Archive for the 'Accounting' Category

Accounting for Inventory After Purchase and Before Resale

U.S. GAAP requires that inventory values on the balance sheet be stated at the lower of cost or market value. If inventory declines in value while being held it must be written down to the “current replacement cost,” which can be between the actual realizable value and the realizable value less discounted by a normal profit margin. This value then represents a new cost basis, from which the inventory could still decline but cannot increase in value.

Under International Accounting Standards, the values are to be the lower of cost or “net realizable value,” which is similar in definition to the current replacement cost adjusted for selling costs. A key difference, however, is that this does not represent a new cost basis. Should the inventory subsequently increase in value, the writedown can be reversed up to the original cost basis.

Under both accounting standards, the inventory values for certain commodities are stated at market value even when this is above the original cost basis.

Posted on 16th September 2007
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Determining Inventory Cost

U.S. GAAP (ARB 43, SFAS 151) and International Accounting Standards (IAS 2) outline similar procedures for allocating costs to inventory.

Included costs:

  • Cost of purchase
  • Cost of conversion
  • Other costs related to bringing the inventories to the present location and condition
  • A portion of fixed production overhead, based on normal capacity levels

Excluded costs:

  • Abnormal waste-related costs
  • Labor and variable overhead costs
  • Post-production storage costs
  • Administrative and selling costs

The costs that are included in inventory are capitalized as balance sheet inventory until sold, thus matching the related expenses to the revenue generated. Any excluded costs are expensed as incurred.

Posted on 14th September 2007
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Inventory Accounting: Differences Between U.S. GAAP and International Standards

U. S. GAAP considers inventory cost at the time it was placed in inventory, whereas International Accounting Standards base the cost on the order in which the products are sold. When possible, international standards prefer that the specific identification method be used.

When it is not practical to track inventory costs on a unit basis, international standards permit either the first-in, first-out (FIFO) method or the weighted average cost method. Lifo is not permitted, as it is under U.S. standards. Fortunately, U.S. standards require companies using LIFO to report the FIFO inventory value, and thus it is generally possible to adjust the U.S. financial statements for comparability with firms that do not use LIFO.

Both standards require inventory to be stated at the lower of cost or market value, and inventory that has declined in value must be written down. Under U.S. standards these writedowns cannot be reversed even if the inventory subsequently rises in value. International standards do permit reversal of inventory writedowns.

Posted on 12th September 2007
Under: Accounting, Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis | No Comments »

Computing Free Cash Flow to Equity from Free Cash Flow to the Firm

Free cash flow to equity (FCFE) represents the cash flow a company generates after necessary expenses and expenditures and after satisfying the claims of debtholders. It can be calculated from Free cash flow to the firm (FCFF) as follows:

FCFE = FCFF – After-tax interest expense + Net borrowing.

If the company borrows more in a year than it repays it will have additional funds that could be distributed to shareholders, which is why net borrowing is added to FCFF in order to determine FCFE. Obviously, though, investors would want to consider whether continued borrowing to pay dividends is a sustainable practice.

Posted on 28th August 2007
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Accounting for Debt Retirement

When a company retires debt prior to its scheduled maturity, the difference between the carrying amount and the amount repaid is considered a gain or loss from continuing operations. However, investors may want to consider the gain or loss separately.  The primary difference between carrying value and the amount repaid is likely due to shifts in market interest rates. If rates rise, the value of debt declines and companies could buy back their existing loans at less than face value. However, if they were to replace the loans with new debt they would have to pay the higher current market rate.

If the company is retiring debt and reissuing new debt, investors may want to ignore any resulting gains or losses because they do not reflect the underlying economic condition. At the same time, if new debt is not being issued then the gains or losses are unlikely to recur. Again, it may make sense to ignore the gain or loss for analysis purposes.

