Part 3 B – 1 V3.0 THE IIA’S CIA LEARNING SYSTEM TM Section Topics 1.Basic concepts and underlying principles of financial accounting 2.Intermediate

Part 3 B – 1V3.0

THE IIA’S CIA LEARNING SYSTEMTM

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Section Topics

1. Basic concepts and underlying principles of financial accounting

2. Intermediate concepts of financial accounting

3. Advanced concepts of financial accounting

4. Financial statement analysis

5. Cost of capital evaluation

6. Types of debt and equity

7. Financial instruments

8. Cash management

9. Valuation models

10.Business development life cycles

Part 3, Section B, Introduction

Part 3 B – 2V3.0


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Financial Audit Risks

Financial Statement

Account Balance

Payroll

A/P

A/R

Financial statements

Rank risk and impact (COSO)

High

Low

Material misstatements?

Inherent risk

Control risk

Detection risk


Part 3 B – 3V3.0


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Factors Affecting Risk

• Degree of impact on financial statement• Account characteristics• Business process characteristics• Fraud potential• Organizational characteristics• Types of transactions (i.e., routine, non-

routine, estimated)


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Financial Audit Risks

Financial Statement

Account Balance

Payroll

A/P

A/R

Financial statements

Rank risk and impact (COSO)

High

Low

Material misstatements?

Inherent risk

Control risk

Detection risk

• Existence or occurrence

• Completeness• Rights and

obligations• Valuation or

allocation• Presentation and

disclosure

Mitigation


Part 3 B – 5V3.0


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Common Accounting TermsFill in the blanksAccounting Term Definition

Listing all of an entity’s financial transactions

Residual ownership interest in assets after deducting liabilities

Allocate acquisition costs of intangible assets to periods of benefit

Summary of profitability of an enterprise over a period of time

Recording or representing fair value when value has depleted faster than calculated amortization or depreciation

Amortize

Equity

General ledger

Income statement

Impairment


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United States:• FASB sets standards.• GAAP

– Recognition principles.

– Disclosure principles.

International:• IASB sets standards.• IFRS

– Harmony among countries’ regulations.

– Develop future standards and review current standards.

– Reduce number of allowed alternative treatments.

Accounting Standards

Standards result from many compromises.

Part 3, Section B, Topic 1

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• External financial reporting: not end in itself– Specific (not macroeconomic) data– Includes estimates and judgments– Primarily historical– Not to be used as sole source of data– Has procurement cost

• Data on economic resources (assets) and claims to resources (liabilities and equity)

• Assess amount, timing, and uncertainty of future cash flows

Objectives of Financial Reporting


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Underlying GAAP Accounting Concepts


Qualities of InputConstraints on

PreparersAssumptions Principles

RelevanceReliabilityComparabilityConsistency

Cost/benefitMaterialityIndustry practicesConservatism

Economic entityGoing concernMonetary unitPeriodic reporting

Historical costRevenue recognitionMatchingFull disclosure

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Accounting Qualities

Primary qualities

Secondary qualities

User-specific qualities

Materiality constraint

Comparability Consistency

Relevance Reliability

Decision usefulness

Understandability

Decision makers

Financial data

Predictive valueFeedback value

Timeliness

VerifiabilityNeutrality

Representational faithfulness

Benefits greater than cost constraint

Reasonably informedReasonable diligence


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Revenue Recognition Principle

Realized (or realizable = liquid) Earned

Service substantially performed

Transaction Recognized

Journal entry

Cash or claim to cash received


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When practical, recognize expenses in period when corresponding revenues were recognized.

Matching Principle

March

Product costs expensed

Shoes sold

January

Shoes produced

Period costs expensed

Costs generated

February

Revenue generated


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Which of the following is true?A. Assets being liquidated are valued at fair value.B. Future value computations assume that compound

interest is applied.C. If most assets were valued at current value, it

would be harder to manipulate financial statements.

D. Future payments required by contractual agreement are valued at historical cost.

Answer: B; Future Value = Present Value (1 + Interest Rate)Number of Periods

Discussion Question


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How much cash would you receive initially if you issued a three-year US $100,000 zero-interest-bearing note receivable when market rates were 6%?

Answer: US $100,000 0.83962 = US $83,962; to verify, future value of US $83,962 1.19102 = $100,000.

Discussion Question

Present Value of 1

Periods 3% 4% 5% 6%

3 .91514 .88900 .86384 .83962

Future value of 1

3 1.09273 1.12486 1.15763 1.19102


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Cash basis:

• Not GAAP or IFRS

• Recognizes revenue when cash received

• Recognizes expenses when cash paid

Accrual basis:

• GAAP and IFRS

• Recognizes transactions as they occur

• Recognizes revenue when realized or realizable and earned

Accrual vs. Cash Basis Accounting


Accepted Norm

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Sum of all debits must equal sum of all credits.

Dual-Entry Accounting

CreditDebit

AssetsExpenses

LiabilitiesRevenuesCapital stockRetained earnings


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What is the journal entry and T-account format for plant machinery that is sold for cash in excess of its net book value? What is the type of each account? Is each increasing or decreasing?

Answer: CashAccumulated depreciation–machinery

MachineryGain on sale of machinery

Discussion Question

Dr. Cr.

Cash

Accumulated depreciation–machinery

Machinery

Gain on sale of machinery

(Asset) (Asset)

(Revenue)(Asset disposal)


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T-Account with Beginning and Ending Balances (1 of 2)

Cost of goods sold (COGS) $82,400

Finished goods $82,400

Accounts receivable $85,000

Cash $10,000

Sales returns and allowances $5,000

Sales $100,000

To record 1,000 units sold at $100/unit. All amounts are in US dollars.

Beginning Account Balance + Account Additions in Period = Ending Account Balance + Account Deductions in Period

Journal entry


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Finished Goods*

BXfer-in

from WIP

$900,000

E

$1,100,000

$1,917,600

$82,400

Accounts Receivable

B

E

$300,000

$100,000

$385,000

Sales $10,000$5,000

Cash receiptsSales ret. & allow.

$82,400

COGS

Cash

Sales

Sales Ret. & Allow

$100,000

$5,000$10,000

Key B = Beginning balanceE = Ending balanceXfer-in = Transferred in

T-Account with Beginning and Ending Balances (2 of 2)

T-account

* $900,000 + $1,100,000 = $1,917,600 + $82,400


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Reinforcing Activity 3-5Part 3, Section B, Topic 1

Basic Concepts of Financial Accounting


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The Accounting Cycle


A. Identification and analysis

B. Recording in journal

C. Posting to

general ledger

D. Trial balance and

working papers

E. Adjusting entries and

adjusted trial balance

F. Closing accounts and

post-close trial balance

G. Preparing external

financial statements

H. Reversing

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In the adjusting entries portion of the accounting cycle,which of the following would be true of the adjustment foran accrued expense? (Select all that apply.)I. Debit asset account, interest receivable.II. Debit expense account, interest expense.III. Credit liability account, interest payable.IV. Credit revenue account, interest revenue.V. Each entry decreases the appropriate account.

