Financial Statement Analysis  
Professor Julian Yeo

Class Notes 05: Operating Capacity

Part I: Inventory
1.1 Inventory and LCM Rule
1.2 Inventory for Manufacturing firms
1.3 Inventory system and cost flow assumption, LIFO vs FIFO
1.4 Quality issues – reported inventory
1.5 How to detect inventory manipulation
1.6 Disclosure: Inventory

Part II: Property, Plant and Equipment

2.1 Property, Plant and Equipment – Cost and Depreciation
2.2 Asset Impairment
2.3 Quality Issues – reported PP&E
2.4 Ways to detect PP&E manipulation
2.5 Disclosure: PP&E

Part III: Intangibles

3.1 Acquired vs Internally Generated Intangible Assets
3.2 Quality issues –Intangibles
3.3 Ways to detect manipulations of intangibles
3.4 Disclosure: Intangible assets

Part IV: Other Assets (optional)

4. Other Assets

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Part I: Inventory
1.1 Inventory and LCM Rule
Inventory consists of all goods owned by the company, which are held for sale in the
ordinary course of business.
 For merchandising firms, inventories are physical goods that firms acquire for
sale.
 For manufacturing firms, inventories consist of raw materials inventory
(including both direct and indirect raw materials), work-in-process inventory and
finished goods inventory.

Inventories are classified as a current asset and appear on the balance sheet at the lower
of cost or market value. Following the conservatism principle, losses due to a decrease
below cost in the market value of inventory are recognized in the period of the market-
value decline. In contrast, market value gains (and cost recoveries) are not recognized
until realized, i.e., until the inventory is sold. This procedure is known as the Lower of
Cost or Market (LCM) rule - i.e., the unit cost of an inventory is identified as the lower of
the original (or already reduced) cost or the current market price.

Cost determination involves

 Identifying and measuring all costs incurred to purchase/produce inventory items
and to get them ready for sale
 Measuring the flow of costs between the inventory accounts and eventually to the
income statement
o Cost allocation (e.g., overhead per unit)
o Inventory system (perpetual vs periodic)
o Cost flow assumption (FIFO, LIFO, etc)
o Quantity of inventory (physical count vs estimates, timing of count, etc)

In some cases, companies use cost estimates instead of actual costs. When the cost of
work in process and finished goods inventory is estimated based on norms, it is known as
standard cost. When the cost of merchandise inventory is estimated by subtracting the
average markup from inventory measured at retail prices, it is known as retail method.

Market is the current replacement cost of inventory, provided that market does not
exceed the net realizable value, and that market shall not be less than net realizable value
as reduced by an allowance for normal profit margin.

Net realizable value is the estimated selling price in the ordinary course of business, less
reasonably predictable costs of completion and disposal.

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The cost of inventory should be reduced in the period when its utility is less than its cost.
This situation typically arises when the inventory has physically deteriorated, is obsolete,
or there are reduced selling prices. A write down of inventory to market is generally not
reversed for subsequent recoveries in value. However, reversal is allowed for write
downs in earlier quarters of the same fiscal year.

Notes:
 The value of raw materials if the finished goods into which they are incorporated
are expected to sell at or above cost needs not be marked down.
 If inventory is the hedged item in a fair value hedge, then include the effects of
the hedge in the inventory's cost basis (which may eliminate the need for a lower
of cost or market adjustment).
 Inventories can only be stated above cost when an inventory item has immediate
marketability at a quoted market price, with no substantial cost of marketing, and
interchangeable units. These restrictions make it difficult to state any inventories
above cost, other than for gold and silver, where there is a government-controlled
market at a fixed monetary value. When it is possible to state inventories above
cost, state the inventory at its sale price, reduced by expenditures expected to
incur in the inventory's disposal.

1.2 Inventory for Manufacturing firms

Merchandising vs manufacturing
The general form of the inventory equation is
Beginning Inventory + Additions = Withdrawals + Ending Inventory.

Merchandising firms have only one category of inventories (complete products) and
therefore one inventory equation:
Beginning Inventory + Net Purchases = Cost of Goods Sold + Ending Inventory

Manufacturing firms have three categories of inventories (raw materials, incomplete

products and complete products).

Cost flow chart (manufacturing firms)

Raw Materials
Labor  Work In Process (WIP)  Finished Goods (FG) COGS
Man. Overhead

For each group of costs, we first accumulate costs in separate accounts. We then apply
them into the work in progress (process) inventory as we start transforming raw materials
into products-in-progress.
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Manufacturing Overhead Account – Indirect costs that are part of a firm’s manufacturing
process but cannot be traced directly to products manufactured. Given that the actual
amount of manufacturing overhead is often unknown as we perform various job/batch
orders, we have to apply an estimated amount of manufacturing overhead incurred to
WIP; for convenience and control reasons, we distinguish between the accounts that
accumulate and apply (e.g., we have actual overhead account and applied overhead
account).

The following should not included as part of manufacturing overhead account and should
be expensed in the period it occurs: abnormal waste related to materials, labor, or other
production costs; administrative costs; selling costs.

Work-in-process (WIP) Inventory - Goods undergoing the production process but not yet
fully completed. Such an inventory will be present under both process and job-order
costing systems.

