. For example, rent costs are allocated to activity cost pools on the basis of square-feet area used by different activities. The point here is that all costs do not fit neatly into activity categories. Often, costs may first need to be allocated to activities (Stage 1 of the 2-stage cost-allocation model) before the costs of the activities can be allocated to products (Stage 2).<br />
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Step 5: Compute the Rate per Unit of Each Cost-Allocation Base. Exhibit 5-4, column 5, summarizes the calculation of the budgeted indirect cost rates using the budgeted quantity of the cost-allocation base from Step 3 and the total budgeted indirect costs of each activity from Step 4.<br />
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Step 6: Compute the Indirect Costs Allocated to the Products. Exhibit 5-5 shows total budgeted indirect costs of $1,153,953 allocated to the simple lens and $961,047 allocated to the complex lens. Follow the budgeted indirect cost calculations for each lens in Exhibit 5-5. For each activity, Plastim’s operations personnel indicate the total quantity of the cost-allocation base that will be used by each type of lens (recall that Plastim operates at capacity). For example, lines 15 and 16 of Exhibit 5-5 show that of the 2,000 total setup-hours, the S3 lens is budgeted to use 500 hours and the CL5 lens 1,500 hours. The budgeted indirect cost rate is $150 per setup-hour (Exhibit 5-4, column 5, line 5). Therefore, the total budgeted cost of the setup activity allocated to the S3 lens is $75,000 (500 setup-hours $150 per setup-hour) and to the CL5 lens is $225,000 (1,500 setuphours $150 per setup-hour). Budgeted setup cost per unit equals $1.25 ($75,000 ÷ 60,000 units) for the S3 lens and $15 ($225,000 ÷ 15,000 units) for the CL5 lens.<br />
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Step 7: Compute the Total Cost of the Products by Adding All Direct and Indirect Costs Assigned to the Products. Exhibit 5-5 presents the product costs for the simple and complex lenses. The direct costs are calculated in Step 2, and the indirect costs are calculated in Step 6. The ABC system overview in Exhibit 5-3 shows three direct-cost categories and six indirect-cost categories. The budgeted cost of each lens type in Exhibit 5-5 has nine line items, three for direct costs and six for indirect costs. The differences between the ABC product costs of S3 and CL5 calculated in Exhibit 5-5 highlight how each of these products uses different amounts of direct and indirect costs in each activity area. We emphasize two features of ABC systems. First, these systems identify all costs used by products, whether the costs are variable or fixed in the short run. When making long-run strategic decisions using ABC information, managers want revenues to exceed total costs. Second, recognizing the hierarchy of costs is critical when allocating costs to products. It is easiest to use the cost hierarchy to first calculate the total costs of each product. The per-unit costs can then be derived by dividing total costs by the number of units produced.</div>

In order to apply ABC to Plastim’s costing system, we follow the seven-step approach to costing and the three guidelines for refining costi...

Applying the five step decision making process at plastim

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To decide how it should respond to the threat that Bandix poses to its S3 lens business,Plastim’s management works through the five-step decision-making process <br /><br />Step 1: Identify the problem and uncertainties. The problem is clear: If Plastim wants to retain the Giovanni business for S3 lenses and make a profit, it must find a way to reduce the price and costs of the S3 lens. The two major uncertainties Plastim faces are (1) whether Plastim’s technology and processes for the S3 lens are competitive with  Bandix’s and (2) whether the S3 lens is overcosted by the simple costing system.<br /><br />Step 2: Obtain information. Management asks a team of its design and process engineers to analyze and evaluate the design, manufacturing, and distribution operations for the S3 lens. The team is very confident that the technology and processes for the S3 lens are not inferior to those of Bandix and other competitors because Plastim has many years of experience in manufacturing and distributing the S3 with a history and culture of continuous process improvements. If anything, the team is less certain about Plastim’s capabilities in manufacturing and distributing complex lenses, because it only recently started making this type of lens. Given these doubts, management is happy that Giovanni Motors considers the price of the CL5 lens to be competitive. It is somewhat of a puzzle, though, how at the currently budgeted prices, Plastim is expected to earn a very large profit margin percentage (operating income ÷ revenues) on the CL5 lenses and a small profit margin on the S3 lenses:</div>
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As it continues to gather information, Plastim’s management begins to ponder why the profit margins (and process) are under so much pressure for the S3 lens, where the company has strong capabilities, but high on the newer, less-established CL5 lens. Plastim is not deliberately charging a low price for S3, so management starts to believe that perhaps the problem lies with its costing system. Plastim’s simple costing system may be overcosting the simple S3 lens (assigning too much cost to it) and undercosting the complex CL5 lens (assigning too little cost to it).<br /><br />Step 3: Make predictions about the future. Plastim’s key challenge is to get a better estimate of what it will cost to design, make, and distribute the S3 and CL5 lenses. Management is fairly confident about the direct material and direct manufacturing labor costs of each lens because these costs are easily traced to the lenses. But management is quite concerned about how accurately the simple costing system measures the indirect resources used by each type of lens. It believes it can do much better. At the same time, management wants to ensure that no biases enter its thinking. In particular, it wants to be careful that the desire to be competitive on the S3 lens should not lead to assumptions that bias in favor of lowering costs of the S3 lens.<br /><br />Step 4: Make decisions by choosing among alternatives. On the basis of predicted costs, and taking into account how Bandix might respond, Plastim’s managers must decide whether they should bid for Giovanni Motors’ S3 lens business and if they do bid, what price they should offer.<br /> </div>
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Step 5: Implement the decision, evaluate performance, and learn. If Plastim bids and wins Giovanni’s S3 lens business, it must compare actual costs, as it makes and ships  S3 lenses, to predicted costs and learn why actual costs deviate from predicted costs. Suchevaluation and learning form the basis for future improvements.</div>

To decide how it should respond to the threat that Bandix poses to its S3 lens business,Plastim’s management works through the five-step de...

Simple costing system using a single indirect cost pool

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Plastim has historically had a simple costing system that allocates indirect costs using a single indirect-cost rate, . We calculate budgeted costs for each type of lens in 2011 using Plastim’s simple costing system and later contrast it with activity-based costing.  Exhibit 5-1 shows an overview of Plastim’s simple costing system. Use this exhibit as a guide as you study the following steps, each of which is marked in Exhibit 5-1.<br /> </div>
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Step 1: Identify the Products That Are the Chosen Cost Objects. The cost objects are the 60,000 simple S3 lenses and the 15,000 complex CL5 lenses that Plastim will produce in 2011. Plastim’s goal is to first calculate the total costs and then the unit cost of designing,manufacturing, and distributing these lenses.<br /> </div>
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Step 2: Identify the Direct Costs of the Products. Plastim identifies the direct costs direct materials and direct manufacturing labor of the lenses. Exhibit 5-2 shows the direct and indirect costs for the S3 and the CL5 lenses using the simple costing system. The direct cost calculations appear on lines 5, 6, and 7 of Exhibit 5-2. Plastim classifies allother costs as indirect costs.<br /> </div>
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Step 3: Select the Cost-Allocation Bases to Use for Allocating Indirect (or Overhead) Costs to the Products. A majority of the indirect costs consist of salaries paid to supervisors, engineers, manufacturing support, and maintenance staff, all supporting direct manufacturing labor. Plastim uses direct manufacturing labor-hours as the only allocation base to allocate all manufacturing and nonmanufacturing indirect costs to S3 and CL5. In 2011, Plastim plans to use 39,750 direct manufacturing labor-hours.<br /><br />Step 4: Identify the Indirect Costs Associated with Each Cost-Allocation Base. Because Plastim uses only a single cost-allocation base, Plastim groups all budgeted indirect costs of $2,385,000 for 2011 into a single overhead cost pool.<br /><br />Step 5: Compute the Rate per Unit of Each Cost-Allocation Base</div>
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Step 6: Compute the Indirect Costs Allocated to the Products. Plastim expects to use 30,000 total direct manufacturing labor-hours to make the 60,000 S3 lenses and 9,750 total direct manufacturing labor-hours to make the 15,000 CL5 lenses. Exhibit 5-2 shows indirect costs of $1,800,000 ($60 per direct manufacturing labor-hour 30,000 direct manufacturing labor-hours) allocated to the simple lens and $585,000 ($60 per direct manufacturing labor-hour 9,750 direct manufacturing labor-hours) allocated to thecomplex lens.<br /> </div>
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Step 7: Compute the Total Cost of the Products by Adding All Direct and Indirect Costs Assigned to the Products. Exhibit 5-2 presents the product costs for the simple and complex lenses. The direct costs are calculated in Step 2 and the indirect costs in Step 6. Be sure you see the parallel between the simple costing system overview diagram (Exhibit 5-1)</div>
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and the costs calculated in Step 7. Exhibit 5-1 shows two direct-cost categories and one indirect-cost category. Hence, the budgeted cost of each type of lens in Step 7 (Exhibit 5-2) has three line items: two for direct costs and one for allocated indirect costs. The budgeted cost per S3 lens is $58.75, well above the $53 selling price quoted by Bandix. The budgeted cost per CL5 lens is $97.</div>

