Decision Guidelines - Financial Accounting PDF

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Decision Guidelines IN EVALUATING A COMPANY, WHAT DO DECISION MAKERS LOOK FOR? These Decision Guidelines illustrate how people use financial statements. Decision Guidelines appear throughout the book to show how accounting information aids decision making. Suppose you are considering buying The Walt Disney Company’s stock. How do you proceed? Where do you get the information you need? What do you look for?

Decision

Guidelines

1. Can the company sell its services or products?

1. Look at the net revenue on the income statement. Are revenues growing or falling?

2. What are the main income measures to watch for trends?

2. Look at the gross profit (sales – cost of goods sold), operating income (gross profit – operating expenses), and the net income (bottom line of the income statement). All three income measures should be increasing over time.

3. What percentage of revenue ends up as profit?

3. Divide net income by sales revenue. Examine the trend of the net income percentage from year to year.

4. Can the company collect its receivables?

4. From the balance sheet, compare the percentage increase in accounts receivable to the percentage increase in sales. If receivables are growing much faster than sales, collections may be too slow, and a cash shortage may result.

5. Can the company pay its a. current liabilities? b. current and long-term liabilities?

5. From the balance sheet, compare a. current assets to current liabilities. Current assets should be somewhat greater than current liabilities. b. total assets to total liabilities. Total assets must be somewhat greater than total liabilities.

6. Where is the company’s cash coming from? How is cash being used?

6. On the cash flows statement, operating activities should provide the bulk of the company’s cash during most years. Otherwise, the business will fail. Examine investing cash flows to see if the company is purchasing long-term assets—property, plant, and equipment and intangibles (this signals growth).

Decision Guidelines DECISION FRAMEWORK FOR MAKING ETHICAL JUDGMENTS Weighing tough ethical judgments in business and accounting requires a decision framework. Answering the following four questions will guide you through tough decisions:

Decision

Guidelines

1. What is the issue?

1. The issue will usually require making a judgment about an accounting measurement or disclosure that results in economic consequences, often to numerous parties.

2. Who are the stakeholders, and what are the consequences of the decision to each?

2. Stakeholders are anyone who might be impacted by the decision—you, your company, and potential users of the information (investors, creditors, and regulatory agencies) are all stakeholders. The consequences can be economic, legal, or ethical in nature.

3. Weigh the alternatives.

3. Analyze the impact of the decision on all stakeholders, using economic, legal, and ethical criteria. Ask “Who will be helped or hurt, whose rights will be exercised or denied, and in what way?”

4. Make the decision and be prepared to deal with the consequences.

4. Exercise the courage to either defend the decision or to change it, depending on its positive or negative impact. How does your decision make you feel afterward?

To simplify the analysis, ask yourself these three questions: 1. Is the action legal? If not, don’t do it, unless you want to go to jail or pay monetary damages to injured parties. If the action is legal, go on to questions 2 and 3. 2. Who will be affected by the decision and how? Be as thorough about this analysis as possible, and analyze it from all three standpoints (economic, legal, and ethical). 3. How will this decision make me feel afterward? How would it make me feel if my family reads about it in the newspaper? In later chapters throughout the book, we will apply this model to different accounting decisions.

Decision Guidelines HOW TO MEASURE RESULTS OF OPERATIONS AND FINANCIAL POSITION The managers who operate a business, along with its owners, need to be able to determine whether the venture is profitable. To do this, they need to understand when transactions occur and how and where they should be recorded. Doing so will help ensure the business’s financial statements are accurate and provide a good picture of its operational results and financial position. The following guidelines will help:

Decision

Guidelines

Has a transaction occurred?

If the event affects the entity’s financial position and can be reliably recorded—Yes

Where should the transaction be recorded? How should an increase or decrease in the following accounts be recorded?

If either condition is absent—No In the journal, the chronological record of transactions The rules of debit and credit state: Assets ..................................... Liabilities ............................... Stockholders’ equity ............... Revenues ................................ Expenses ................................

Increase

Decrease

Debit Credit Credit Credit

Credit Debit Debit Debit

Debit

Credit

Where should all of the information for each account be stored?

In the ledger, the book of accounts

Where should all of the accounts and their balances be listed? Where should the following be reported:

In the trial balance

Results of operations?

In the income statement (Revenues – Expenses = Net income or net loss) In the balance sheet (Assets = Liabilities + Stockholders’ equity)

Financial position?

Decision Guidelines EVALUATE A COMPANY’S DEBT-PAYING ABILITY USING ITS NET WORKING CAPITAL, THE CURRENT RATIO, AND THE DEBT RATIO In general, a larger amount of net working capital is preferable to a smaller amount. Similarly, a high current ratio is preferable to a low current ratio. Increases in net working capital and increases in the current ratio improve a company’s financial position. By contrast, a low debt ratio is preferable to a high debt ratio. A decrease in the debt ratio indicates a company’s financial position has improved. Let’s apply what we have learned. Suppose you are a loan officer at Bank of America and The Walt Disney Company has asked you for a $20 million loan to launch a new theme park ride. How will you make this loan decision? The Decision Guidelines show how bankers and investors use two key ratios.

