ACC201

Assets and Liabilities

 Long Lived Assets
Depreciation Methods
Straight Line (SL): Simply
divide asset price minus
salvage value by number of
years of useful life
Accelerated schedules result
in moving tax payments
back in time. This creates
value due to time value of
money
 Sum of Year’s Digit (SOYD)
If useful life is N years, add
total of the years, say T
First year fraction to be
depreciated = N/T
Second year fraction to be
depreciated = (N-1)/T
…
Last year fraction to be
depreciated = 1/T
SOYD is an accelerated
depreciation schedule
For example, suppose the life
of the asset is N = 4 years.
Then the fractions are:
first year 4/10
second year 3/10
third year 2/10
fourth year 1/10
Multiply above fractions by
(Initial BV – Salvage Val) to
obtain Depreciation
th
At the end of 4 year
remaining BV will be
reduced to Salvage Val
 Double Declining
Depreciate at Twice the
Straight Line of Total
Remaining Undepreciated
Price
Stop when depreciated
amount reaches Price –
Salvage Value. For the last
year the amount is what
makes total depreciation
equal to Price – Salvage
Value
Example: A firm has
machinery that cost
$60,000,000 and has an
estimated useful life of 4
years. The salvage value will
be $12,000,000. Find the
depreciation under the above
three methods
SL: $60M - $12M = $12M
4
SOYD: First year fraction is
4/10, and Depreciation =
($60M - $12M)*4/10=$19.2M
Second year fraction is 3/10,
and Depreciation =
($60M - $12M)*3/10=$14.4M
etc.
DD: First Year is double of
SL (without salvage value)
= $60M * 2 / 4 = $30M
Remaining Balance = $60M -
$30M = $30M
Second Year is double of SL
of remaining balance
= $30M * 2 / 4 = $15M
Remaining Balance = $30M -
$15M = $15M
Second Year is double of SL
of remaining balance
= $30M * 2 / 4 = $15M
Remaining Balance = $30M -
$15M = $15M
Third Year is double of SL of
remaining balance
= $15M * 2 / 4 = $7.5M
But value left to be
depreciated is < $7.5M as:
Price – Salvage Value =
$48M
If $7.5M was depreciated
then total value depreciated
would add to:
$30M + $15M + $7.5M =
$52.5M > $48M
Maximum depreciation
possible for year 3
= remaining value
= depreciation for year 3
= $48M - $45M = $3M
Year 4 depreciation is $0
All numbers $M
Year S/L SOYD DD
1 12 19.2 30
2 12 14.4 15
3 12 9.6 3
4 12 4.8 0
 Units of Production
If a machinery has a useful
life of N units, and during an
accounting period it is used
for M units, then the
depreciation will be
(M/N)*Price
 Depletion
If a natural resource can
produce N units, and during
an accounting period M
units have been produced,
then the depreciation will be
(M/N)*Price
For example, an oil well, or a
iron ore mine
 Sinking Fund Depreciation
Not allowed in the US
IRR = Cash Flowt – Depret
Book Valuet-1
Effect of the following on NI,
Equity, Assets, ROA, ROE,
Taxes and Turnover in the
early years of the asset:
A) Straight Line Versus
Accelerated Methods
B) Depreciable Life
C) Salvage value
Early Years S/L Accel
NI G L
Equity G L
Assets G L
ROA G L
ROE G L
Sales/Assets L G
Taxes G L
Cash Flows L G
 Impairment
Remaining Book Value
(Carrying Amount) of asset
= Purchase Price –
Accumulated Depreciation
If the value of the asset as
measured by expected future
cash flows from its use and
disposal is less than carrying
value, then the firm should
recognize Impairment. This
is the Recoverability Test
This could happen due to
increased costs, decreased
demand for product, changes
in government regulations
etc. Management has
discretion in recognizing
Impairment
4 criteria for impairment
(lack of recoverability of
carrying amount):
A) Book Value greater than
discounted value of cash
flows
B) Increased costs
C) Adverse future outlook
D) Worsening business
environment
Under US GAAP, once
Impairment is recognized it
cannot be reversed
Not so for IAS
Amount of Impairment
should be counted as a loss
in the Income Statement
Impairment has no impact
on the Cash Flow statement
Impact of Impairment on
Equity, NI, ROE, ROA, D/E,
Depreciation etc present and
subsequent years
 SFAS 143
SFAS 143 concerns future
liabilities that may happen
due costs of future disposal
of assets. Mostly
environmental cleanup costs
For example, a copper mine
would require cleanup after
its useful life has expired
This expense is recognized
when the asset is bought. It is
referred to as Asset
Retirement Obligation
(ARO)
Firms must recognize the
ARO liability in the period
the asset was acquired
The liability equals the
market value, and if that is
not available the present
value of cash flows that will
be required to extinguish the
liability
An asset equal to the initial
liability is added to the
Balance Sheet, and
depreciated over the life of
the asset
The result is an increase in
both assets and liabilities.