Plastim has historically had a simple costing system that allocates indirect costs using a single indirect-cost rate, . We calculate budget...

Undercosting and Overcosting

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The following example illustrates how averaging can result in inaccurate and misleading cost data. Consider the cost of a restaurant bill for four colleagues who meet monthly to discuss business developments. Each diner orders separate entrees, desserts, and drinks. The restaurant bill for the most recent meeting is as follows:</div>
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If the $108 total restaurant bill is divided evenly, $27 is the average cost per diner. This cost-averaging approach treats each diner the same. Emma would probably object to paying $27 because her actual cost is only $15; she ordered the lowest-cost entree, had no dessert, and had the lowest-cost drink. When costs are averaged across all four diners, both Emma and Matthew are overcosted, James is undercosted, and Jessica is (by coincidence)  accurately costed.Broad averaging can lead to undercosting or overcosting of products or services:<br /><br />  Product undercosting a product consumes a high level of resources but is reported to have a low cost per unit (James’s dinner).   Product overcosting a product consumes a low level of resources but is reported to have a high cost per unit (Emma’s dinner).<br /><br /> </div>
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What are the strategic consequences of product undercosting and overcosting? Think of a company that uses cost information about its products to guide pricing decisions. Undercosted products will be underpriced and may even lead to sales that actually result in losses sales bring in less revenue than the cost of resources they use. Overcosted products lead to overpricing, causing these products to lose market share to competitors producing similar products. Worse still, product undercosting and overcosting causes managers to focus on the wrong products, drawing attention to overcosted products whose costs may in fact be perfectly reasonable and ignoring undercosted products that in fact consume large amounts of resources.</div>

The following example illustrates how averaging can result in inaccurate and misleading cost data. Consider the cost of a restaurant bill f...

Activity based costing systems

<br />One of the best tools for refining a costing system is activity-based costing. Activity-based<br />costing (ABC) refines a costing system by identifying individual activities as the fundamental cost objects. An activity is an event, task, or unit of work with a specified purpose—for example, designing products, setting up machines, operating machines, and distributing products. More informally, activities are verbs; they are things that a firm does. To help make strategic decisions, ABC systems identify activities in all functions of the value chain, calculate costs of individual activities, and assign costs to cost objects such as products and services on the basis of the mix of activities needed to produce each product or service.<br />
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Plastim’s ABC System<br />After reviewing its simple costing system and the potential miscosting of product costs, Plastim decides to implement an ABC system. Direct material costs and direct manufacturing labor costs can be traced to products easily, so the ABC system focuses on refining theassignment of indirect costs to departments, processes, products, or other cost objects.Plastim’s ABC system identifies various activities that help explain why Plastim incurs the costs it currently classifies as indirect in its simple costing system. In other words, it breaks up the current indirect cost pool into finer pools of costs related to various activities. To identify these activities, Plastim organizes a team comprised of managers from design, manufacturing, distribution, accounting, and administration.<br />
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Defining activities is not a simple matter. The team evaluates hundreds of tasks performed at Plastim before choosing the activities that form the basis of its ABC system. For example, it decides if maintenance of molding machines, operations of molding machines, and process control should each be regarded as a separate activity or should be combined into a single activity. An activity-based costing system with many activities becomes overly detailed and unwieldy to operate. An activity-based costing system with too few activities may not be refined enough to measure cause-and-effect relationships between cost drivers and various indirect costs. Plastim’s team focuses on activities that account for a sizable fraction of indirect costs and combines activities that have the same cost driver into a single activity. For example, the team decides to combine maintenance of molding machines, operations of molding machines, and process control into a single activity molding machine operations because all these activities have the same cost driver: molding machine-hours. The team identifies the following seven activities by developing a flowchart of all thesteps and processes needed to design, manufacture, and distribute S3 and CL5 lenses.<br /><br />a. Design products and processes<br />b. Set up molding machines to ensure that the molds are properly held in place and parts<br />are properly aligned before manufacturing starts<br />c. Operate molding machines to manufacture lenses<br />d. Clean and maintain the molds after lenses are manufactured<br />e. Prepare batches of finished lenses for shipment<br />f. Distribute lenses to customers<br />g. Administer and manage all processes at Plastim<br /><br />These activity descriptions form the basis of the activity-based costing system sometimes called an activity list or activity dictionary. Compiling the list of tasks, however, is only  the first step in implementing activity-based costing systems. Plastim must also identify the cost of each activity and the related cost driver.<br /><br />1. Direct-cost tracing. Plastim’s ABC system subdivides the single indirect cost pool into seven smaller cost pools related to the different activities. The costs in the cleaning and maintenance activity cost pool (item d) consist of salaries and wages paid to workers who clean the mold. These costs are direct costs, because they can be economically traced to a specific mold and lens.<br /><br />2. Indirect-cost pools. The remaining six activity cost pools are indirect cost pools. Unlike the single indirect cost pool of Plastim’s simple costing system, each of the activity-related cost pools is homogeneous. That is, each activity cost pool includes only those narrow and focused set of costs that have the same cost driver. For example, the distribution cost pool includes only those costs (such as wages of truck drivers) that, over time, increase as the cost driver of distribution costs, cubic feet of packages delivered, increases. In the simple costing system, all indirect costs were lumped together and the cost-allocation base, direct manufacturing labor-hours, was not a cost driver of the indirect costs.<br /><br />Determining costs of activity pools requires assigning and reassigning costs accumulated in support departments, such as human resources and information systems, to each of the activity cost pools on the basis of how various activities use support department resources.<br /><br />3. Cost-allocation bases. For each activity cost pool, the cost driver is used (whenever possible) as the cost-allocation base. To identify cost drivers, Plastim’s managers consider various alternatives and use their knowledge of operations to choose among them. For example, Plastim’s managers choose setup-hours rather than the number of setups as  the cost driver of setup costs, because Plastim’s managers believe that more complex setups take more time and are more costly.

One of the best tools for refining a costing system is activity-based costing. Activity-based costing (ABC) refines a costing system by iden...

