Financial Reports Exam 2 Beginning of chapter questions and Review of Key Topics

Are there any alternatives to the allowance method?

An alternative to the allowance method is the direct write-off method. Using this method, adjusting entries are not recorded, and any bad debt that does arise simply is written off as bad debt expense. The direct write-off method is not permitted by GAAP except in limited circumstances.

Why are unrealizable gains and losses on available-for-sale securities not reported in the income statement, but instead are reported in other comprehensive income, and then shown in Accumulated Other Comprehensive Income (AOCI) in the balance sheet?

Available-for-sale securities are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are viewed as insufficiently relevant performance measures to be included in net income. Instead, those amounts are shown in Other Comprehensive Income (OCI) and accumulated in an owners' equity account (AOCI). It's likely that holding gains in some periods will be offset by holding losses in other periods. When the investment is sold, the net amount of gain or loss is removed from AOCI and recognized in net income.

Are you correct that, by using LIFO, Kroger reports lower inventory and lower profits? Why would Kroger do that?

Because Kroger uses LIFO instead of FIFO, reported inventory in the balance sheet is lower. For the year ended February 1, 2020, Kroger reported LIFO inventory of $7,084 million, compared to $8,464 million that it would have reported under IFO. This is a difference of $1,380 million. In the previous year, the difference between LIFO and FIFO was $1,277 million. This means the LIFO effect (or LIFO reserve) has increased by $103 million (from 1,277 million to 1,380 million). An increase in the LIFO reserve is recorded as an increase in COGS, decreasing profits. Howeve, the LIFo reserve had decreased in the current year, COGS would be deceased, and profits would have been higher. Kroger likely uses LIFO for reporting purposes because of the tax advantages of reporting lower income. In addition, management may believe LIFO better matches sales revenue and COGS.

What approaches might CHS have used to arrive at the $200 million bad debt provision?

CHS would determine the balance in the allowance for uncollectible accounts that is necessary to show net accounts receivable at the appropriate carrying value and then would record whatever adjustment and corresponding bad debt expense resulted in that balance. It likely would use an aging of accounts receivable to calculate the appropriate balance. It might also use a percentage of net sales to estimate bad debt expense, particularly on an interim bases, but that approach would only be allowed if it produced a similar carrying value as the balance sheet approach.

Explain how asset impairment differs from depreciation, depletion, and amortization. How do companies measure impairment losses for property, plant, and equipment and intangible assets with finite useful lives?

Depreciation, depletion, and amortization reflect a gradual consumption of the benefits inherent in a long-lived asset. An implicit assumption in allocating the cost of an asset over its useful life is that there has been no significant reduction in the anticipated total benefits or service potential of the asset. Situations can arise, however, that cause a significant decline or impairment of those benefits or service potentials. Determining whether to record an impairment loss for an asset and actually recording the loss is a two-step process. The first step is a recoverability test- and impairment loss is required only when the undiscounted sum of estimated future cash flows from an asset is less than the asset's book value. The measurement of impairment loss- step 2 - is the difference between the asset's book value and its fair value. If an impairment loss is recognized, the written-down book value becomes the new cost base for future cost allocation.

How does Dollar General avoid counting all its inventory every time it produces financial statements?

Dollar General uses the dollar-value LIFO retail inventory method. The retail inventory estimation technique avoids the counting of ending inventory by keeping track of goods available for sale not only at cost but also at retail prices. Each period's sales, at sales prices, are deducted from the retail amount of goods available for sale to arrive at ending inventory at retail. This amount is then converted to cost using a cost-to-retail percentage.

Do the terms depreciation, depletion, and amortization all mean the same thing?

Each of these terms refers to the cost allocation of assets over their service lives. The term depreciation is used for plant and equipment, depletion for natural resources, and amortization for intangible assets.

What is goodwill and how is it measured?

Goodwill represents the unique value of the company as a whole over and above all identifiable tangible and intangible assets. Because goodwill can't be separated from a company, it is not possible for a buyer to acquire it without also acquiring the whole company or a substantial portion of it. Goodwill will appear as an asset in a balance sheet only when it was paid for in connection with the acquisition of another company. The capitalized cost of goodwill equals the acquisition consideration exchanged for the acquired company less the fair value of the net assets acquired. Goodwill is a residual asset; it's the amount left after other assets are identified and valued.

Describe to your friend the various costs to include in the initial cost of property and equipment.

In addition to the purchase price, the cost of property and equipment might include the cost of transportation, installation, testing, legal fees to establish title, and any other costs of bringing the asset to its condition and location for use.

