Special Items in Financial Statement

Special Items in Accounting
www.corporatebridge.net

Dheeraj Vaidya
Corporate Bridge Academy
dheerajvaidya@corporatebridge.net
Private and Confidential Not for Circulation
Inventory Valuation Methods
Methods of Inventory Accounting
First-In First-Out (FIFO)

This method assumes that the first units purchased are the first units sold
The cost of most recent purchases is assigned to ending inventory
Last-In First-Out (LIFO)

The LIFO inventory costing method assumes that the last units purchased are the first to be sold
The costs of beginning inventory and earlier purchases go to ending inventory
Weighted average costing

This method assumes that the units are sold without regard to the order in which they are purchased
Instead, it computes COGS and ending inventories as a simple weighted average
Example
Summary Inventory Records
Inventory on January 1st, 2006
Inventory purchased in 2006
Cost of goods available for sale in 2006
Inventory sold in 2006
No. of units
600
200
800
$/unit
100
150
Total cost
60,000
30,000
90,000
550
250
137,500
Calculate gross profit for the following methods of inventory valuation

a) FIFO
b) LIFO
c) Weighted Average Costing
Also show the Balance sheet and Income Statement Flow

FIFO:
Calculation of gross profit
FIFO
Sales
COGS (550 @ $100)
Gross Profit
137,500
(55,000)
82,500
Balance Sheet Effect

Assets
Liability
Shareholders Equity
$55,000 flows
through the Income
Statement as expense
$55,000
cost of goods sold
Inventory cost as on January 1st,

2006 is taken
LIFO:
LIFO
Sales
COGS (200 units @ $150)
COGS (350 units @ $100)
Gross Profit
Last purchased inventory taken first

and the remaining from the
beginning of the year inventory
137,500
(30,000)
(35,000)
72,500

Assets
$65,000
cost of goods sold
Liability
Shareholders Equity
$65,000 flows
through the Income

Weighted Average Cost
Calculation of Weighted average cost
Total cost
Total units
Average cost
90,000
800
112.5
Weighted Average cost

Sales
COGS (550 @ $112.5)
Gross Profit

Assets
Liability
Shareholders Equity
$61,875 flows
through the Income
$61,875
cost of goods sold
Weighted average cost taken as per

calculation above
137,500
(61,875)
75,625
Summary
Summary
FIFO Costing
LIFO Costing
Average Costing
COGS
55,000
65,000
61,875
Ending Inventory
35,000
25,000
28,125
FIFO: 200*150+50*100 = $35,000

LIFO: =250*100 = $25,000
Average Costing: = 112.5 * 250 = $28,125
Financial Statement Effects

In an environment of Stable Prices
All three inventory valuation methods (FIFO, LIFO and Weighted Average costs) will yield the same
results for Inventory, COGS and Earnings
In an environment of Rising Prices and Increasing or Stable Inventory

Item
LIFO
FIFO
COGS
Higher
Lower
Higher as inventory reflects the most
recently purchased items
Ending Inventory
and Working Capital
Lower as inventory reflects the prices

of items purchased at lower prices
Net Worth
Lower because earnings and inventory

is lower
Higher because earnings and inventory

is higher
Lower Taxes
Higher Taxes
Lower because COGS is higher
Higher because COGS is lower
Same
Same
Higher because of lower tax outgo
Lower because of higher tax outgo
Taxes
Earnings
Pre-tax Cash Flows
After-tax Cash flows
Analytical adjustments
Profitability
LIFO produces higher COGS balances and are better measure of true economic costs
In an environment of rising prices, LIFO produces income that are lower than FIFO
Gross margins and profit margins are lower due to lower income under LIFO
For FIFO firms, profitability ratios should be recalculated using estimates of what COGS would
have been under FIFO
Liquidity
FIFO produces inventory figures that are higher and are a better measure of economic value
LIFO, however, uses prices that are outdated (in an environment of rising prices)
Liquidity ratios such as current ratios are higher under FIFO than in LIFO
For LIFO firms, Liquidity ratios should be recalculated using inventory balances that have been
restated using LIFO reserve
Assets
LIFO Reserve
Liability
LIFO Reserve
x Tax Rate
Shareholders Equity
LIFO Reserve
x (1-Tax Rate)
Solvency
Solvency ratio like debt ratio, debt-to-equity ratio will be lower under FIFO because of higher denominator
For firms that use LIFO, ratios should be calculated using asset and equity figures restated by
using LIFO reserve
Change in depreciation policy
Change in Depreciation Policy
Depreciation Policies
Straight Line Depreciation Method
Sum-of-years digit Method
Double declining method
Written Down value method
Effect of Changes in Depreciation Methods

