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Week 4 and 5 MBA 503- Managerial Decision Making Fall 2012


Colin Haime Fall 2012

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Performance has occurred The amount of revenue can be reasonable measured Collection of payment is reasonably assured Sounds easy?

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Accounts receivable balances Accounting for returns/discounts Bad debt expense & allowance for doubtful accounts

Common methods of Bad Debt calculation
1) Direct Write Off 2) % of Sales 3) Aging of A/R balances

Are any of them correct? What are their issues?

When do we recognize revenue and how much? When do we recognize Bad Debts and how much?

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Ratio analysis
? For example
? A/R turnover ? Days sales in A/R ? Current Ratio

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Relations between amounts Sales/A/R/ Bad Debts

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Per PDF file

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Defn: “Amounts owed to an entity by customers for goods and services provided on credit”
John Friedlan, Financial Accounting, 2nd edition, McGraw Hill, 2007

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Defn of an asset:”Economic resources that provides future benefits to an entity”
John Friedlan, Financial Accounting, 2nd edition, McGraw Hill, 2007

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Recognition that a previously recorded Accounts receivable will not provide a future benefit due to the fact we will not collect it, or will we??? Didn’t the rules of revenue recognition require us to determine if collection is reasonably assured???

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It computes uncollectible-account expense as a percentage of revenue.

This method is also called the income-statement approach.

This method is a balance-sheet approach because it focuses on accounts receivable. Individual receivables from specific customers are analyzed based on how long they have been outstanding.

When do we recognize revenue and how much? When do we recognize Bad Debts and how much?

Earnings Management

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Matching of Inventory cost of items sold against the benefit (revenue received) Should amounts be in Inventory or COGS? One or the other!! Total Inventory Cost is a function of

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?Price * Quantity

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Price is the issue not quantity

?First In First Out (FIFO) ?Last in First Out (LIFO)
(Not allowed in Canada)

?Weighted Average (WA) ?Specific Unit Cost

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Obsolescence Title/Ownership Timing and its effect on ratios

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Interconnection between the following:
? Cost of Goods Sold (Income Statement) ? Inventory Asset (Balance Sheet)

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Ratios
? For example
? ? ? ? Inventory turnover Gross Margins Current ratio Quick Ratio

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Concerns
? ? ? ? What is a capital asset? How to value a capital asset? Amortization? Impairment?

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Matching of costs to benefits Methods of amortization
? ? ? ? Straight Line Double Declining balance Units of production Other ideas?

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Amortization is an expense Increased Amortization decreases Net Income (and vice versa) Amortization decreases Net Book Value of assets on Balance sheet More amortization lower the asset values

LO-1

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Long-lived assets are known by other names as well.
? ? Tangible long-lived assets are sometimes called fixed assets, because they are fixed in place Tangible and intangible long-lived assets (excluding goodwill) can be combined under the heading capital assets

LO-2

Building
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Land
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Purchase price Construction costs
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Purchase price
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Legal fees

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Surveying fees Broker’s Commissions
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Legal fees
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Appraisal fees

Equipment
Purchase price
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Architectural fees

Sales taxes

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Transportation costs
Installation costs

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LO-2

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The total cost of a combined purchase of land and building is allocated in proportion to their relative market values
? Example:
? ClubLink purchased an existing golf course for $15 million ? Appraised values are land – 60%, building – 20%, roads, paths & irrigation – 10%, golf carts 5%, maintenance, club house – 5%

LO-2

Asset cost includes:
Capitalized interest: Interest on debt incurred during the construction

All materials and labour traceable to the construction

LO-2

Type of Expenditure

Identifying Characteristics

Accounting Treatment Expense (I/S)

Ordinary 1. Maintains normal operating condition repairs and 2. Does not increase productivity maintenance 3. Does not extend life beyond original estimate Extraordinary 1. Major overhauls or partial repairs replacements 2. Extends life beyond original estimate Additions 1. Increases productivity 2. May extend useful life 3. Improvements or expansions

Capitalize (B/S) Capitalize (B/S)

LO-3

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Allocation of the cost of long-lived tangible assets over their productive lives using a systematic and rational method The adjusting entry needed:
? Debit Amortization Expense ? Credit Accumulated Amortization

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Book value of an asset:
? Acquisition Cost – Accumulated Amortization

LO-3

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Because amortization involves allocating the cost of tangible assets, rather than determining their current values, the amounts reported on a balance sheet for long-lived tangible assets are likely to differ from their current market values.