➤ USING NET WORKING CAPITAL AND THE CURRENT RATIO

Decision How can you measure a company’s ability to pay its current liabilities with its current assets? Who uses net working capital and the current ratio for decision making?

Guidelines Net working capital = Total current assets - Total current liabilities Current ratio =

Total current assets Total current liabilities

Lenders and other creditors, who must predict whether a borrower can pay its current liabilities. Stockholders, who know that a company that cannot pay its debts is not a good investment because it may go bankrupt. Managers, who must have enough cash to pay the company’s current liabilities.

What are good values for net working capital and the current ratio?

There is no correct answer for this. It depends on the industry as well as the individual entity’s ability to generate cash quickly and primarily from operations. A company with strong operating cash flow can operate successfully with a low amount of net working capital as long as cash comes in through operations at least as fast as the company’s accounts payable become due. A current ratio of, say, 1.10–1.20 is sometimes sufficient. A company with relatively slow cash flow from operations needs a higher current ratio of, say, 1.30–1.50. Traditionally, a current ratio of 2.00 was considered ideal. Recently, acceptable values have decreased as companies have been able to operate more efficiently. Today, a current ratio of 1.50 is considered strong. Although not ideal, cash-rich companies like Disney can operate with a current ratio at or near 1.0.

➤ USING THE DEBT RATIO

Decision How can you measure a company’s ability to pay its total liabilities? Who uses the debt ratio for decision making?

Guidelines Debt ratio =

Total liabilities Total assets

Lenders and other creditors, who must predict whether a borrower can pay its debts. Stockholders, who know that a company that cannot pay its debts is not a good investment because it may go bankrupt. Managers, who must have enough assets to pay the company’s debts.

What is a good value of the debt ratio?

It depends on the industry: A company with strong cash flow can operate successfully with a high debt ratio of, say, 0.70–0.80. A company with weak cash flow needs a lower debt ratio of, say, 0.50–0.60. Traditionally, a debt ratio of 0.50 was considered ideal. Recently, values have increased as companies have been able to operate more efficiently. Today, a normal value of the debt ratio is around 0.60–0.70.

Decision Guidelines HOW CAN THE RISK OF NOT COLLECTING RECEIVABLES BE MANAGED? A company faces management and accounting issues when it extends credit to customers. Suppose you open a health club near your college. Assume you let customers use the club and bill them later for their monthly dues. Let’s look at the issues you will encounter by extending credit to your customers as well as the plan of action you can use to resolve each issue:

Issue

Plan of Action

1. What are the benefits and the costs of extending credit to customers?

1. The benefits are increased sales. The costs are the risk of not collecting the amounts owed to the business.

2. How do you know which customers to extend credit to?

2. Run credit checks on prospective customers. Extend credit only to creditworthy customers.

3. How do we keep employees from stealing customer payments?

3. Separate cash handling and record-keeping responsibilities. See Chapter 4.

4. How can we maximize cash flow from customer payments?

4. Keep a close eye on customers’ payment habits. Send second and third statements to slow-paying customers, if necessary. Better solution: Have customers sign agreements for automatic payment by electronic funds transfers (EFTs) from their bank accounts each month. (See Chapter 4.)

Decision Guidelines HOW SHOULD UNCOLLECTIBLE RECEIVABLES BE MEASURED AND REPORTED? The main issues and action plans related to accounting for receivables that may be uncollectible are as follows. (Assume the amounts in the “Plan of Action” column are for the health club you started, referenced in the Decision Guidelines on page 257.)

Issue

Plan of Action

1. How do you measure and report receivables on the balance sheet?

1. Report them at their net realizable value, which is the amount you expect to collect for them. Report receivables at net realizable value: Balance sheet Receivables................................................... Less: Allowance for uncollectible accounts... Receivables, net............................................

2. How do you measure and report the expense associated with the failure to collect receivables?

$1,000 (80) $ 920

2. Report it on the income statement as uncollectible-account expense (or doubtful-account expense or bad-debt expense). Measure the expense of not collecting from customers: Income statement $8,000 Sales (or service) revenue.............................. Expenses: Uncollectible-account expense.................. 190

Decision Guidelines ACCOUNTING FOR INVENTORY Suppose a Williams-Sonoma store stocks two basic categories of merchandise: ■

High-end cookware, small electric appliances, cutlery, and kitchen furnishings

■

Small items of low value, such as cup holders and bottle openers, which are located near the checkout area.

The store manager is considering how accounting will affect the business. Let’s examine several decisions the manager must make to properly account for the store’s inventory.

