Lecture 4

QUESTION 3
a. Identify the main concerns in analysis of accounts receivable.
b. Describe information, other than that usually available in financial statements,
that we should collect to assess the risk of noncollectibility of receivables.

a. The two most important questions facing the financial analyst with respect to
receivables are: (1) Is the receivable genuine, due, and enforceable?, and
(2) Has the probability of collection been properly assessed? While the
unqualified opinion of an independent auditor lends some assurance with
regard to these questions, the financial analyst must recognize the
possibility of an error of judgment as well as the lack of complete
independence.

b. Description of the receivables in the notes to financial statements usually

do not contain sufficient clues to allow a reliable judgment as to whether a
receivable is genuine, due, and enforceable. Consequently, knowledge of
industry practices and supplementary sources of information must be used
for additional assurance, e.g.:
 In some industries, such as compact discs, toys, or books, a
substantial right of merchandise return exists and allowance must be
made for this.
 Most provisions for uncollectible accounts are based on past
experience although they should also make allowances for current and
emerging industry conditions. In practice, the accountant is likely to
attach more importance to the former than to the latter. The analyst
must, in such cases, use one’s own judgment and knowledge of
industry conditions to assess the adequacy of the provision for
uncollectible accounts.
 Information that would be helpful in assessing the general level of
collection risks with receivables is not usually found in published
financial statements. Such information can, of course, be sought from
the company directly. Examples of such information are: (1) What is
customer concentration? What percent of total receivables is due from
one or a few major customers? Would failure of any one customer have
a material impact on the company's financial condition? (2) What is the
age pattern of the receivables? (3) What proportion of notes receivable
represent renewals of old notes? (4) Have allowances been made for
trade discounts, returns, or other credits to which customers are
entitled?
 The analyst, in assessing current financial position and a company's
ability to meet its obligations currently—as expressed by such
measures as the current ratio—must recognize the full impact of
accounting conventions that relate to classification of receivables as
"current." For example, the operating cycle concept allows the
inclusion of installment receivables, which may not be fully collectible
for years. In balancing these against current obligations, allowance for
such differences in timing of cash flows should be made.
QUESTION 4
a. What is meant by the factoring or securitization of receivables?
b. What does selling receivables with recourse mean? What does it mean to sell
them without recourse?
c. How does selling receivables (particularly with recourse) potentially distort the
balance sheet?

a. Factoring or securitization of receivables refers to the practice of selling

all or a portion of a company’s receivables to a third party.

b. When receivables are sold with recourse, the third party purchaser of
the receivables retains the right to collect from the company that sold
the receivable if the receivable proves uncollectible. When receivables
are sold without recourse, the purchaser of the receivables assumes
the collection risk.

c. When receivables are sold with recourse, the balance sheet reports the
cash received from the sale of the receivable. However, the balance
sheet may or may not report the contingent liability to the receivables
purchaser for uncollectible receivables purchased with recourse—this
depends on who assumes the risk of ownership.

Q15
Analysts must be alert to what aspects of goodwill in their analysis of financial
statements?

One of the more common solutions applied by analysts to the analysis of

goodwill is to simply ignore it. That is, they ignore the asset shown on the
balance sheet. As for the income statement, under current accounting
standards, goodwill is no longer amortized, but is subjected to an impairment
test annually and written down if required. Often, however, the write-down
expense is treated with skepticism and is frequently ignored. By ignoring
goodwill, analysts ignore investments of very substantial resources in what
may often be a company's most important and valuable asset. Ignoring the
impact of goodwill on reported income is no solution to the analysis of this
complex item. Even considering the limited information available, an analyst is
better off evaluating the accounting numbers for goodwill rather than
dismissing them altogether.