Guidelines for refining a costing system

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Refining a Costing System<br />A refined costing system reduces the use of broad averages for assigning the cost of<br />resources to cost objects (such as jobs, products, and services) and provides better measurement<br />of the costs of indirect resources used by different cost objects—no matter how<br />differently various cost objects use indirect resources.<br /><br />Reasons for Refining a Costing System<br />There are three principal reasons that have accelerated the demand for such refinements. </div>
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1. Increase in product diversity. The growing demand for customized products has led companies to increase the variety of products and services they offer. Kanthal, the Swedish manufacturer of heating elements, for example, produces more than 10,000 different types of electrical heating wires and thermostats. Banks, such as the Cooperative Bank in the United Kingdom, offer many different types of accounts and services: special passbook accounts, ATMs, credit cards, and electronic banking. These products differ in the demands they place on the resources needed to produce them, because of differences in volume, process, and complexity. The use of broad averages is likely to lead to distorted  and inaccurate cost information.<br /><br />2. Increase in indirect costs. The use of product and process technology such as computer-integrated manufacturing (CIM) and flexible manufacturing systems (FMS), has led to an increase in indirect costs and a decrease in direct costs, particularly direct manufacturing labor costs. In CIM and FMS, computers on the manufacturing floor give instructions to set up and run equipment quickly and automatically. The computers accurately measure hundreds of production parameters and directly control the manufacturing processes to achieve high-quality output. Managing more complex technology and producing very diverse products also requires committing an increasing amount of resources for various support functions, such as production scheduling, product and process design, and engineering. Because direct manufacturing labor is not a cost driver of these costs, allocating indirect costs on the basis of direct manufacturing labor (which was the common practice) does not accurately measure how resources are being used by different products.<br /><br />3. Competition in product markets. As markets have become more competitive, managers have felt the need to obtain more accurate cost information to help them make important strategic decisions, such as how to price products and which products to sell. Making correct pricing and product mix decisions is critical in competitive markets because competitors quickly capitalize on a company’s mistakes. Whereas the preceding factors point to reasons for the increase in demand for refined cost systems, advances in information technology have enabled companies to implement these refinements. Costing system refinements require more data gathering and more analysis, and improvements in information technology have drastically reduced the costs to gather, validate, store, and analyze vast quantities of data.<br /><br />Guidelines for Refining a Costing System<br />There are three main guidelines for refining a costing system. In the following sections, we delve more deeply into each in the context of the Plastim example.</div>
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<li> Direct-cost tracing. Identify as many direct costs as is economically feasible. This guideline aims to reduce the amount of costs classified as indirect, thereby minimizing the extent to which costs have to be allocated, rather than traced.</li>
<li> Indirect-cost pools. Expand the number of indirect-cost pools until each pool is more homogeneous. All costs in a homogeneous cost pool have the same or a similar causeand- effect (or benefits-received) relationship with a single cost driver that is used as the cost-allocation base. Consider, for example, a single indirect-cost pool containing both indirect machining costs and indirect distribution costs that are allocated to products using machine-hours. This pool is not homogeneous because machine-hours are a cost driver of machining costs but not of distribution costs, which has a different cost driver, number of shipments. If, instead, machining costs and distribution costs are separated into two indirect-cost pools (with machine-hours as the cost-allocation base for the machining cost pool and number of shipments as the cost-allocation base for the distribution cost pool), each indirect-cost pool would become homogeneous.</li>
<li>Cost-allocation bases. As we describe later in the chapter, whenever possible, use the cost driver (the cause of indirect costs) as the cost-allocation base for each homogenous indirect-cost pool (the effect).</li>
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Refining a Costing System A refined costing system reduces the use of broad averages for assigning the cost of resources to cost objects (s...

Debits and credits

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The term debit indicates the left side of an account, and credit indicates the right side. They are commonly abbreviated as Dr. for debit and Cr. for credit. They do not mean increase or decrease, as is commonly thought. We use the terms debit and credit repeatedly in the recording process to describe where entries are made in accounts. For example, the act of entering an amount on the left side of an account is called debiting the account. Making an entry on the right side is crediting the account. When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits. Note the position of the debit side and credit side in Illustration 3-4. The procedure of recording debits and credits in an account is shown in Illustration 3-5 for the transactions affecting the Cash account of Sierra Corporation. The data are taken from the Cash column of the tabular summary in Illustration 3-3.</div>
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Every positive item in the tabular summary represents a receipt of cash; every negative amount represents a payment of cash. Notice that in the account form, we record the increases in cash as debits and the decreases in cash as credits. For example, the $10,000 receipt of cash (in blue) is debited to Cash, and the −$5,000 payment of cash (in red) is credited to Cash. Having increases on one side and decreases on the other reduces recording errors and helps in determining the totals of each side of the account as well as the account balance. The balance is determined by netting the two sides (subtracting one amount from the other). The account balance, a debit of $15,200, indicates that Sierra had $15,200 more increases than decreases in cash. That is, since it started with a balance of zero, it has $15,200 in its Cash account.<br />
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DEBIT AND CREDIT PROCEDURES<br />
Each transaction must affect two or more accounts to keep the basic accounting equation in balance. In other words, for each transaction, debits must equal credits. The equality of debits and credits provides the basis for the double-entry accounting system. Under the double-entry system, the two-sided effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions. The double-entry system also helps to ensure the accuracy of the recorded amounts and helps to detect errors such as those at MF Global as discussed in the Feature Story. If every transaction is recorded with equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the credits. The double-entry system for determining the equality of the accounting equation is much more effi cient than the plus/minus procedure used  earlier.<br />
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Dr./Cr. Procedures for Assets and Liabilities<br />
In Illustration 3-5 for Sierra Corporation, increases in Cash an asset are entered on the left side, and decreases in Cash are entered on the right side. We know that both sides of the basic equation (Assets = Liabilities + Stockholders’ Equity) must be equal. It therefore follows that increases and decreases in liabilities have to be recorded opposite from increases and decreases in assets. Thus, increases in liabilities are entered on the right or credit side, and decreases in liabilities are entered on the left or debit side. The effects that debits and credits have on assets and liabilities are summarized in Illustration 3-6.</div>
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Asset accounts normally show debit balances. That is, debits to a specifi c asset account should exceed credits to that account. Likewise, liability accounts normally show credit balances. That is, credits to a liability account should exceed debits to that account. The normal balances may be diagrammed as in Illustration 3-7.<br />
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Knowing which is the normal balance in an account may help when you are trying to identify errors. For example, a credit balance in an asset account, such as Land, or a debit balance in a liability account, such as Salaries and Wages Payable, usually indicates errors in recording. Occasionally, however, an abnormal balance may be correct. The Cash account, for example, will have a credit balance when a company has overdrawn its bank balance by spending more than it has in its account. In automated accounting systems, the computer is programmed to fl ag violations of the normal balance and to print out error or exception reports. In manual systems, careful visual inspection of the accounts is required to detect normal balance problems.<br />
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Dr./Cr. Procedures for Stockholders’ Equity  equity is comprised of two parts: common stock and retained earnings. In the transaction events earlier in this chapter, you saw that revenues, expenses, and the payment of dividends affect retained earnings. Therefore, the subdivisions of stockholders’ equity are common stock, retained earnings, dividends, revenues, and expenses. COMMON STOCK Common stock is issued to investors in exchange for the stockholders’ investment. The Common Stock account is increased by credits and decreased by debits. For example, when cash is invested in the business, Cash is debited and Common Stock is credited. The effects of debits and credits on the Common Stock account are shown in Illustration 3-8.</div>
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RETAINED EARNINGS Retained earnings is net income that is retained in the business. It represents the portion of stockholders’ equity that has been accumulated through the profi table operation of the company. Retained Earnings is increased by credits (for example, by net income) and decreased by debits (for example, by a net loss), as shown in Illustration 3-10.</div>
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DIVIDENDS A dividend is a distribution by a corporation to its stockholders. The most common form of distribution is a cash dividend. Dividends result in a reduction of the stockholders’ claims on retained earnings. Because dividends reduce stockholders’ equity, increases in the Dividends account are recorded with debits. As shown in Illustration 3-12, the Dividends account normally has a debit balance.</div>
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REVENUES AND EXPENSES When a company recognizes revenues, stockholders’ equity is increased. Revenue accounts are increased by credits and decreased by debits. Expenses decrease stockholders’ equity. Thus, expense accounts are increased by debits and decreased by credits. The effects of debits and credits on revenues and expenses are shown in Illustration 3-13.<br />
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Credits to revenue accounts should exceed debits; debits to expense accounts should exceed credits. Thus, revenue accounts normally show credit balances, and expense accounts normally show debit balances. The normal balances may be diagrammed as in Illustration 3-14</div>