The following inventory equations apply to Manufacturing firms:

Beginning raw materials inventory + Raw materials purchased =

Raw materials transferred to production departments + Ending raw materials inventory

Beginning work in process inventory + Production costs =

Cost of goods finished + Ending work in process inventory

Beginning inventory of finished goods + Cost of goods finished =

Cost of goods sold + Ending inventory of finished goods

For each of the inventory equations:

 The left hand side of the equation represents the sources and the right hand side
represents the uses.
 The cost of beginning inventory is given (was calculated in the previous year).
 For merchandising firms, and for raw materials inventory in manufacturing firms,
the amount of net purchases during the year is provided by the accounting system,
and so the only issue is how to allocate the cost of the sources (beginning
inventory plus net purchases) between the two uses (withdrawals and ending
inventory).
 For work in process inventory, the cost of additions includes the cost of raw
materials used in production (i.e., the withdrawals from the raw materials
inventory account) as well as other production costs (direct labor and overhead

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 costs). The total cost of the sources (beginning inventory plus production costs) is
allocated between two uses: cost of goods finished and ending inventory.
 For finished goods inventory, the cost of additions is the cost of goods finished
during the year (that is, the withdrawals from the WIPI account). The total cost of
the sources (beginning balance plus cost of goods finished), which measures the
cost of goods available for sale, is allocated between COGS and ending inventory.

Fixed production overhead costs are costs that remain stable regardless of production
volume, such as equipment and building maintenance, depreciation, and factory
administration and management. Fixed overhead production costs is allocated based on
actual usage of production facilities in the period, divided by the normal capacity of
those facilities. Normal capacity is the production that you expect a facility to achieve
over a number of periods under normal circumstances, including a loss of capacity caused
by planned maintenance. Variable production overhead costs vary with production
volume, and are allocated based on actual usage of production facilities. Any
unallocated overhead should be treated as an expense in the period in which it occurs.

In each of the four cases (merchandising inventory, RM, WIP and FG), we know
conceptually how to measure the left-hand side of the equation (i.e., the cost of the
sources). So the question of how to measure the cost of inventory is equivalent to the
question of how to allocate the cost of the sources between the two alternative uses:
withdrawals and ending inventory. The answer to the latter question depends on two
accounting choices:
 The inventory system - i.e., the method of measuring and recording inventory
transactions (perpetual or periodic)
 The cost flow assumption – i.e., the approach for assigning costs to units (FIFO,
LIFO, average cost or specific identification)

1.2.1 Journal Entries for manufacturing cost flows

For manufacturing firms, the accounting procedures

Accumulate costs incurred to complete the work
Assign costs to the work done

Factory material costs – There are two stages:

As good purchased:

Dr Raw Materials Inventory

Cr Accounts Payable

To transfer costs into production:

Dr WIP Inventory (direct materials)
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 Dr Manufacturing Overhead (indirect materials)
Cr Raw Materials Inventory

Factory labor costs:

Dr WIP Inventory (direct labor)
Dr Manufacturing Overhead (indirect labor)
Cr Factory Labor (total labor used)

Manufacturing overhead – using predetermined overhead application rate to assign costs

to products:

Dr WIP Inventory
Cr Manufacturing Overhead

Assigning costs to finished goods – when jobs finished, total costs accumulated in WIP
are assigned to completed products:

Dr Finished Goods Inventory

Cr WIP Inventory

Assigning costs to products as goods are sold – two stages:

To transfer costs to products sold:
Dr Cost of Goods Sold
Cr Finished Goods Inventory
To record sale:
Dr Accounts Receivable
Cr Sales Revenue

Under- or overapplied manufacturing overhead

 Overheads are allocated using predetermined rate
 Costs allocated may not equal actual costs
o Underapplied: assigned costs less than actual costs incurred
o Overapplied: assigned costs greater than actual costs incurred

End-of-period adjustment usually taken directly to Cost of Goods Sold:

For Over-allocation:
Dr Manufacturing Overhead
Cr COGS

For Under-allocation:
Dr COGS
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 Cr Manufacturing Overhead

Estaimating cost of productions

Example: Intel

Estimate the cost of productions based on the information available.

COGS = $15,556

1. Start by adjusting inventories and COGS to FIFO (if the firm uses LIFO)
Finished Goods
BB FG + Finished – COGS = EB FG
Finished = EB FG + COGS - BB FG

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 Work in Process
BB WP + Used + Production costs – Finished = EB WP
BB WP + cost of production – Finished = EB WP
cost of production = EB WP - BB WP + EB FG + COGS - BB FG

In this example, cost of production = 14918

1.3 Inventory system and cost flow assumption, LIFO vs FIFO

1.3.1 Inventory system
Perpertual system
All inventory transactions are recorded as they occur
Periodic systme
Inventory and COGS are determined at the end of the period

1.3.2 Cost Flow Assumption

 First-in-fist-out (FIFO): COGS is based on old costs; ending inventory is based on
recent costs
 Last-in-first-out (LIFO): COGS is based on recent costs; ending inventory is
based on old costs
 Weighted average: Both COGS and ending invnetopry are base don average costs
 Specific Identificiation: Units in COGS and ending inventory are assigned their
actual csots

FIFO is the most commonly used assumption, followed by LIFO, weighted average then
specific identification. Many companies use more than one cost flow assumption. For
example, it is quite common to see LIFO for domestic inventories and FIFO or weighted
average for foreign inventories. LIFO companies typically have significant investments
in inventory and oeprate in industries where product costs are generally increasing over
time.

A summary of the effect of valuation method on COGS and Inventories:

FIFO LIFO
Inventory recent prices older (may be very old) prices
Cost of goods sold older prices recent prices
If prices are rising: lower COGS higher COGS
higher net income lower net income

1.3.3 LIFO and LIFO Reserves

1.3.3.a So why LIFO?
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  Postpone income taxes – LIFO conformity rule (if choose LIFO for tax purpsoes,
must also choose LIFO for financial reporting)
 Better matching of costs against revenue
 Ability to manipulate income by timing inventory transaction (e.g., liquidation of
old LIFO layers)

1.3.3.b So why NOT LIFO?

