FSA exam 1

JetBlue example 1: customer bought $4000 ticket but missed the flight, has 1 year to use the flight credit

- At Payment: debit cash 4000, credit unearned revenue 4000 - at flight: debit unearned revenue 2000 (some portion for the flight), credit revenue 2000 - JetBlue recognizes that 10% of flight credits go unused --> recognize $100 in revenue every time $90 in credits are used - this speeds revenue recognition up

what creates DTAs?

- BDE (decreasing BDE will decrease DTAs) - unearned revenue (new revenue recognition rules made DTAs increase for airlines bc they recognized more unearned revenue when they revised prior years) - another ex - recording unearned revenue bc of future discounts given to customers will create DTA

what does it mean if LIFO reserve decreased in the current year?

- COGS under FIFO would have been bigger than COGS LIFO --> pretax income would have been lower under FIFO --> paid more in taxes using LIFO than FIFO

what impact does LIFO vs FIFO have as input costs rise?

- FIFO gives higher ending inventory - LIFO gives higher COGS (lower NI)

KSR case - how to account for delivering more than the customer ordered

- KSR delivered more processors than the customer ordered - but KSR kept these processors in inventory - should include this in COGS, especially if they think they'll never get these processors back - this is inflating inventory and reducing COGS

Accounts that tend to move together (for red flag analysis)

- Revenue and COGS - Revenue and AR - COGS and Inventory

factors responsible for a decrease in the LIFO reserve

- a decrease in LIFO inventory levels (LIFO liquidation) - decrease in input prices of inventory

what is on the income statement after the 1st year of a finance lease?

- amortization expense = PV of asset / # of years in lease - interest expense = interest listed on the NEXT year of the amortization table (bc expense when incurred)

what do you typically do when you make a sale to a distributor but they have the right to return/cancel later?

- book revenue at time of sale - also book an estimated sales return

treatment of sales commissions and impact on taxes

- capitalizing sales commissions creates DTLs (increases tax expense relative to financial expenses) - expensing commissions decreases tax expense - no effect on cash flows

how does unearned revenue create a DTA

- collect cash now, so must pay taxes on it - won't recognize this cash as revenue in financial income until it's earned later on (financial income will increase in future compared to taxable income)

When does a DTA occur?

- comes from a book/tax difference, when we know that we will have tax deductions later (taxable income will be lower than financial income in the future) - Bad Debt Expense and Unearned revenue creates DTAs

JetBlue case - accounting for frequent flyer plans - incremental cost method

- common under old revenue recognition rules - record SGA expense = fraction of ticket given away to customers x incremental costs incurred on the flight

what costs are "incremental" when it's related to acquisition of a contract?

- costs are incremental if they're only incurred when a contract is successfully signed - ex sales commissions

KSR case - revenue recognition issues

- customers ability to pay depends on if they are approved to receive grants, but KSR recognizes revenue before the customer has received the grant (maybe keep this product as an asset on the BS until customer pays, make sure KSR has an allowance account) - KSR recognized sales when part of the product development wasn't complete (have they earned this?) - impact: higher revenue, higher return on sales

capitalizing sales commissions

- debit an asset for the commissions paid, credit cash - do this when we can quantify the timing and amount of the future benefits

amortizing a sales commission that has been capitalized

- divide the commission amount by the number of years that are relevant (ex - the number of years the commission is paid in advance) - debit commission expense, credit the commission asset

why does it matter how we account for discounts given to customers to rush their sales from next year to this year?

- economic opportunity cost - giving up full sales price of those sales - disclosure - if this isn't representative of the future, should be disclosed in MD&A - hurts comparability - not a typical business practice

Adjusting entry - to undo COGS assoc with revenue adjustments

- estimate COGS using prior numbers - ratio of COGS to sales revenue (COGS prior year / sales prior year) x the sales $ that we reversed = COGS assoc with those sales - debit inventory, credit COGS

how does finance vs operating lease impact EBITDA?

- finance lease gives higher EBITDA - operating lease includes both interest expense and amortization expense in the higher line item on the IS (COGS or SGA), both of these are included in EBITDA

how does finance vs operating lease impact EBIT?

- finance lease will give higher EBIT - the operating lease includes interest expense in either COGS or SGA, which is included in EBIT - finance lease shows interest expense as its own line item, which is lower than EBIT on the IS

what should we do to make Sears (has own credit card division) and Walmart (credit card sales facilitated through 3rd party bank) more comparable?