Answer: II and III. Both entries increase the appropriate account.

Discussion Question


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Tests interrelationships by grouping transactions through the journals to the general ledger

Segmented Audit Cycles—Revenues Cycle

$100

Cash

$90

Bad Debt Expense

Sales

Cash sale$100

Credit sale$200 B

A

Cash Discounts Taken

$20C

Sales Ret. & Allow.

$20C

Accounts Receivable

B $1,000

$1,030

$20 Cash receipts$20

E$200 Sales ret. & allow.

Charge-off uncoll.$50B

A

C

D

E

$50 B

Allowance for Uncollectible Accounts

Estimated bad debt expense$800

$90$840

D


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Segmented Audit Cycles—Expenditures Cycle

Purchase Returns and Allowances

$40

Selling and Administrative Expense Control Accounts

$70H To subsidiary accts., e.g., taxes

Manufacturing Expense Control Accounts

$150G To subsidiary accts., e.g., taxes

C

Purchase Discounts

$20 B

Manufacturing expenses

Selling & admin. expenses

Purchase Accts., e.g., Raw Materials

$120D

Accounts Payable

Cash disbursements$100

$20

$120Purchases: Raw materials

$500$40

PP&E

Prepaid insurance$10

A

PP&E

$500E

$100

Cash

A

$150

$70

$10

Prepaid Expenses

F

Purch. ret. & allow.B

Purchase discountC

D

E

F

G

H


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An auditor for the production or conversion and inventory cycle notices that actual direct labor (DL) costs were 140% higher than applied DL. This amount was charged to cost of goods sold, and management noted that it was due to approved overtime. What should the auditor do?

Sample answer: Due to the size of the variance, the auditor should question whether the DL spending variance should be considered material. If so, it would need to be prorated among raw materials, WIP, and finished goods.

Discussion Question


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External Financial Statements

Income Statement

Shareholders’ Equity

Balance Sheet

Statement of

Cash Flows


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Summary of profitability over a period of time

Income Statement

RevenuesRevenues

ExpensesExpenses

GainsGains

LossesLosses

Income (Revenues + Gains)Income (Revenues + Gains)

Expenses (Expenses + Losses)Expenses (Expenses + Losses)

GAAP IFRS

Primary operations Secondary operations (not including investments by or distributions to owners)

All operations


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Single-Step Income Statement—Steel, Inc., Y6

Revenues Revenues from wholly-owned operations US $1,854,715

Income from joint ventures 4,201

Interest income 1,929

Other gains 58,281

Pre-acquisition interests, net of tax 184

Total revenues 1,919,310

Expenses Cost of goods sold 1,526,990

Selling, general and administrative 156,862

Other expense 3,585

Income tax expense 86,871

Minority interests, net of tax 1,934

Total expenses 1,776,242

Net Income $143,068


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Multistep Income Statement (1 of 2)—Steel, Inc., Y6Revenues US $1,854,715

Operating expenses:

Cost of goods sold 1,526,990

Selling, general, and administrative 156,862

Income from wholly-owned operations 170,863

Operating income from joint ventures 4,201

Operating income 175,064

Other income (expense):

Interest income 1,929

Interest expense (3,498)

Gain on divestiture of joint ventures 56,856

Gain (loss) on sale of assets 1,425

Other income (expense) (87)

Total other income (expense) 56,625

Income before income taxes, minority interests, and pre-acquisition interests $231,689


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Multistep Income Statement (2 of 2)—Steel, Inc., Y6

Income before income taxes, minority interests and pre-acquisition interests

US $231,689

Income tax expense (86,871)

Income before minority interests and pre-acquisition interests 144,818

Minority interests, net of tax (1,934)


Net income $143,068

Net income per share—basic $4.68

Net income per share—diluted $4.65

See Notes to Consolidated Financial Statements


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Additional Income Statement Items

Net sales

– Cost of goods sold

Gross profit on sales

– Operating expenses

Operating income

+/ – Other gains and losses

Earnings before taxes

– Tax expense

Income from continuing operations

+/ – Discontinued operations

+/ – Extraordinary items

+/ – Changes in accounting principle

Net income

Must be clearly distinguishable; separately report gain/loss from continuing operations and from

disposal.

Both unusual in nature and infrequent in occurrence.

Separately disclose effect on net income of change; must justify

change unless externally required.


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Statement of Comprehensive Income—Steel, Inc., Y6

Income tax expense US $(86,871)

Income before minority interests and pre-acquisition interests 144,818

Minority interests, net of tax (1,934)


Net income 143,068

Other comprehensive income

Foreign currency translation adjustment, net of tax 1,845

Comprehensive income $144,913

Net income per share—basic* $4.68

Net income per share—diluted* $4.65

* It is not necessary to report EPS related to comprehensive income.

Net Income + Other Comprehensive Income = Comprehensive Income


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• What organization owns and owes and where money originated at a moment in time

• Assets = Liabilities + Equity• Current vs. noncurrent (or long-term)

– Listed from most to least liquid

• Equity– Investments by owners (contributed capital)– Undistributed earnings (retained earnings)– Distributions to owners (dividends)

Balance Sheet


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Balance Sheet—Steel, Inc., August 31, Y6

ASSETS LIABILITIES & SHAREHOLDERS’ EQUITY

Current assets: USD Current liabilities: USD

Cash and cash equivalents $25,356 Current portion of L/T debt $100

Restricted cash 7,725 A/P 70,608

A/R – allow. for doubtful accts. 121,319 Other current liabilities 80,404

A/R from related parties 19 Total current liabilities 151,112

Inventories 263,583 Deferred income taxes 9,916

Deferred income taxes 7,285 L/T debt, less current portion 102,829

Prepaid expenses and other 15,105 Other L/T liabilities 46,742

Total current assets 440,392 Shareholders’ equity:

PP&E, net 312,907 Common stock, par 30,779

Other assets: APIC 137,281

Goodwill 266,675 Retained earnings 564,165

Intangibles 11,092 Foreign currency trans. adj. 1,874

Other assets 13,632 Total shareholders’ equity 734,099

Total assets $1,044,698 Total liabilities and equity $1,044,698


A snapshot of performance at one point in time

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Statement of Shareholders’ Equity

Prior period balances

+/– change in (∆) net income (loss), dividends, and stock issuances/repurchases

= ending balancesExamples:

∆ Retained earnings Cash dividend

– US $5,000

∆ Preferred stock– 100 preferred shares repurchased

for US $15/share (market price)Treasury stock

– US $1,500

∆ Common stock

1,000 shares issued@ US $1 par value

Receive US $10,000

∆ Par value

+ US $1,000

∆ Additional paid-in capital

+ US $9,000

– US $1,500

Cash outlay Net income

+ US $100,000


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Steel, Inc., started a period with US $350,000 in retained earnings. They had US $500,000 in revenues and US $400,000 in expenses and had a US $425,000 balance in retained earnings at the end of the period. How much was the cash dividend paid during this period?