Posted on 27th August 2007
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Translating Foreign Subsidiary Balance Sheet – Illustrating the Temporal Method

Unlike the all-current method, the temporal method requires that most assets and liabilities be valued using the exchange rate in effect at the time the asset or liability was created. Only those assets and liabilities with fixed foreign currency values (monetary assets and liabilities) are translated at the current exchange rate.

Consider a business that starts a foreign subsidiary on July 30 with the following assets, liabilities and equity:

balancesheet.jpg

At the time the foreign subsidiary is established, the exchange rate is one foreign unit per dollar. Unfortunately, the company has poor timing and overnight the exchange rate plummets such that the foreign currency is only worth $0.50. If the company consolidates its foreign subsidiary’s results using the temporal (or remeasurement) method, the results will be adjusted as follows:

remeasurement.jpg

The value of inventory and fixed assets did not change. Theoretically, the change in exchange rates would not affect the value of such assets – they would simply be worth more units of the foreign currency. Since all liabilities in this simple example are monetary, they are all affected by the change in exchange rates. What is interesting is that the value of the assets falls by less than the value of the liabilities – so the parent company actually translates the change as a net gain.  This can vary on a case by case basis depending on the size of the change in rates, the direction of the change, and the relative proportions of non-monetary assets and liabilities held.

Since assets and liabilities are affected in different ways, using the temporal method can result in changes to certain financial ratios as the balance sheet is converted into parent currency. In this case, before translation the subsidiary’s current ratio was 2.67 and debt as a percentage of assets was 42%. After translation, the parent would report the subsidiary’s current ratio as 3.67 and the debt/assets ratio as 26%.

Posted on 26th August 2007
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Projected Benefit Obligation (PBO)

When measuring the potential liability of a pension fund, there are several relevant measures. The Projected Benefit Obligation (PBO) represents the present value of all benefits employees are expected to earn during employment.  For businesses that are assumed to be going concerns, this measure is the most appropriate estimate of the total future liability.

Posted on 25th August 2007
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Computing Free Cash Flow to the Firm from the Statement of Cash Flows

Free cash flow to the firm (FCFF) represents the cash flow that a company generates in an accounting period, after paying operating expenses and making necessary expenditures. This cash flow represents the return to all providers of capital, whether debt or equity. It can be used to pay off debt, repurchase shares, pay dividends or be retained for future growth opportunities.

FCFF can be calculated from the statement of cash flows as follows:

FCFF = Cash flow from operations + After-tax interest expense – Capital expenditures

Depending on the company being analyzed, investors may want to deduct acquisitions as well as capital expenditures. Essentially acquisitions are a means of buying capacity that could othewise be built through capex.

Posted on 22nd August 2007
Under: Accounting, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks | 5 Comments »

Computing Free Cash Flow to the Firm from Net Income

Free cash flow to the firm (FCFF) represents the cash flow that a company generates in an accounting period, after paying operating expenses and making necessary expenditures. This cash flow represents the return to all providers of capital, whether debt or equity. It can be used to pay off debt, repurchase shares, pay dividends or be retained for future growth opportunities.

The basic calculation is FCFF = NI + NCC + Int (1-T) – FCInv – WCInv

Were NI is net income, NCC is non-cash charges such as depreciation, Int(1-T) is the after-tax interest payments on debt, FCInv is the investment in fixed capital (capital expenditures) and WCInv is the investment in working capital.

Investors may want to further distinguish between investments in fixed capital that represent required maintenance and those that are intended to generate growth.

Posted on 21st August 2007
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Restructured or Impaired Debt

When a borrower encounters financial distress, creditors may agree to accept assets as payment for the debt or to restructure (modify the terms) of the original agreement. If the debt is extinguished, the debtor and creditor must recognize gains or losses equal to the difference between the carrying amount of the debt and the amount actually given as repayment. When it is restructured, however, the accounting guidelines frown upon the borrower recognizing a gain due to its own financial distress. Instead, no gain can be recognized as long as the gross cash flows (undiscounted) exceed the original amount borrowed.

Posted on 21st August 2007
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