Impact on Cash Flows

NO IMPACT?
Impact on Earnings
Firm that chooses an accelerated method of depreciation instead of using straight-line will tend to have
greater depreciation expense and lower net income
Will continue if the firm is investing in new assets that the lower depreciation on old asset is more than
offset by the higher depreciation on new assets
Impact on Operating Performance

ROE?
Retained Earnings?
Impact of Change in Depreciation Policy
Depreciaton Expense
Net Income
Assets
Equity
Return on Assets
Return on Equity
Turnover Ratios
Cash Flows
Straight Line
Lower
Higher
Higher
Higher
Higher
Higher
Lower
Same
Accelerated (WDV)
Higher
Lower
Lower
Lower
Lower
Lower
Higher
Same
Change in depreciation policy of Jet Airways from WDV to SLM

Wrote back Rs9.2bn into its P&L, which helped the company to report profits during the quarter
It also helped Jet to report higher net worth, which will help in keeping reported gearing low
TCS, the software major, increased its depreciation policy on computers from 2 years to 4
years. As a result, 1QFY09 PBT was higher by an estimated Rs500m (c.4% of net profit in
1QFY09).
10
Operating and Financial leases
11
Introduction to Leases
Leases
Contractual agreement between the lessor (owner of asset) and the lessee (rents the asset)
Gives the lessee the right to use specific property
Specifies the duration of the lease and rental payments
Obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee
Who are the concerned parties?

Lessee: Transportation (Trucks, Aircrafts), Real Estate (Building), Construction Agriculture
Lessors: Captive Leasing companies, Banks and other Independents
Rationale for leases

Financial
Operational
Leasing ready-to-use equipment can be more

attractive if the asset requires lengthy preparation
and set-up
Leases may not require any money down and may

be a less costly means of financing
Leasing avoids having to own the asset that will be

required only seasonally, temporarily or
sporadically (leasing contract can be tailored)
Lease payments can be tailored to suit the lessees

cash flows (up to 100% financing, instead of 80%
limit by banks)
Leasing for short periods protects against

obsolescence
Leases may contain less restrictive covenants than

other types of lending arrangements
Disadvantages of leases?
12
Lessees Perspective: Capital Leases vs. Operating Leases
Operating Leases
Leases that do not transfer substantially all the benefits and risks of ownership are operating leases
Lessee rents the property
Lessee accrues rent expense
Capital lease
Capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided
the lease is non-cancelable
Lessee economically owns the property
Lessee records the leased asset in the balance sheet (i.e. capitalizes the asset) and reflects the
corresponding lease obligation
Leases that do not meet any of the four criteria are accounted for an Operating
Lease
Test1: Transfer of ownership
Test 2: Bargain purchase option?
Test 3: Lease term > = 75% of economic life ?
Test 4: Present value of payments >= 90% Fair Market Value?
Yes
Capital Lease
No
Operating Lease
13
Lessees Perspective: Classification of Leases
Example : Lessees Perspective: Classification of Leases