Answer: US $350,000 + (US $500,000 – US $400,000) – X = US $425,000US $450,000 – X = US $425,000 X = US $25,000

Discussion Question


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Statement of Shareholders’ Equity—Steel, Inc., Y6

(All amounts in USD) Common Stock,* $1 Par

Additional Paid-In Capital

Retained Earnings

Accum. Other Comp. Income

Total

Balance, Aug. 31, Y5 $30,476 $125,845 $423,178 $29 $579,528

Net income 143,068 143,068

For. currency trans. adj. 1,845 1,845

Common stock issued 303 4,296 4,599

Stock based compensation expense 3,060 3,060

Tax benefits from stock options exercised 4,080 4,080

Cash dividends paid (2,081) (2,081)

Balance, Aug. 31, Y6 $30,779 $137,281 $564,165 $1,874 $734,099

*Simplified statement combines Class A and Class B shares.


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Cash levels at beginning and end of period• Net cash flows from operations, investing, financing

Statement of Cash Flows

Net income

+ Noncash expenses: depreciation, amortization, etc.

+ Paper losses from investing/financing – Paper gains from investing/financing

+ Net decrease in current noncash assets or – Net increase in current noncash assets

+ Net increase in current liabilities – Net decrease in current liabilities

+ Amortization of discounts on bonds – Amortization of premiums on bonds

= Net cash flows from operations


Used to reconcile income statement and balance sheet

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Statement of Cash Flows—Steel, Inc., Y6Net income US $143,068

Noncash items included in income (16,380)

Changes in assets and liabilities (21,473)

Net cash provided by operating activities 105,215

Capital expenditures (86,583)

Acquisitions, net of cash acquired (77,237)

Other changes in investing activities (33,967)

Net cash used in investing activities (197,787)

Dividends declared and paid (2,081)

Other changes in financing activities 98,927

Net cash provided (used) by financing activities 96,846

Effect of exchange rate changes on cash 437

Net increase in cash and cash equivalents 4,711

Cash and cash equivalents at beginning of period 20,645

Cash and cash equivalents at end of period $25,356

Operating activities

Net changes

Investing activities

Financing activities


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Statement InterrelationshipsSteel Inc. Statement of Operations, Aug. 31, Y6

Revenues Total revenues US $1,919,310

Expenses Cost of goods sold 1,526,990

Other expenses 249,252

Total expenses 1,776,242

Net income US $143,068

Steel Inc. Balance Sheet, Aug. 31 Y6

Current assets: USD

Cash, S/T investments $25,356

Other 415,036

Total current assets 440,392

Noncurrent assets 604,306

Total assets $1,044,698

Current liabilities: 151,112

L/T liabilities 159,487

Common stock, par A 22,793

Common stock, par B 7,986

APIC 137,281

Retained earnings 564,165

Foreign currency trans. adj. 1,874

Total shareholders’ equity $734,099

Total liabilities and equity $1,044,698

Shareholders’ Equity Par A Par B APIC Ret. Earn. AOCI Total

Balance, Aug. 31, Y5 $22,490 $7,986 $125,845 $423,178 $29 $579,528

Net income 143,068 143,068

For. currency trans. adj. 1,845 1,845

Common stock issued 303 4,296 4,599

Stock compensation 3,060 3,060

Tax benefits (options) 4,080 4,080

Cash dividends paid (2,081) (2,081)

Balance, Aug. 31, Y6 $22,793 $7,986 $137,281 $564,165 $1,874 $734,099

Steel Inc. Statement of Cash Flows, Aug. 31, Y6

Net income US $143,068

Net cash provided by operating activities 105,215

Net cash used in investing activities (197,787)

Excess tax benefit from stock options exercised 4,080

Dividends declared and paid (2,081)

Other changes in financing activities (see book for details) 94,847

Net cash provided (used) by financing activities 96,846

Effect of exchange rate changes on cash 437

Net increase in cash and cash equivalents 4,711

Cash and cash equivalents at beginning of period 20,645

Cash and cash equivalents at end of period US $25,356


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Which of the following applies more to theincome statement than the balance sheet?

A. Evaluating if inventory levels are sufficient

B. Evaluating capital structure

C. Evaluating liquidity

D. Evaluating creditworthiness

Answer: D. The income statement shows net profits from primary activities, a key creditworthiness indicator.

Discussion Question


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Identify the proper statement with its use.

Answers:

Discussion Question

1. Includes primary short-term measure of success

2. Includes primary long-term measure of success

3. Helps determine financial flexibility

4. Helps form a picture of an organization’s prospects and priorities

Statement of cash flows

Income statement

Balance sheet

Statement of shareholders’ equity


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An integral part of the financial statements• Contingent liabilities• Subsequent events• Contractual obligations• Accounting policies and valuation methods• Change in accounting policies• Capital stock disclosures• Others: Credit claims, deferred taxes, lease

information, off-balance-sheet arrangements, etc.

Disclosures/Footnotes


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• Income statement includes judgments and estimates (audit risk) and varied accounting methods.

• Balance sheet omits qualitative, nonfinancial measures.

• Statement of cash flows can be complex: direct vs. indirect, plus inclusion of allowances, noncash transactions, etc.

• Voluntary accounting method changes can distort reported net income.

Limitations of the Statements


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• Standard 1210.A.2• SAS No. 99:

– Be professionally skeptical.– Communicate with management.– Randomize audit tests.– Investigate management overrides of controls.

Fraud in Financial Statements

Type of risk

Pervasiveness Risk attributes Significance (materiality)

Likelihood of material misstatement


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If sales revenue and the customer base for a firm haveremained stable but inventory and gross margin haveincreased significantly, which of the following couldexplain this?A. Production efficiency has increased.B. Sales price per unit has increased.C. Inventory was deliberately overstated.D. All of the above.

Answer: D. Further investigation could help narrow the possible reasons for this change.

Discussion Question


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Falsified reporting: Usually overstating/understating assets/liabilities or revenues/expenses

Fraudulent Financial Reporting

Manipulation of accounting records and supporting documents

Omission of events

Intentional misapplication of accounting

principles


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Fraudulent Financial ReportingRed Flags

• Fictitious revenues

• Improper asset valuation

• Concealed liabilities

• Improper disclosures


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• Government bonds• Industrial revenue bonds• Corporate bonds• Debenture bonds• First mortgage/mortgage

bonds• Callable bonds• Subordinate bonds• Serial bonds• Term bonds• Income bonds

Bond features:• Restrictive covenants• Sinking fund requirements• Call provisions• Stock warrants

Types of Bonds


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What’s the yield-to-maturity (YTM) of a three-year US $100,000 note receivable bearing annual interest at 6% when the current market rate for a similar investment is 5%? Is this a discount or a premium?

Answer: US $100,000 0.06 = US $6,000 interest payment. Market rate is used for PV of both principal and interest. YTM = (US $100,000 .86384) + (US $6,000 2.72325) = US $86,384 + US $16,340 = US $102,724, a premium.