 Understated inventory, assets and equity
 Understated income for growing companies
 Investor concerns regarding earnings quality (e.g., LIFO effects)

Under FIFO, the cost of any units purchased will eventually be included in the cost of
goods sold. On the other hand, under LIFO, if the firm purchases sufficient quantities of
inventory, the costs in the beginning inventory may never be included in the cost of
goods sold. (These costs will remain in the inventory as a "LIFO layer.")

1.3.3c LIFO Reserves - additional disclosure

In the US, due to tax code requirements, many companies are using LIFO as their
inventory cost flow assumption. A company that values its inventories under LIFO, must
disclose its LIFO Reserve (also called the Allowance to reduce inventory to LIFO) which
is the difference between inventories valued at LIFO and inventories valued under current
replacement cost (usually FIFO).

This measures the potential effect of inventory liquidation. It is also important because it
enables users of financial statements make better comparisons of firms using different
valuation methods (in particular, it facilitates comparing inventory turnover ratios as well
as current ratios). The change in the allowance balance from one period to the next is
called the LIFO effect.

The LIFO Reserve is the difference between the FIFO cost of inventories and the book
value of inventories (which it is at least partially based on the LIFO assumption):

LIFO reserve = InventoryFIFO – InventoryLIFO.

The Income statement effects of using LIFO:

For merchandising firms, the inventory equation states that:

COGSFIFO = BIFIFO + Purchases - EIFIFO

COGSLIFO = BILIFO + Purchases – EILIFO

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(Purchases are independent of the cost flow assumption).1

Subtracting (1) from (2) and rearranging terms:

COGSLIFO - COGSFIFO = (EIFIFO – EILIFO) - (BIFIFO – BILIFO) = LIFO Reserve

The change in the LIFO reserve from one period to the next is called the LIFO effect. It
indicates the amount by which COGS exceeds (falls below – when it is negative) the
amount that would have been reported had the company used FIFO in valuing all its
inventories.

Since COGS is deducted in the calculation of pre-tax income:

Pre-tax incomeLIFO – Pre-tax incomeFIFO = - LIFO Reserve

And the difference between the reported income tax expense and the amount that would
have been reported had the company used FIFO in valuing all its inventories is

(5) Income tax expenseLIFO - Income tax expenseFIFO = - LIFO reserve  tax rate.

The difference in net income is therefore

(6) Net IncomeLIFO - Net IncomeFIFO = - LIFO reserve (1 - tax rate).

The balance sheet (cumulative) effects of using LIFO:

As retained earnings are equal to cumulative net income since the formation of the
company, and the LIFO effect on net income is to reduce net income by the change in the
LIFO reserve multiplied by one minus the tax rate, we have:

(7) Retained EarningLIFO – Retained EarningsFIFO = - LIFO reserve (1 - tax rate)

1
In the context of manufacturing companies, “inventory” includes all three components
(RM, WIP, and FG), and “purchases” is equal to the sum of raw material purchased
during the year (i.e., the addition to the RMI account) and production costs other than raw
material (i.e., the additions to the WIPI account other than raw material). With these
definitions, equations (1) and (2) hold for manufacturing companies too, and so all the
LIFO effects described below hold as well.
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Companies that use LIFO for financial reporting typically also use LIFO for tax
reporting. We emphasized many time before that financial and tax reporting choices are
independent. This is true in general, but not when a company uses LIFO for tax
reporting. The tax code specifies that if LIFO is used for tax reporting, it must also be
used for financial reporting. As tax considerations are the primary reason for the use of
LIFO, we can assume that whenever LIFO is used in the financial statements it is also
used for tax reporting. Thus, the cumulative amount of taxes postpone by the use of
LIFO is:

(8) Cumulative taxes postponed by the use of LIFO = LIFO reserve  tax rate.

So, under the assumption that the taxes that the firm postponed were invested in current
assets, we can summarize the balance sheet effects of LIFO (relative to FIFO) as follows:
Inventory is lower by the amount of the LIFO reserve
Other current assets are higher by the product of the LIFO reserve and the tax rate
Retained earnings are lower by the product of the LIFO reserve and one minus the tax
rate.

Examples of the LIFO Effect (∆ LIFO Reserve)

The most likely explanation for an increase in the LIFO reserve over a period is an
increase in average costs. Decreases in the LIFO reserve are typically due to falling costs
or depletion (liquidation) of LIFO layers.

Example 1:

Assume the following transactions:

Year 1: bought 2 units for $10 each and 3 units for $12 each; sold 3 units.
Year 2: bought 2 units for $15 each; sold 2 units.
Year 3: bought 2 units for $11 each; sold 2 units.

Assume further that the company uses LIFO and that the marginal tax rate is 40%.

Solution to example 1:
LIFO LIFO COGSLIFO NIFIFO –
Year EILIFO EIFIFO reserve reserve - COGSFIFO NILIFO
1 2*10 2*12 4 4 4 2.4
2 2*10 2*15 10 6 6 3.6
3 2*10 2*11 2 -8 -8 -4.8

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The LIFO reserve increased as costs rose and decreased as costs fell.

Example 2:

Assume the following transactions:

Year 1: bought 4 units for $10 each; sold 1 unit.
Year 2: bought 4 units for $12 each; sold 3 units.
Year 3: bought 2 units for $12 each; sold 5 units.

Assume further that the company uses LIFO and that the marginal tax rate is 40%.

Solution to example 2:

LIFO LIFO COGSLIFO NIFIFO –

Year EILIFO EIFIFO reserve reserve -COGSFIFO NILIFO
1 3*10 3*10 0 0 0 0
2 3*10+1*12 4*12 6 6 6 3.6
3 1*10 1*12 2 -4 -4 -2.4

Note:
 The LIFO reserve increased as costs rose from period 1 to period 2.
 The first period LIFO layer was "dipped into" in the third period.
 The LIFO reserve decreased in the third period because lower cost layers in the
LIFO inventory had been sold.
 The LIFO cost of goods sold was less than the FIFO cost of goods sold in the
third period because costs in the older LIFO layer were included in the third
period’s cost of goods sold. Net income was thus higher for the LIFO firm than
the FIFO firm, and due to the LIFO conformity rule, this means taxes were higher
for the LIFO firm as well (for the year, not cumulative).