An equipment with a market price of (FMV) of US$100,000 and useful life of 5 years is leased
to a lessee for a period of 4 years. The lease payments are US$26,000 a year. The borrowing
rate for the firm is 8%, and the rate implicit in the lease is 7%. There is no provision for
Lessee to purchase asset at the end of the lease term, nor any bargain purchase option.
Test 1
Does the lease transfer ownership of the property to the lessee by the end of the
non-cancellable lease term?
Answer
No
Test 2
Does the lease contain an option to purchase the leased property at a bargain price?
Cost to purchase asset at end of lease
Estimated asset value at end of lease
na
na
14
Lessees Perspective: Classification of Leases
Test 3
Is the lease term greater than or equal to 75% of the estimated economic life of the
leased property?
Estimated useful life (years)
75% of estimated useful life
Non-cancellable Lease term (years)
Difference
5.0
3.8
4.0
-0.25
Difference is negative
implies capital Lease
Test 4
Does the present value of rental and other minimum lease payments, excluding that portion
of the payments representing executory cost, equal or exceed 90 percent of the fair value
of the leased property?
Value of leased asset
90% of value of leased asset (at lease inception)
"Present Value" of lease
Difference
$100,000
$90,000
$88,067
$1,933
If difference is negative,
then Capital Lease
15
Lessees Perspective: Operating Lease Accounting
Operating Lease ( At inception)
Assets
Shareholders Equity
Shareholders Equity
No Entry
No Entry
Liability
Operating Lease ( as payments are made)

Assets
Liability
Cash reduced by
periodic lease
payments
Flows through Income

statement as rent
expense
Effect on Cash Flows

Total lease payment reduces cash flow from operations
Operating leases do not affect the lessees liabilities and hence, are referred to as off-balance
sheet financing
Footnote disclosure of lease payment for each of the next five years is required
16
Lessees Perspective: Capital Lease Accounting

Capital Lease ( at inception)
Assets
Present value of
minimum lease
payment
Liability
Shareholders Equity
Shareholders Equity
Present value of
minimum lease
payment
Capital Lease ( as payments are made)

Assets
a)
Cash reduced by
periodic lease
payments
Liability
Lease obligation is
reduced by periodic
lease payment LESS
Interest payment

statement as Interest
expense and
Depreciation expense
b) Leased property is
reduced by
depreciation
amount
Interest expense = Discount rate times the Lease liability at the beginning of the period
Depreciation Period calculations
If lease transfers ownership, depreciate asset over the economic life of the asset.
If lease does not transfer ownership, depreciate over the term of the lease.
Effect on Cash Flows

Only portion of the lease payment that is considered interest payment reduces CFO
Part of the lease payment considered payment on principal reduces CFF

17
Lessees Perspective: Example
Example (continued) : Operating lease and Capital Lease

An equipment with a market price of (FMV) of US$100,000 and useful life of 5 years is leased
to a lessee for a period of 4 years. The lease payments are US$26,000 a year. The borrowing
rate for the firm is 8%, and the rate implicit in the lease is 7%. There is no provision for Lessee
to purchase asset at the end of the lease term, nor any bargain purchase option
Operating Lease
If we assume that the lease is an Operating Lease
a) Balance Sheet: No Impact
b) Income Statement Effect: Lease payments of $26,000 treated as expense
c) Cash Flow: Lease payment of $26,000 treated as outflow for Cash flow from operations
Capital Lease
In the earlier illustration, the lease was a capital Lease
Balance Sheet at Inception
a) Present value at 7% is $88,067
b) Both Asset and Liability increases by the present value of lease payments at inception
Assets
US$88,097
Liability
Shareholders Equity
US$88,097
18
Lessees Perspective: Accounting

Capital Lease: Balance Sheet Effect (as payments are made)

