Test bank for financial statement analysis valuation 4th edition by easton mcanally sommers zhang

Test Bank for Financial Statement Analysis & Valuation, 4th Edition, by Easton, McAnall

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Module 6 Asset Recognition and Operating Assets Learning Objectives – Coverage by question True/False

Multiple Choice

Exercises

Problems

Essays

LO1 – Apply inventory costing methods.

1-3

1-4

1-2

1-3

1

LO2 – Examine inventory disclosures in financial statements.

4

5-7

3, 4, 6

1-3

LO3 – Analyze inventories and the related accounts payable.

5, 6

8-12

5-7

1-3

LO4 – Apply capitalization and depreciation of tangible assets.

7-10

13-15

8, 9

LO5 – Evaluate asset sales, impairments, and restructuring activities.

11-13

16-20

10-12, 15

4, 7

LO6 – Analyze tangible assets and related activities.

14

21-23

13-15

5-7

© Cambridge Business Publishers, 2018 6-1

1

2

3, 4

Financial Statement Analysis & Valuation, 5th Edition

Module 6: Asset Recognition and Operating Assets

True/False Topic: Manufacturing Costs in Inventory LO: 1 1. The three components of manufacturing costs are direct materials, direct labor, and manufacturing overhead.

Answer: True Rationale: These three components make up the manufacturing cost for manufacturing companies.

Topic: Inventory Costing and the Balance Sheet LO: 1 2. LIFO inventory costing yields more accurate reporting of the inventory balance on the balance sheet.

Answer: False Rationale: LIFO assumes that the most recently purchased goods are sold, thus the cost of the oldest items remain in the inventory balance. Hence, the balance sheet reports inventories at less current costs.

Topic: FIFO Inventory Costing and Profit LO: 1 3. In general, in a period of falling prices, LIFO produces higher gross profits than FIFO. Answer: True Rationale: Gross profit is affected by the choice of inventory costing method. Specifically, in periods of rising costs and prices, FIFO produces higher gross profits then LIFO because lower- cost inventories (i.e., first inventories bought are first out) are matched against sales revenues at current market prices. The converse holds true in periods of falling prices.

Topic: LIFO and FIFO Disclosures LO: 2 4. Companies using LIFO are required to disclose the amount at which inventory would have been reported had it used FIFO. Similarly, companies using FIFO are required to disclose what their inventory would have been if the company had used LIFO. Answer: False Rationale: Only the first sentence is true. The disclosure of the LIFO reserve is required for those companies using LIFO inventory costing. This disclosure allows analysts to adjust the balance sheet and income statement for LIFO effects when comparing LIFO and FIFO companies.

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-2

Topic: Inventory Turnover LO: 3 5. Increasing inventory turnover rate will improve profitability.

Answer: False Rationale: Profitability depends on both turnover and profit margin on the inventory. A company could increase turnover by dropping prices to zero. Items would fly off the shelves, but that would mean no profit.

Topic: Cash Conversion Cycle LO: 3 6. The cash conversion cycle is defined as: Days sales outstanding – Days inventory outstanding + Days payable outstanding Answer: False Rationale: Cash conversion cycle equals Days sales outstanding plus Days inventory outstanding less Days payable outstanding.

Topic: Depreciation Assumptions LO: 4 7. In order to estimate depreciation expense using the double-declining-balance method, managers must estimate the asset’s useful life and its salvage value.

Answer: False Rationale: Salvage value does not enter into the calculation of double-declining-balance method depreciation.

Topic: Depreciation for Tax Purposes LO: 4 8. When a firm uses an accelerated method of depreciation for tax reporting in order to minimize its tax burden, it will not really save any tax dollars in the end because depreciation method merely changes the timing of the depreciation expenses but not the total.

Answer: False Rationale: An accelerated method for taxes brings real savings. Paying lower taxes early on allows the company to reinvest the additional cash flows into additional operating assets. As well, the present value of a dollar of tax in the future is worth less than a dollar today.

