effective = (income tax expense/pretax income)

statutory = tax rate of the jurisdiction where the firm operates

What are the effects on 1st year of Net Income when you capitalize?

What are the Effects of Capitalizing vs. Expensing

for Total Assets?

Increase in Total Assets = Capitalize

Decrease in Total Assets = Expense

What are the effects of Stockholders' Equity when you  Capitalize or Expense?

Higher Stockholders' Equity = Capitalize

Lower Stockholders' Equity = Expense

Higher CFO when capitalize

Lower CFO when expense

Lower Debt Ratio and Lower Debt-to Equity when capitalize

HigherDebt Ratio and Higher Debt-to Equity when expense

What are the effects on ROA and ROE for the 1st year when you capitalize vs. expense?

Higher ROA and ROE 1st year = capitalize

Lower ROA and ROE 1st year = expense

Higher ROA and ROE 1st year = Capitalize

Lower ROA and ROE 1st year = Expense

Merchandising firms, such as wholesalers, have ready to sell inventory. If this is the case, inventory is in one account on the B.S.

Manufacturing firms normally report inventory using three separate accounts: Raw materials, Work in Process, and finished goods.

The Choice of INVENTORY COST FLOW Method affects the firm's IS, BS, and several other important ratios.

Cost flows methods can also vary the firm's income taxes and, hence, cash flows.

Generally, inventory is reported on the Balance Sheet (BS)at cost and a writedown (loss) is recognized when: - the market value declines below cost.

Don't confuse this with the valuation method for inventory, which is the:

- lower of cost or net realizable value for firms   reporting under IFRS.

- or Lower of cost or market for firms reporting    under GAAP.

COGS = Beg. Inv. + purchase - End Inventory

The easiest way to remember this equation is to think of the end result.

End Inv. = Beg Inv. + purchases - COGS.

Cost is the basis for most inventory valuation.

Product Costs: (rules are similar under GAAP and IFRS) Products costs are capitalized in the Inventories account on the Balance Sheet. These include:

- Purchase cost

- Conversion costs

- Allocation of fixed production overhead

- Other costs necessary to bring inventory to its present location and condition.

Capitalizing inventory cost as an asset, expense recognition is delayed until the inventory is sold.

Period Costs: these costs are not capitalized but are expensed in the period incurred. These include:

- Unallocated portion of fixed production overhead

- Abnormal waste of materials, labor, or overhead.

- Storage Costs (unless required as part of production process)

- Administrative overhead.

- Selling costs.

Under IFRS, inventory is reported on the balance sheet at the lower of cost or net realizable value.

Net Realizable Value (NRV) = Estimated sales price less the estimated selling costs.

If NRV is less than the balance sheet costs, then the inventory is written down.

Also, inventories can be "written-up", but only to the extent that a previous write-down to NRV was recorded previously.

Inventories are reported on the Balance Sheet at the lower of cost or market.

- Market is usually equal to replacement costs; however, market cannot be greater than NRV, or less than NRV minus a normal profit margin. There is a range where market can be reported, it is the range of the normal profit margin.

If inventory recovers value, under US GAAP, no write-up will be allowed.

IFRS:

- Specific Identification

- FIFO -

-Weighted average Cost

GAAP does everything that IFRS does, but also LIFO.

********LIFO is not permissible under IFRS.***********

First in, First out. The advantage of FIFO is that ending inventory is valued based on the most recent purchases, arguably the best approximation of current replacement cost.

When prices are rising, FIFO will understate COGS, which overstate earnings.

Last in, First Out. LIFO produces better matching in the income statement since COGS and sales revenue are both measured using recent prices.

- When prices are rising, LIFO COGS will be higher than FIFO COGS, and earnings will be lower. Lower earnings translate into lower income taxes, which increase CASH FlOW.

LIFO conformity Rule: The U.S. Tax Code states that those firms who use LIFO for tax purposes to also use LIFO for financial reporting purposes.

