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General Principles and Objectives of Financial Reporting General Principles and Objectives of Financial Reporting
: Events and accounting entries may be at different General Principles and Objectives of Financial Reporting
Purpose = to assist development and revision of accounting standards
??????????CopyRight 2009By GFEDU ?Principle financial statements
?Income statement:
Revenues:from major or central operations Expenses:from major or central operations Gains & losses:from peripheral or incidental transactions
Reports on the performance of the firm and explain some, but not all of the changes in the assets, liabilities, and equity of the firm between balance sheet dates. Classification of items is subject to management discretion.
??????????CopyRight 2009By GFEDU
?Principle financial statements
?Statement of cash flows:
Investing CF
Result from acquisition or sale;Must be reported on a gross basis
Financing CF Result from issuance or retirement of debt and equity securities and dividends paid. CF from
operations
From all transactions that are neither investing nor financing
?Principle financial statements
?Statement of stockholders ’equity:
Reports the amounts and sources of changes in equity from transactions with owners.?Financial footnotes:
Required by GAAP or the SEC
About accounting methods and the assumptions and estimates Are audited
Additional info. On some items such as fixed assets, inventory Contingent losses —(1) probable (2) reasonably estimated:
e.g. litigation, expropriation, repurchase agreements
?Supplementary Schedule
Operating income by region or segment; Reserves for an oil company;About hedging activities
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?Principle financial statements
?MD&A
Required:
?Results from operations, with a discussion of trends in sales and expenses
?Capital resources and liquidity, with a discussion of trends in cash flows
?A general business overview based on known trends ?Additional:
?Significant effects of currently known trends, events, and uncertainties
?Liquidity, capital sources
?Discontinued operations, extraordinary items, and other unusual or infrequent items
?Extensive disclosures in interim financial statements ?A segment ’s need or contribution
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s financial statements, usually conducted by public accountants;
??????????CopyRight 2009By GFEDU ?Format of Income Statement
Revenues from sales of goods and services -COGS Gross profit -Other expenses
Not reflect interest expense, independent of capital structure
Operating income from continuing operations For creditors, government
and shareholders
+ Other income and revenues
Include investment income and gains/losses from sales of assets
Re urring in ome before I & T from ontinuing operations Persistent
-Financing costs
Related to capital structure;Best indicator of future earnings
Recurring (pretax) income from continuing operations For the government and the shareholders
Operating expenses
Prepared using the accrual method;
US&IAS GAAP does not require particular format
??????????CopyRight 2009By GFEDU
+/-Unusual or infrequent items
Pretax earnings from continuing operations -Income tax expense
Net income from continuing operations (The Line)For the shareholders only
+/-Income from discontinued operations
+/-Extraordinary items
+/-Cumulative effects of accounting changes Net income
Net of taxes ?FRQWLQXHG?
?
Accrual accounting ?Example:
Which of the following statements about accrual accounting is false?(A)Net income before taxes is considered the best indicator of future
earnings.
(B)The completed contract method produces more volatile earnings than
does the percent-of-completion method
(C)Revenue should be recognized when the earnings process is complete,
costs can be reliably determined, and payment is assured.
(D)Under the accrual concept, revenue is recognized when the earnings
process is completed and ultimate realization is assured.
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?Revenue recognition
Matching principle for revenues and expenses accounting
Provide virtually all of the goods or services and the expected associated cost must be measurable.1Completion of the earning process
For long-term projects:
2Reasonable assurance of payment
total COGS to date Cumulative revenue =expected total COGS revenue §·
§·¨?
¨?¨?
?1¨?
?1
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If cash is received before providing, revenue is not recognized
Used when no way to estimate the likelihood of collecting the
costs of the goods and services are known.
Revenue Recognition Method
??????????CopyRight 2009By GFEDU ?Revenue recognition
?Example 1:
When accounting for long-term projects, which revenue recognition method should be used when the revenues are paid up front, but the costs, which can be estimated, will be incurred over the next three years?