LO-3

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Require three amounts:
1. Asset cost 2. Estimated useful life 3. Estimated residual value

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Land is the only tangible asset that is assumed to have an unlimited (indefinite) useful life
? Because of this, land is not amortized

LO-3

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Straight-line method Units-of-production method Declining-balance method

LO-3

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Formula:

Amortization Expense per Year
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=

Cost - Residual Value Life in Years

Amortization expense is a constant amount each year. Accumulated amortization increases by an equal amount each year. Book value decreases by the same equal amount each year.

LO-3

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Step 1:
Amortization = Rate Cost - Residual Value Life in Units of Production

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Step 2:
Number of Amortization Amortization × Units Produced = Expense Rate for the Year

LO-3

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Formula:
Net Book Value

Annual Amortization = Expense
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(

2 Useful Life in Years

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Net book value =

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Amortization expense amounts are higher in the early years of an asset’s life and lower in the later years Sometimes called an accelerated amortization method.

Cost – Accumulated Amortization

LO-4

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Impairment exists when the carrying amount of a long-lived asset exceeds its fair value Calculation:
? Loss = Book Value – Fair Value

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The loss is typically included with other expenses reported below “operating income”

LO-5

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A gain or a loss?

If Cash > BV, record a gain (credit). If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss.

LO-5

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Although gains on disposal work the same as revenues, they are not reported with sales revenues because they arise from nonoperating activities rather than normal operations. Instead, they are reported below operating income in the bottom half of the income statement.

LO-6

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Most common types: ? Patents ? Trademarks and trade names ? Copyrights ? Licensing rights ? Franchises ? Goodwill

LO-6

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Acquisition
? Almost all intangible assets are recorded as assets only if they have been purchased ? The costs of almost all self-constructed or selfdeveloped intangibles are reported as expenses, often as research and development costs

LO-6

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If a limited life:
? Straight-line basis over its useful life

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If an unlimited life:
? Not amortized, but are subject to impairment tests ? Examples are goodwill and trademarks

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A separate accumulated amortization account is seldom used for intangibles

LO-6

Goodwill
Occurs when one company buys another company Only purchased goodwill is an intangible asset

The amount by which the purchase price exceeds the fair market value of net assets acquired

LO-6

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All attempts at finding the natural resources are included in the cost of the asset
? Example: Drilling for oil

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Once the costs are capitalized, the costs are systematically allocated using depletion (similar to amortization) Units-of--production is very common for calculating depletion in this industry

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LO-8

Insufficient capacity results in lost sales

VERSUS
Excessive costs reduce profits

LO-8

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This ratio measures the sales dollars generated by each dollar invested in fixed assets
Fixed = Asset Turnover Net Sales Revenue Average Net Fixed Assets

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Generally a high or increasing turnover ratio suggests better use of fixed assets

LO-9

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Differences in amortization affect the financial analyses and the conclusions that are drawn
? Different amortization methods ? Different estimated useful lives ? Different estimated residual values

LO-9

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Can sidestep differences by focusing on financial measures that exclude the effects of amortization
? EBITA: “Earnings before interest, taxes, and amortization” ? Allows analysts to conduct financial analyses without having to think about possible differences in amortization ? BUT doesn’t tell the whole story

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Return on Assets? Return on equity? Non cash item… Free cash flow no effect

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Long-lived assets
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Intangible assets Optimal level of investment Impact of amortization differences
? Fixed asset turnover ratio

Acquisition costs Amortization methods Impairment losses Disposal

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Matching of costs to benefits Methods of amortization
? ? ? ? Straight Line Double Declining balance Units of production Other ideas?

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Amortization is an expense Increased Amortization decreases Net Income (and vice versa) Amortization decreases Net Book Value of assets on Balance sheet More amortization lower the asset values

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Return on Assets? Return on equity Non cash item… Free cash flow no effect

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Matching of Inventory cost of items sold against the benefit (revenue received) Common Methods
? ? ? ? First In First Out (FIFO) Last in First Out (LIFO) Weighted Average (WA) Specific Unit Cost

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Obsolescence Title/Ownership Timing and its effect on ratios

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Interconnection between the following:
? Cost of Goods Sold (Income Statement) ? Inventory Asset (Balance Sheet)

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Ratios
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Inventory turnover Gross Margins Current ratio Quick Ratio


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