- find adjusted ROE for Sears - back out numbers related to its credit card division from AR, revenue, and income - see in an Exhibit of operating income by segment that the credit business is responsible for 50% of sales --> assume this is also true for NI to get adjusted NI number

How does BDE create a DTA

- for financial reporting, you include BDE immediately when you estimate uncollectible accounts --> lowers income - for tax: can't count this as an expense until you determine what is actually uncollectible --> taxable income will be lower in the future

industries with low days in inventory

- grocery stores - fast fashion retailers - tech companies that try to have JIT inventory - car manufacturers (JIT inventory) - news company (USA today)

adjusting entry - find tax effects of the first 2 entries

- gross margin assoc with these entries = 605M sales - assoc COGS - divide the assoc COGS by this gross margin and multiply by the tax rate - this is the amount you use in the entry - debit taxes payable, credit tax expense

how does finance vs operating lease impact cash flow from operations?

- higher cash flow from operations under finance lease - bc only classify the interest portion of the cash outflow as an operating outflow

when to expense sales commissions

- if theres no expected future benefit - if the customers are paid for some distinct good or service that we can estimate the value of: debit SGA, credit cash - if the customers are paid just to be a customer: debit revenue, credit cash

adjusting entry - to undo $605 in sales revenue that didn't meet revenue recognition criteria

- if we don't have cash from the "sales" - debit sales revenue, credit AR - if we have cash from the sales - debit sales revenue, credit unearned revenue

comparison of the asset and liability for finance lease

- initially are equal, but then fall out of sync - the asset tends to be smaller than the total liabilities (asset is reduced through SL amortization but the liability goes down slowly at first bc initial payments are mostly going towards interest)

what is on the balance sheet after the 1st year of a finance lease?

- interest payable = interest listed on the NEXT year of the amortization table (accrued this and owe it, but don't pay until the beginning of the year), this is the same amount as the interest expense on the IS this year - current portion of the lease liability = the principal reduction amount on the amortization table for NEXT year - noncurrent portion of the lease liability = end balance of the liability on the table for NEXT YEAR - the current and noncurrent portions on the BS sum to the end balance of the lease liability for the current year

JetBlue - how does the new revenue recognition standard affect the financial statements?

- liability booked under deferred revenue method > liability booked under the incremental method (for frequent flyer points) - new rules made a Long term liability for the loyalty program - RE decreased under new rules - now booking something that was revenue as unearned revenue - assets increased under the new rules bc they created a DTA when restating prior years

what to do to examine an increase in PPE

- look at sales revenue / PPE - look at PPE / total assets and compare to industry average

industries with large days in inventory

- luxury goods - stuff w long production time like Boeing - alcohol companies w products that take a long time to mature

what might a company be doing if Days inventory increases but GM % decreases?

- may be discounting products to try to get them out of inventory

JetBlue example 3: airline sells extra leg room, food on the flight, etc

- new rules say these additional sales are contract modifications (can't buy leg room if you haven't bought a plane ticket) - reduces revenue recognition?

operating leases - old rules

- no asset recorded - no liability recorded - cash payments are recorded as rent expense - expenses are the same in every year of the lease - total expenses = total of cash payments - expenses are classified depending on the use of the leased asset (COGS if it's used for manufacturing, SGA if not) - cash payment is an operating cash outflow on SCF

how to classify Lone Star's advertising costs for ad campaigns that haven't occurred yet

- observation: cash outlays and ad expenses spiked, but actual ad campaigns didn't increase - should have treated this cost as a prepaid asset, not as an expense bc the related ad campaign hasn't actually occurred - the effect: reduced this year's income by booking an expense instead of an asset and increased next year's income by not booking the expense when the promotion occurs

finance / capital leases

- record an asset initially equal to the PV of payments and amortize this each year on a straight line basis (yearly amortization = PV / # years in lease) - record a liability initially equal to the PV of payments, reduce this each year based on the amortization schedule - record interest expense and amortization expense (the S/L amortization of the asset) - expenses are higher in early years than in later years (interest expense decreases over time) - total expense = total of cash payments - record interest as an interest expense line item on IS - record amortization expense based on the type of leased asset (either in COGS or SGA) - portion of cash payment going towards interest = operating cash outflow on SCF - portion of cash payment going towards repaying the liability = financing cash outflow

operating leases under the new rules

- record an asset initially equal to the PV of payments, then amortize in a diff way - record a liability initially equal to the PV of payments, then reduce based on amortization table - record interest expense based on amortization table - record amortization expense - this is a plug # - expenses are the same in every year of the lease - total expenses = total of cash payments - interest and amortization expense are aggregated together into 1 line item on the IS, depending on type of asset (COGS or SGA), often called "rent expense" or "lease expense" - cash payment is an operating cash outflow on the SCF

JetBlue case, frequent flyer plans - deferred revenue method

- required under new revenue recognition rules - split the ticket price into 2 parts - the flight and the frequent flyer points (to be redeemed later) - when flight is booked: total ticket price is unearned revenue - when flight is taken: the portion of the ticket price related to the flight is now earned revenue, the portion related to the flyer points is unearned revenue - the portion of ticket price related to flyer points will be "earned" once the traveler redeems those points

why might mgmt choose LIFO?