=
Assets
a)
Cash reduced by
periodic lease
payments of
US$26,000
Liability
Lease obligation is
reduced by periodic
lease payment
US$26,000 LESS
US$6,165
Shareholders Equity
statement as Interest
expense of US$6,165
and Depreciation
expense of US$22,017
b) Leased property is
reduced by
depreciation
amount of
US$22,017
Capitalized lease calculations
Year
0
1
2
3
4
(a)
Beginning
Leasehold
Value
$88,067
$68,232
$47,008
$24,299
(b)
Interest
Expense (a) X
7%
$6,165
$4,776
$3,291
$1,701
(c)
Lease
payment
$26,000
$26,000
$26,000
$26,000
(d)
Ending
(e)
(f)
Leasehold value Depreciation Book Value
(a+b-c)
Expense
of Assets
$88,067
$88,067
$68,232
$22,017
$66,051
$47,008
$22,017
$44,034
$24,299
$22,017
$22,017
$0
$22,017
$0
Note: a) The book value of assets decline each year by the depreciation amount as shown in column (f)
b) Depreciation (term of 4 years) = $88,067/4 = $22,017
c) Principal repayments equals the lease payments LESS interest expense
d) The asset (column f) is being depreciated at a rate that is different from the rate of amortization for
the liability (column d), the two values are equal only at the inception and termination of the lease
19
Comparison of Operating and Capital Leases

Income Statement Effect
Year
1
2
3
4
Capital Lease
Operating Expense =
Total Expense
$26,000
$26,000
$26,000
$26,000
Operating Expense
$22,017
$22,017
$22,017
$22,017
Non-operating
expense
$6,165
$4,776
$3,291
$1,701
Total Expense
$28,181
$26,793
$25,307
$23,718
Income Statement Effect

Income Statement Effects
$29
Operating income is higher for capital lease

(This is because depreciation expense for capital lease
is lower than the lease payments)
Net income is lower in early years for capital lease
Operating
lease
$28
Expense ('000 $)
Operating Lease
$27
$26
$25
$24
Capital lease
$23
$22
$21
1
Years
Cash Flow Effect

Operating Lease
Year
1
2
3
4
Cash flow from

operations
($26,000)
($26,000)
($26,000)
($26,000)
Capital Lease
Cash flow from
operations
($6,165)
($4,776)
($3,291)
($1,701)
Cash flow from

financing
($19,835)
($21,224)
($22,709)
($24,299)
In operating lease, the total cash payment reduces

cash flow from operations
In capital lease, the part of lease payment considered
payment on principal reduces cash flow from financing
activities
Total CF is unaffected by the accounting treatment
20
Lessees Perspective: Ratio Effects

Effect on Financial Statements
Financial Statement
Capital Lease
Operating Lease
Assets
Higher
Lower
Liabilities
Higher
Lower
Net Income (in early years)
Lower
Higher
Cash flow from operations
Higher
Lower
Cash flow from financing
Lower
Higher
Total Cash Flow
Same
Same
Effect on Ratios
Financial Statement
Capital Lease
Operating Lease
Current ratio
Lower
Higher
Working Capital
Lower
Higher
Asset Turnover
Lower
Higher
Return on assets
Lower
Higher
Return on equity
Lower
Higher
Debt/Equity
Higher
Lower
21
Capitalization vs Expensing
22
Capitalization versus expensing
Capitalize
Means show the cost as an asset on the balance sheet
These assets have future benefits
Expense
Benefits are immediate
Or future benefits are too uncertain or immaterial
Costs flow through the financial statements
Cost incurred
Capitalization
Expensing
Income
Statement
Balance Sheet
Net Income
(Depreciation or
Amortization
Expense)
CFI Outflow
Net Income
(Expense)
CFO outflow
Management discretion in exercising these choices can significantly impact the financial
statements and the ratios
23
WorldCom Case
Most infamous example of inflating earnings through improper capitalization of

expenses
Transaction
$3.8bn 2001-02
expenditure on
line costs
Regulators?
What was
required as per
GAAP
What WorldCom
did?
Accounting
Treatment
$3.8bn must be
treated as
operating
expense
WorldCom
capitalized the
costs
Financial
Statement
Effects
Pre-tax Income
should be
deducted by
$3.8bn
$3.8bn was
capitalized and
put on the
balance sheet
(for
amortization)
WorldCom declared
bankruptcy in July 2002.
Chief accounting and
finance executives charged
with securities fraud
24
Financial Statement Effects
Income Statement Effects