Goodwill is measured by the excess of cost over the fair market value of
tangible net assets acquired in a transaction accounted for as a purchase. It is
the excess of the purchase price over the fair value of all the tangible assets
acquired, arrived at by carefully ascertaining the value of such assets—at least
in theory. The analyst must be alert to the makeup and the method of valuation
of Goodwill as well as to the method of its ultimate disposition. One way of
disposing of the Goodwill account, frequently preferred by management, is to
write it off at a time when it would have the least impact on the market's
assessment of the company's performance. (for example, in a period of losses
or reduced earnings).
 Q16
Explain when an expenditure should be capitalized versus when it should be
expensed.

- Costs are capitalized as assets when these expenditures are expected to

bring the entity value beyond the current year. If the value associated with
the expenditure will be used up in the current period, the expenditure is
expensed

Case 4-3
FIFO LIFO Average cost
Sales (1,000 x $25).......................... $25,000 $25,000 $25,000
Cost of sales:
Beginning inventory..................... 0 0 0
Add: Purchases............................ 23,200 23,200 23,200
Less: Ending inventory................ (11,700) (9,100) (10,312)
Cost of sales.................................... 11,500 14,100 12,888
Gross profit..................................... 13,500 10,900 12,112
Operating expenses....................... 5,000 5,000 5,000
Net income....................................... $ 8,500 $ 5,900 $ 7,112
Net income per share..................... $4.25 $2.95 $3.56
NOTES: (1)FIFO inventory computation is based on 500 units at $15 and
300 at $14.
(2) LIFO inventory computation is based on 100 units at $10, 300
units at $11, and 400 units at $12.
(3) Average cost is obtained by dividing $23,200 by 1,800 units
purchased, yielding an average unit price of $12.89.
b. Financial Ratio Computations
FIFO LIFO Average Cost
(1) Current ratio …………………….. 2.47 2.36 2.41
(2) Debt-to-equity ratio ……………. 67.8% 71.3% 69.6%
(3) Inventory turnover ……………… 2.00 3.10 2.50
(4) Return on total assets ………… 9.8% 7.0% 8.3%
(5) Gross margin 54.0% 43.6% 48.5%
ratio………………….
(6) Net profit as percent of sales……. 34.0% 23.6% 28.5%
d. LIFO Effects. Under conditions of fluctuating inventory costs, the LIFO
inventory method will have a smoothing effect on income. Moreover, the
LIFO method results, in times of cost increases, in an unrealistically low
reported inventory figure. This, in turn, will lower the current ratio of a
company and at the same time tend to increase its inventory turnover
ratio. The LIFO method also affords management an opportunity to
 manipulate profits by allowing inventory to be depleted in poor years,
thus drawing on the low cost base pool. FIFO Effects. The use of FIFO in
the valuation of inventories will generally result in a higher inventory on
the balance sheet and a lower cost of goods sold than under LIFO
resulting. This would result in a higher net income. Average Cost
Effects. The average cost method smoothes out cost fluctuations by
using a weighted average cost in the valuation of inventories and cost of
goods sold. The resulting net income will be close to an average of the
net income under LIFO and FIFO.

Problem 4-7 (30 minutes)

STRAIGHT-LINE
Beginning Depreciation Net income Net income
Year book value expense before taxes after taxes ROA
1 $300,000 $60,000 $40,000 $30,000 10%
2 $240,000 $60,000 $40,000 $30,000 12.5%
3 $180,000 $60,000 $40,000 $30,000 16.67%
4 $120,000 $60,000 $40,000 $30,000 25%
5 $ 60,000 $60,000 $40,000 $30,000 50%

SUM-OF-THE-YEARS’-DIGITS = 1+2+3+4+5 = 15
Beginning Depreciation Net income Net income
Year book value expense before taxes after taxes ROA
1 $300,000*5/15 = $100,000 $0 $0 0%
2 $200,000(300*4/15)= 80,000 $20,000 $15,000 7.5%
3 $120,000 $60,000 $40,000 $30,000 25%
4 $ 60,000 $40,000 $60,000 $45,000 75%
5 $ 20,000 $20,000 $80,000 $60,000 300%