1.3.4 Income manipulation under LIFO

Under LIFO, COGS includes the latest units purchased. So if prices are rising, managers
can reduce income by purchasing abnormal quantities of inventories close to the end of
the year, and they can increase income by postponing normal purchases (and so
liquidating old LIFO layers.

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Example 3:

On December 1, 2015, the firm purchased 100 units at $70 per unit. On December 21 the
firm sold 90 units for $90 each.

Income statement
Sales 8,100
COGS (90*70) (6,300)
1,800

Suppose the purchase price on December 25 was $85. If the firm uses LIFO it can reduce
reported income by purchasing new units. For example, if the firm buys 90 units, the
income statement would be:

Income statement
Sales 8,100
COGS (90*85) (7,650)
450

Note that
 COGS is based on units we did not have on the date of sale.
 Under FIFO, this type of income manipulation does not work.

This solution assumes a periodic inventory system. The same type of income
manipulation is also possible when the firm uses the perpetual inventory system, but to a
lesser extent. However, it is probably a safe assumption to make that whenever a
company assumes LIFO, it uses the periodic inventory system (which maximizes the
benefits of LIFO).

1.4 Quality issues – reported inventory

 Manipulating inventory write downs
 Timing inventory transactions to manipulate reported income (LIFO and weighted
average), especially liquidation of old LIFO layers
 Misrepresenting inventory including in inventory items that do not belong to the
company (e.g., consignment, bill and hold sales) or misrepresenting quantities or
types of items owned
 Capitalizing costs which are not directly related to the acquisition or
manufacturing of inventory
 Over-producing to reduce fixed cost per unit and increase reported income

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1.5 How to detect inventory manipulation
1. Inventory/COGS
A high level or increase in this ratio may indicate accounting quality or economic issues,
especially when focusing on finished goods and work in process inventory:

Accounting issues
 Excess capitalization of inventory costs
 Over production to reduce reported cost per unit
 Old and potentially obsolete inventory items that should have been written down

Economic issues
 Inefficient inventory management
 Difficulties in selling inventory
 Low liquidity of inventories

2. Accounts Payable/Net Purchases

Large changes in this ratio may indicate financial difficulties. An increase in the ratio
may suggest company’s inability to pay. A decrease in the ratio may suggest loss of
vendors’ confidence in the company. A relative stable high level indicates market power
over vendors
Note: i. to estimate purchases, Purchases = ∆Inv + COG.
ii. accounts payable may include liabilities unrelated to net purchases

3. Steps in converting from LIFO to FIFO

 Increase inventory by LIFO Reserve
 Reduce other assets by LIFO Reserve * marginal tax rate (tax)
 Increase Retained Earnings by LIFO Reserve * (1- tax)
 Reduce COGS by ∆LIFO Reserve
 Increase income tax expenses by ∆LIFO Reserve*tax
 Increase Net Income by ∆LIFO Reserve*(1-tax)

4. Using off balance sheet transaction to mask inventory

To boost earnings or improve reported financial ratios, a company may choose to move
inventory into a joint venture or other off-balance sheet entity. A careful reading and
analysis of joint venture disclosures will help identify whether a significant increase in
inventory might have been shifted off-balance sheet. For example, a joint venture may
produce and sell inventory to the parent company. The parent company may control the
purchases of inventory from this entity. Therefore, financial analysis of the parent
company’s inventory balance may be obfuscated by inventory increasing on the balance
sheet of the joint venture partner.

1.6 Disclosure- Inventory

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It is typical to find the following disclosure related to inventory:
 The cost of inventory is shown on the balance sheet.
 The basis for stating inventories, any changes in this basis, and the impact of such
a change on net income
o The accounting policy applied for inventory (e.g., LIFO vs. FIFO) will
typically be described in the summary of significant accounting policies
following the financial statements. The Inventory footnote provides more
detailed information on significant inventory items.
o The amount of the LIFO reserve or the excess of current cost over LIFO
cost, as well as the net income effect of dipping into LIFO layers, are often
disclosed in the inventory footnote. The SEC requires that the excess of
current replacement cost over LIFO cost and the income effect of
depleting LIFO layers be disclosed in 10-K filings (since the early 1970's).
Many firms also disclose these numbers in their annual reports. The FIFO
cost of the inventory may be used to approximate the replacement cost of
the firm's inventory if it is not materially different.
 Inventories are typically aggregated into inventory pools, with similar products
lines in each pool.
 Any goods that are stated above cost
 Any goods that are stated at their sales prices
 Significant estimates applicable to inventories
 Also, if the amount of a loss from the application of the lower of cost or market
rule is substantial, the amount should be disclosed as a separate line item in the
income statement.

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Part II: Property, Plant and Equipment
2. Property, Plant and Equipment – Cost and Depreciation

2.1 Cost
Property, plant and equipment (PP&D) are long-lived assets that provide the firm with
operating capacity and have physical substance. PP&E are reported on the balance sheet
at cost less accumulated depreciation, possibly adjusted downward for impairment.

Cost includes all expenditures attributable to bringing the asset operable.

For assets that require significant construction periods, cost also includes interest on
borrowing during construction that could have been avoided had construction not
occurred. In order to capitalize interest during construction, construction must have
begun, expenditures on construction had been made, and interest costs had been incurred.
The amount of interest capitalized depends on the amount and timing of expenditures and
the amount of cost of borrowings.