(A)Sales basis method
(B)Percentage-of-completion method (C)Completed contract method (D)Installment sales method
??????????CopyRight 2009By GFEDU
?Example 2:
When accounting for long-term projects, which revenue recognition method should be used when the revenues are paid up front, but the costs are highly uncertain, and will be incurred over the next three years?
(A)Sales basis method
(B)Percentage-of-completion method (C)Completed contract method (D)Installment sales method
?Example 3:
When accounting for long-term projects, which revenue recognition method should be used when costs are all incurred at the time of sale but the proceeds will be received over the next year with a high likelihood of collection?
(A) Sales basis method (B) Cost recovery method (C) Completed contract method (D) Installment sales method
$FFRXQWLQJ LQFRPH DQG DVVHWV WKH DFFUXDO FRQFHSW ?Percentage-of-completion method versus completed contract method
?Assume AAA company has a contract to build a ship for 1000 while a reliable estimate of the contract ’s total cost is 800. Assume further that the project produces the year-end billings, collections, and incurred costs shown in the figure.
2004
20052006Total Amounts billed 6002002001000Cash received 4004002001000Cost incurred
400
300
100
800
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AAA balance sheet using percentage of completion
Cumulative200620052004
Cash200100=400-3000=400-400
Accounts receivable00200=600-400
Memo: construction-in-progress year-end
balance (not shown explicitly on the
balance sheet—netted with advance
billings)
875=700+(700/800)*0.2500=400+0.5*200
Net construction-in-progress075=max (0,875-800)0=max (0,500-600)
Total assets200175200
Memo: advance billings year-end balance
(not shown explicitly on the balance
sheet—netted with construction-in-
process)
0800(as billed)600(as billed)
Net advance billings00100
Total liabilities00100
Retained earnings200175100
Total liabilities & equity200175200
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Cumulative200620052004
Cash2001000
Accounts receivable00200
Memo: construction-in-progress year-end balance (not
shown explicitly on the balance sheet—netted with
advance billings)
0700400
Net construction-in-progress000
Total assets200100200
Memo: advance billings year-end balance (not shown
explicitly on the balance sheet—netted with
construction-in-process)
0800600
Net advance billings0100200
Total liabilities0100200
Retained earnings20000
Total liabilities & equity200100200
Comparison between the two methods (during the project)
Percentage of completion Completed contract
Cash flows Same Same
Net income Higher Lower
Income volatility Lower Higher
Total assets Higher Lower
Construction in process account Higher Lower
Amounts billed Same Same
Net [construction in progress minus advance billings]Higher Lower
Shareholder equity Higher Lower
Ratio of liabilities to equity and liabilities to assets Lower Higher
Under both methods, at the end of the contract only cash and retained earnings are listed on the balance sheet;
Long-term assets are not affected by the selection of the methods
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?Comparison between the two methods
?Example:
AAA has a contract to build a building for 100,000 with an estimated
time to completion of three years. A reliable estimate for the project would
be 60,000. In the first year, AAA incurred costs totaling 24,000.
(1)Under the percentage of completion method, AAA will report a first year
profit of?
(A)16,000
(B)36,000
(C)40,000
(D)76,000
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??????????CopyRight 2009By GFEDU ?Example:
(2) Under the completed contract method, AAA will report a first year
profit of?(A)16,000(B)0(C)36,000(D)40,000
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Below and above the line items
Items
Descriptions Notes
Gains or losses from the disposal of a portion of a business segment;
Gains or losses from the sale of assets or investments in subsidiaries;Reported pre-tax above the line.
Affect future cash flow or
not?
Provisions for environmental remediation;
Impairments, write-offs, write-downs and restructuring costs;
Integration expenses associated with business that have been recently
acquired
R eading MD&A and
footnotes
Both unusual and infrequent and material in nature:Losses from expropriation of assets;
Gains or losses from early retirement of debt (judged to be both unusual and infrequent);
Uninsured losses from natural disasters both unusual and infrequent
Really accidental or not?