Topic: R&D Costs LO: 4 9. R&D expense is treated as an operating expense, not a capital expenditure, unless the R&D assets acquired have an alternative future use.

Answer: True Rationale: Although the R&D assets are similar to regular plant assets, under GAAP, R&D costs are expensed unless the R&D assets have alternative future uses.

© Cambridge Business Publishers, 2018 6-3

Financial Statement Analysis & Valuation, 5th Edition

Topic: R&D Costs LO: 4 10. Next year, Chemical Corporation plans to build a laboratory dedicated to a special project. The company will not use the laboratory after the project is finished. Under GAAP, this laboratory should be expensed.

Answer: True Rationale: R&D costs must be expensed under GAAP unless they have alternative future uses. If these assets do, indeed, have alternative future uses, they will be capitalized and depreciated.

Topic: Gains on Sale of Assets LO: 5 11. The gain or loss on the sale of the asset is computed by: Gain / (Loss) on sale = Market value of asset – Net book value of asset Answer: False Rationale: The correct equation involves the proceeds received, which may differ from the asset’s market value.

Topic: Restructuring Costs LO: 5 12. Employee severance costs, as part of board-approved restructuring plans, are reported in the income statement even if the actual payment for these costs occurs in subsequent periods.

Answer: True Rationale: Employee severance costs are reported in the income statement as an expense and as a liability on the balance sheet in the period the restructuring program is announced. Subsequent payments to employees reduce the restructuring liability.

Topic: Asset Impairment LO: 5 13. Impairment of long-term assets is determined by comparing the sum of the present value of the asset’s expected future cash flows to the asset’s net book value.

Answer: False Rationale: Impairment of long-term assets is determined by comparing the sum of expected future (undiscounted) cash flows from the asset with its net book value. If the asset is deemed to be impaired, it is written down to its market value and the write-down is recorded as an expense in the income statement.

Topic: Percent Used Up LO: 6 14. The percent used up ratio indirectly measures the likelihood of future capital expenditures that the company will have to make.

Answer: True Rationale: Percent used up of plant assets is equal to accumulated depreciation divided by the cost of depreciable assets. If accumulated depreciation is high, the percent used up will be high, indicating that the equipment is nearing the end of its life cycle. New equipment will likely have to be purchased in the near future.

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-4

Multiple Choice Topic: Inventory Costs for Manufacturing Companies LO: 1 1. Other than raw materials and manufacturing overhead, what is the third component of inventories for manufacturing companies?

A) Direct labor B) Indirect labor C) Equipment cost D) Processing cost E) All of the above Answer: A Rationale: Three components of manufacturing costs are materials, direct labor, and overhead.

Topic: Cost of Goods Sold Using FIFO Method (Numerical calculations required) LO: 1 2. Aiello, Inc. had the following inventory in fiscal 2016. The company uses the FIFO method of accounting for inventory.

Beginning Inventory, January 1, 2016: 130 units @ $15.00 Purchase 200 units @ $18.00 Purchase 50 units @ $13.50 Purchase 110 units @ $15.75 Ending Inventory, December 31, 2016: 120 units The company’s cost of goods sold for fiscal 2016 is: A) $6,090.00 B) $6,045.00 C) $6,157.50 D) $5,305.75 E) None of the above Answer: A Rationale: Costs of goods available for sale* Less Ending Inventory (110 units @ $15.75) Less Ending Inventory (10 units @ $13.50) Cost of goods sold

$7,957.50 1,732.50 135.00 $6,090.00

*Cost of goods available for sale: (130 units × $15) + (200 units × $18) + (50 units × $13.50) + (110 units × $15.75) = $7,957.50

© Cambridge Business Publishers, 2018 6-5

Financial Statement Analysis & Valuation, 5th Edition

Topic: Cost of Goods Sold Using LIFO Method (Numerical calculations required) LO: 1 3. Aiello Inc. had the following inventory in fiscal 2016. The company uses the LIFO method of accounting for inventory.

