Reporting and Analyzing Operating Assets
When a company increases its allowance for uncollectible accounts, it also records bad debt expense in the income statement. If a company overestimates the allowance account, bad debt expense is too high and net income is understated. As well, accounts receivable (net of the allowance account) and total assets are both understated on the balance sheet. In future periods, the company will not need to add as much to its allowance account since it is already overestimated (or, it can reverse the excess existing allowance balance). As a result, future net income will be higher.
On the other hand, if a company underestimates its allowance account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense as accounts are written off.
If inventory costs are stable, the per unit dollar cost of inventories (beginning or ending) tends to be approximately the same under different inventory costing methods and the choice of method does not materially affect net income. To see this, remember that FIFO profits include holding gains on inventories. If the inflation rate is low (or inventories turn quickly), there will be less holding gains (inflationary profit) in inventory.
FIFO holding gains occur when the costs of earlier purchased inventory are matched against current selling prices. Holding gains on inventories increase with an increase in the inflation rate and a decrease in the inventory turnover rate. Conversely, if the inflation rate is low or inventories turn quickly, there will be fewer holding gains (inflationary profit) in inventory.
If inventory costs are rising, (a) Last-in, first-out yields the lowest ending inventory (b) Last-in, first-out yields the lowest net income, (c) First-in, first-out yields the highest ending inventory, (d) First-in, first-out yields the highest net income, (e) Last in, first-out yields the highest cash flow because taxes are lowest.
When costs are consistently rising, LIFO inventory costing method yields a significant tax benefit because LIFO increases COGS which reduces pretax income and taxes payable.
Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule. When the replacement cost for inventory falls below its (FIFO or LIFO) historical cost, the inventory must be written down to its replacement cost (market value). The rationale is that, if market value has dropped, the inventory cost overstates the future economic benefit of selling the inventory.
As an asset is used up, its cost is removed from the balance sheet and transferred to the income statement as expense. Capitalization of costs onto the balance sheet and subsequent removal as expense is the essence of accrual accounting. If a depreciable asset is immediately expensed upon purchase, profit would be too low in the year of purchase and too high in later years as revenues earned by the asset are not matched with a corresponding cost. The proper matching of expenses and revenues is essential for proper income measurement.
When a company revises its estimate of an asset's useful life or its salvage value, depreciation expense must be recalculated. One way is to depreciate the current undepreciated cost of the asset (original cost – accumulated depreciation) using the revised assumptions of remaining useful life and salvage value.
PPE is considered to be impaired when the sum of the asset’s undiscounted expected future cash flows is less than its current net book value. An impairment loss is calculated as the difference between the asset's net book value and its current fair value.
The primary benefit of accelerated depreciation relates to tax reporting – higher depreciation deductions in the early years of the...
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