The term debit indicates the left side of an account, and credit indicates the right side. They are commonly abbreviated as Dr. for debit a...

Identify the sections of a classified balance sheet

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you learned that a balance sheet presents a snapshot of a company’s fi nancial position at a point in time. It lists individual asset, liability, and stockholders’ equity items. However, to improve users’ understanding of a company’s fi nancial position, companies often use a classifi ed balance sheet instead. A classifi ed balance sheet groups together similar assets and similar liabilities, using a number of standard classifi cations and sections. This is useful because items within a group have similar economic characteristics. A classifi ed balance sheet generally contains the standard classifi cations listed in Illustration 2-1.</div>
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CURRENT ASSETS<br />
Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 2-2, Franklin Corporation had current assets of $22,100. For most businesses, the cutoff for classifi cation as current assets is one year from the balance sheet date. For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use the supplies in operations within one year.<br />
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These groupings help fi nancial statement readers determine such things as (1) whether the company has enough assets to pay its debts as they come due, and (2) the claims of short- and long-term creditors on the company’s total assets. Many of these groupings can be seen in the balance sheet of Franklin Corporation shown in Illustration 2-2 on the next page. In the sections that follow, we explain each of these groupings.<br />
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Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year. The operating cycle of a company is the average time required to go from cash to cash in producing revenue—to purchase inventory, sell it on account, and then collect cash from customers. For most businesses, this cycle takes less than a year, so they use a one-year cutoff. But for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or long-term. Common types of current assets are (1) cash, (2) investments (such as shortterm U.S. government securities), (3) receivables (accounts receivable, notes receivable, and interest receivable), (4) inventories, and (5) prepaid expenses (insurance and supplies). Companies list current assets in the order in which they expect to convert them into cash. Follow this rule when doing your homework.</div>
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 Illustration 2-3 presents the current assets of Southwest Airlines Co. in a recent year.</div>
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LONG-TERM INVESTMENTS<br />
Long-term investments are generally (1) investments in stocks and bonds of other corporations that are held for more than one year, (2) long-term assets such as land or buildings that a company is not currently using in its operating activities, and (3) long-term notes receivable. In Illustration 2-2, Franklin Corporation reported total long-term investments of $7,200 on its balance sheet. Google Inc. reported long-term investments on its balance sheet in a recent year as shown in Illustration 2-4.</div>
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PROPERTY, PLANT, AND EQUIPMENT<br />
Property, plant, and equipment are assets with relatively long useful lives that are currently used in operating the business. This category includes land, buildings, equipment, delivery vehicles, and furniture. In Illustration 2-2, Franklin Corporation reported property, plant, and equipment of $29,000. Depreciation is the allocation of the cost of an asset to a number of years. Companies do this by systematically assigning a portion of an asset’s cost as an expense each year (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the balance sheet at cost less accumulated depreciation. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset’s life. In Illustration 2-2, Franklin Corporation reported accumulated depreciation of $5,000. Illustration 2-5 presents the property, plant, and equipment of Tesla Motors, Inc. in a recent year.</div>
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INTANGIBLE ASSETS</div>
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Many companies have assets that do not have physical substance and yet often are very valuable. We call these assets intangible assets. One common intangible is goodwill. Others include patents, copyrights, and trademarks or trade names that give the company exclusive right of use for a specifi ed period of time. In Illustration 2-2, Franklin Corporation reported intangible assets of $3,100.BIllustration 2-6 shows the intangible assets of media and theme park giant The Walt Disney Company in a recent year.<br />
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you learned that a balance sheet presents a snapshot of a company’s fi nancial position at a point in time. It lists individual asset, liab...

Analyzing accounting changes

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There are several points an analyst must consider when analyzing accounting changes. First, accounting changes are “cosmetic” and yield no cash flow consequences either present or future. This means the financial condition of a company is not affected by a change in accounting. Second, while an accounting change is cosmetic, it can sometimes better reflect economic reality. For example, a company’s decision to extend the depreciable lives of its machinery might be an attempt to better match costs with actual usage patterns. In principle, a necessary condition for a change in accounting methods is that the change better reflect the underlying economics.<br /><br /> Third, an analyst must be alert to earnings management. Earnings management is less of an issue in the adoption of new standards although managers may time its adoption for a period when its effect is most favorable (or least detrimental). However, in the case of voluntary accounting changes, earnings management is a likely motivation. While managers sometimes manage earnings through changes in accounting principles, the more popular and shrewd method of earnings management is by changing accounting estimates. Unlike a change in accounting principle, where the cumulative effect is highlighted in the income statement, information about changes in estimates often is buried in the notes. To illustrate, the motive for Delta Airlines’ change in depreciation policy, described in Illustration 6.2, is apparent when we examine its pattern in operating losses around that time: Year 2, $(675) million; Year 3, $(575) million; Year 4, $(447) million. This pattern depicts a marked improvement over time a compounded decrease in losses of 13% per annum. However, when we restate reported numbers as per the original depreciation methods, we see the following pattern in operating losses: Year 2, $(675) million; Year 3, $(609) million; Year 4, $(583) million. This shows the accounting change increases income by $34 million in Year 3 and by $136 million in Year 4. The decline in operating losses using the original data is, thus, amere 5% per annum.<br /> </div>
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Another concern with accounting changes is earnings manipulation. Unlike earnings management, which is window dressing within the confines of GAAP, earnings manipulation arises when companies stray beyond acceptable practices. When the SEC staff spots such accounting practices, the company is asked to restate its financial statements. Such restatements, reported in Accounting Enforcement Releases (or AERs), suggest that a company is adopting excessively aggressive accounting practices. While honest errors do arise, an analyst should be concerned when a company is forced by the SEC to restate its financial statements. At a minimum, this reflects poor earnings quality, and an analyst must take extra care when analyzing financial statements of such companies.<br /><br />Fourth, an analyst must assess the impact of accounting changes on comparisons across time. It is important for an analyst to compare “apples with apples.” This means making sure any comparisons (especially across time) are made with a consistent set of accounting rules. Such comparisons are possible under the latest accounting rules, at least for the years reported in the latest financial statements. However, there is no such guarantee for changes in estimates and when examining prior information that is many years earlier. If the company reports the effects of accounting changes for prior years’ data in its notes, the income history can be adjusted. If no such information is reported, an analyst must be aware of the potential limitations for any comparisons across time. This is important because companies sometimes change accounting estimates to window-dress earnings history.<br /><br />Finally, an analyst would want to evaluate the effect of an accounting change on both economic income and permanent income. For estimating permanent income, the analyst can use the reported numbers under the new method and ignore the cumulative effect, if any. For estimating economic income of the current period, both the current and cumulative effect are included. More generally, an analyst must evaluate the ability of the change to better reflect economic reality. If the change is arbitrary or seems to impair the ability of the numbers to reflect economic reality, then we can undo the effects of the change using note information.<br /><br /><b>Special Items</b><br />Special items refer to transactions and events that are unusual or infrequent, but not both. These items are typically reported as separate line items on the income statement as part of income from continuing operations. Often, special items are nonroutine items that do not meet the criteria for classification as extraordinary items. Special items constitute the most common and important class of nonrecurring items. As reported in Exhibit 6.5, their frequency is increasing. The frequency of special items has increased dramatically, from 1% of reporting companies through the 1980s to nearly 48% of reporting companies. Most of this increase has been concentrated in special items that reduce income, primarily restructuring expenses. The magnitude of special items has remained fairly constant at about 2% of sales, with negative effects consistently higher in absolute value than positive effects. These items, when they occur, can have a significant impact on reported profits, often turning a profitable year into a loss. They are generally the most transitory item in income from continuing operations.<br /><br />Exhibit 6.6 shows the makeup of one-time special charges both by frequency and by dollar value. Restructuring charges and asset write-offs of goodwill, inventory, and property, plant, and equipment (PP&E) form the bulk of such charges. Of these, impairment of long-lived assets and restructuring charges constitute the two major categories of special items. There are two differences between them. First, restructuring charges are </div>
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associated with major reorganizations of a company as a whole or within a division. Restructuring often involves a change in business strategy, financing, or physical reorganization of the business. On the other hand, asset impairments are narrower in scope, involving the write-down or write-off of a class of assets. A second major difference is that asset impairments are mainly accrual accounting adjustments, while restructuring charges often involve substantial cash flow commitments either contemporaneously or in the future. Special items pose challenges for analysis. First, the economic implications of special items, such as restructuring charges, are complex. Second, many special items are discretionary and, hence, serve earnings management aims. The remainder of this section focuses on the two major types of special items: asset impairments and restructuring charges. </div>