This will affect financial
ratios, for example return on
assets will decline, debt
equity ratio will increase, etc
Each accounting period the
ARO is grown using an
interest rate. You grow the
ARO to reflect increasing
costs (inflation) with time.
The accretion expense will
be an expense on the Income
Statement (even though
there are no cash flows
associated with AROs)
Lower NI due to accretion
expense and also larger
depreciation (assets larger)
D/E is lower
Turnover is lower
ROA and ROE are lower
Interest Coverage is lower
 Inventories
There are 3 forms of costing
for inventories:
FIFO (First In First Out)
LIFO (Last In First Out)
Average
Remember, the above are not
methods for inventory
valuation, but for costing.
Valuation may be done by
LCM (Lower of Cost or
Market)
1) LIFO (Last In First Out)
Latest items (last in) of
inventory are assumed to be
sold first
2) FIFO (First In First Out)
Oldest items (first in) of
inventory are assumed to be
sold first
3) Average Cost Inventory is
valued at average cost. The
costs and values lie in the
range between LIFO and
FIFO
The usual situation is
inflation, increasing prices
with time, rather than
decreasing prices (deflation)
[LIFO Diagram]

LIFO: As the COGS are

recent, it more accurately
reflects current production
costs. However the inventory
is likely undervalued due to
the old prices, leading to
total assets being
undervalued. Result is more
accurate Income Statement
but less accurate B/S
US firms prefer to use LIFO
due to it producing lower
taxes
FIFO: As older items (which
were produced during a time
of lower prices) exit first, this
gives a higher value for
Inventory (remaining items
in inventory) and lower
COGS
Lower COGS => Lower
Costs => Higher EBIT =>
Higher NI & Higher Taxes
Higher Inventory => Higher
Total Assets
Also the remaining items in
inventory show the price of
production more accurately
than the other methods, and
therefore possibly show the
price at which they can be
sold more accurately
Result is less accurate
Income Statement but more
accurate B/S
Example: Suppose a firm
over a year (the accounting
period) has the following
inventory transactions:
Beginning Inventory: 20
Units @ $100 per unit =
$2,000
Purchases during the year:
March 15: 10 units @ $120
per unit = $1,200
July 21: 30 units @ $150 per
unit = $4,500
November 15: 25 units @
$160 per unit = $3,200
The firm sells 60 units
during the year
LIFOCOGS = 25*$160 +
30*$150 + 5*$120 = $9,100
LIFOEnd-Inventory =
20*$100 + 5*$120 = $2,600
FIFOCOGS = 20*$100 +
10*$120 + 30*$150 = $7,700
FIFOEnd-Inventory =
25*$160 = $4,000
Note that sum of COGs and
Inventory are same in both
methods ($11,700), as indeed
they both add up to total cost
of all units sold and
remaining
Actual flow of physical units
in and out of the inventory
has nothing to do with the
accounting method used
The above are Inventory
Costing, not Valuation
methods
Lower of cost or market
(LCM) value is taken as
Inventory value
Cost of Goods Sold + Ending
Value of Inventory =