Discussion Question

Present Value of 1

Periods 3% 4% 5% 6%

3 .91514 .88900 .86384 .83962

Present Value of an Ordinary Annuity of 1

3 2.82861 2.77509 2.72325 2.67301


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Par, discount, or premium Amortization

Discounts and Premiums on Bonds

YTM Discount Premium Already Amortized

(Example from prior slide) Y1 $102,724

Carrying Value of Bonds Effective Interest Rate

Y1 $102,724 0.05 $5

Carrying Value of Bonds

Bond Interest Expense

,136

Bond Interest Expense Interest Paid in Period

Y1 $5,136 $6,000 ($864) Premium

Y2 Carrying Value $102,724 $864 $101,860

Bond Amortization Amount

Market (Effective) Rate

Stated Bond Rate

6%

7%

5%

Discount

Premium 6%

Par 6%

6%

Note: All amounts in US dollars.


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Fraud risk, e.g.,

• Overstating by recording false receivables• Understating by improperly recognizing

receivables in later period

Revenue Recognition Misuses


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• Repurchase agreement• Misuses

– Trade loading/channel stuffing.– High ratio of returns: either delay recognition until

warranties expire or record returns as they occur.

• Recognize at sale only if:– Sales aren’t on consignment.– Prices easily determined.– Theft or loss cannot revoke obligation to pay.– Not a transfer payment.– Returns can be estimated.

Point-of-Sale Recognition


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Installment sales method• Used when title transfers at final payment.• At sale, recognize revenue up to cost of goods sold

plus direct expenses, e.g., selling and administrative.• Gross profit deferred until cash collected.

Cost recovery method• No basis for estimating collectibility.• Defers all profit recognition until collections exceed

cost of goods sold.

Revenue Recognition After Delivery


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Using the percentage-of-completion method, how much revenue should be recognized in June for a construction project that has incurred $100 in to-date costs, should cost $400 in total, and has collected $200 in total revenue, of which $25 was already recognized? (All amounts in thousands of US dollars.)

Discussion Question

Cost - to - Cost Percent Complete

To - Date Costs Incurred $100 0.25Most Recent Total Cost Estimate $400

To - Date Revenue to Recognize

Cost - to - Cost Percent Complete Total Re venue

0.25 $200 $50

Cur

rent Period's Portion of Revenue

To - Date Revenue to Recognize - Pr ior Period

Revenue Recognized $50 - $25 $25


Answer:

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A lease has the following terms. Under US GAAP, is this an operating lease or a capital lease?• Lessor retains title at the end of the lease.• Lease has no bargain purchase option.• Lease term spans 6 years; estimated remaining life

is 10 years.• Present value of the lease payments is $80,000; current market value is $100,000.

Answer: Operating lease. None of the four capital lease criteria are satisfied: III would need to be 75% or more; IV would need to be 90% or more.

Discussion Question


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Defined contribution plans• Promise required annual

contribution.• Annual pension expense =

required contribution.• Actual benefits depend on

market returns.

Defined benefit plans• Promise specific level of

retirement benefits.• Minimum pension liability =

actuarial present value of expected minimum payments at retirement.

• Accumulated benefit obligation = service cost +/– actual return on plan assets.

• If accumulated benefit obligation > fair value of plan assets, record liability.

Pensions

Service cost measured by vested benefit obligation, accumulated benefit obligation, or projected benefit obligation (best).


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Assets with no physical substance (but not financialinstruments)• Subject to interpretation or estimation, e.g., cost or

expense recognition issues• Purchased vs. internally created• Examples

– Copyrights– Patents– Trade names or trademarks– Contracts– Leases– Customer intangibles– Goodwill

Intangibles

®

©™


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Limited life(e.g., extraction rights)

Valuation of Intangibles

Indefinite life(e.g., goodwill, brand)

Amortized over period

Fair value tested annually


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• Allocates cost of tangible assets over periods of expected use.

• Land is not depreciated.• Depreciable base = cost less salvage value.• Service life accounts for wear plus obsolescence.• Example: Machine A, with original cost of $50,000,

salvage value of $5,000, service life of 3 years or 5,000 units produced.

Depreciation

-

Depreciable Base $45,000 $15,000/YearEstimated Service Life 3 Years

Straight Line Depreciation per Period

Note: All amounts are in US dollars.


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Example: Machine A, with original cost of $50,000, salvage value of $5,000, service life of 3 years or 5,000 units produced If Machine A made 2,000 units in Year 2, what would be the year’s depreciation using the activity method?

Answer:

Discussion Question

Depreciable Base Units in Period Total Estimated Units in Service Life$45,000 2,000 units

$18,0005,000 units

Activity Depreciation per Period

Note: All amounts are in US dollars.


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Example: Machine A, with original cost of $50,000, salvage value of $5,000, service life of 3 years or 5,000 units produced

For Machine A, calculate depreciation and end-of-year book value for all years using a 200% declining balance.

Answer: Straight line of 1/3 x 2 = 2/3 or 66.7%

Discussion Question

Year Beginning of Year Asset Book Value

Rate Depreciation Charge

End-of-Year Book Value

1 $50,000 66.7% $33,350 $16,650

2 $16,650 66.7% $11,106 $5,544

3 $5,544 66.7% $544 * $5,000

*Depreciation of $3,698 reduced in Y3 to reflect salvage value.


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• Contingent liabilities– A loss contingency that

is recorded.– Amount of loss can be

estimated reasonably.– Probable a liability will

likely exist on or before financial statement date.

• Contingency states:– Probable– Reasonably possible– Remote

• Examples– Lawsuits– Warranties and

guarantees– Premiums and coupons

Contingent Liabilities


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A firm with 50,000 common shares outstanding for the first quarter issues 40,000 more on April 1. The firm has net income of US $350,000 and has paid US $10,000 in common dividends and US $5,000 in preferred dividends. What is its basic earnings per share (EPS)?

Discussion Question

Weighted Average Shares Outstanding

Months Outstanding= Shares Outstanding ×

12 Months3 9

= 50,000 × + 90,000 × = 80,000 Shares12 12

Net Income Preferred DividendsEPS =

Weighted Average Sh

ares Outstanding

US $350,000 US $5,000= = US $4.31 per Share

80,000 Shares


Answer:

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Convertible bonds—if-converted method• Numerator increases: Bond interest expense eliminated,

increasing net income.• Denominator increases: Assumes bonds converted at start of

period or date of issuance (prorated).

Warrants and options—treasury stock method• Denominator increases by net incremental shares:

– Warrants converted at start of period or when issued.

– Proceeds used to repurchase stock, so net income stays same.

– For example, exercise price US $10; stock price US $20. 2 warrants exercised for 2 shares and US $20, which is used to repurchase 1 share, leaving 1 net incremental share.

EPS with a Complex Capital Structure


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• A distribution of profits, not an expense.

• Audit registrar and disbursement process.

• Dividend policy: retained earnings vs. dividends.