Income Statement
Expensing
Capitalizing
Income Variability
Greater variability
Smoothening effect on net

income from year to year
Less matching of revenues and

costs
Cost deferred and matched with

revenues
Profitability (Early years)
Lower as all expenses flow

through the IS
Higher as cost is amortized
Profitability (Later years)
Higher as all cost has been

expensed
Lower due to amortization of

capitalized cost
Expensing
Capitalizing
Asset and Liability
Lower
Higher
Leverage Ratios (debt/equity,

debt/asset)
Higher
Lower due to higher base
Book Value/Share
Lower
Higher
Expensing
Capitalizing
Cash Flow from Operations
Lower
Higher
Cash Flow from Investing
Higher
Lower
Same
Same
Matching of revenues
Balance Sheet Effects

Balance Sheet
Cash flow effects

Cash Flow
Total Cash Flows
25
Capitalization of interest
Capitalized interest is the interest incurred during the construction of long-lived assets.
Capitalized interest is included as the initial cost of the asset on the balance sheet instead of
being charged off as interest expense on the income statement
Qualifying assets for capitalized interest
They must require a period of time to make them ready for use
Assets under construction for use in operations
Discrete assets intended for sale or lease
What is the Capitalization period?

Capitalization period begins when
Expenditures for the asset have been made
Activities for readying the asset are in progress
Interest costs are being incurred
Capitalization period ends when
Asset is substantially complete and ready for its intended use
26
Intangibles Assets
27
Intangibles Capitalized or Expensed

Patents
Goodwill
Advertisements
28
Accounting for Research and Development

Future benefits from R&D expenditures is highly uncertain at the start of a project
SFAS 2 requires virtually all R&D expenditures to be expensed as incurred
Principle of conservatism is applied in case of R&D
However, when one firm buys another firm, the total purchase price must be apportioned
among the individual assets acquired
Immediately written off
$5,000
$4,000
In-process
R&D (no future
alternative)
$600
In-process R&D with

almost certain future
$400
Tangible Assets
Purchase price
SFAS 2 requires that a portion of purchase price be allocated to in-process R&D and be
immediately written off
Managers have a strong incentive to allocate a large portion of the purchase price to
purchased in-process R&D
29
Accounting for Software Development Costs

More liberal for accounting internal expenditures for software development
Software development cost is a major costs for many small, growth service companies and
thats their main asset
This prompted FASB to be more liberal while formulating SFAS 86

Expensed as
incurred
Capitalized and
amortized
Technologically feasible
Research
expenditures
Development
expenditures
Before
After
30
Intangibles Example
Example: Intangibles
An enterprise is developing a new production process. During the year 2001, expenditure incurred
was Rs. 10 lakhs, of which Rs. 9 lakhs was incurred before 1 December 2001 and 1 lakh was incurred
between 1 December 2001 and 31 December 2001. The enterprise is able to demonstrate that, at
1 December 2001, the production process met the criteria for recognition as an intangible asset.
The recoverable amount of the know-how embodied in the process (including future cash outflows
to complete the process before it is available for use) is estimated to be Rs. 5 lakhs.
How much is recognized as intangible assets
How much is recognized is expensed
During the year 2002, expenditure incurred is Rs. 20 lakhs. At the end of 2002, the recoverable
amount of the know-how embodied in the process (including future cash outflows to complete
the process before it is available for use) is estimated to be Rs. 19 lakhs.
How much is recognized as intangible assets?
What is the impairment?
31
Intangibles: Capitalize/ Expense
Intangible Asset
Research and development
Treatment as per US GAAP

Expensed as incurred
Patents and copyrights
Costs incurred in development are expensed but if a patent or

copyright is purchased then the cost is capitalized
Franchise and license costs
Capitalized by the purchasing firm
Brands and trademarks
Capitalized by the purchasing firm
Advertising costs
Expensed as incurred
Goodwill
May be recognized and capitalized only in purchase transactions.