For assets that require significant dismantlement, restoration, or other disposal

expenditures¸cost includes the present value of expected cash outflows at retirement.
This is typical for oil and gas production facilities, nuclear facilities, mining and chemical
industries. An asset retirement obligation is recognized to balance the addition to the
asset cost; the accretion of the liability over time is included in operating expenses. The
present value of changes in expected cash outflows is recognized as an increase or
decrease in both the asset and liability.

More specifically:
Acquisition Dr PP&E
Cr Cash
Cr Asset retirement obligation
Periodically Dr Depreciation
Cr Accumulated Depreciation

Dr Accretion Expense
Cr Asset retirement obligation*
*note: present value increases overtime for liability
Retirement Dr Asset retirement obligation
Cr Cash

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Assets could be acquired without paying cash. Noncash asset acquisition includes:

Assets acquired by issuing debt or equity instruments:

Assets and financial instrument recorded at the estimated fair value of the asset or
financial instrument, whichever is more readily determinable

Assets acquired in exchange for other assets:

 For exchange with commercial substance (dissimilar assets where the future
cash flows are expected to change significantly), new asset is recorded at its
estimated fair value, the resulting gain or loss is recognized in income.
 For exchange with no commercial substance (similar assets), new asset is
recorded at the book value of the old asset.

Assets acquired in combined transaction:

The total of the acquisition cost and fair value of any liabilities assumed is allocated to
the assets acquired based on their relative fair values

Assets acquired in business combinations:

Generally recorded at estimated fair value.

Subsequent expenditures are capitalized if they extend the asset’s useful life or increase
the quantity or quality of the asset services beyond original expectations. Additions,
replacements and improvements are generally capitalized. Repairs and maintenance
expenditures are generally expensed as incurred. There is significant discretion to
expense or capitalize subsequent expenditures.

2.1.1 Depreciation
Depreciation is the procedure of allocating the depreciable cost of PP&E to the periods in
which the entity consumes the asset’s benefits.

Depreciable cost = cost – residual value

Residual value = estimated proceeds from selling the asset at the end of its economic life

Assets are depreciated over their expected economic useful life, which is often shorter
than the physical life. Land is not subject to depreciation but land improvements are
typically depreciated.

Assets held for sale are not depreciated (already reported at the lower of cost or fair value
less cost to sell). Assets under construction are not depreciated, depreciation will only
begin after the assets are completed. Idle assets are depreciated.

Firms may select one or more of several alternative depreciation methods:

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 - Straight-line-method: same amount of depreciation each period of use. This is the
most commonly used method.
- Unit-of-production method: same amount of depreciation for each unit of
output/input
- Accelerated depreciation: larger amount of depreciation in the early years of the
asset useful life. Methods include double-declining balance, sum-of-the-year-
digit.
- Modified Accelerated Cost Recovery System (MACRS) for tax purposes: this is
similar to double-declining balance but it assumes zero salvage value, has specific
depreciation period for each asset class, assumes that the asset is purchased and
retired at the middle of the fiscal year, and uses 150% or 100% (instead of 200%
under double-declining balance) for different asset class.

2.1.2 Assets classified as held for sale

When an entity wishes to dispose of or liquidate it. It must meet all of the following
criteria:
 Management commits to a plan to sell or dispose of the asset
 The asset is available for immediate sale in its current condition
 There is an active program to locate a buyer
 The sale is probable, and should be complete within one year
 The sale price of the asset is reasonable in relation to its fair value
 It is unlikely that the plan to sell will be altered or withdrawn

2.2 Asset Impairment

Assets are subject to impairment tests when there is an indicator of impairment. For
example:
 Signifciant decrease in the asset's market price
 Significant adverse change in the asset's manner of use, or in its physical
condition Significant adverse change in legal factors or the business climate that
could affect the asset's value
 Excessive costs incurred to acquire or construct the asset
 Historical and projected operating or cash flow losses associated with the asset
 The asset is more than 50% likely to be sold or otherwise disposed of significantly
before the end of its previously estimated useful life

Impairment tests should be performed at the asset group level. An asset group is a unit of
accounting, which represents the lowest level for which identifiable cash flows from one
or more assets are mostly independent of the cash flows of other asset groups.

An impairment loss is recognized if carrying amount of the asset or asset group is greater
than the undiscounted cash flows expected to result from the use and eventual disposition
of the asset or asset group. (Expected cash flows should be net of future capital
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expenditures require to obtain the benefits from the asset or asset group.) The
impairment loss is measured as the difference between the fair and book values of asset
or asset group.

These cash flow estimates should incorporate assumptions that are reasonable in relation
to the assumptions the entity uses for its budgets, forecasts, and so forth. If there are a
range of possible cash flow outcomes, then consider using a probability-weighted cash
flow analysis. If there are multiple assets in the asset group being tested, then use as the
remaining useful life of the group the remaining useful life of the primary asset in the
group (which cannot be land or an intangible asset that is not being amortized).

Example: Expected cash flows and impairment losses

A manufacturing facility with a carrying amount of $48 million is tested for impairment.
Two courses of action are under consideration:

The expected cash flows are $44.1 million (undiscounted), which is less than carrying
amount of $48 million. An impairment loss needs to be recognized.

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To recognize impairment loss, the company needs to estimate the fair value of the
facility (which is generally the present value of the expected cash flows). For example, if
the fair value is $35 million, the following entry would need to be made:

Dr Accumulated Depreciation/ PP&E $13

Cr Impairment Loss $13

2.2.1 Impairment losses

Impairment losses are typically classified as an unusual item in the income statement.
Although we have seen firms occasionally include impairment charges in COGS or
SG&A. Reversal of impairment losses are prohibited.