• At date of declaration, dividend becomes a liability.

• Types– Cash dividends– Liquidating dividends– Property dividends– Stock dividends

Dividends


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At the beginning of next year, a firm’s effective tax rate is scheduled to increase significantly. Which of the following would be most likely to require scrutiny as a potential source of fraud in the current year’s financial statements and taxable income?

A. Unusually large deferred tax assets

B. Unusually large deferred tax liabilities

C. Differing amounts for taxable income and reported pretaxfinancial income

Answer: A. Deferred tax assets would increase the current year’s tax and reduce future taxes when the tax rate would be higher.

Discussion Question


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Equity Security Investments

Ownership level Recorded at Valuation Unrealized gains/losses

Passive interest: < 20%

Cost Fair value method: Report unrealized net gain/loss of similar securities in portfolio

• If available-for-sale, record in other comprehensive income and separate component of stockholders’ equity

• If trading, record as part of net income

Significant influence: 20% to 50%

Cost adjusted by investor’s share of investee’s net income/dividends

Equity method: Proportional share of investee’s net income/loss, dividends

Not recognized

Controlling interest: > 50%

Fair market value Consolidated financial statements

Not recognized


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• Companies form partnerships and mergers to increase their influence over a market or over a company with a purchasing interest.

• Types of practices– Partnerships– Business combinations and mergers– Special purpose entities (SPEs)

Partnerships, Combinations, and Consolidations


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• Required under GAAP and IFRS.• Records assets and liabilities at fair value (FMV),

excess of cost over FMV is goodwill.• Excess of market over book value is depreciated/

amortized for applicable assets.• Acquired retained earnings not recognized. • Investee earnings after acquisition are included.

Purchase Accounting

Indirect acquisition costs

Expensed

Direct acquisition costs

Capitalized


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Present results of operations and financial position asif entities were a single company.

Steps in consolidation:1. Determine ownership percentage and minority interests

of each subsidiary.2. Book value of subsidiary = investee’s net assets x

ownership percentage. Allocate purchase price vs. book value differences to underlying asset and liability accounts—requires estimates!

3. Record eliminating entries to reverse intercompany transactions and balances.

4. Issue consolidated statements.

Consolidated Financial Statements


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A UK firm has accounts payable with US clients, and it wants to minimize exchange rate risk. The US interest rates are currently higher than the UK rates. What should the firm do?A. Buy a forward exchange contract for USD now.B. Wait and buy on the spot market.C. Buy on the spot market now.

Answer: A. US currency is trading at a discount now, so a forward contract would be a valid fair value hedge.

Discussion Question


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Remeasurement• If subsidiary uses parent’s

reporting currency as functional currency.

• Uses historical exchange rates from time of transactions.

• Temporal method remeasures balance sheet accounts other than cash, claims to cash, and their associated expenses.

Translation• If subsidiary uses local

country’s currency as functional currency.

• Current rate method translates all assets and liabilities using the exchange rate as of the balance sheet date.

• Paid-in capital accounts use historical transaction date rates.

Remeasurement or Translation

Both methods translate income statement amounts using average exchange rates.


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Financial ratios:

• Quantitatively relate two or more numbers mathematically for comparison as a percentage or number of times or days.

• Help auditors find irregularities.

• Gain relevance when compared to competitors’ ratios or to firm’s historical data, but this requires making the sources reasonably comparable through:– Benchmarking.– Common-size financial statements.– Adjustments for inflation, historical cost, accounting

method.

Use of Ratios in Analysis


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Common-Size Financial Statements—HorizontalASSETS % Change Difference Year 6 Year 5

Current assets: USD USD USD

Cash, S/T investments 22.82% $4,711 $25,356 $20,645

Restricted cash — 7,225 7,725 —

A/R – allow. for doubtful accts. 137.41% 70,218 121,319 51,101

A/R from related parties (91.59%) (207) 19 226

Inventories 148.22% 157,394 263,583 106,189

Deferred income taxes 124.36% 4,038 7,285 3,247

Prepaid expenses and other (2.58%) (400) 15,105 15,505

Total current assets 123.65% 243,479 440,392 196,913

PP&E, net 87.48% 146,006 312,907 166,901

Other assets:

Investment in/adv. to joint venture (95.19%) (175,292) 8,859 184,151

Goodwill 76.19% 115,321 266,675 151,354

Intangibles 319.52% 8,448 11,092 2,644

Other assets (36.32%) (2,722) 4,773 7,495

Total assets 47.25% $335,240 $1,044,698 $709,458


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Common-Size Financial Statements—Vertical

Revenues Revenues from wholly owned operations US $1,854,715 96.63%

Income from joint ventures 4,201 0.22%

Interest income 1,929 0.10%

Other gains 58,281 3.04%

Pre-acquisition interests, net of tax 184 0.01%

Total revenues 1,919,310 100.00%

Expenses Cost of goods sold 1,526,990 79.56%

Selling, general and administrative 156,862 8.17%

Other expense 3,585 0.19%

Income tax expense 86,871 4.53%

Minority interests, net of tax 1,934 0.10%

Total expenses 1,776,242 92.55%

Net income US $143,068 7.45%

Base value


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• Analytical procedures can detect:– Differences that aren’t expected.– Absence of expected differences.– Potential errors.– Potential irregularities or illegal acts.– Other unusual or nonrecurring

transactions.

• Include nonfinancial data in analysis.• Ratios helpful before and during audit.

Auditor’s Financial Statement Analysis


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Which of the following investments would be preferable assuming that investors want to minimize risk but still receive a positive return?

Answer: Firm B, because operating leverage is lower but financial leverage index is still positive.

Discussion Question

(all amounts in thousands of USD) Firm A Firm B

Total costs $3,400 $1,600

Fixed costs $2,100 $600

Return on common equity (ROCE) 0.258 0.282

Return on assets (ROA) 0.193 0.269

Fixed CostOperating Leverage =

Total Cost

$2,100 $600A = = 0.62 B = = 0.38

$3,400 $1,600

ROCEFinancial Leverage Index =

ROA

0.258 0.292A = = 1.34 B = = 1.09

0.193 0.269


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• Show ability to pay short-term obligations without undue hardship.

• The higher the ratio, the stronger the liquidity.

• Current ratio: If too high, too much invested in low-yield short-term assets.

• Cash ratio: More conservative, most short-term measure.

• Quick ratio: Compared to cash ratio, shows effect of inventory on liquidity.

Liquidity/Short-Term Debt Ratios

Current AssetsCurrent Ratio =

Current Liabilities

Cash and Marketable SecuritiesCash Ratio =

Current Liabilities

Cash, Cash Equiv., ReceivablesQuick Ratio =

Current Liabilities


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In comparison to an industry debt ratio benchmark of 0.6, a firm has 0.8. The debt-to-equity ratio benchmark is 0.37, and the firm has 0.44. Which of the following is true relative to the benchmarks?

A. The firm has low financial leverage.

B. The debt ratio implies that few liabilities exist.

C.The debt-to-equity ratio implies that debt levels shouldbe reduced for equity financing.