There are several points an analyst must consider when analyzing accounting changes. First, accounting changes are “cosmetic” and yield no ...

Accounting for Intangibles Identifiable Intangibles

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Identifiable intangibles are intangible assets that are separately identified and linked with specific rights or privileges having limited benefit periods. Candidates are patents, trademarks, copyrights, and franchises. Companies record them at cost and amortize them over their benefit periods. The writing off to expense of the entire cost of identifiable intangibles at acquisition is prohibited.<br /></div>
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Unidentifiable Intangibles<br />Unidentifiable intangibles are assets that are either developed internally or purchased but are not identifiable and often possess indefinite benefit periods. An example is goodwill. When one company acquires another company or segment, it needs to allocate the amount paid to all identifiable assets (including identifiable intangible assets) and liabilities according to their fair market values. Any excess remaining after this allocation is allocated to an unidentifiable intangible asset called goodwill. Goodwill can be a sizable asset, but it is recorded only upon purchase of another entity or segment (internally developed goodwill is not recorded on the balance sheet). Its makeup varies considerably it can refer to an ability to attract and retain customers or to qualities inherent in business activities such as organization, efficiency, and effectiveness. Goodwill implies earning power. Stated differently, goodwill translates into future excess earnings, where this excess is the amount above normal earnings.<br /><br /><b>Amortization of Intangibles</b><br />When costs are capitalized for identifiable tangible and intangible assets, they must be subsequently amortized over the benefit periods for these assets. The length of a benefit period depends on the type of intangible, demand conditions, competitive circumstances, and any other legal, contractual, regulatory, or economic limitations. For example, patents are exclusive rights conveyed by governments to inventors for a specific period. Similarly, copyrights and trademarks convey exclusive rights for specific periods. Leaseholds and leasehold improvements are benefits of occupancy that are contractually set by the lease. Also, if an intangible materially declines in value (applying the recoverability test), it is written down.<br /><br /><b>Analyzing Intangibles</b><br />Analysts often treat intangibles with suspicion when analyzing financial statements. Many analysts associate intangibles with riskiness. We encourage caution and understanding when evaluating intangibles. Intangibles often are one of the more valuable assets a company owns, and they can be seriously misvalued. Analysis of goodwill reveals some interesting cases. Since goodwill is recorded only when acquired, most goodwill likely exists off the balance sheet. Yet we know that goodwill is eventually reflected in superearnings. If superearnings are not evident, then goodwill, whether purchased or not, is of little or no value. To illustrate this point, consider the write-off of goodwill reported by Viacom.<br /><br />Our analysis of intangibles other than goodwill also must be alert to management’s latitude in amortization. Since less amortization increases reported earnings, management might amortize intangibles over periods exceeding their benefit periods. We are probably confident in assuming any bias is in the direction of a lower rate of amortization. We can adjust these rates if armed with reliable information on intangibles’ benefit periods.<br /><br />In analyzing intangibles, we must be prepared to form our own estimates regarding their valuation. We must also remember that goodwill does not require amortization and that auditors have a difficult time with intangibles, especially goodwill. They particularly find it difficult to assess the continuing value of unamortized intangibles. Our analysis must be alert to the composition, valuation, and disposition of goodwill. Goodwill is written off when the superior earning power justifying its existence disappears. Disposition, or write-off, of goodwill is frequently timed by management for a period when it has the least impact on the market.</div>

Identifiable intangibles are intangible assets that are separately identified and linked with specific rights or privileges having limited ...

Capitalizing versus expensing financial statement and ratio effects

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Capitalization is an important part of accounting. It affects both financial statements and their ratios. It also contributes to the superiority of earnings over cash flow as a measure of financial performance. This section examines the effects of capitalization (and subsequent allocation) versus immediate expensing for income measurement and ratio computation.<br /><br /><b>Effects of Capitalization on Income</b><br />Capitalization has two effects on income. First, it postpones recognition of expense in the income statement. This means capitalization yields higher income in the acquisition period but lower income in subsequent periods as compared with expensing of costs. Second, capitalization yields a smoother income series. Why does immediate expensing yield a volatile income series? The answer is volatility arises because capital expenditures are often “lumpy” occurring in spurts rather than continually while revenues from these expenditures are earned steadily over time. In contrast, allocating asset cost  over benefit periods yields an accrual income number that is a more stable and meaningful measure of company performance.<br /><br /><b>Effects of Capitalization for Return on Investment</b><br />Capitalization decreases volatility in income measures and, similarly, return on investment ratios. It affects both the numerator (income) and denominator (investment bases) of the return on investment ratios. In contrast, expensing asset costs yields a lower investment base and increases income volatility. This increased volatility in the numerator (income) is magnified by the smaller denominator (investment base), leading to more volatile and less useful return ratios. Expensing also introduces bias in income measures, as income is understated in the acquisition year and overstated in subsequent years.<br /><br /><b>Effects of Capitalization on Solvency Ratios</b><br />Under immediate expensing of asset costs, solvency ratios, such as debt to equity, reflect more poorly on a company than warranted. This occurs because the immediate  expensing of costs understates equity for companies with productive assets.<br /><br /><b>Effects of Capitalization on Operating Cash Flows</b><br />When asset costs are immediately expensed, they are reported as operating cash outflows. In contrast, when asset costs are capitalized, they are reported as investing cash outflows. This means that immediate expensing of asset costs both overstates operating cash outflows and understates investing cash outflows in the acquisition year in comparison to capitalization of costs.</div>

Capitalization is an important part of accounting. It affects both financial statements and their ratios. It also contributes to the superi...