Decision

Guidelines

Which inventory • system to use? •

Expensive merchandise Cannot control inventory by visual inspection

System or Method Perpetual system for high-unit-cost items

•

Can control inventory by visual inspection

Periodic system for the small, low-value items

•

Unique inventory items

Specific unit cost for one-of-a-kind objects because they are unique

Which costing • method to use? •

Most current cost of ending inventory Maximizes reported income when costs are rising

•

Most current measure of cost of goods sold and net income

•

Minimizes income tax when costs are rising

•

Middle-of-the-road approach for income tax and reported income

FIFO

LIFO

Average

Decision Guidelines PLANT ASSETS AND RELATED EXPENSES FedEx Corporation, like all other companies, must make some decisions about how to account for its plant assets and intangibles. Let’s review some of these decisions.

Decision

Guidelines

Capitalize or expense:

General rule: Capitalize all costs that provide future benefit for the business such as a new package-handling system. Expense all costs that provide no future benefit, such as a repair to an airplane.

• A cost associated with a new asset?

Capitalize all costs that bring the asset to its intended use, including the purchase price, transportation charges, and taxes paid to acquire the asset.

• A cost associated with an existing asset?

Capitalize only those costs that add to the asset’s capacity or to its useful life. Expense all other costs as maintenance or repairs.

Which depreciation method to use: •

For financial reporting?

Use the method that best allocates the cost of an asset through depreciation expense against the revenues produced by the asset. Most companies use the straight-line method.

•

For income tax?

Use the method that produces the fastest tax deductions (MACRS). A company can use different depreciation methods for financial reporting and for income tax purposes. In the United States, this practice is both legal and ethical.

How to account for natural resources?

Capitalize the asset’s acquisition cost and all later costs that add to the natural resource’s future benefit. Record depletion by the units-of-production method by transferring the amount extracted to inventory and eventually to cost of goods sold.

How to account for intangibles?

Capitalize the asset’s acquisition cost and all later costs that add to its future benefit. For intangibles with finite lives, record amortization expense. For intangibles with indefinite lives, measure the impairment in value and record a loss for that amount.

How to record impairments in long-term assets?

Every year, conduct a two-step impairment process for most longterm assets: STEP 1: Compare the net book value with expected cash flows from the asset. If net book value > expected cash flows, the asset is impaired. Otherwise, the asset is not impaired. STEP 2: For all impaired assets under step 1, reduce the carrying value of the asset from net book value to fair value. Record a loss for the difference.

How profitable is the company?

Return on assets (ROA) = Net profit margin ratio × Total asset turnover = (Net income/Net sales) × (Net sales/Average total assets)

Decision Guidelines INVESTING IN STOCK Suppose you’ve saved $5,000 to invest. You visit a nearby Edward Jones office, where the broker probes for your risk tolerance. Are you investing mainly for dividends or for growth in the stock price? These guidelines offer suggestions for what to consider when investing in stock.

Investor Decision

Guidelines

Which category of stock to buy for: •

A safe investment?

Preferred stock is safer than common, but for even more safety, invest in high-grade corporate bonds or government securities.

•

Steady dividends?

Cumulative preferred stock. However, the company is not obligated to declare preferred dividends, and the dividends are unlikely to increase.

•

Increasing dividends?

Common stock, as long as the company’s net income is increasing and the company has adequate cash flow to pay a dividend after meeting all obligations and other cash demands.

•

Increasing stock price?

Common stock, but again only if the company’s net income and cash flow are increasing.

•

How to identify a good stock to buy?

There are many ways to pick stock investments. One strategy that works reasonably well is to invest in companies that consistently earn higher rates of return on assets and on equity than competing firms in the same industry. Another, called “value investing,” is to invest in companies that have high earnings but relatively low price/earnings multiples compared to other companies in the same industry. Still another is to select companies with solid earnings in industries that are expected to grow.

Decision Guidelines WHAT CASH FLOW FACTORS DIFFERENTIATE A HEALTHY COMPANY FROM AN UNHEALTHY COMPANY? What are the signs of good financial health from the standpoint of cash f lows? How can you differentiate a healthy company from an unhealthy one? Here are a few guidelines: 1.

2.

3.

The primary source of cash inflows should be operations. In general, the cash flow a company generates should exceed its net income. When the indirect method is used, one of the largest positive adjustments to net income is usually the add-back for depreciation and amortization expense. Declining inventory and receivables balances can also be signs of healthy cash flows from operations. In contrast, a negative cash flow from operations is a danger sign. Companies that, over the long run, use rather than provide cash from operations, do not remain in business. The net cash flow from investing activities is usually negative. To see cash flowing out of an entity for purchases of long-term assets is a sign that the company is focused on growth, and is investing for the future. Healthy companies can also be expected to sell long-term assets from time to time that they no longer need for their core business operations or to make room for new assets. This will result in some positive cash flow from investing activities for a company, but the amount will be relatively small and relatively rare. In contrast, weak companies often have positive net cash flows from investing activities because they are trying to generate cash by selling their fixed assets. Companies that do this as a primary source of cash are eroding their assets and, in effect, contracting their businesses, which hampers their ability to remain in business over the long run. Cash flow from financing activities such as issuance of debt or capital stock provides cash on an as-needed basis for selective investing activities. However, net cash generated from financing activities should not exceed net cash provided by operating activities over extended period...