- rising input costs and want lower taxes - if other firms in the industry are using LIFO - may use LIFO to lower income to avoid scrutiny from regulators - LIFO conformity rule

asset turnover equation

- sales / assets - measure of efficiency - tells us the $ of sales guaranteed per $ of assets - higher asset turnover --> more efficient

revenue recognition for death care industry

- sales price is split between funeral service and perpetual care of the grave - the portion related to perpetual care is treated as unearned revenue forever (a liability) - costs are expensed as incurred

KSR case - how to account for paying customers to develop software

- should reduce revenue when you pay someone to be your customer (debit revenue, credit cash) - by not reducing revenue for these costs, KSR inflates revenue and gross margin

JetBlue example 2: customer gets frequent flyer points when they use their ticket

- slows revenue recognition down - the portion of the ticket that goes toward points is reported as unearned revenue

how to find the yearly amortization of the asset for operating lease under the new rules

- start with the total cash payment - this is what we want the total expense to be - find interest expense on the amortization table (for the current year, this will be the interest listed on the NEXT year) - subtract this interest expense from total expense = amortization expense for current year (plug) - this is what we will reduce the CV of the lease asset by this year - must do this every year

list of inconsistencies b/w finance and operating leases under the new rules

- the asset is different (will be smaller under finance lease) - timing of expenses is different, so NI for the year is different (finance lease has higher expenses in early years) - classification of expenses on the IS is different (aggregated together for operating leases) - SCF is different (finance lease splits outflows between operating and financing outflows)

why would KSR be aggressive in recognizing revenues?

- to get more customers (prove that you'll stay in business, the expensive product is worth it, etc) - management wants to meet analyst forecasts - stock options - cash needs (line of credit increases when quarterly earnings exceeds a certain amount)

how to deal with customer acquisition costs

- typically expensed today - insurance industry is an exception - these firms can capitalize direct response marketing costs for customers, showing they've responded specifically to the advertising and which can result in probable future benefits - new guidance: incremental costs related to the acquisition of a contract that lasts > 1 year should be capitalized and amortized over the length of the contract

common size financial statements

- useful for spotting differences in trends - for income statements: divide each amount by the firm's own sales revenue for that year --> express each line item as % of sales revenues - for Balance sheets: divide each amount by the firm's own total assets for that year --> express each line item as a % of total assets - across firms: diffs in % for a given year can give insights into diffs in the firms' strategies - across time: diffs in % for the same firm across time can help reveal important trends

what creates DTLs?

- using SL depreciation for financial accounting (tax uses accelerated depreciation) - capitalizing commissions while treating them as an expense for tax - increasing the useful life of PPE - reducing pension expense bc of a change in assumptions

reasons not to use LIFO

- very small differences b/w LIFO and FIFO - firms may have large tax loss carry forwards so they aren't paying taxes - firms in cyclical industries w/ extreme fluctuations in inventory levels may avoid LIFO bc of high probability of LIFO liquidations - b/c of the LIFO conformity rule, lowering taxes also means lowering financial profits - use of LIFO could trigger debt covenant violations - LIFO records are more costly and harder to maintain

What causes a DTL?

-b/c of book/tax differences, we postpone paying taxes to the future (taxable income will be higher than financial income in the future) - caused by using accelerated depreciation for taxes but Straight line for financial purposes (lots of deductions now to taxable income, but depreciation for taxes will be lower in the future) - caused by capitalizing commissions for financial purposes but treating them as an expense for taxes

What does IFRS allow for inventory?