Answer: C. The benchmark of 0.37 uses less debt in its equity financing than the firm does.

Discussion Question


Part 3 B – 80V3.0


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If the gross profit margin, the operating profit margin, and the net profit margin all declined proportionally from the prior year, which of the following is most likely the cause?A. Increased cost of goods soldB. Increased selling, general, and administrative

expensesC. Increased sales priceD. Increased tax rate

Answer: A. Since all ratios decreased, the cost of goods sold must have increased or the sales price must have decreased.

Discussion Question


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• “Return” and “investment” can be defined many ways.

• ROA’s net income should consist only of income from continuing operations.

• DuPont ROI shows how profits are a function of both markup over cost and efficiency of asset usage.

Return on Investment (ROI) Ratios

Net IncomeReturn on Assets (ROA) =

Average Total Assets

Net Income Preferred DividendsReturn on Common Equity (ROCE) =

Average Common Equity

DuPont ROI = Profit Margin × Total Asset Turnover

Net Inco=

me Sales ×

Sales Average Total Assets


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What is the DuPont return on equity (ROE) for a firm that has $200 in net income, $900 in average total assets, $2,000 in sales, $1,000 in total assets, and $800 in total equity?

Discussion Question

DuPont ROE = Profit Margin × Total Asset Turnover × Equity Multiplier

Net Income Sales Total Assets= × ×

Sales Average Total Assets Total Equity

$200 $2,000 $1,000= × × = 0.1 × 2.22 × 1.25

$2,000 $900 $800 = 0.278

Note: All amounts in thousands of US dollars.


Answer:

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• Average A/R turnover

• Average days’ A/R

Average A/R Turnover and Average Days’ A/R

Net Credit SalesA/R Turnover =

Average A/R

365Receivables Collection Period =

A/R Turnover Ratio


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In Year 6, average inventory turnover for Steel, Inc., was 8.26 times, and its inventory processing period was 44.2 days. If in Year 7, the ratios were 5.09 times and 71.7 days, which of the following could be true? (Select all that apply.)

I. Cost of goods sold increased.

II. Inventory is becoming obsolete.

III. Competitors are gaining market share.

Answer: Either II or III could cause a large rise in inventory levels.

Discussion Question


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• Accounts payable (A/P) turnover

• Accounts payable payment period

Accounts Payable (A/P) Turnover and Accounts Payable Payment Period

Cost of Goods SoldA/P Turnover =

Average A/P

365A/P Payment Period =

A/P Turnover Ratio


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A growing firm is assessing current working capital requirements. It has the following averages: 58 days to convert raw materials into goods and sell them, 32 days to collect on A/R, and 15 days to pay for raw materials. What is its cash conversion cycle?

A. 11 days

B. 41 days

C. 75 days

D. 90 days

Answer: C. 58 + 32 – 15 = 75 days

Discussion Question


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A firm has a high fixed assets turnover ratio. What conclusion can a financial analyst draw from this?A. The firm may be overcapitalized.B. Someone may be stealing inventory.C. The firm may be undercapitalized.D. The company is profitable.

Answer: C. A high ratio could mean that the firm can’t afford to buy enough assets.

Discussion Question


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Shows percentage of stock value returned as dividends in period

Dividend Yield

Dividends per Common ShareDividend Yield =

Market Price per Common Share


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Financial Statement Analysis


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• Projects with no readily available market value.• Set minimum return rate, and if RI is positive,

investors will get their return and excess can go to retained earnings.

• Evaluations using ROI only can lead to rejection of profitable projects; RI helps focus on long-term gains and total monetary value of gains.

Residual Income (RI)

RI = Income Minimum Return Rate Investment


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Comparison Between Ratios

SalesA/R

Profits

Finished Goods InventoryInventory Turnover Ratios

Overall Inventory=+

+

A/R Turnover Ratio + A/R Aging Schedule = Receivables Outstanding

Current AssetsCurrent Ratio =

Current Liabilities Working Capital =

Current Assets Current Liabilities


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• Should be augmented with other data.• Beware of “window dressing.”• Industry averages = mediocre goals.• Competitors highly diversified.• International: language, currency.

Limitations of Ratios

“Same” ratio and financials, different assumptions

Different results

US $170,863Return on Assets (ROA) = = 0.195

US $1,044,698 US $709,4582

US $143,068= = 0.202

US $709,458


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Capital structure ratio• Low = able to pay debts without reliance on

long-term debt

Analysis of Capital Investments

Average Long-Term Debt

Capital Structure Ratio = Long-Term Debt Shareholders' Equity


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What is the current asset value of an investment that costs an organization $1,000 in Year 1 and is expected to earn returns of $400 in Year 1, $500 in Year 2, and $600 in Year 3 and has a required return of 10%?

Discussion Question

n

t = 1

1 2 3

Cash Flow for PeriodCurrent Asset Value =

1 Required Rate of Return

$400 $500 $600= $1,000

1 0.1 1 0.1 1 0.1

= $1,000 $363.64 $413.22 $450.79 = $227.65

Period



Answer:

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Cost of debt

Cost of equity• Efficient markets theory: stock prices

automatically and immediately react to financial and other publicly available data.– Weak, semistrong, strong forms.– Accounting tricks won’t fool market overall.

Cost of Debt and Cost of Equity

Cost of Debt = Yield-to-Maturity (YTM) 1 Tax Rate


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• Cost of preferred stock

• Cost of common stock– For stock with constant dividends, divide dividend

by required rate of return to get stock value.

Cost of Stock

Preferred Dividend

Cost of Preferred Stock = Share Price Flotation Costs

Current Dividend 1 gShare Price of Stock =

Required Return g

Expected Dividend = Current Dividend 1 g

Where g = dividend growth rate


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Capital asset pricing model

• Beta (β)– 0, item, such as a T-bill, is not affected by the market.– 0.5, for every increase (decrease) of 2, the security changes 1.– 1.0, an average security.– 2.0, for every increase (decrease) of 1, security changes 2.

• Risk-free return: benchmark no-risk government security (e.g., in US, a T-bill).

• Portfolio return: e.g., Standard & Poor’s.

Cost of Retained Earnings

Expected Return on Security =

Risk-Free Return β Portfolio Return Risk-Free Return


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An organization finances its equity solely through retained earnings, at an internal cost of 12%. Its average cost of all debt interest and fees is 15%. It has a 35% tax rate and a 40% debt to 60% equity weighting. What is its weighted average cost of capital (WACC)?

Discussion Question

Debt Debt Equity EquityWACC = Weight Cost 1 Tax Rate Weight Cost

= 0.4 0.15 1 0.35 0.6 0.12 = 0.111


Answer:

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Debt versus Equity

Debt Financing Equity Financing

High debt = more difficult financing. High equity reduces financial leverage.

Creditors prefer low debt ratio. Shareholders prefer more leverage.

Debt interest is tax-deductible. Dividends are paid after taxes.