When recognizing an impairment loss, the new carrying amount of the asset is its former
carrying amount, less the impairment loss. This means that the depreciation of that asset
should now be calculated using its now-reduced carrying amount.

An impairment loss for an asset group is allocated to the long-lived assets in the group
based on their relative carrying amounts (Goodwill, indefinite-lived intangibles are tested
for impairment separately and are excluded from this loss allocation).

Example: Allocating an impairment loss

A manufacturing facility with long-lived assets A-D, current assets and liabiltiies, with an
aggregated $2.75 million is tested for impairment. The test indicates an impairment of
$600,000. The loss is allocated to the long-lived assets as follows:

2.3 Quality Issues – reported PP&E

 Excess capitalization

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  At acquisition: costs which are not directly related to the acquisition of an asset or
its preparation for use
 After acquisition: repair and maintenance or other costs which do not improve the
asset or extend its life
 Manipulating depreciation estimates (useful life, residual value)
 Manipulating impairment charges (impairment indicator, asset grouping, amounts
and timing of expected cash flows, discount rate)
 Manipulating cost estimates (especially assets acquired in noncash transactions,
asset group, or business combination transactions, asset retirement obligations)
 Interest Capitalization (mixing financing with operating/investing activities)
 Manipulating the classification of assets as depreciable (for construction in
progress and assets held for sale)
 Using noncash transaction purchasing capital expenditures

2.3.1 Depreciation add-back vs depreciation expensed

Depreciation expensed is not the same as depreciation add-back on the statement of cash
flows. For growing companies, depreciation expensed < depreciation add-back. For
declining companies, depreciation expensed > depreciation add-back.

Example: Depreciation expense vs depreciation add-back

Company A’s only activity in year 1 is to produce inventory. The only production cost is
$100 depreciation. This is included in the ending inventory at end of year 1. In year 2,
the only activity is to sell the inventory for $300.

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In this example, the difference between the depreciation addback and depreciation
expense is equal to the change in inventory.

2.4 Ways to detect PP&E manipulation

1. Net PP&E/Sales
A high level or an increase in this ratio may indicate

Accounting quality issues

 Overstated cost estimates of assets acquired in non-cash or combined
transactions
 Excess capitalization
 Insufficient depreciation (overstated useful lives or residual values)

Economic issues
 Over-investment
 Inefficient asset utilization

2. Depreciation Expense/Total Sales

Especially when comparing two companies with similar profiles, the lower ratio may
indicate more aggressive depreciation policies/assumptions.

3. Free Cash Flows vs Earnings

Opposite trends in free cash flow and earnings, where free cash flow is small or
declining, suggest that firm may be overcapitalizing operating expenditures.

4. Estimating the average useful life of the assets

Gross PP&E(t-1) / Depreciation Expense (t)= average useful life
The longer the depreciable useful life, the lower the depreciation expense, the more
likelihood of reporting higher net income.

5. Accumulated depreciation/ depreciation

A high level of this ratio indicates the old (and typically small) historical costs are used to
measure assets and depreciation.

6. Accumulated Depreciation/Gross PP&E

The higher or increase in the ratio indicates more potential need for future capex. In
estimating the age of the assets, multiply this ratio by useful life.

7. Net PP&E/Depreciation Expense

This approximates the remaining depreciable years. The fewer remaining depreciable
years, the greater potential need for future capex.

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8. Impairment or disposal losses
Large and frequent impairment charges or disposal losses suggest that the firm
overcapitalizes operating expenditures or overstates the assets’ useful lives or residual
values.

9. Asset replacement ratio (capex*/depreciation)

A high level or an increase in this ratio may indicate excess capitalization, over-
investment, insufficient depreciation, or that recorded assets and related depreciation are
significantly smaller than their current values.

10. Capex*/sales
A high level or an increase in this ratio may indicate excess capitalization or over-
investment.

11. Growth in capex*

A high level of this ratio may indicate excess capitalization or over-investment.

*capex should include both cash and noncash expenditures. Capex (maintenance) is the
cash counterpart of depreciation.

Example: Quality of reported PP&E and Depreciation

Evaluate the quality of reported PP&E and depreciation of Company C in 2008.

Company D is a peer company.

The PP&E/Sales ratio of Company C declined gradually over the last five years, suggesting that material
earnings overstatement related to PP&E is unlikely. The other ratios were relatively stable, at least in
recent years, again suggest that material earnings overstatement is unlikely. A similar conclusion emerges
from the cross sectional comparison. The two companies have very similar ratios and trends, except that

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Company C is more capital intensive. Neither companies appears to grow organically, as the
capex/depreciation is close to one. Alternatively, it may be that the company makes noncash acquisition of
PP&E, which are not reflected in the capex ratios (if noncash capex was included, the ratios would have
been more informative). In addition, business combinations, which increase PP&E and depreciation, are
not captured by capex. A comparison of the useful life and average age estimates suggest that most assets
are in the latter parts of their useful year, which in turn suggest that the companies are on average in the late
maturity or declining stages of their product life cycles.

12. Accrued capital expenditures

There are situations in which a company purchases capital expenditures, but has not yet paid
for them in cash. The balance sheet impact is to increase property, plant, and equipment and
increase an accrued liability. Since no cash has been expended for the property, there is not a
cash outflow shown for such expenditures under capital expenditures on the cash flow
statement. Rather, the company records capital expenditures on the cash flow statement (an
investing cash outflow) when the amounts are actually paid in cash in a subsequent period.