Reported below the line
Extraordinar y items (P62)
Unusual or infrequent items (P62)
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Below and above the line items
Has decided to dispose of but either has not yet done so or did so in the current year after it had generated income or losses;
The business must be physically and operationally distinct from the rest of the firm.Measurement date ?phase out period Income or loss is reported separately;
On measurement date, Accrue any estimated loss during the phase out period and on the sale.
Past income statement must be restated.
Any expected gain on the disposal cannot be
reported until completion of the sale.
The sale may provide information about future cash flows.
Discontinued operations (P61)
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Below and above the line items
Accounting changes (P63)
Typically reported below the line on the current year statement
Do not affect cash flow;Try to observe its potential
impact on future operating results
Exceptional: reported directly in current year ’s retained earnings account
Don ’t require restatement of
prior statements.
Prior period adjustments: from an incorrect method to an acceptable one.
Disclosure about the error ’s nature and its impact on net income is required.
Typically reported in net income, but some times directly to retained earnings.
Prior year ’s statement do not need to be restated unless:1)From LIFO to another 2)To or from the full-cost method
3)To or from the percentage-of-completion method
4)Any change just prior to IPO The changes are reported below the line.
Estimate
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?Below and above the line items
?Example:
Which of the following statements about nonrecurring items is false?
(A) Cumulative effects resulting from a change in the accounting
method for inventory are reported in the cost of goods sold.
(B) Unusual or infrequent items are reported before taxes above net
income.
(C) A change in accounting principle is reported in the income
statement net of taxes after extraordinary items and before net
income.
(D) Gains or losses from extraordinary items and discontinued
operations are reported net of taxes at the bottom of the income
statement before net income.
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Company type Description SFAS 128 & 129
Simple capital structure With no potentially
dilutive securities
Report only basic EPS
Complex capital structure With potentially dilutive
securities, such options,
warrants, convertible
securities.
Report both basic and diluted EPS.
Basic EPS
Income before discnt. Opr. 2.4
Discnt. Opr. -0.35
Net income 2.05
Diluted EPS
Income before discnt. Opr. 1.95
Discnt.Opr. -0.28
Net income 1.67
F or discontinued operations,
extraordinary items, or
cumulative effects of an
accounting change (below the
line net of tax)
Per share value of these
items must be reported
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?Example
?During 2006, GF Inc. had net income of 100,000, paid dividends of
50,000 to its preferred stockholders, and paid 30,000 in dividends to
its common shareholders. GF common stock account showed the
following:
net income-preferred div.
basic EPS=
weighted avg. number of common shares outstanding
2001-1-6Shares issued and outstanding at
the year beginning
10,000
2004-1-6Shares issued4,000
2007-1-610% stock dividend
2009-1-6Shares repurchased for the treasury3,000
?Effect of stock dividend and stock split on the weighted
average number of shares outstanding
Stock dividend Stock split
More shares but the same percentage of the total shares outstanding
Applied to all shares issued prior to the events, not applied to those issued after
the event date
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CopyRight 2009By GFEDU ?The treasury stock method
?Assumes that the hypothetical funds received by the company from the exercise of the options are used to purchase shares of the company ’s common stock in the market at the average market price;?The contingent shares in acquisition should be included in the calculation of diluted EPS if the target has been met as of the end of the reporting period.
?Each potentially dilutive security must be examined separately to determine if it is actually dilutive.
?
convertible debt int. (1-t)convertible debt shares
basicEPS
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adjusted income available for common shares diluted EPS=
weighted avg. common & potential common shares out
convertible net income convertible debt -preferred div.preferred div.interest ao
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(1)shares from shares from shares conversion of conversion of issuable from conv. pfd. shares conv. debt stock opt.t weighted average shares ? ??aoaoaoao???????? ????????????????????????