Debt has flotation costs. Retained earnings have no flotation costs, but capital stock does.

Debt financing gives no ownership rights.

Equity financing gives away ownership rights.

Nonpublic companies (no stock or private stock) have fewer disclosures and total control but illiquid stock; owners are personally less diversified.

Publicly traded companies have extensive disclosure requirements and less control but more liquid stock; owners can diversify.


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Ranking by liquidityand default risk • Preservation of

capital primary goal• Base index

– In US, T-bills backed by full faith and credit of government, or no risk

Credit and working capital policies

Types of Debt and Equity

Policy Fixed assets Permanent current assets

Shorter-term assets

Aggressive

Moderate

Conservative

Long-term financing Short-term financing


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• Trade credit• Accrued expenses• Letters of credit (L/Cs)• Money market instruments and mutual funds

– T-bills– Commercial paper (CP)– Bankers’ acceptances (BAs)– Repurchase agreements (repos)

Types of Short-Term Debt


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• Government-backed securities– T-notes– Municipal notes

• Other asset-backed securities– Pledging receivables/factoring– Pledging inventory– Securitization

• Lines of credit

Types of Short-Term Debt (continued)


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Categories of Debt SecuritiesTrading Available-for-Sale Held-to-Maturity

Description Intent to sell soon for profit based on short-term changes

Default category for all securities not falling elsewhere

Positive intent and ability to hold until maturity

Recorded at… Cost Cost Cost

Subsequently valued at…

Fair value (market value not in liquidation)

Fair value Amortized cost (cost +/– amortization of discount/premium)

Discount/ premium

Not amortized Amortized if sold prior to maturity

Amortized as normal

Unrealized holding gains/ losses?

Recognition in net income

Recognition in other comprehensive income and as separate component of shareholders’ equity

No recognition


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• Common stock• Preferred stock• Stock value

– Par value = legal capital– Additional paid-in capital

• Retained earnings

• Authorized• Issued • Outstanding

Types of Equity Securities

Book value

Primary market

Underwriter

Market value

Secondary market


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An organization reacquires 1,000 shares of $1 par value stock for $20/share. (It originally received $10/share.) Later that year, the shares are reissued for $30/share. Which of the following would be the correct entries using the cost method? (All amounts are in US dollars.)

Answer: Repurchase: I, Reissuance: IV

Discussion Question

I. Treasury stock $20,000

Cash $20,000

II. Cash$10,000

Treasury stock $10,000

III. Treasury stock$10,000

Cash $10,000

Retained earnings $20,000

IV. Cash$30,000

Treasury stock $20,000

Additional paid-in capital $10,000Part 3, Section B, Topic 6

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• Contracts requiring one party to pay another party some amount based on an underlying price or value

• Forward-type contracts– Forwards, futures,

swaps

• Option-type contracts– Right, not obligation

• Terminology– Counterparty risk

(settlement risk; credit risk)

– Over-the-counter trading– Exchange-traded

securities– Cap, floor, collar– Put and call– Long and short– Naked short selling

Financial Instruments—Derivatives


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• Management risk• Market risk• Legal risk

• Trader risk• Model risk• Portfolio leverage risk

Derivative Risk

Required to Deliver Required to Accept Delivery

Hedger

Baker

Hedger

Miller

Speculator

Speculator

e.g., Future

e.g., Forward

e.g., Future


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An organization defines speculating and specifically bans the practice. Segregation of duties provides review and approval; otherwise managers have no limits on their derivative investments. Which of the following should an audit focus on? (Select all that apply.)I. Managers could divert derivative profits to personal accounts.II. There could be large potential loss due to trading on the

margin.

III. Derivative selections could be illiquid.IV. Derivatives could be concentrated with a single

counterparty.

Answer: II, III, and IV. These require additional controls. I is less likely due to segregation of duties.

Discussion Question


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• Over-the-counter contract. • Counterparty exposure: Each party required to

perform, but each could still default.• Both limit their potential profits.• Parties usually “cash-settle.”

Forwards

Seller wants to reduce chance of price falling.

Buyer wants to reduce chance of price rising.

Hedger

Baker

Hedger

Miller

Required to Deliver Required to Accept DeliveryForward Contract

Opposite risk profiles


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• Like forwards but traded on an organized futures exchange or its clearinghouse.– Limited number of underlyings– Specified prices and delivery times

• Clearinghouse greatly reduces counterparty risk by acting as counterparty to each side.

• Reversing trade settles prior to delivery.• Party with an interest in the underlying that wants to

mitigate risk is hedger, other is speculator.– Required to deliver = going short– Required to accept delivery = going long

Futures


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1: Go long on bond forward contract (accept bonds in future at price set now). As interest rates rise, price of bond falls.

2: Purchase short futures contract as hedge. Equal risk, opposite profile.

3: Net result: Symmetric payoff profile. Reduces downside potential at cost of upside potential plus fees.

Hedging Bond Purchase with a Bond Future

Interest Rates

Price 3

1

2


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• Over-the-counter exchange of payment streams for specific time period– Payment stream: current

portion owed on liability

• Symmetrical payoff profile

• Counterparty risk– Credit risk limited to

fraction of notional principal

• Interest rate swaps– Coupon swaps– Basis swaps

• Currency swaps• Commodity swaps• Swaptions

Swaps


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ABC and DEF each need to borrow US $10 million. • ABC can borrow at 8% fixed or 6-month LIBOR + 1%. • DEF can borrow at 10% fixed or 6-month LIBOR + 2%.

ABC takes the former deal, DEF the latter. They form a coupon swap and split the comparative advantage at 0.5% each. After 6 months, if LIBOR goes up, will both parties continue to benefit equally from the swap? Explain your answer.

Suggested answer: As the floating rate rises, the party paying the net floating rate will benefit relatively less.

Discussion Question

Net Payment = ( Payment to Lender Payment to Counterparty

Payment from Counterparty)

ABC = ( 8% LIBOR 7.5%) = LIBOR 0.5%

DEF = ( LIBOR 2% 7.5% LIBOR) = 9.5% fixed


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• Buying options is hedging (like buying insurance).

• Hedger has limited downside potential, unlimited upside potential.

• Selling options is speculating (like selling insurance).

• Speculator has limited upside potential, unlimited downside potential.

Option-Type Contracts

Dec 100 XYZ CALL 10

Asymmetric payoff profiles (buyer’s perspective)

Dec 100 XYZ PUT 10

Share Price

Max. loss

Profit

010

−10

20

100110

908070

Premium Cost

Strike price

Share Price

Max. loss

Profit

010

−10

20120130

11010090


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Managing Liquidity

Liquidity

Synchronizing cash inflow and outflow transactions

Precautionary motive

Speculation


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Cash Receipt Controls

MailedMailedElectronic

Point-of-sale (POS)

POS controls• POS receipts• Manager reconciliation vs.

cash count• Locking deposit envelope• Accounting entries

Mailed payment controls• Lockbox (best)• Check images• Internal processing

– Only specific mail room employees open mail.