Beginning Value of
Inventory + Goods
Purchased
Think of Inventory in a box
The amount that exits is
COGS and the amount that
enters is Goods Purchased
In above example:
Goods Purchased = 10*$120
+ 30*$150 + 25*$160 =
$9,700
Begin Value of Inventory =
20*$100 = $2,000
FIFOCOGS +
FIFOEnd-Inventory =
$9,700 + $2,000 = $11,700
And same for LIFO
LIFOCOGS +
LIFOEnd-Inventory =
$9,100 + $2,600 = $11,700
Comparison of impact on
Inventory, Earnings, Taxes,
Cash Flows and B/S due to
three different methods in an
inflationary environment:
 FIFO LIFO
Inventory G L
Earnings G L
Taxes G L
Cash Flows L G
B/S Assets G L
 COGS L G
Profitability G L
Liquidity L G
COGS/Avg L G
Inven
Inven/Sales G L
Inven/Assets G L
GAAP: Inventory is valued
at the lower of cost or
market price (LCM)
Increases in value of
inventory are ignored,
whereas losses need to be
accounted for (holding
period loss)
Increases will result in
greater value when the goods
are actually sold rather than
just sitting in inventory
For comparing firms can do
a FIFO to LIFO conversion,
or vice versa
LIFOReserve =
FIFOInventory –
LIFOInventory
COGSFIFO =
COGSLIFO –
LIFOReserve-End +
LIFOReserve-Beg
If we wish to be conservative
in estimating COGSLIFO
then an rough adjustment is:
COGSLIFO =
COGSFIFO + Higher
Value of Beginning FIFO Inv
due to Inflation that is
BeginFIFO-Inventory
*Inflation rate
When a firm using LIFO
sells more than it purchases
(declining units in Inventory)
the older cheaper units will
be sold, inflating profits (as
cost of production
understated)
This is dipping into the
LIFO reserve, also known as
“LIFO Liquidation”
LIFO reserve can also fall
due to deflation
Difference between
International Accounts
Standards 2 and GAAP
IAS2 says FIFO or Average
Cost methods should be
favored over LIFO
GAAP requires LCM
writedowns to be made for
items separately, whereas
IAS allows aggregates for
similar items
Example: ABC Ltd. reports
the following
Year 2015 2016
FIFO Invent 1,400 1,450
LIFO Reserve 230 265
By LIFO basis accounting:
COGS = 4,150; NI = 120;
Tax rate = 40%; ROE = 6%
1) ABC’s Turnover?
Turnover is COGS divided
by Average Inventory
FIFO Basis Turnover:
2*4,150/(1,400 + 1,450) =
2.9122
LIFO inventory for 2015 =
1,400 – 230 = 1,170
LIFO inventory for 2016 =
1,450 – 265 = 1,185
LIFO Basis Turnover:
2*4,150/(1,170 + 1,185) =
3.5244
Income if ABC used FIFO
basis?
LIFO Reserve has increased
by: 265 – 250 = 15
FIFO basis Income before
Tax would increase by 15
FIFO basis Income after Tax
would be:
120 + 15*(1 – 0.40) = 129
ROE on FIFO basis?
Both Equity and Income will
change
Average Equity by LIFO is:
120/0.06 = 2,000
For FIFO basis we increase
Equity by average tax
adjusted LIFO Reserve:
2,000 + 0.5*(230 + 265)*(1 –
0.40) = 2,148.5
FIFO basis ROE:
129/2,148.5 = 6.004%
 Taxes
Financial statements are:
1) Book (for reporting
purposes)
2) Tax (to compute taxes)
 Terminology
Pretax Income (book) is
reported on I/S
More complete but
cumbersome would be
Income Before Income Tax
for Financial Reporting.