?Example: EPS with convertible debt
?During 2006 GF corp. reported net income of 115,600 and had 200,000 shares of common stock outstanding for the entire year. GF also had 1,000 shares of 10%, par 100 preferred stock outstanding during 2006. During 2005, GF issued 600 1,000 par, 7% bonds for 600,000 (issued at par). Each of these bonds is convertible to 100 shares of common stock. The tax rate is 40%. Compute the 2006 basic and diluted EPS.
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?Example: EPS with convertible preferred stock
?During 2006, GF reported net income of 115,600, and had 200,000 shares of common and 1,000 shares of preferred stock outstanding for the entire year. GF ’s 10%, 100 par value of preferred-stock shares are each convertible to 40 shares of common stock. The tax rate is 40%.?Compute basic and diluted EPS.
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During 2006, GF reported net income of 115,600, and had GF has 5000 shares outstanding all year. GF had 2000 Example: EPS with convertible bonds, convertible preferred,
Sample balance sheet
Assets Liabilities and owners’equity
Current assets Current liabilities
Cash and cash equivalents Except Marketable securities,
reported at historical cost; Translated
using prevailing exchange rate;
Accounts & notes payable
Marketable securities Hard to measure and omitted items:
brand names, customer lists
Income taxes payable
Accounts and notes receivable Current portion of long-term debt
Inventories Unearned revenue
Prepaid expenses Miscellaneous other payables
Deferred taxes
Miscellaneous current assets
Total current assets
Plant, property, equipment Long-term debt
Capital lease obligations
Investment in affiliates
Other fixed assets Deferred taxes
Total other assets
Total assets Total liabilities
Total other liabilities
Longer than one year;
Total current liabilities
To be
paid
within
one
year
Hard to measure and
omitted items:
potential losses from
legal actions;
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Sample balance sheet
Owner’s equity
Preferred stock
Common stock
Retained earning
Other equity items
Total owner’s equity
In the order of priority in case of liquidation
Total assets
Total liabilities and owner’s equity
?Example:
Which of the following statements is false?
(A) The statement of stockholder’s equity lists ownership interest in
order of payment preference upon liquidation of the firm.
(B) Retained earnings are the total earnings of the company since its
inception less all the dividends ever paid out.
(C) Common stock is listed at its sale price with the excess over par
listed in a contra account called additional paid-in capital.
(D) Preferred stock receives dividends and any cash during
liquidation before common shareholders.
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?The statement of cash flows
assets =liabilities+equity
assets=liabilities+equity
cash+non-cash assets=liabilities+equity
cash=liabilities+equity-non-cash assets
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Principal purposes and uses of the statement of cash flows
Primary purpose:
Information about a company ’s cash receipts and cash payments during an accounting https://www.sodocs.net/doc/19861556.html,rmation about a company ’s operating, investing and financing activities.Important information for investment decision making:Regular operations generate enough cash to sustain the business Enough cash is generated to pay off existing debts as they mature The firm is likely to need additional financing.Unexpected obligations can be met
The firm can take advantage of new business opportunities as they arise.FASB states that:
How the firm obtains and spends cash
The firm ’s borrowing and debt repayment activities The firm ’s sale and repurchase of its ownership securities
The firm ’s dividend payments and other cash distributions to owners Other factors affecting the firm ’s liquidity and solvency
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CopyRight 2009By GFEDU
?Example:
The statement of cash flow is least likely to provide which of the following items of information for investment decision making?
A.Whether unexpected obligations of the firm can be met.
B.Whether the firm is likely to need additional financing.
C.Whether the firm can take advantage of new business opportunities as they arise.
D.Whether the firm ’s management has demonstrated sound fiscal management.