NOTE: this is one area where there needs to be conformity between Financing and Tax accounting.

This is a simple and objective method. 

WAC is computed by dividng the Total Goods Available for Sale (beginning inventory +purchases) by total quantity available for sales.

EQ: Total Goods available for Sales/Total quantity available for sales.

When prices are stable, the cost flow assumption has no effect on ending inventory.

Meaning, when prices are stable, it doesn't matter if you used LIFO, FIFO, or WAC

- When prices are rising, COGS is greater under LIFO than under FIFO and ending inventory is less. 

- COGS under weight averaged cost method, when prices are rising or falling, WAC will fall between FIFO and LIFO.

During periods of rising or falling prices, FIFO provides the most useful measure of ending inventory. THIS IS IMPORTANT!!!!

- FIFO inventory is made up of the most recent purchases. These purchases can be viewed as an approximation of current replacement cost, which best represents the current economic value.

- LIFO is made up of older inventory left over. This could be outdated material or irrelevant pricing for the market values. 

- For analytical purposes,  change LIFO basis to FIFO basis when analyzing a company.

EQ = COGS/(average inventory)

Inventory ratios cannot be viewed in isolation, but should be compared to industry comparables.

Low inventory turnover means high number of days in inventory

EQ # of days in Inventory = 365/ (inventory turnover)

High Inventory turnover is preferable, because you reduce the risk of obsolescensce and minimize carrying costs such as storage, insurance, and handling. But if you have too high of turnover, you could be missing out on sales.

Inventory ratios are directly affected by the firm's choice of cost flow method. You must be aware that cost flow methods do affect these ratios.

When prices are rising:

LIFO results in:

- higher COGS

- Lower taxes

- lower net income (EBT and EAT)

- lower inventory balances

- lowering working cap (CA-CL)

- higher cash flows (less taxes paid out)

FIFO results in the exact opposite:

- lower COGS

- higher taxes

- higher NI (EBT and EAT)

- higher inventory balances

- higher working cap (CA-CL)

- lower cash flows (more taxes paid out)

The effects of inventory method on profitability, liquidity, activity, and solvency.

***assuming prices are rising***

Profitability:

- LIFO produces higher COGS in the income statement adn will result in lower earnings.

- Profitability measures that includes COGS will be lower under LIFO.

EX) higher COGS will result in lower gross, operating, and NI profit margins compared to FIFO.

Liquidity:

- LIFO results in lower inventory value on the Balance sheet.

- Since inventory (a current asset) is lower in LIFO, current ratio, a popular measure of liquidity, is alos lower under LIFO compared to FIFO.

- Working Cap is lower as well because CA are lower.

- However, quick ratio is unaffected, because inventory i is not included in the current assets for quick ratio.

Activity:

- inventory turnover (COGS/avg. inventory) is higher for firms that use LIFO compared to FIFO.

- REMEMBER, Under LIFO, COGS is valued at more recent, higher prices; while inventory is valued at older, lower prices. 

- The # of days  of inventory (365/inventory turnover) is therefore lower under LIFO compared to FIFO.

Solvency:

- LIFO results in lower total assets (TA) compared to FIFO, because LIFO inventory is lower.

- Lower TA under LIFO resutl in lower Equity (Assets - liabilities).

- Since TA and EQ are lower under LIFO, the debt ratio and the debt to equity ration are higher under LIFO compared to FIFO.

It is hard to compare companies who have different inventory cost methods. That is why it is necessary to convert LIFO to FIFO and vice versa.

LIFO reserve = FIFO inventory - LIFO inventory

FIFO Inventory = LIFO Inventory +LIFO reserve.

But once you have converted the assets from LIFO to FIFO, it is necessary to adjust the liabilities because COGS will be out of balance.

This is why we must convert to LIFO from FIFO COGS.