Some authors prefer Book
Income
(Income) Tax Expense (book)
is based on Pretax Income. It
is reported in I/S
Taxable Income (tax) is the
income on which taxes are
computed
Taxes Payable (tax) is tax
liability based on Taxable
Income
Income Tax Paid is actual
cash paid to the IRS during
a year (book). This includes
refunds or payments for
prior years
Tax Expense can be broken
down into: Taxes Payable
(actual tax return liability)
and Deferred Income Tax
Expense
Effective tax rate
= Income tax expense
Pretax Income
Deferred Tax Assets increase
when a timing difference
results in:
Taxable income > Pretax
Income
Leading to: Taxes Payable >
Income Tax Expense
Warranties and Tax Loss
Carryforwards are typical
sources of Deferred Tax
Assets
A firm is not allowed for tax
purposes to recognize an
expense due to warranties
until it actually occurs. It
will however recognize the
expense in its book
Deferred Tax Liabilities arise
when:
Income Tax Expense > Taxes
Payable
Timing Difference can arise
between Pretax Income and
Taxable Income due to, for
example S/L versus
Accelerated Depreciation
1) Temporary Difference
goes away with time
2) Permanent Difference (for
example due to Municipal
Bond interest payments)
persists through time
Income Tax Expense =
Income Taxes (actually
payable or paid) + Change in
Deferred Tax Liability
Example: Suppose Income
Tax Expense = $5M and
Taxes Payable = $4M
Debit: Income Tax Expense
for $5M
Credit Income Tax Payable
for $4M
And Credit Deferred Tax
Liability for $1M
Deferral Method now
replaced by the Liability
Method for calculating
Deferred Tax Liability
In the Deferral Method:
1) Income Tax Expense was
calculated from Pretax
Income and tax rates
2) Deferred Tax Liability
was calculated
This is problematic if future
tax rates change
In the Liability Method:
1) Future taxes are estimated
to compute the Deferred Tax
Liability
2) Income Tax expense is
computed
Example of Deferred Tax
Liability: Suppose a firm
depreciates an asset it
purchased for $12,000 over 3
years using S/L
Asset lasts 4 years and
produces revenues of $8,000
every year. Tax rate is 34%
Tax Calculation
Depre Taxable Taxes
Income Payable
Yr 1 4,000 4,000 1,360
Yr 2 4,000 4,000 1,360
Yr 3 4,000 4,000 1,360
Yr 4 0 8,000 2,720
Reporting

Dep Pretax Tax Def

Inc Exp Tax
Liab
Yr 1 3K 5K 1.7K 340
Yr 2 3K 5K 1.7K 680
Yr 3 3K 5K 1.7K 1,020
Yr 4 3K 5K 1.7K 0
Example of Deferred Tax
Asset: Warranty Expenses
Suppose a firm has revenues
of $20M for two years from
selling a product. It will only
incur a warranty expense of
$2M during year 2. Suppose
tax rate is 34%
Tax Calculation

Warr Taxable Taxes

Exp Income Payable
Yr 1 0 20M 6.8M
Yr 2 2M 18M 6.12M
Reporting
Warr Pretax Tax
Exp Income Expense
Yr 1 1M 19M 6.46M
Yr 2 1M 19M 6.46M
Deferred Tax Asset for Yr 1
= $6.8M - $6.46M = $0.54M
Yr2 the DTA reverses
Changes in Tax Rates
Liability Method: Revalue
all existing DTAs and DTLs
using the tax rates that will
be applicable when the DTAs
or DTLs reverse
A Tax Increase => DTL
increase. For example,
consider Depreciation
For tax purposes machinery
is depreciated faster than for
accounting purposes. This
means that in later years the
firm will not be able to
shelter income using
depreciation
This would imply that an
increase in tax rates in the
later years would increase
income tax in those years,
thus today DTL will increase
If DTL > DTA and increase
in tax rates => increase in
Income Tax expense =>
decrease in NI and Equity
If DTL > DTA and decrease
in tax rates => decrease in
Income Tax expense =>
increase in NI and Equity
Example of an increase in
tax rates, say from 30% to
45%.
Now taxes have increased by
50%, that is (45% -
30%)/30% = 50%
A firm has a DTL of $10,000
Its DTL will increase to
$10,000*(1 + 0.50) = $15,000
Change (increase) in DTL =
$5,000
Suppose its DTA is $4,000
Its DTA will increase from
$4,000 to $6,000
Change (increase) in DTA =
$2,000
Change in Income Tax Exp =
Change in DTL – Change in
DTA = $5,000 - $2,000 =
$3,000
Are DTLs liability or equity?
If high probability of
reversal then liability,
otherwise equity
What is the value of a DTL?
It is the undiscounted value
for accounting purposes
In real terms you should
discount it and find the
present value
For example, there is a DTL
that you expect to reverse in
5 years for $1,000. It has an
accounting value of $1,000
but a present value of
$712.99 at a discount rate of
7%
If you are analyzing the
firm, treat the difference
($287.01) as equity
A firm should decrease DTL
and increase Equity if it
concludes that a DTL will
not be reversed in the future.
This could happen if capital
expenditures are growing.
Increase in Equity would
decrease ratios like ROE and
book D/E.
Similarly if it is believed that
a DTA will not be reversed,
then DTA should be
decreased, accompanied by a
corresponding decrease to
Equity.