Accounting for long term assets

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This section explains the concept of long-term assets and the processes of capitalization, allocation, and impairment<br /><br /><b>Capitalization, Allocation, and Impairment</b><br />The process of long-term asset accounting involves three distinct activities: capitalization, allocation, and impairment. Capitalization is the process of deferring a cost that is incurred in the current period, but whose benefits are expected to extend to one or more future periods. It is capitalization that creates an asset account. Allocation is the process of periodically expensing a deferred cost (asset) to one or more future expected benefit periods. This allocation process is called depreciation for tangible assets, amortization for intangible assets, and depletion for natural resources. Impairment is the process of writing down the book value of the asset when its expected cash flows are no longer sufficient to recover the remaining cost reported on the balance sheet. Thissection discusses each of these three accounting activities.<br /><br /><b>Capitalization</b> </div>
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A long-term asset is created through the process of capitalization. Capitalization means putting the asset on the balance sheet rather than immediately expensing its cost in the income statement. For hard assets, such as PPE, this process is relatively simple; the asset is recorded at its purchase price. For soft assets such as R&D, advertising, and wage costs, capitalization is more problematic. Although all of these costs arguably produce future benefits and, therefore, meet the test to be recorded as an asset, neither the amount of the future benefits, nor their useful life, can be reliably measured. Consequently, costs for internally developed soft assets are immediately expensed and are not recorded on the balance sheet.<br />One area that has been particularly troublesome for the accounting profession has been the capitalization of software development costs. GAAP differentiates between two types of costs: the cost of software developed for internal use and the cost  of software that is developed for sale or lease. The cost of computer software developed for internal use should be capitalized and amortized over its expected useful life. An important factor bearing on the determination of software’s useful life is expected obsolescence. Software that is developed for sale or lease to others is capitalized and amortized only after it has reached technological feasibility. Prior to that stage of development, the software is considered to be R&D and is expensed accordingly.<br /><br /><b>Allocation</b> </div>
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 Allocation is the periodic assignment of asset cost to expense over its expected useful life (benefit period). Allocation of costs is called depreciation when applied to tangible fixed assets, amortization when applied to intangible assets, and depletion when applied to natural resources. Each refers to cost allocation. We must remember that cost allocation is a process to match asset cost with its benefits it is not a valuation process. Asset carrying value (capitalized value less cumulative cost allocation) need not reflect fair value.<br />Three factors d</div>
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etermine the cost allocation amount: useful life, salvage value, and allocation method. We discuss these factors shortly. However, each of these factors requires estimatesnestimates that involve managerial discretion. Analysis must consider the effects of these estimates on financial statements, especially when estimates change.<br /><br /><b>Impairment</b> </div>
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When the expected (undiscounted) cash flows are less than the asset’s carrying amount (cost less accumulated depreciation), the asset is deemed to be impaired and is written down to its fair market value (the discounted amount of expected cash flows). The effect is to reduce the carrying amount of the asset on the balance sheet and to reduce profitability by a like amount. The fair value of the asset, then, becomes the new cost and is depreciated over its remaining useful life. It is not written up if expected cash flows subsequently improve. From our analysis perspective, two distortions arise from asset impairment:</div>
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<li>Conservative biases distort long-term asset valuation because assets are written down but not written up.</li>
<li> Large transitory effects from recognizing asset impairments distort net income.</li>
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Note that asset impairment is still an allocation process, not a move toward valuation. That is, an asset impairment is recorded when managers’ expectations of future cash inflows  from the asset fall below carrying value. This yields an immediate write-off in a desire to better match future cost allocations with future benefits.</div>

This section explains the concept of long-term assets and the processes of capitalization, allocation, and impairment Capitalization, Alloc...

The cost of inventories for manufacturing consists of three components

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The cost of inventories for manufacturing consists of three components:<br />1. Raw materials the cost of the basic materials used to manufacture the product.<br />2. Labor the cost of the direct labor required to transform the product to a finished state.<br />3. Overhead the indirect costs incurred in the manufacturing process, such as depreciation of the manufacturing equipment, supervisory wages, and utilities.<br /><br />Companies can estimate the first two components fairly accurately from design specifications and time and motion studies on the assembly line. Overhead is often the largest component of product cost and the most difficult to measure at the product level. In total, overhead must be allocated to all products produced. But which products get what portion of the total? Accountants generally subscribe to the notion that those products consuming most of the resources (e.g., requiring the most costly production machinery or the most engineering time) should be allocated most of the overhead.Inventory costing for manufacturing companies is generally covered in managerial accounting courses and is beyond the scope of this text. Analysts need to be aware, however, that overhead cost allocation is not an exact science and is highly dependent on the assumptions used.<br /> </div>
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Analysts also need to understand the effect of production levels on profitability. Overhead is allocated to all units produced. Instead of expensing these costs as period expenses, they are included in the cost of inventories and remain on the balance sheet until the inventories are sold, at which time they are reflected as cost of goods sold in the income statement. If an increase in production levels causes ending inventories to increase, more of the overhead costs remain on the balance sheet and profitability increases. Later, if inventory quantities decrease, the income statement is burdened by not only the current overhead costs, but also previous overhead costs that have been removed from inventories in the current year, thus lowering profits. Analysts need to be aware, therefore, of the effect of changing production levels on reported profits.<br /><br /><b>Lower of Cost or Market</b><br />The generally accepted principle of inventory valuation is to value at the lower of cost or market. This simple phrase masks the complexities and variety of alternatives to which it is subject. It can significantly affect periodic income and inventory values. The lower-of-cost-or-market rule implies that if inventory declines in market value below its cost for any reason, including obsolescence, damage, and price changes, then inventory is written down to reflect this loss. This write-down is effectively charged against revenues in the period the loss occurs. Because write-ups from cost to market are prohibited (except for recovery of losses up to the original cost), inventory is conservatively valued.<br /><br /><b>Market </b>is defined as current replacement cost through either purchase or reproduction. However, market value must not be higher than net realizable value nor less than net realizable value reduced by a normal profit margin. The upper limit of market value, or net realizable value, reflects completion and disposal costs associated with sale of the item. The lower limit ensures that if inventory is written down from cost to market, it is written down to a figure that includes realization of a normal gross profit on subsequent sale. Cost is defined as the acquisition cost of inventory. It is   computed using one of the accepted inventory costing methods—for example, FIFO, LIFO, or average cost. Our analysis of inventory must consider the impact of the lower-of-cost-or-market rule. When prices are rising, this rule tends to undervalue inventories regardless of the cost method used. This depresses the current ratio. In practice, certain companies voluntarily disclose the current cost of inventory, usually in a note.<br /><br /></div>

The cost of inventories for manufacturing consists of three components: 1. Raw materials the cost of the basic materials used to manufactur...