DFFUXDO FRQFHSW Cash flow statement
Examples of balance sheet items:Receivables; inventories; prepaid expenses; taxes, interest and miscellaneous payables; deferred taxes
Examples of income statement items:
Focus on liquidity rather than profitability of the company;SFAS95: all interest and dividend revenue
All income taxes, even if arising from financing or investing Cash sales; cash cost of sales; cash general and administrative expenses; cash taxes; interest paid and received; dividends received.
Represents the purchase or sale of productive assets for cash (physical
(fixed) assets and investment)Including:
Capital expenditure for long-term assets;Proceeds from the sales of assets;Payments for business acquired;
Cash flow from investment in joint ventures and affiliates and l ong-term investment in securities.
The same under indirect or
direct methods
+/-CFI
Represents changes in the working capital accounts and all items through income statement.
+/-CFO
(P110)
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Cash flow statement
+/-CFF
Debt financing including both short and long term financing (typically interest-bearing debt or deep-discount debt);
Dividend payment;
Change in equity accounts
The same under indirect or direct
methods Non cash investing and financing activities are not included in the cash flow statement:Retire debt by issuing equity securities to the lender;Convert preferred stock to common stock;
Obtain long term assets by issuing notes payable to the seller;
+ Beginning of period cash
The purchase of non-cash assets by issuing equity or debt securities
=end cash balance account
Interpretation of cash flows:
CFO is the most important component as it tells how much cash is generated by the sales activities.Cash flows can indicate problems with liquidity and solvency.
Trends in cash flows can be extrapolated to estimate how the company will be performing over the next years. (discrepancy between cash flow trends and income trends)
Although do not result in immediate cash flow, they typically involve an investing and/or financing decision, so analyst should consider into past
and current performance and future
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??????????CopyRight 2009By GFEDU ??????????CopyRight 2009By GFEDU
?Example 1:
?The write-off of obsolete equipment would be classified as?
?What for the sale of obsolete equipment??Example 2:
Which of the following not considered a CFF activity?(A) Receipt of cash from the sale of capital stock.(B) Receipt of cash from the sale of bonds (C) Payment of cash for dividends (D) Payment of interest on debt.
?Example 3:
Which of the following would not cause a change in CFI?(A) The sale of a division of the company (B) The purchase of new machinery.(C) An increase in the depreciation expense
(D) The sale of obsolete equipment with no remaining book value.?Example 4:
Which of the following would not cause a change in CFO?(A) A decrease in notes payable (B) An increase in interest expense (C) An increase in accounts payable (D) An increase in cost of goods sold.
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Calculation of CFO by indirect method
Net income
+ Non cash expenses or losses -Non cash revenues or gains (+/-Non operating items)+/-Changes in operating asset accounts +/-Changes in operating liability accounts
Balance sheet items (working capital)
=CFO
Income statement items
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Example:Income statement
Sales 1600COGS -1350Gross profit 250Depreciation expense 100Interest expense
47Equity in earnings of investment 2Gain on the sale of old machine 10Income before taxes 115
Incomes taxes:Current 35Deferred
10Net income after taxes
70
??????????CopyRight 2009By GFEDU
Example
Balance sheet
Assets Beg.End Net Liabilities & equity Beg.End Net Cash
100
292
192
Accounts payable
450470
20
Accounts receivables 20028080Mortgage 600550-50Inventory 800
700
-100Bank note
0100100PP&E
1000102020Deferred taxes 80
90
10Accumulated depreciation -300-340-40Common stock 40041010Investments 10
12
2
Retained earnings 280344
64
Total assets
181********Total liabilities & equity
181********
?Example:
?Additional information:
?Dividends of 6 were paid to shareholders.
?One new common share was sold at par value. Par is 10 per share.?Fixed assets were sold for 30. Original cost of these assets was 80, and 60 of accumulated depreciation has been charged to the original cost.
?New fixed assets were purchased for 100. To pay for this acquisition, a 10 year, 100 note was issued to a bank.
?The firm recognized a 2 gain from a subsidiary using the equity method. No cash was received.?Calculate the CFO, CFI & CFF?