For example, see below Pep Boys (PBY) supplementary cash flow information in their 2014
10-K:
2014 2013 2012

2.5 Disclosure – PP&E

 Depreciation expense
 Totals for the major classes of depreciable assets
 Accumulated depreciation
 Description of the methods used to compute depreciation
 Describe the impaired asset or asset group, and the circumstances leading to the
impairment
 The amount of the impairment loss
 The method used to determine fair value
 If a public company, the segment in which the impaired asset is reported

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Part III: Intangibles
3.1 Acquired vs Internally Generated Intangible Assets
Intangible assets are long-term assets other than financial instruments that lack physical
substance. Examples include brand names, patents, trademarks, franchises, copyrights,
permits, licenses, etc.

Intangible assets are either developed internally, acquired from others directly or via
business combination (more common). While acquired intangible assets are capitalized,
most internally-generated intangible assets are omitted from the balance sheets. Research
and development costs are typically expensed as incurred. Exceptions to capitalized
R&D include: direct-response advertising, software developed for internal use, and
software developed for sale to third parties. Acquired “in-progress R&D” can be
capitalized since 2009.

Intangible assets are classified as either goodwill, finite-lived, or indefinite-lived on the

balance sheet.

3.1.1 Goodwill
Intangible assets are reported separately from goodwill if they arise from a legal right or
are separable from the business. Goodwill reflects the fair value of all other intangibles
including human capital, customer base, expected synergies, and (possibly) overpayment.

Goodwill is measured as the excess of fair value of the consideration transferred and
other equity claims (previous holdings, non-controlling interests) over the fair value of
the business’ net identifiable assets. Goodwill is not amortized but are subject to
impairment test annually and when there are indicators of impairment. The impairment
test must be performed at the same time each year. Impairment loss is recognized if
carrying value> fair value.

Impairment is tested at the reporting unit level and is recognized only if the reporting
unit’s fair value is lower than its book value. A reporting unit is typically an operating
segment or one level below an operating segment.

The best source of information for the fair value of a reporting unit is from a quoted
market price in an active market, followed by a valuation technique based on multiples of
earnings or revenue. Compare the implied fair value of the reporting unit's goodwill with
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its carrying amount. To calculate implied fair value, allocate the fair value of a reporting
unit to all of its assets and liabilities, including any unrecognized intangible assets, just
like accounting for a business acquisition and the fair value was the price paid to acquire
it. The implied fair value of goodwill is the excess of the fair value of the reporting unit
over the amounts assigned to its assets and liabilities.

Effective 2012, firms may avoid goodwill impairment if qualitative factors suggest that it
is not likely that goodwill is impaired.

Example: Impairment test for goodwill

Company A has three reporting units. Calculate goodwill impairment.

Answer: Only Unit 3 will report a goodwill impairment of $150.

3.1.2 Intangible assets with finite lives

Intangible assets with finite lives are accounted for the same as PP&E. A class of
intangible assets is a group of assets having a similar nature and use in an entity's
operations. Examples of intangible asset classes are brand names, copyrights, franchises,
licenses, models, patents, and recipes.

A defensive intangible asset is an intangible asset acquired by an entity which does not
intend to actively use the asset, but instead intends to hold the asset to prevent others
from using it. A defensive asset rarely has an indefinite life, because its effect diminishes
over time due to various competitive factors.

Costs associated with internal-use software development are either charged to expense
as incurred or capitalized. Most costs including preliminary project stage, post-
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implementation and operation stage (involves training and maintenance) should be
expensed as incurred. Costs incurred during application development stage (such as
software coding, hardware installation and testing) can be capitalized. For upgrades and
enhancements, only capitalize these costs if it is probable that they will result in
additional functionality. If an upgrade is essentially maintenance, it should be expensed.
The useful life used for amortization is typically 3 to 5 years as technological
obsolescence or product displacement may occur over longer periods of time.

Certain website development costs can be capitalized. Costs during (i) application and
development stage activities such as the acquisition of software tools, buying an Internet
domain name, developing code, purchasing various types of hardware, installing
applications on web servers, and testing applications and (ii) graphics development stage
such as web page design, color, images, and the general look and feel of the site can be
capitalized.

3.1.3 Intangible assets with indefinite lives

Intangible assets with indefinite lives are not amortized but are subject to impairment test
annually and when there are indicators of impairment. The impairment test must be
performed at the same time each year. Impairment loss is recognized if carrying value is
greater than fair value.

3.1.4 Internally generated intangibles vs acquired intangibles

Example:
A start-up is formed on January 1st 2001 with 2,500 with cash and 500 loan. The firm
incurred $200 operational costs in 2001. Assume no tax.

Case A: The firm develops R&D on its own ($300). In the years 2002 and 2003 the firm
generates $1,000 in revenues and $400 operating costs, not including R&D expenses

Case B: the firm purchases R&D for $300. The firm assessed the useful life of the asset
to be two years. In the years 2002 and 2003 the firm generates $1,000 in revenues and
$400 operating costs, not including R&D expenses

Observe time-series pattern of RNOA for both cases.

3.2 Quality issues –Intangible assets

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  Improperly capitalizing intangibles
 Manipulating fair value estimates of acquired intangibles
 Classifying finite-life intangibles as having indefinite life
 Overstating the useful lives of finite life intangibles
 Manipulating impairment charges
 Misclassifying operating expense as R&D or advertising
 Cutting or timing investments in R&D, advertising, human capital or other
internally-developed intangibles
 Conducting R&D via non-consolidated partnerships or joint ventures to avoid
having to expense the R&D
 Conducting R&D for non-consolidated partnerships or joint ventures and
recognizing fee revenue, which effectively offsets the R&D expense

3.3 Ways to detect manipulations of Intangible asset

1. Intangibles/Sales
A high level or increase in this ratio may indicate:

Accounting issues
 Overstated fair value estimates at acquisition
 Designation of finite-life intangibles as having indefinite lives
 Excess capitalization of internally-generated intangibles
 Insufficient amortization (e.g., overstated useful lives)
 Impaired intangibles that should have been written down
 New business combinations

Economic issues
 Overinvestment
 Overpayment (goodwill)
 Inefficient asset utilization
 New business combinations

2. Finite-life intangibles/amortization
A high level may indicate overstated useful life.

3. Impairment losses
Large or frequent impairment charges suggest that the firm overstates the fair values
or useful lives of intangible assets.