Beginning Inventory, January 1, 2016: 130 units @ $15.00 Purchase 200 units @ $18.00 Purchase 50 units @ $13.50 Purchase 110 units @ $15.75 Ending Inventory, December 31, 2016: 120 units The company’s cost of goods sold for fiscal 2016 is: A) $6,090.00 B) $1,800.00 C) $5,305.75 D) $6,157.50 E) None of the above Answer: D Rationale: Costs of goods available for sale* Less Ending Inventory (120 units @ $15) Cost of goods sold

$7,957.50 1,800.00 $6,157.50

*Cost of goods available for sale: (130 units × $15) + (200 units × $18) + (50 units × $13.50) + (110 units × $15.75) = $7,957.50

Topic: Financial Statement Effects of LIFO versus FIFO LO: 1 4. In times of falling prices, choosing LIFO over FIFO as an inventory cost method would affect the financial statements as follows: A) Cost of goods sold will be higher and ending inventory will be lower B) Cost of goods sold will be lower and ending inventory will be lower C) Cost of goods sold will be higher and ending inventory will be higher D) Cost of goods sold will be lower and ending inventory will be higher E) None of the above Answer: D Rationale: When prices are falling, the more recent, lower prices will be transferred to the income statement (last in are the lowest prices). Thus, COGS will be lower. Conversely, the earliest, highestpriced inventory will remain on the balance sheet.

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-6

Topic: LIFO Reserve LO: 2 5. Assume that Barber Co. uses the LIFO inventory costing method for both tax and financial reporting purposes. The balance sheet reports inventories at $297 million. Then, in its footnotes, the company reports that inventories would have been $327 million had the company used the FIFO method.

The difference between these two numbers ($30 million) is referred to as: A) LIFO reserve B) LIFO conformity rule C) LIFO holding gain D) Inventory temporary difference E) None of the above Answer: A Rationale: Companies using LIFO are also required to state the amount at which inventory would have been reported had it used FIFO. The difference between the two is called the LIFO reserve.

Topic: Converting LIFO Inventory to FIFO Inventory (Numerical calculations required) LO: 2 6. The January 28, 2017 (fiscal year 2016) financial statements of Caleres, Inc. reported the following information (in thousands).

Cost of sales Inventories, net LIFO reserve

2016 $1,517,397 585,764 4,345

2015 $1,529,527 546,745 4,094

If Caleres had used the FIFO method of inventory costing, 2016 inventory would have been: A) $506,852 million B) $590,109 million C) $504,752 million D) $581,419 million E) None of the above Answer: B Rationale: FIFO Inventory = LIFO inventory + LIFO reserve = $585,764 million + $4,345 million = $590,109 million

© Cambridge Business Publishers, 2018 6-7

Financial Statement Analysis & Valuation, 5th Edition

Topic: Converting LIFO COGS to FIFO COGS (Numerical calculations required) LO: 2 7. The January 28, 2017 (fiscal year 2016) financial statements of Caleres, Inc. reported the following information (in thousands).

Cost of sales Inventories, net LIFO reserve

2016 $1,517,397

2015 $1,529,527

585,764 4,345

546,745 4,094

If Caleres had used the FIFO method of inventory costing, 2016 COGS would have been: A) $1,517,648 thousand B) $1,551,301 thousand C) $1,553,198 thousand D) $1,517,146 thousand E) None of the above Answer: D Rationale: FIFO COGS = LIFO COGS – Increase in LIFO reserve = $1,517,397 – ($4,345 – $4,094) = $1,517,146 thousand

Topic: Inventory Turnover LO: 3 8. The 2016 financial statement of Willamette Valley Vineyards reported Net revenues of $19,425,412 and Cost of goods sold of $7,204,884. Note 3 to the financial statements reported that Inventories consisted of: 2016 817,836 6,634,014 4,518,806