-doesn't allow LIFO - firms may use LIFO for domestic products and FIFO for international products

new revenue recognition standard - 5 steps

1. ID contract with customer - can be written, oral, or implied and collection must be "probable" 2. ID the separate performance obligations in the contract (what goods/services are actually promised? are goods / services distinct?) 3. determine transaction price - consider rights of return, rebates, fair value of non-cash consideration, and variable consideration 4. allocate the transaction price to the separate performance obligations - based on relative standalone selling prices 5. recognize revenue when or as the firm satisfies a performance obligation

How to calculate tax impact in the current year of the use of LIFO

1. approximate by assuming tax rate of 35% and multiplying that by the change in LIFO reserve - if LIFO reserve increased during the year, this means COGS under LIFO increased --> lower net income under LIFO --> LIFO created tax savings 2. find effective tax rate in the footnotes and multiply by the change in LIFO reserve - but the effective rate contains effects of some unrelated permanent differences, so may not be the best choice 3. find how much using FIFO would have increased or decreased NI (usually in an inventory footnote) and calculate how much using FIFO would have decreased or increased COGS (the change in the LIFO reserve) - the difference b/w the change in COGS and change in NI under FIFO is the extra (or less) taxes paid on that year's taxable income

determining if goods/services are distinct

1. can the customer benefit from the good/service on its own or with other readily available resources? - no: not distinct, combine with other goods/services until there is a bundle of distinct goods/services if yes: 2. are the promises separable from other goods/services? -questions to ask: no significant service of integrating? no significant modification or customization? not highly dependent on or interrelated with other goods/services? - if yes: count as separate performance obligations

Ex - 2 cases of performance obligations when a company sells a TV and customized remote control together, can turn the TV on without the remote but remote is only valuable with the TV

1. firm delivers TV first, remote second - there are 2 performance obligations b/c the customer benefits from the TV on its own and benefits from the remote control using a readily available resource (the TV) 2. the firm delivers the remote first and the TV second - there's only 1 performance obligation b/c the remote provides no benefit to the customer either on its own or with readily available resources (bc TV hasn't been delivered yet)

2 options for accounting for pass-through sales from a 3rd party (buy product from 3rd party, facilitate sale of product to customer)

1. if we ever own the product / bear risk to it - recognize the full sales price to customer as revenue - recognize the cost of the product in COGS 2. we don't own the product, its a "consignment" and we do nothing except facilitate the sale (amazon ex) - recognize revenue only for our services (not the full sales price of the product) - don't recognize the cost of the product in COGS (only costs related to our service) - same NI either way, - option 1 inflates revenue - Lone Star case - Sino Forest case (just held the trees, didn't actually do anything)

common sources of fraud

1. recognizing revenue too early 2. overstating ending inventory at quarter end (overstate inventory, understate COGS, can meet expectations about quarterly earnings)

collection period

365 days / receivables turnover

Gross margin %

= (revenue - COGS) / revenue - common retail GM % is 35% - higher GM % assoc with luxury goods

Inventory turnover

= COGS / Inventory - # of times the firm empties and restocks inventory each year - high inventory turnover --> restocking a lot

Equation for finding what ending inventory would have been under FIFO instead of LIFO

= Ending inventory under LIFO + LIFO Reserve in that year

days in inventory

= average inventory / (COGS / 365 days) = 365 / inventory turnover ? - how many days stuff sits in inventory - luxury goods have high days inventory

cash to cash cycle

= days in inventory + collection period - payables period - tells us the # of days that elapse b/w paying our suppliers and collecting from our customers - ex: cash to cash cycle of 13 days means that we collect from customers 13 days after paying suppliers - apple has a negative cash to cash cycle - collects from customers before paying suppliers

Equation for finding what COGS would have been under FIFO instead of LIFO

COGS under LIFO - Increase in LIFO reserve OR COGS under LIFO + Decrease in LIFO Reserve

ROE equation

Net Income/Shareholder's Equity - tells us how effective mgmt has been in managing the resources provided by SH - ROE is mean reverting - competition tends to drive a firm's ROE back down to a normal level

DuPont Decomposition

ROE = return on sales (aka net profit margin) x Asset turnover x Financial leverage

What does the LIFO reserve tell us?

Tells us how ending inventory would be different under FIFO - also tells us how total COGS (total of past and present COGS) would have been different under FIFO

comparison of the asset and liability under operating lease new rules

asset will tend to equal the total lease liability in all time periods

financial leverage equation

assets / equity - tells us the $ of assets deployed per $ of equity - higher number --> more highly levered - tends to magnify whatever else is going on in the DuPont Decomposition

Days payable

average accounts payable / (COGS / 365))

how to calculate the tax savings to date (accumulated) for using LIFO instead of FIFO

multiply the total LIFO reserve balance in the current year x tax rate - technically will pay these taxes eventually, but don't record a DTL for these amounts

LIFO conformity rule

must use LIFO for financial purposes if you use LIFO for tax purposes

return on sales equation

net income/sales - tells us how much $ we get to keep for each $ of sales

receivables turnover

net sales / net accounts receivable