This would decrease Equity
and increase ratios like ROE
and book D/E.
Analysis of Financial
Liabilities
Bond Features and
Terminology
Bonds issued at Par:
1) Book value = Par value
2) Coupon Payments =
Interest Expense
3) Money received by sale
and repayment of Face at
maturity goes to Cash Flows
from Financing in Cash
Flow Statement
4) Interest payments are
accounted for in Cash Flow
from Operations
Premium Bonds:
1) Book Value
= Par + Premium
2) Premium amortized to
zero at maturity
3) Coupons are taken to
consist of two parts: Interest
Expense + Premium
Amortization
Hence for a premium bond
interest expense is less than
coupon payment
4) Interest Expense =
Beginning BV x Rate of
Discount at Issuance
Example for Premium Bond
Bond Face value: $1,000,000
Coupon Rate 9% per annum
paid semi-annually
6 years to maturity
Market rate of return = 7%
per annum
Price of Bond = $1,096,633
Suppose Bond sold for Cash,
then Assets in the form of
Cash increases by $1,096,633
Liabilities in the form of
Long Term Debt increases
by $1,000,000 and a
Premium of $96,633
Interest Expense for the first
period will be:
$1,096,633*0.035 = $38,382
Premium Amortization =
$1,000,000*0.045 - $38,382 =
$6,618
Premium post Amortization
= $90,015
Cash Flow Statement has
two entries:
1) Cash Flows from
Financing (CFF): $1,096,633
2) Cash Flows from
Operations: $45,000
Book Value post amortiz
(beginning of next period) =
Long Term Debt + Premium
post Amortiz = $1,000,000 +
$90,015 = $1,090,015
Interest Expense for the
second period will be:
$1,090,015*0.035 = $38,151
(note, it is the rate of return
when the bond was sold,
rather than the rate of
return at the second period)
Premium Amortization =
$1,000,000*0.045 - $38,151 =
$6,849
Premium post Amortization
= $83,166
Cash Flow Statement will
have a single entry ($45,000)
as Cash Flows from
Operations
The coupons of $45,000 will
pay the interest and amortize
the Premium down to ZERO
over the 6 years as the 12 six-
monthly coupons of $45,000
and the final payment of
$1,000,000 generates a
return of 3.5% on the initial
investment of $1,096,633 (see
lectures on Time Value of
Money)
This will leave a Book Value
of $1,000,000 which will be
repaid at the end of the 6 yrs
Similarly for a discount
bond, Interest Expense is
more than coupon payments.
For a discount bond:
1) The B/S shows a Book
Value equal to Par and a
discount
2) The discount is also
amortized to zero over the
life of the bond
Example for Discount Bond
Bond Face value: $1,000,000
Coupon Rate 9%
6 years to maturity
Market rate of return = 10%
Price of Bond = $955,684
Suppose the Bond sold for
Cash, then Assets in the form
of Cash increases by
$955,684
Liabilities in the form of
Long Term Debt increases
by $1,000,000 and a Discount
of $44,316
Interest Expense for the first
period will be: $955,684*0.05
= $47,784
Discount Amortization =
$47,784 - $1,000,000*0.045 =
$2,784
Discount post Amortization
= $41,532
Cash Flow Statement has
two entries, one the $955,684
as Cash Flows from
Financing (CFF) and the
other ($45,000) as Cash
Flows from Operations
Book Value post
amortization (beginning of
next period) = Long Term
Debt + Discount post
Amortization = $1,000,000 +
($41,532) = $958,468
Interest Expense for the
second period will be:
$958,468*0.05 = $47,923
(note, it is the rate of return
when the bond was sold,
rather than the rate of
return at the second period)
Discount Amortization =
$47,923 - $1,000,000*0.045 =
$2,923
Discount post Amortization
= $38,609
Cash Flow Statement will
have a single entry ($45,000)
as Cash Flows from
Operations
Zero Coupon is a discount
bond with no coupons paid.
Hence the Discount is not
amortized, but rather paid
off at maturity
The first period will show a
CFF equal to the price for
which the Bond sells, but
CFO will be zero
Example of Zero Coupon:
On Jan 1 2010 XYZ Corp.
issued a Zero Coupon bond
due on Dec 31 2020. Face
value of the bond is
$1,000,000 and rate of return
is 6% compounded annually
What will be the impact of
the sale of the Zero Coupon
on Interest Expense, and on
CFO?