Winemaking and packaging materials Work-in-process Finished goods

$

Total inventories

$11,970,656

$

2015 690,292 6,058,701 3,883,469

$10,632,462

The inventory turnover for 2016 was: A) 0.57 B) 0.64 C) 0.59 D) 1.71 E) None of the above Answer: B Rationale: Inventory turnover = COGS / Average inventory = $7,204,884 / [($11,970,656 + $10,632,462) / 2] = 0.6374 = 0.64

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-8

Topic: Days Inventory Outstanding (Numerical calculations required) LO: 3 9. The January 28, 2017 (fiscal year 2016) financial statements of Caleres, Inc. reported the following information (in thousands):

Cost of sales Inventories, net LIFO reserve

2016 $1,517,397 585,764 4,345

2015 $1,529,527 546,745 4,094

The 2016 average days inventory outstanding is: A) 136.2 days B) 133.9 days C) 121.5 days D) 49.6 days E) None of the above Answer: A Rationale: Average days inventory outstanding = (365 x Avg. Inventory) / COGS = [365 x (($585,764 + $546,745)/2)] / $1,517,397 = 136.2

Topic: Inventory Turnover (Numerical calculations required) LO: 3 10. The 2016 financial statements of CVS Health Corporation reported the following information (in millions):

Net sales Cost of sales Inventories, net

2016 $177,526 148,669 14,760

2015 $153,290 126,762 14,001

The inventory turnover ratio for 2016 is: A) 9.22 B) 11.48 C) 9.33 D) 10.34 E) None of the above Answer: D Rationale: Inventory turnover = COGS / Average inventory = $148,669 / [($14,760 + $14,001) / 2] =10.34

© Cambridge Business Publishers, 2018 6-9

Financial Statement Analysis & Valuation, 5th Edition

Topic: Gross Profit (Numerical calculations required) LO: 3 11. CarMax Inc. reports sales of $15,875,118 thousand and cost of sales of $13,691,824 thousand for the year ended February 28, 2017.

The gross profit for the year is: A) $2,183,294 thousand B) $1,464,362 thousand C) 86.2% D) 13.8% E) There is not enough information to determine gross profit.

Answer: A Rationale: Gross profit = Sales – COGS = $15,875,118 thousand – $13,691,824 thousand = $2,183,294 thousand.

Topic: Cash Conversion Cycle (Numerical calculations required) LO: 3 12. Hauser Corporation has the following metrics for 2016.

Amount in days Days sales outstanding Days payables outstanding Days inventory outstanding

2016 36.5 24.8 59.1

The cash conversion cycle for 2016 is: A) 2.2 days B) 61.3 days C) 47.4 days D) 70.8 days E) None of the above Answer: D Rationale: Cash conversion cycle = Days sales outstanding + Days inventory outstanding – Days payable outstanding =36.5 days + 59.1 days – 24.8 days = 70.8 days

Topic: Depreciation Assumptions LO: 4 13. Which of the following estimates are not always required when calculating depreciation expense?

Select all that apply.

A) Depreciation rate B) Useful life C) Depreciation method D) Salvage value E) None of the above Answer: D Rationale: If the double-declining-balance method is used to determine depreciation, salvage value is not required. Therefore the correct answer is D.

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-10

Topic: Depreciation Expense: Double-Declining-Balance Method (Numerical calculations required) LO: 4 14. Central Supply purchased a new printer for $67,500. The printer is expected to operate for nine (9) years, after which it will be sold for salvage value (estimated to be $6,750).

How much is the first year’s depreciation expense if the company uses the double-declining-balance method?

A) $15,000 B) $ 7,500 C) $18,000 D) $13,500 E) None of the above Answer: A Rationale: Depreciation rate: 2 ×Straight-line rate (1/Useful life) = 2 × (1/9) Depreciation expense, Year 1: $67,500 × 2 x 1/9 = $15,000

Topic: Comparing Depreciation Expense LO: 4 15. One difference between straight-line and double-declining-balance depreciation methods is that: A) Straight-line method will fully depreciate the asset more quickly.