Under US GAAP goodwill is subject to an impairment test
Computer software &

development costs
All costs incurred in feasibility studies are expensed but subsequent

development costs of an established product can be capitalized
32
Deferred Tax
33
Introduction to accounting for Income taxes
Difference between Financial & tax reporting
Indian GAAP
Income Tax Act
Generally accepted accounting

principles is a set of rules for
preparing financial statements
Internal Revenue Services

Code sets rules for preparing
tax returns
Pretax Financial Income
Taxable Income
Income Tax Expense
Income Taxes Payable
Income tax expense from GAAP and income tax payable from Income Tax Act do not equal
When income and expense are treated differently on financial statements than it is on the
companys tax returns results in Deferred tax asset or Deferred tax liabilities
Purpose of accounting for income tax

Recognize deferred tax liability or deferred tax asset for the tax consequences of amounts that will
become taxable or deductible in future years as a result of transactions or events that already have
occurred
34
Temporary differences
Difference between the tax basis of an asset or liability and its reported (carrying or book)
amount in the financial statements that will result in taxable amounts or deductible amounts
in future years
Deferred Tax Liability

Accounting
Income >
Taxable Income
Future Taxable
Amounts
Deferred Tax
Liability
Accelerated depreciation on tax return (straight line on income statement)
Installment sales of property (installment method for taxes)
Unrealized gain from recording investments at fair value (taxable when asset is sold)
Deferred Tax Asset

Accounting
Income <
Taxable Income
Future
Deductible
Amounts
Deferred Tax
Asset
Rent or subscriptions collected in advance
Warranty expenses are accrued on income statement (tax deductible only when warranty claims are paid)
Deferred compensation cost is recognized as it is earned (tax deductible only when payments are made)
Asset impairment
Post retirement benefit expenses
35
Deferred tax Illustration Temporary Difference
Example 1: Deferred tax calculations

Toy & Co. purchases an asset each year for three years. Asset 1 in the first year, Asset 2 in the second year and
Asset 3 in the third year. The cost of each of these assets is US$10,000, with no salvage value and 4 years life.
Double declining balance method is used on tax returns and straight line for financial statements
Calculate the Deferred tax liability from Year 1 to Year 4.
Tax return calculations (DDB)
Asset 1
Asset 2
Asset 3
Total DDB depreciation
Year 1
5,000
5,000
Year 2
2,500
5,000
7,500
Year 3
1,250
2,500
5,000
8,750
Year 4
1,250
1,250
2,500
5,000
Income Statement (straight line)

Asset 1
Asset 2
Asset 3
Total SL depreciation
Year 1
2,500
2,500
Year 2
2,500
2,500
5,000
Year 3
2,500
2,500
2,500
7,500
Year 4
2,500
2,500
2,500
7,500
Cumulative Deferred Tax Liability

Deferred liability @ 30% tax rate
Cumulative Deferred liability
Year 1
750
750
Year 2
750
1,500
Year 3
375
1,875
Year 4
-750
1,125
Year 1: (5,000 2,500) * (30%) = 750

Year 2: (7,500 5,000) * (30%) = 750
Year 3: (8,750 7,500) * (30%) = 375
Year 4: (5,000 7,500) * (30%) = -750
Temporary difference
reverses from Year 4
If there is no reversal of deferred liability, the cumulative deferred liability will continue to
increase as long as the firm continues to grow
36
Permanent differences
Permanent differences
Results mainly from revenues or expenses that affect pretax income or taxable income, but not both
No deferred liability or assets are created as these differences are permanent
Common sources of permanent difference
Tax-exempt interest received from US municipal bond obligations
Premium on life insurance policies where the company is beneficiary (not deductible for tax purposes)
Allowable tax credits
Goodwill amortization (under IAS)
As these differences are never deferred but are considered decreases or increases in the effective tax
rate
If the only difference between taxable and pretax incomes were a permanent difference, then tax expense
would be simply tax payable
Illustration: Permanent difference