$FFRXQWLQJ LQFRPH DQG DVVHWV WKH DFFUXDO FRQFHSW Calculation of CFO by direct method
Cash collections Net sales –increase in receivables
-Cash inputs -COGS +decrease in inventory +increase in accounts payable -Cash expenses -Wages –decrease in wages payable
-Cash interests -Interest expense + increase in interest payable
-Cash taxes -Tax expense + increase in taxes payable + increase in deferred taxes
CFO
Under US and IAS GAAP, the CFO can be presented in both ways.
The direct method presents more information and requires more information to prepare, and is better for analysis.
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Example
Income statement
Sales 100,000COGS 40,000Wages
5000Depreciation expense 7000Interest expense
500Income from continuing operations 47,500Gain on the sale of land 10,000Income before taxes 57,500Provision for taxes 20,000Net income
37,500Common dividend declared
8,500
??????????CopyRight 2009By GFEDU
([DPSOH
Balance sheet
Assets 20032004Liabilities & equity 20032004Cash
9,00033,000Accounts payable 5,0009,000Accounts receivables 9,00010,000Wages payable 8,0004,500Inventory 7,0005,000Interest payable 3,0003,500Land 40,00035,000Taxes payable 4,0005,000Gross PP&E
60,00085,000Dividend payable 1,0006,000Less: Accumulated depreciation -9,000-16,000Bonds 10,00015,000Net PP&E 51,00069,000Deferred taxes 15,00020,000Good will
10,000
10,000
Common stock 50,00040,000Retained earnings
30,000
59,000Total assets
126,000
162,000
Total liabilities & equity 126,000
162,000
Calculate the CFO, CFI & CFF in both methods?
Source of discrepancies
Discrepancies between changes reported on the balance sheet and reported in the cash flow statement are typically due to:Mergers and acquisitions Changes in exchange rates
Under SFAS 95:
Inventories and accounts receivable acquired in a merger or acquisition of another company are treated as investing activity, not operating activities, and acquisition transaction is only reported on the balance sheet, thus CFO is not changed.
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?Free cash flow
?=Operating cash flow –net capital expenditures
?= Operating cash flow –(total capital expenditures –after tax proceeds from asset sales) ?Classification of dividends and interest payments
US GAAP (SFAS 95)IAS GAAP (IAS 7)
Dividends paid ?CFF
Interest paid and Dividends paid ?CFO/CFF
All interest and dividend receipts ?CFO Interest receipts& dividend receipts ?CFI/CFO
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Study Session 9
READING ASSIGNMENTS Reading 35 Inventories
International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CEA, and Michael A. Broihahn, CFA
Reading 36 Long-Lived Assets
International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CEA, and Michael A. Broihahn, CFA
Reading 37 Income Taxes
International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CEA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA
Reading 38 Long-Term Liabilities and Leases
International Financial Statement Analysis, by Thomas R. Robinson, CFA, Jan Hendrik van Greuning, CFA, R. Elaine Henry, CFA, and Michael A. Broihahn, CFA
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?Cost definition
?Merchandise inventories costs
?Purchasing, transportation, receiving, inspecting, etc. ?Manufactured inventories costs
?Direct materials, direct labor, and manufacturing overhead.
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?US GAAP requires
?Inventory valuation on the basis of lower of cost or market (LCM): applied regardless of the inventory costing method used.
?If replacement cost is rising, gains are ignored and reported at cost. ?Losses due to obsolescence, deterioration etc. are recognized and inventory written down to its new market value.
sell price of inv-sell cost if replace cost>NRV,
Market=net realizable value
if replace cost NRV Inventory accounting methods muse be the same for taxes as for financial reporting. $QDO\VLV RI LQYHQWRULHV inv=begin inv+purchase-COGS purchase= inv-begin inv+COGS COGS=begin inv+purchase- inv COGS+ inv=begin inv+purchase ending ending ending ending