Inventory costing effects on profitability

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To summarize, the financial results of using each of the three alternative methods are as follows:</div>
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As the examples presented here highlight, gross profit can be affected by the company’s choice of its inventory costing method. In periods of rising prices, FIFO produces higher gross profits than LIFO because lower cost inventories are matched against sales revenues at current market prices. This is sometimes referred to as FIFO’s phantom profits as the gross profit is actually a sum of two components: an economic profit and a holding gain. The economic profit is equal to the number of units sold multiplied by the difference between the sales price and the replacement cost of the inventories (approximated by the cost of the most recently purchased inventories):<br /><br />Economic profit =   30 units  X  ($800  - $600)  = $6,000<br /> </div>
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The holding gain is the increase in replacement cost since the inventories were acquired and is equal to the number of units sold multiplied by the difference between the current replacement cost and the original acquisition cost:<br /><br />Holding gain  = 30 units X  ($600 -  $500)  = $3,000<br /><br />Of the $9,000 in reported gross profit, $3,000 relates to the inflationary gains realized by the company on inventories it purchased some time ago at prices lower than current prices. Holding gains are a function of the inventory turnover (e.g., how long the goods remain on the shelves) and the rate of inflation. Once a serious problem, these gains have been mitigated during the past decade due to lower inflation and management scrutiny of inventory quantities through improved manufacturing processes and better inventory controls. In countries with higher inflation rates than the United States, however, FIFO holding gains can still be an issue.<br /><br /><b>Inventory Costing Effects on the Balance Sheet</b><br />In periods of rising prices, and assuming that the company has not previously liquidated older layers of inventories, LIFO reports ending inventories at prices that can be significantly lower than replacement cost. As a result, balance sheets for LIFO companies do not accurately represent the current investment that the company has in its inventories. John Deere, for example, recently reported inventories under LIFO costing nearly $2 billion. Had these inventories been valued under FIFO, the reported amount would have been $3 billion, a 50% increase. More than $1 billion of invested capital was omitted from its balance sheet.<br /><br /><b>Inventory Costing Effects on Cash Flows</b><br />The increase in gross profit under FIFO also results in higher pretax income and, consequently, higher tax liability. In periods of rising prices, companies can get caught in a cash flow squeeze as they pay higher taxes and must replace the inventories sold at replacement costs higher than the original purchase costs. This can lead to liquidity problems, an issue that was particularly acute in the high inflationary period of the 1970s.<br />One of the reasons frequently cited for the adoption of LIFO is the reduction of tax liability in periods of rising prices. The IRS requires, however, that companies using LIFO inventory costing for tax purposes also use it for financial reporting. This is the LIFO conformity rule.<br /> </div>
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Companies using LIFO inventory costing are required to disclose the amount at which inventories would have been reported had the company used FIFO inventory costing. The difference between these two amounts is called the LIFO reserve. Analysts can use this reserve to compute the amount by which cash flow has been affected both cumulatively and for the current period by the use of LIFO. For example, John Deere reports the following in a recent annual report:</div>
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LIFO inventories are reported on the balance sheet at $1,999 million. Had the company used FIFO inventory costing, inventories would have been reported at $3,001 million. The difference of $1,002 million is the LIFO reserve. This is the amount by which inventories and pretax income have been reduced because the company adopted LIFO. Assuming a 35% tax rate, Deere has saved more than $350 million ($1,002 million  X 35%) through the use of LIFO inventory costing. During 2004, the LIFO reserve increased by $52 million ($950 million to $1,002 million). For 2004, then, LIFO inventory costing decreased pretax income by $52 X million and decreased taxes by $18 million ($52 million  35% tax rate). The net decrease in income is, therefore, $34 million in that year.</div>

To summarize, the financial results of using each of the three alternative methods are as follows: As the examples presented here highl...

Inventory accounting and valuation

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Inventories are goods held for sale as part of a company’s normal business operations. With the exception of certain service organizations, inventories are essential and important assets of companies. We scrutinize inventories because they are a major component of operating assets and directly affect determination of income.<br /><br />The importance of costing methods for inventory valuation is due to their impact on net income and asset valuation. Inventory costing methods are used to allocate cost of goods available for sale (beginning inventory plus net purchases) between either cost of goods sold (an income deduction) or ending inventory (a current asset). Accordingly, assigning costs to inventory affects both income and asset measurements. The inventory equation is useful in understanding inventory flows. For a merchandising company:<br /><br />Beginning inventories   Net purchases   Cost of goods sold   Ending inventories<br />This equation highlights the flow of costs within the company. It can be expressed alternatively as shown in the graphic on the next page<br /><br />The costs of inventories are initially recorded on the balance sheet. As the inventories are sold, these costs are removed from the balance sheet and flow into the income statement as cost of goods sold (COGS). Costs cannot be in two places at the same time; either they remain on the balance sheet (as a future expense) or are recognized currently in the income statement and reduce profitability to match against sales revenue. An important concept in inventory accounting is the flow of costs. If all inventories acquired or manufactured during the period are sold, then COGS is equal to the cost of the goods purchased or manufactured. When inventories remain at the end of the accounting period, however, it is important to determine which inventories have been sold and which costs remain on the balance sheet. GAAP allows companies several options to  determine the order in which costs are removed from the balance sheet and recognized as COGS in the income statement.<br /><b> </b></div>
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<b>Inventory Cost Flows</b><br />To illustrate the available cost-flow assumptions, assume that the following reflects the inventory records of a company:</div>
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Now, assume that 30 units are sold during the year at $800 each for total sales revenue of $24,000. GAAP allows companies three options in determining which costs to match against sales:<br /><b>First-In, First-Out</b> </div>
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This method assumes that the first units purchased are the first units sold. In this case, these units are the units on hand at the beginning of the period. Under FIFO, the company’s gross profit is as follows:</div>
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Also, because $15,000 of inventory cost has been removed, the remaining inventory cost to be reported on the balance sheet at the end of the period is $41,000.<br /><b>Last-In, First-Out </b></div>
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Under the LIFO inventory costing assumption, the last units purchased are the first to be sold. Gross profit is, therefore, computed as</div>
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And because $18,000 of inventory cost has been removed from the balance sheet and reflected in COGS, $38,000 remains on the balance sheet to be reported as inventories. It is important to note that LIFO is not allowed in many countries of the world. The primary reason for this is that use of LIFO can reduce or delay tax payments, which is unpopular with governments. Partly because of this, LIFO is not allowed under IFRS as a method for valuing inventories.<br /><br /><b>Average Cost</b> </div>
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This method assumes that the units are sold without regard to the order in which they are purchased and computes COGS and ending inventories as a simple weighted average as follows:</div>
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COGS is computed as a weighted average of the total cost of goods available for sale divided by the number of units available for sale ($56,000/100 = $560). Ending units reported on the balance sheet are $39,200 (70 units x  $560 per unit).</div>

Inventories are goods held for sale as part of a company’s normal business operations. With the exception of certain service organizations,...