We first find the price of the
bond to be:
 10
$1,000,000/1.06 = $558,395
The Interest Expense for
year 1 will be:
$558,395 * 0.06 = 33,504
As nothing is paid to bond
nd
owner, for the 2 year the
Book Value of the debt
liability will increase to:
558,395 + 33,504 = 591,899
And the Interest Expense for
nd
the 2 year will be:
591,899 * 0.06 = 35,514
 th
And so on till the 10 year
when the Book Value will
reach the maturity value of
$1,000,000
If a Bond is paid off (retired)
early, then the difference
between the price paid by
the firm (to retire the bond)
and the book value of the
bond is an “Extraordinary
Loss” or “Extraordinary
Gain”
An Extraordinary Gain is
likely when interest rates are
high, and therefore prices of
Bonds issued earlier are low
Similarly if market rates of
return are low, then an
Extraordinary Loss is likely
 Leases
A Lessee leases an asset for
use from a Lessor (asset
owner). There are two types
of accounting treatments for
leases: Capital Lease and
Operating Lease
In a Capital Lease the lease
is treated as if the Lessee has
purchased the asset
Hence the asset enters the
left side of the B/S and the
future payments to be made
for the lease enter the right
side of the B/S as a Liability
If the lease meets any one of
the four following
conditions, then it is treated
as a Capital Lease:
1) At the end of the lease the
Lessee becomes the owner of
the asset
2) The lease contract
includes a “bargain purchase
option”, that is the asset can
be purchased by the Lessee
at a lower price
3) The PV of the payments to
be made to the Lessor by the
Lessee exceeds 90% of Fair
Market Value of the asset
The discount rate for finding
the PV is the lower of the
Lessee’s marginal rate of
borrowing, and the rate in
the lease contract
4) If the length of time for
which the asset is leased is
greater than 75% of the
useful life of the asset
Example: An equipment
with a market price (FMV)
of $100,000 and useful life of
5 years is leased to a Lessee
for a period of 4 years
The lease payments are
$26,000 a year
The borrowing rate for the
firm is 8%, and the rate
implicit in the lease is 7%
There is no provision for
Lessee to purchase asset at
the end of the lease term, nor
any bargain purchase option
Is it a Capital Lease or an
Operating Lease?
1) and 2) not satisfied.
The rate for discounting will
be 7% (lower of 7% & 8%)
At that rate the PV of the
payments is $88,070. So PV
of payments to be made is
only 88.07% of FMV < 90%
So 3) is not satisfied
4 years/5 years = 80% >
75%, 4) is satisfied
So the lease should be
treated as a Capital Lease
Suppose lease was OL
Then no B/S impact
$26,000 expense on IS and
outflow for CFO
Suppose lease was CL
Then an asset and a liability
of $88,070 when the lease is
entered into
For the first period:
Interest Expense =
$88,070*7% = $6,165
Depreciation Expense =
$88,070 / 4 years = $22,017
Total Expenses = $22,017 +
$6,165 = $28,182 > Lease
Payment of $26,000
So in the earlier years of the
lease, use of CL rather than
OL results in greater
expenses (lesser NI)
Situation reverses in later
years
At the beginning of the
second year CL will be lower
by:
$26,000 - $6,165 = $19,835
So the CL at the beginning of
second year will be:
$88,070 - $19,835 = $68,235
The payment for the lease is
divided into two parts in the
CF Statement:
CFO has the IE of ($6,165)
This gets smaller over the
years
CFF has the liability
reduction of ($19,835) This
gets larger over the years
CFI will not change (CL
reported as “non-cash
investment and financing
activity”)
The total CF for both (OL &
CL) will be same at $26,000
For ratios like ROA, Asset
Turnover etc, remember that
CL increases Assets of the
firm
For D/E, remember that CL
increases Liabilities
Advantages and
Disadvantages of OL and CL
OL keeps risk with Lessor,
lower leverage, higher NI in
earlier years
CL provides tax advantages,
Comparisons of OL and CL
OL do not have any B/S
impact, whereas CL do
Assets higher under CL
Liabilities higher under CL
In CL the asset is treated as
being financed by a
borrowing, so CFF lower