FIFO COGS=LIFO COGS - (end. LIFO reserve - beg. LIFO reserve)

or

FIFO COGS = LIFO COGS - (change in LIFO reserve)

refer to page 186 of book #3 for an example. And then problems 186-187 as well.

LIFO reserve is equal to the difference between LIFO inventory and FIFO inventory.

LIFO reserve = LIFO inventory - FIFO inventory

- LIFO reserve will increase each period when prices are rising and inventory quantities are stable or increasing.

- Also, if the firm is liquidating its inventory, or when prices are falling, the LIFO reserve will decline.

LIFO liquidation occurs when a LIFO firm's inventory quantities are declining. 

- In this situation, the older, lower costs are now included in COGS. Which results in higher profits and higher taxes. (notice that these profits are phantom because they are not sustainable, meaning you can't sell off inventory forever).

When prices are decreasing, inventory value is higher under LIFO than under FIFO, so the LIFO reserve declines.

Face Value-  Also known as Par value or Maturity value. The face value is used to calculate coupon payments.

Coupon rate: the interest rate stated in the bond that is used to calculate the coupon payments.

Market rate of interest- rate of return required by bondholders and depends on the bond's risks. This rate fluctuates which can affect the bond's value.

Balance Sheet Liability: BS liability of a bond is equal to the present value of the remaining cash flows (coupon payments and face value), discounted at the market rate of interest at issuance. At maturity, liability will equal the face value of the bond. The balance sheet liability is also known as the book value or carrying vlue of the bond liability.

Interest Expense: Calculated by multiplying the Book value of the bond liability at the beginning of the period by the market rate of interest on the bond when it was issued. (BVbeg * r(coupon rate or market interest rate)

Bond issued at Par= Market rate of interest is equal to coupon rate. 

Bond Issued at Premium or Discount= Market rate of interest at issuance is not equal to the coupon rate.

Discount = Coupon rate < market rate of interest.

This means market interest rate is higher, therefore, the price of the bond is lower. The lower price of a bond is called a "Discount."

NOTE: Investors will pay less (that is why it is discounted) for a coupon rate that is lower than the market rate. Remember, coupon rate is what you earn in interest payments.

Premium = Coupon rate > Market rate. Bond price and the proceeds received will be greater than face value. Investors will pay more for the above-market coupon payments.

Proceeds of a debt issue and the repayment of principal amounts are considered FINANCING CASH FLOW = CFF

Cash interest paid is an operating Cash Flow = CFO

Amortization of bond premiums and discounts do not affect cash flows as they are recognized.

When a Company issues a bond, both assets and liabilities initially increase by the bond proceeds. At any point in time, BV of the bond liability will equal the PV (of remaining cash flows) discounted at market rate at issuance.

Premium bonds: are reported on the balance sheet at more than their face value. The Premium is amortized (reduced), the book value of the bond liability  will decrease until it reaches its face value at maturity.

Discount Bonds: reported on the BS at less than face value. as the discount is amortized (added), the BV of the bond liability will increase until it reaches face value at maturity

If bonds are issued at premium or discount, interest expense is not just cash paid for interest, it would include amortization as well. 

**Interest expense includes amortization of discount/premiums.**

Effective interest rate method:

Int. Exp = BV of Bondbeg value * mkt interest at issue.

- Premium Bond: interest expense is less than the coupon payment (mkt. rate < coupon rate). THE difference between interest expense and the coupon interest payment is the amortization of the premium.

-So premiums will subtract amortization from bond liability on the balance sheet.

- Discount Bond: interest expense is greater than the coupon interest expense (mkt. rate>coupon rate). The difference between interest expense and coupon interest payments is a negative amortization. This means that the amortization or difference is added to the liability on the balance sheet.

- Therefore, int. exp. will increase over time as the bond liability increases.

U.S. GAAP must report interest expense at Cash Flow from OPerations. CFO

IFRS can Report interest expense as either Operating activity or financing activity.