What are some common types of intangible assets, and what is the accounting treatment for purchased versus internally developed intangible assets?

Intangible assets generally represent exclusive rights that provide benefits to the owner. They include items such as patents, copyrights, trademarks, franchises, and goodwill. Reporting purchased intangibles is similar to reporting purchased property, plant, and equipment. We record purchased intangible assets at their original cost plus all other costs, such as legal fees, necessary to get the asset ready for use. Reporting intangible assets that are developed internally is quite different. Rather than reporting these in the balance sheet as assets, we typically expense them in the income statement in the period we incur those internal development costs.

What does it mean for CHS to securitize its receivables?

Securitization is a method used to sell accounts receivable. In a typical secularization, a company creates a "special purpose entity" that buys receivables from the company and issues securities that are collateralized by the receivables. Securitization allows CHS to obtain cash for its receivables sooner than it could otherwise, and to reach a large pool of investors at favorable financing rates.

What is the purpose of disclosing the difference between the reported LIFO inventory amounts and replacement cost, assuming that replacement cost is equivalent to a FIFO basis?

The LIFO conformity rule requires that if a company uses LIFO to measure taxable income, it also must use LIFO for external financial reporting. The choice of using LIFO instead of FIFO for financial reporting, however, will affect amounts reported for inventory and COGS. This difference makes it harder to compare companies using LIFO to companies using FIFO. To make this comparison easier, companies using LIFO can disclose the amount of inventory they would have reported under FIFO. Kroger's disclosure note offers this additional information.

How is the LIFO method used to calculate inventories? Is this permissible according to GAAP?

The LIFO method uses the assumption that the most recent inventory purchased is sold first. Yes, this method is permissible according to generally accepted accounting principles. A company need not use the same method that represents its actual inventory flow.

Explain the allowance method of accounting for bad debts

The allowance method is used to report the carrying value of accounts receivable at the net amount expected to be collected. In an adjusting entry, we record bad debt expenses and reduce accounts receivable indirectly by crediting a contra account to accounts receivable for an estimate of the amount that eventually will prove uncollectible.

What is the index formulation used for?

The dollar-value LIFO retail method uses a price index to first convert ending inventory at retail to base year prices. Yearly LIFO layers are then determined, and each layer is converted to the year's current year retail prices using the year's price index and then to cost using the layer's cost-to-retail percentage.

Why are expenditures for research and development reported in the income statement instead of the balance sheet?

The reason for this approach include: (1) the difficulty in predicting which individual research and development project will ultimately provide benefits and (2) the difficulty in establishing a direct relationship between research and development costs and specific future revenue. In other words, even if R&D costs do lead to future benefits, it's difficult to objectively determine the size of the benefits and in which periods the costs should be expensed if they are capitalized. For these reasons, the FASB takes a conservative approach and requires R&D costs to be expensed immediately.

Why are. unrealized gains and losses on trading securities reported in the income statement?

Trading securities are acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are often viewed as relevant performance measures that should be included in net income.

Weyerhaeuser determines depletion based on the "volume of timber estimated to be available." Explain this approach.

Weyerhaeuser is using the units-of-production method to determine depletion. The units-of-production method is an activity-based method that computes a depletion (or depreciation or amortization) rate per measure of activity and then multiplies this rate by actual activity to determine periodic cost allocation. The method is used by Weyerhaeuser to measure depletion of the cost of timber harvested and the amortization of logging roads. Logging roads are intangible assets because the company doe snot own the roads.

Explain why Coke accounts for some of its investments by the equity method and what that means.

When an investor does not have "control," but still is able to exercise significant influence over the operating and financial policies fo the invest, the investment should be accounted for by the equity method. Coke owns between 20% and 50% of the voting shares of some of the companies it invests in. By the equity method, Coke recognizes investment income in an amount equal to its percentage share of the net income earned by those companies, instead of the amount of that net income it receives as cash dividends. The rationale is that as the invest earns additional net assets, Coke's share of those net assets increases.

How should you respond? Why are held-to-maturity securities treated differently from other investment securities?

You should explain that if an investor has the positive intent and ability to hold the securities to maturity, investments in debt securities are classified as held-to-maturity and reported at amortized cost in the balance sheet. Increases and decreases in fair value are not reported in the financial statements. The reasoning is that the changes are not as relevant to an investor who will hold a security to its maturity regardless of those changes. Changes in the fair value between the time a debt security is acquired and the day it matures to a prearranged maturity value aren't as important if sale before maturity isn't an alternative.