Preliminary Income
Tax-exempt interest income
Premiums paid on life insurance
Pretax Income / Taxable Income
Preliminary tax liability (40%)
Less eligible tax credits
Tax expense / tax liability
Effective tax rate/ Statutory tax rate
Income Statement
80,000
20,000
-5,000
95,000
NA
NA
28,000
29.5%
Tax Return
80,000
80,000
32,000
-4,000
28,000
40.0%
No deferred liability or
assets are created
37
Deferred Taxes
Study of BSE-100 companies
Source of Deferred Tax

Depreciation
Fiscal allowances on fixed assets
Interest Accrued
Lease Adjustments
Deferred Revenues
Others
Companies
78 companies
HUL, ITC & M&M
Canara Bank, Allahbad Bank
SBI, MRPL, HDFC
ONGC
Others
% of total
94.75%
2.15%
0.67%
0.58%
0.44%
1.41%
Source: Chartered Accountant Journal, July 2006
38
Analysts note on Deferred Taxes

The analyst should consider the firms growth rate and capital spending levels when
determining whether the difference will actually reverse
Impairment generally result in creation of Deferred tax assets since the write-down of assets
is recognized immediately for financial reporting, but not for tax purpose until the asset is
sold
Restructuring also leads to creation of Deferred tax assets since for financial reporting
purpose the costs are recognized immediately when restructuring is complete, but not
expensed for tax purpose until actually paid
Deferred tax liability or assets is expected to reverse

Valued for accounting purpose at its undiscounted value
Deferred tax liability or assets is NOT expected to reverse

The difference should be treated as Equity
39
Contingent Liabilities
40
Contingent Liability
Contingent liabilities represent potential expenses for a company where the outcome is
dependent upon one of more future events
If it is probable the liability will crystallize then the full amount must be accrued in the
financial statements
However, if payment is less than probably (usually interpreted to be a probability of less than
50%) then no entry is made in the balance sheet; although a contingency is disclosed in the
notes to the accounts
Common contingencies include loan guarantees, product warranties and legal claims
Do Nothing
41

Special Items in Financial Statement

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Special Items in Financial Statement

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Special Items in Accounting

Special Items in Accounting

Private and Confidential Not for Circulation

Special Items in Accounting

Inventory Valuation Methods

Private and Confidential Not for Circulation

Methods of Inventory Accounting

Special Items in Accounting

First-In First-Out (FIFO)

The cost of most recent purchases is assigned to ending inventory

Last-In First-Out (LIFO)

The costs of beginning inventory and earlier purchases go to ending inventory

Weighted average costing

Instead, it computes COGS and ending inventories as a simple weighted average

Calculate gross profit for the following methods of inventory valuation

Private and Confidential Not for Circulation

Methods of Inventory Accounting

Special Items in Accounting

Calculation of gross profit

Balance Sheet Effect

Inventory cost as on January 1st,

Calculation of gross profit

Last purchased inventory taken first

Balance Sheet Effect

Private and Confidential Not for Circulation

Methods of Inventory Accounting

Weighted Average Cost

Special Items in Accounting

Calculation of Weighted average cost

Calculation of gross profit

Weighted Average cost

Balance Sheet Effect

Weighted average cost taken as per

Private and Confidential Not for Circulation

FIFO: 200*150+50*100 = $35,000

Financial Statement Effects

In an environment of Stable Prices

Special Items in Accounting

In an environment of Rising Prices and Increasing or Stable Inventory

Lower as inventory reflects the prices

Lower because earnings and inventory

Higher because earnings and inventory

Lower because COGS is higher

Higher because COGS is lower

Higher because of lower tax outgo

Lower because of higher tax outgo

Pre-tax Cash Flows

After-tax Cash flows

Private and Confidential Not for Circulation

Special Items in Accounting

Private and Confidential Not for Circulation

Special Items in Accounting

Change in depreciation policy

Private and Confidential Not for Circulation

Change in Depreciation Policy

Special Items in Accounting

Straight Line Depreciation Method

Sum-of-years digit Method

Double declining method

Written Down value method

Effect of Changes in Depreciation Methods

Impact on Cash Flows

Impact on Operating Performance

Private and Confidential Not for Circulation

FIFO: 200150+50100 = $35,000