Current assets cash and cash equivalents

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Current assets include cash and other assets that are convertible to cash, usually within the operating cycle of the company. An operating cycle, shown in Exhibit 4.1, is the amount of time from commitment of cash for purchases until the collection of cash resulting from sales of goods or services. It is the process by which a company converts cash into short-term assets and back into cash as part of its ongoing operating activities. For a manufacturing company, this would entail purchasing raw materials, converting them to finished goods, and then selling and collecting cash from receivables. Cash represents the starting point, and the end point, of the operating cycle. The operating cycle is used to classify assets (and liabilities) as either current or noncurrent. Current assets are expected to be sold, collected, or used within one year or the operating cycle, whichever is longer.1 Typical examples are cash, cash equivalents, short-term receivables, short-term securities, inventories, and prepaid expenses. </div>
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The excess of current assets over current liabilities is called working capital. Working capital is a double-edged sword companies need working capital to effectively operate, yet working capital is costly because it must be financed and can entail other operating costs, such as credit losses on accounts receivable and storage and logistics</div>
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costs for inventories. Many companies attempt to improve profitability and cash flow by reducing investment in current assets through methods such as effective credit underwriting and collection of receivables, and just-in-time inventory management. In addition, companies try to finance a large portion of their current assets through current liabilities, such as accounts payable and accruals, in an attempt to reduce working capital. Because of the impact of current assets (and current liabilities) on liquidity and profitability, analysis of current assets (and current liabilities) is very important in both  credit analysis and profitability analysis. We shall discuss these issues at length later in the book. In this chapter, we limit analysis to the accounting aspects of current assets, specifically their valuation and expense treatment.<br /><br /><b>Cash and Cash Equivalents</b><br />Cash, the most liquid asset, includes currency available and funds on deposit. Cash equivalents are highly liquid, short-term investments that are (1) readily convertible into cash and (2) so near maturity that they have minimal risk of price changes due to interest rate movements. These investments usually carry maturities of three months or less. Examples of cash equivalents are short-term treasury bills, commercial paper, and money market funds. Cash equivalents often serve as temporary repositories of excess cash.<br /><br />The concept of liquidity is important in financial statement analysis. By liquidity, we mean the amount of cash or cash equivalents the company has on hand and the amount of cash it can raise in a short period of time. Liquidity provides flexibility to take advantage of changing market conditions and to react to strategic actions by competitors. Liquidity also relates to the ability of a company to meet its obligations as they mature. Many companies with strong balance sheets (where there exists substantial equity capital in relation to total assets) can still run into serious difficulties because of illiquidity.<br /><br />Companies differ widely in the amount of liquid assets they carry on their balance sheets. As the graphic indicates, cash and cash equivalents as a percentage of total assets ranges from 2% (Target) to 22% (Dell). These differences can result from a numberof factors. In general, companies in a dynamic industry require increased liquidity to take advantage of opportunities or to react to a quickly changing competitive landscape<br /> </div>
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In addition to examining the amount of liquid assets available to the company, analysts must also consider the following:</div>
<ol>
<li>To the extent that cash equivalents are invested in equity securities, companies risk a reduction in liquidity should the market value of those investmentsdecline.</li>
<li> Cash and cash equivalents are sometimes required to be maintained as compensating balances to support existing borrowing arrangements or as collateral for indebtedness. For example, eBay, Inc., was required under the terms of a lease to place $126 million out of its $400 million in cash and investment securities as collateral for the term of the lease. These investments were, therefore, not available to meet normal operating needs of the company.</li>
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Current assets include cash and other assets that are convertible to cash, usually within the operating cycle of the company. An operating ...

Liabilities at the “edge” of equity convertible debt

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Sometimes, companies issue debt that can be converted into equity shares at maturity. Such debt is called convertible debt. Convertible debt is the classic hybrid security as it is a combination of features of both debt and equity. Usually, convertible debt allows the holder an option to convert at a fixed price. Therefore, conversion will occur only if the share price is higher than the conversion price at maturity. If it is not, the debt holders can ask for repayment of principal. </div>
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Current accounting rules under both US GAAP (ASC 470-20) and IFRS (IAS 32) recognize the mixed nature of convertible debt. Specifically, companies issuing convertible debt must separately account for the liability (debt) and equity (conversion option) components on the date of the issue. The amount allocated to the liability is estimated by determining the fair value of a pure debt security that is similar in every other respect to the convertible security. Once the liability amount is estimated, the amount allocated to equity is simply the residual value of the convertible security.<br /><br />We clarify with an example. Consider a company that issues 1 million 10-year convertible  bonds with a face value of $100 and a coupon rate of 3%. Each bond allows theholder to purchase four shares of the company at maturity. A pure bond with a similar maturity and risk profile is expected to have an effective interest rate of 8%. The proceeds from this issue amounted to $105 million. To estimate the value of the equity and the debt components, we first need to determine  the value of the pure bond with a similar maturity and coupon. Note the coupon payment per bond is $3 per year and maturity is 10 years. Given an effective interest rate of 8%, the present value of this bond is $66.45. Therefore, the amount allocated to the liability will be $66.45 million, and the discount on the bond issue will amount to $33.55 million ($100 million   $66.45 million). This discount is amortized over the bond’s term in a similar manner as illustrated in Exhibit 3.1. Since the proceeds from the bond issue come to $105 million, the premium of $38.55 million ($105 million   $66.45 million) is attributable to the equity component, assuming no deferred tax effects.<br /> </div>
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Companies sometimes issue bonds with attached warrants on the company’s equity. Warrants entitle the holder to buy the underlying stock of the issuer at a fixed exercise price until the expiration date, similar to a call option. This is different from convertible debt because the bonds and the warrants are separate securities, and the holder can sell the warrants or the debt separately. The accounting treatment for warrants is similar t that for convertible bonds. That is, the bonds are accounted for as debt and the warrants as equity at their respective fair values on the date of issue.<br /><br /><b>Redeemable Preferred Stock</b><br />Analysts must be alert for equity securities (typically preferred stock) that possess mandatory redemption provisions making them more akin to debt than equity. These securities require a company to pay funds at specific dates. A true equity security does not impose such requirements. Examples of these securities, under the guise of preferred stock, exist for many companies. Tenneco’s annual report refers to its preferred stock redemption provision as follows:</div>
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The SEC asserts that redeemable preferred stocks are different from conventional equity capital and should not be included in shareholders’ equity nor combined with nonredeemable equity securities. The SEC also requires disclosure of redemption terms and five-year maturity data. Accounting standards require disclosure of redemption  requirements of redeemable stock for each of the five years subsequent to the balance sheet date. Companies whose shares are not publicly traded are not subject to SEC requirements and can continue to report redeemable preferred stock as equity. Still, our analysis should treat them for what they are an obligation to pay cash at a future date.<br /><br /><b>Minority Interest</b><br />A company may own a controlling share (usually more than 50%), but not all, of the equity of another company. The company that owns the controlling share is called a parent and the company that is thus owned a partially owned subsidiary. Minority interest (also called noncontrolling interest ) refers to the portion of the partially owned subsidiary’s shareholders’ equity that belongs to the minority (outside) shareholders. It is truly an intermediate capital form. Because it does not belong to the parent company’s shareholders, it cannot be regarded as part of the parent company’s shareholders’ equity. However, even though it belongs to outsiders, it is in the nature of shareholders’ equity and therefore cannot also be classified as a liability.<br /><br />Parent companies are required to consolidate the subsidiary’s financial statements in their own. In the consolidated statements, the assets and liabilities (and the revenues and expenses) of the subsidiary are aggregated with that of the parent. When the subsidiary is partially owned, shareholders’ equity cannot be aggregated, because the entire subsidiary’s equity does not belong to the parent. Accordingly, US GAAP and IFRS require companies to report minority interest in the consolidated balance sheet as a separate line item that is not part of parent shareholders’ equity. However, most companies do report minority interest as part of total equity. In a similar manner, the proportion of the net income of a partially owned subsidiary that belongs to the minority shareholders is shown in the consolidated income statement as a separate line item called minority interest (or noncontrolling interest ). Exhibit 3.14 presents an example of how minority (noncontrolling) interest is reported both in the balance sheet and the income statement.</div>
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Whether one needs to include or exclude minority interest depends on the analysis objective. For example, if we wish to determine the ROCE of the shareholders of a company, we must exclude minority interest both in the numerator (income) and denominator (equity) of the ratio. But if the objective is to compute the ROCE of the combined business entities that comprise a company, then we should include minority interest in the computation. In the example in Exhibit 3.14, ROCE of the Bristol-Myers Squibb shareholders is 23% ($3,709   $15,956), but ROCE of the combined businesses of Bristol-Myers Squibb and its subsidiaries is 33% ($5,260   $15,867).<br /></div>

Sometimes, companies issue debt that can be converted into equity shares at maturity. Such debt is called convertible debt. Convertible deb...