4. R&D/Sales or Advertising/Sales
The level and change in this ratio has implications on current earnings quality and
future earnings. Since R&D are expensed during the period when the expenditures
are incurred, when firms cut R&D, it increases current earnings but it is detrimental to
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 future earnings. Problems with this indicator include: operating expenditures
classified as R&D, unreported R&D (via joint ventures, partnership). For firms with
significant advertising expenses, advertising/sales provides similar information.

5. R&D capitalization
It is common for some analysts to estimate the amount of R&D capital and capitalize
it on the balance sheet. Steps in R&D capitalization include:
1. Increase intangible assets by R&D capital
R&D Capitalt = (4/5)*R&Dt+ (3/5)*R&Dt-1+ (2/5)*R&Dt-2+(1/5)*R&Dt-3
2. Increase Deferred Tax Liability by R&D Capitalt x marginal tax rate
3. Increase equity by R&D Capitalt x (1- marginal tax rate)
4. Add R&D expenditures back to operating income (typically in SG&A)
5. Subtract R&D amortization from operating income
6. Adjust the income tax expense accordingly

3.4 Disclosure - Intangibles

 Aggregate amount of goodwill, as a separate line item in the balance sheet
 Aggregate amount of goodwill impairment losses, as a separate line item in the
income statement
 Goodwill impairment associated with a discontinued operation
 Changes in the carrying amount of goodwill during the period
 The amount of any unallocated goodwill and the reasons for not allocating it
 For each goodwill impairment loss, describe the facts and circumstances leading
to the impairment, the amount of the impairment, and the method used to
determine the fair value of the associated reporting unit
 For those intangible assets subject to amortization, both in total and by major
asset group the total amount of intangible assets acquired, significant residual
values, and the weighted-average amortization period are reported
 For those intangible assets not subject to amortization, both in total and by major
asset group the total amount of intangible assets acquired are reported
 The amount of research and development assets acquired in the period, written off
in the period, and the income statement line item in which the write-offs are
aggregated.
 For those intangible assets subject to amortization, the gross carrying amount,
accumulated amortization, amortization expense for the period, and the estimated
amortization expense for each of the next five years.
 For those intangible assets not subject to amortization, the total carrying amount.
The policy on treating costs incurred to renew or extend the terms of intangible
assets.
 For those intangible assets not renewed or extended in the period, the costs
incurred in the period to renew or extend the assets.
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  For intangible assets having renewal or extension terms, the weighted-average
period before the next renewal or extension, broken down by major asset class.

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Part IV: Other Assets
4. Other Assets
Assets that are technically individually immaterial and do not belong to any of the other
categories can be grouped under “other assets”. However, we often see Intangible assets
being aggregated together with other assets. Examples include debt issuance costs, long-
term prepaid rent, deferred compensation, deferred taxes, long-term receivables (e.g.,
from insurance), security deposits, restricted cash, cash surrender value of life insurance
policies, derivatives, property currently not used in operations. Most items classified as
“other assets” are reported at historical cost or amortized cost.

Other assets/Sales is often computed. A high level or increase in this ratio may indicate
earnings overstatement as (i) expenditures that should have been expensed were
capitalized and hidden in “other assets” and/or (ii) revenues or gains associated with low
quality assets (e.g., long term receivables that may be problematic to collect) are hidden
under “other assets”.

Annual disclosure of the following is required:

 Any other current assets > 5% of total assets
 Any other non-current assets > 5% of total assets
 Deferred costs > 5% of total assets

4.1 Direct Response Advertising

Direct-response advertising involves activities where the audience can be shown to have
responded specifically to an advertising campaign. Direct-response advertising costs
(such as idea development, writing advertising copy, artwork, printing and mailing,
magazine space, payroll costs and portion of employee time spent specifically on direct-
response advertising) can be capitalized when there is a reliable and demonstrated
relationship between total costs and future benefits resulting directly from the incurrence
of those costs.

For example, an entity has reliable evidence that, if it sends out 100,000 pieces of direct-
mail advertising, it will receive 2,500 responses. Thus, the cost of obtaining 2,500
responses is the cost incurred to send out the 100,000 mailings. With such information,
an entity can use historical information to make reliable predictions about the relationship
between current expenditures required to obtain future revenue. If such historical
information is available, then advertising costs can be accrued and charge them to
expense when the related revenue is recognized.
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There is no limit to the period over which you can amortize advertising costs. However,
since the reliability of accounting estimates decreases over time, the amortization period
is typically no more than one year or one operating cycle. The duration of amortization is
driven by the type of advertising; many campaigns only last for a few months, while the
impact of a mail order catalogue may be substantially longer.

Example: AOL
In the event where costs such as “Subscriber acquisition costs” are capitalized, one could
easily adjust operating income as if all costs were expensed immediately (instead of
being capitalized and amortize over the operating cycle). In the example below, AOL
capitalized its Subscriber Acquisition Costs and amortized the costs over two years, an
analyst could easily calculate what revised net income would look like had those costs
were expensed immediately.

To elaborate further, if one were uncomfortable with the Development costs (part of
R&D that is for software) being capitalized, one could easily calculate the impact on net
income had those costs been expensed immediately.

In this example, AOL expensed its acquired R&D. Technically, AOL was allowed to
capitalize its Acquired R&D. To give AOL its benefit of the doubt, we would not
expense them instead in our calculation of revised net income.

Observe the time series patterns of net income prior and post adjustments.

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