Coupon Payments are outflows of cash. 

 These bonds make no periodic payments of interest. Also known as "pure discount bonds." They are issued at discount from their par value and their annual interest expense is implied, not explicitly paid.

Actual interest payments are included in the face value at  maturity.

Ex) One company has a value of $50,000 in cash sales. The Company sold $1,000,000 face value of zero coupon bond maturing in three years. assume market rate of 10% at issuance.

How much did Company A receive for its bonds?

What is interest expense over the three years

What are the cash Flows?

discounted @10% of $1million is $751,315 at t=0

at t=1, interest expense in $751,315 * 10% = $75,131

int expense + face valuebeg(751,315+75,131) = $826,446

Issuing a bond involves legal and accounting fees, printing costs, sales commissions, and other fees. 

IFRS: issuance costs are included in th measurement of the liability, thereby increasing the effective interest rate.

GAAP: firms capitalize issuance costs as an asset (prepaid asset) and allocate the costs over the term of the bond.

When bonds mature, no gain or loss is recognized.

At maturity, premiums and discounts have been fully amortized; thus, the book value of the bond liability and the face value are the same.

A firm may choose to redeem bonds before maturity because interest rates have fallen, because the firm has generated surplus cash through operations, or because funds from the issuance of equity make it possible

When bonds are redeemed before maturity; a gain or loss is recognized by subtracting the redemption price from Book Value of the bond liability at the reacquisiton date.

Redemption price - Book Value = gain/loss on redeeming.

GAAP: any remaining bond issuance costs must also be written and included in the gain or loss calculation. Writing off the cost of issuing the bond will reduce a gain ro increase a loss.

NOTE: gains/losses are reported on the income statement under income from continuing operations, HOWEVER, analysts should take the gain/loss out of the income statement because these redeemings don't happen too often.

Debt covenants are restrictions placed on debt issuer to protect bondholder's interests.

Debt covenants can reduce default risk and decrease interest costs.

Usually these debt covenants hold restrictions on sale of assets, dividends, share repurchases, M&A, and issuance of other debt. ALSO, they may hold limits on certain financial ratios

The book value of a bond liability is calculated based on the market rate at issuance.

When the market rate of interest changes, it will result in a change in value of the bond.

THERE IS AN INVERSE RELATIONSHIP BETWEEN MARKET INTEREST RATES AND BOND PRICES.

Increase in market interest rate = decrease in the Fair Value of bond liability. 

Historically, changes in market values did not affect balance sheet values of liabilities. Recent changes in both US GAAP and IFRS provide for more discloser of changes in the fair values of liabilities and for more liabilities to be reported on the balance sheet at fair value.

Convertible Bonds are bonds which have an option to turn into share of equity.

When valuing a conversion option, US GAAP ignores the option when a convertible bond is issued and all of the bond proceeds are reported as a liability.

Under IFRS, the issuer reports the pure bond liability as debt and the conversion option as part of the stockholders' equity.

Analysts should consider the likelihood that convertible bonds will be converted (ex compare the conversion price and market price of the firm's shares) and adjust the debt-to-equity ratio to determine the effect of conversion on the firm's leverage ratios.

Bonds that have warrants attached, the issuer separately values the bond liability and the warrants.

The value of the bond (without the warrants) is reported as a liability and the value of the warrants is reported in stockholder's equity.

As a general rule:If a financial instrument requires the repayment of principal in the future, it must be reported as a liability  on the balance sheet.

EX) Preferred Stock : you have to give a certain dividend each quarter. This is a liability 

A contractual arrangement whereby the Lessor (Owner of asset), allows the Lessee to use the asset for a specified period of time in return for period payments.

Leases are classified as either Finance (Capital) leases and Operating leases.

Leasing has certain benefits:

- less costly

reduced risk of obsolescence.

Less restrictive provisions compares to other forms of financing

- Off balance-sheet financing

- tax reporting advantages.