– Employee who doesn’t open mail compares remittance advice vs. check totals.

– Controller compares mail room total to bank deposit receipt, journal entries, reported sales.

Electronic payments controls• Improved speed and control• Customer remittance

information sent directly to accounting system

• A/R automatically updated• Funds automatically routed to

correct accounts


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Which of the following steps are used or allowed for physical check processing? For electronic payment processing? (Select all that apply.)

I. Payor issues payment instructions

II. Use of check images for transfer of value

III. Clearing

IV. Communication

V. Settlement

Answer: physical: I, II, III, V; electronic: IV, V

Discussion Question


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Cash Payment Controls

Purchase request

Purchase order (PO) Supplier

Receiving recordInspection

Accounting department

3-way match

Receiving department

Treasurer

Authorize payment Disbursement

PO

Invoice

Manager approval

Goods

Bill of lading

+

Invoice

+

Positive payHole punch for physical forms

Disbursement controls

Master payee file


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A seller offers terms of 1/15 n30. If the buyer would need to borrow from a line of credit at a rate of 16% to pay early, should the buyer pay early or when net is due?

Answer: Pay early.

Discussion Question

Effective Cost of Discount

Discount % 365=

1 Discount % Net Period Discount Period

0.01 3651/15 n30 = = 0.2457

1 0.01 30 15


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Incentive for Offering a Cash Discount

Discount Period Net Period

Discount Period

Net Present Value of Cash Discount = PV PV

Avg. Credit Sale × 1 Discount %Present Value =

Cost of Capital1 + Discount Period ×

365

Present Val

Net Period

Discount Period

Net Period

Avg. Credit Saleue =

Cost of Capital1 + Net Period ×

365

US $50,000 × 1 0.011/15 n30 = = US $49,235

0.1311 + 15 ×

365

US $50,01/15 n30 =

00 = US $49,467

0.1311 + 30 ×

365

NPV = US $49,235 US $49,467 = (US $232)

Terms: 1/15 n30,US $50,000 average credit sale,13.1% cost of capital


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The slides that follow use this example to present various perpetual inventory cost flow methods:• July: No beginning inventory.• July 1: Purchase 8,000 units @ US $10/unit.• July 4: Sell 2,000 units. • July 12: Purchase 12,000 units @ US $12/unit.• July 15: Sell 9,000 units.• July 26: Purchase 4,000 units @ US $14/unit.• Cost of goods available for sale = US $280,000.

Inventory Cost Flow Methods—Perpetual


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• Oldest goods used first• Violates matching principle

• Difficult to manipulate

FIFO Inventory Valuation

Date Transaction Cost Balance Calc. Balance

July 1 Purchase 8,000 $10 = $80,000 8,000 $10 $80,000

July 4 Sale 2,000 $10 = ($20,000) 6,000 $10 $60,000

July 12 Purchase 12,000 $12 = $144,000 (6,000 $10) + (12,000 $12)

$204,000

July 15 Sale (6,000 $10) + (3,000 $12) =

($96,000) 9,000 $12 $108,000

July 26 Purchase 4,000 $14 = $56,000 (9,000 $12) + (4,000 $14) $164,000

Cost of Goods Available for Sale – Ending Inventory = COGS

US $280,000 – $164,000 = $116,000

All amounts in US dollars.


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• Newest goods used first• Not IFRS; is GAAP

• Assuming inflation, undervalues inventory

LIFO Inventory Valuation

Date Transaction Cost Balance Calc. Balance

July 1 Purchase 8,000 $10 = $80,000 8,000 $10 $80,000

July 4 Sale 2,000 $10 = ($20,000) 6,000 $10 $60,000

July 12 Purchase 12,000 $12 = $144,000 (6,000 $10) + (12,000 $12)

$204,000

July 15 Sale 9,000 $12 = ($108,000) (6,000 $10) + (3,000 $12) $96,000

July 26 Purchase 4,000 $14 = $56,000 (6,000 $10) + (3,000 $12)

+ (4,000 $14)

$152,000


US $280,000 – $152,000 = $128,000

All amounts in US dollars.


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• Called moving if perpetual• Simple

• Income cannot be manipulated

Moving Average Cost Inventory Valuation

Date Transaction Cost Unit Balance Average Cost Balance

July 1 Purchase 8,000 $10 = $80,000 8,000 $10.00 = $80,000

July 4 Sale 2,000 $10 = ($20,000) 6,000 $10.00 = $60,000

July 12 Purchase 12,000 $12 = $144,000 18,000 $11.3333

* = $204,000

July 15 Sale 9,000 $11.3333 = ($102,000) 9,000 $11.3333

= $102,000

July 26 Purchase 4,000 $14 = $56,000 13,000 $12.1538

** = $158,000

*Average cost = ($60,000 + $144,000)/18,000. **New average cost = ($102,000 + $56,000)/13,000.


US $280,000 – $158,000 = $122,000

All amounts in US dollars. Part 3, Section B, Topic 9

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• Each specific item in inventory is tracked separately.

• Special order or low-volume, high-cost goods.

• Manipulate COGS, ending inventory, and net income by selecting from otherwise identical inventory the item with a lower or higher cost.

• Indirect costs not easily specifically identified.

Specific Identification Method


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• Shrinkage• Lower of cost or market (LCM)

– Ceiling: Market cannot be greater than inventory’s net realizable value (NRV).

– Floor: Market cannot be less than NRV less an ordinary profit margin.

– NRV is sales price less cost of completion and transportation or disposal.

– Ceiling helps prevent overstatement.– Floor helps prevent understatement.

Adjusting Inventory


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What is the Year 2 economic value added (EVA) for a firm with a 12% WACC, $300 in net income, $5 in interest expense, and the following other balances?

Discussion Question


Account Y1 End Y2 EndNotes payable $10 $12Current maturities of long-term debt $20 $24Long-term debt $40 $44Shareholders’ equity $1,000 $1,200

EVA = Net Income + Interest Expense Beginning Capital × WACC

Where Beginning Capital = Beginning Balances of

(Notes Payable + Current Maturities of Long-Term Debt

+ Long-Term Debt + Shareholders' Equ

ity)

Y2 = $300 + $5 $10 + $20 + $40 + $1,000 × 0.12 = US $176.60


Answer:

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Valuation Models


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Business Development Life Cycle

Internal audit focus

Risks

Establish control framework.

Formalize internal controls.

Maintain control integrity; internal controls formalized.

Audits to increase efficiencies and streamline decision processes without loss of control integrity.

• Loose management.

• Strategy omits controls.

Capacity constraints encourage workarounds.

Labor cuts could threaten segregation of duties.

• Entrenched bureaucracy.• Management may

manipulate earnings.• Layoffs threaten control

continuity.

Emergence Growth Maturity Decline


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Questions?

End of Section B

Part 3, Section B

Documents

Part 3 B – 1 V3.0 THE IIA’S CIA LEARNING SYSTEM TM Section Topics 1.Basic concepts and underlying principles of financial accounting 2.Intermediate