GAAP states, a lesse must classify a lease as a finance lease if any one of the following criteria are met:

1. Title of the leased asset is transferred to the lessee at the end of the lease period.

2. bargain purchase option exists. Meaning if you have a deal to purchase the asset at the end of the life at a discount.

3. Lease period is 75% or more of the asset's economic life.

4. PV of the lease payments in 90% or more of the fair value of the leased asset.

NOTE: in a finance lease, the interest rate used by the lessee is the lower of the lessee's incremental borrowing rate and the lessor's implicit lease rate.

Only affect of the Operating Lease to the Financial Statements is to the Income Statement.

Rental Expense is the only charge on the financial statements, and it is not reported on the balance sheet; which gives it the name of "Off-balance sheet financing"

Cash Flow for rental expense is an outflow from CFO (operations).

At the inception of the lease, the PV of the future minimum lease payments is recognized as an asset and as a liability on the lessee's balance sheet. 

Asset is depreciated over the term of the lease, the asset is depreciated in the income statement and interest expense is recognized. 

Int Exp = lease liability at the beginning * interest rate implicit to the lease.

Cash Flow Statement:

Lease payment is separated into two parts: principal and interest.

The principal portion is equal to lease payment minus interest expense. 

Interest expense is an outflow from operating activities. (CFO)

Principal is outflow from Financing activities. (CFF)

Finance Lease results in both an increase in Assets and Liabilities.

This affects leverage ratios, turnover ratios, current and working cap ratios.

Income Statement: operating income (EBIT) will be higher for companies using finance leases. Operating leases use the entire lease payment as interest expense, while only the depreciation of the finance leased asset is treated as an operating expense (not the interest portion of the lease payment)

The asset being leased will be used for 75% of its useful life.

Inputs, 4 years, 6 interest, 10,000 payments, and 0 FV.

What is PV?

PV = $34,651

What is depreciation expense for the four years?

$34,651/4 = $8663.

year Beg. Value Int. 6% Lease  Liability      BV

0 $34,651$34,651

1 $34,651 $2,079 10,000 26,730   25,998

2 26,730 1,604 10,000 18,334   17,326

3 18,334 1,100 10,000 9,434      8,663

4 9,434 566 10,000 0                  0

Notice column 5 has depreciation of fixed $8663 every year, but the Liability does not follow the same schedule. This is because of the differing interest expense. Which is higher in the early years, but lower in the later years.

This is just a simple amortization schedule but for a lease

Finance Lease:

Assets: higher

Liabilities: higher

NI (early years): Lower

NI (later): Higher

Total NI: Same

EBIT Higher

CFO: Higher

CFF: Lower

Total Cash Flow: Same

Ratios:

Current ratio Lower

Working Cap Lower

Asset turnover Lower

ROA Lower

ROE Lower

D/A Higher

D/E Higher

There are two types of Finance leasing: Sales-Type Lease and Direct Financing Lease.

Sales-Type Lease: if PV of Lease payments exceeds the carrying value of the asset.

 Lessor reports gross profit as if the asset were sold for the fair value of the lease.

The lessor reports a lease receivable at inception and interest income over the life of the lease. The lease payment is treated as part interest income (CFO) and part principal reduction (CFI).

Direct Financing Lease: when the PV of lease payments equals the asset's carrying value. The lessor reports a lease receivable at the inception of the lease and interest income over the life the asset. The lease payment is treated as part interest income(CFO) and part principal reduction (CFI).

Take or pay contract or throughput arrangement, the purchasing firm commits to buy a minimum quantity of an input (usually a raw material) over a specified period of time.

Analysts should adjust the financial statements for off-balance sheet activities such as operating activities, take or pay agreements, throughput activities,  and receivable sales with recourse.

In each case, assets and liabilities are increased by the appropriate adjustment. It may also be necessary to reclassify some cash flows from operations to cash flows from financing.