B) Double-declining-balance method will fully depreciate the asset more quickly.

C) Income taxes paid will be lower under the double-declining-balance method.

D) Losses on disposal will be lower under the straight-line method.

E) None of the above Answer: E Rationale: Neither method depreciates assets fully more quickly (that is, to the residual value more quickly) than the other. In fact, if the salvage value is $0, the double-declining-balance method will never fully depreciate the asset. The salvage value relative to the original cost and the asset life will determine which method reaches salvage value more quickly. Thus A, B, and D are all incorrect. C is incorrect because taxes paid are determined by the tax code and not by GAAP depreciation method choice.

Topic: Asset Impairment LO: 5 16. An asset is impaired when the asset’s carrying value is: A) Greater than the sum of discounted expected cash flows.

B) Less than the sum of discounted expected cash flows.

C) Less than the sum of undiscounted expected cash flows.

D) Greater than the sum of undiscounted expected cash flows.

E) None of the above Answer: D Rationale: As asset is impaired if its carrying (net book) value is greater than the sum of undiscounted expected cash flows from that asset.

© Cambridge Business Publishers, 2018 6-11

Financial Statement Analysis & Valuation, 5th Edition

Topic: Research and Development Expenses – Building with no Alternate Use LO: 5 17. Dow Chemical Corporation plans to build a laboratory dedicated to a special project. The company will not use the laboratory after the project is finished. Under GAAP, this laboratory should be: A) Capitalized and depreciated.

B) Expensed in the current year.

C) Depreciated and expensed.

D) Capitalized only.

E) None of the above Answer: B Rationale: Project-directed or highly-specific research buildings and equipment with no alternate uses must be expensed as incurred.

Topic: Restructuring Charges (Numerical calculations required) LO: 5 18. Fey Enterprises recorded a restructuring charge of $16.2 million during fiscal 2016 related entirely to the closing of its division located in Denver, Colorado. The company’s financial statement footnotes indicated that expected employee separation payments amounted to $12.6 million and that fixed asset write-downs accounted for the remainder. Nickolas had never before incurred restructuring charges. At the end of the year, the company’s balance sheet included a restructuring accrual of $2,700,000.

The cash flow effect of Fey Enterprises’ restructuring during fiscal 2016 is: A) $0 (there was no cash flow effect in 2016) B) $13,200,000 C) $16,800,000 D) $ 9,900,000 E) $21,600,000 Answer: D Rationale: The total restructuring charge accrued was $12.6 million because asset write-downs are not accrued. That is, there is no credit to a liability account for write-downs, the assets are credited (reduced). Thus, the company must have paid $12,600,000 - $2,700,000 = $9,900,000 in cash during fiscal 2016.

Topic: Restructuring Charges (Numerical calculations required) LO: 5 19. InterTech Corporation recorded pretax restructuring charges of $1,033.5 million in 2017. The charges consisted of asset write-downs of $681 million, costs associated with exit or disposal activities of $99 million, and employee severance costs of $253.5 million. The company paid $108 million cash to settle these restructuring charges during the year (2017).

At year end, the restructuring accrual associated with these charges was: A) $ 1,033.5 million B) $ 326.0 million C) $ 253.5 million D) $ 244.5 million E) There is not enough information to determine the amount.

Answer: D Rationale: Of the $1,033.5 million total restructuring charge, only the exit costs and severance costs must eventually be settled in cash. The asset write downs are not accrued—they reduce the assets on the balance sheet. The company accrued $99 million + $253.5 million = $352.5 million as a liability.

Thus, if the company paid $108 million cash, the remaining accrual is $244.5 million at year end.

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-12

Topic: Restructuring Charges (Numerical calculations required) LO: 5 20. Acadia, Inc. recorded restructuring charges of $235,542 thousand during fiscal 2017 related entirely to anticipated employee separation payments. Acadia, Inc. had never before incurred restructuring charges. At the end of the year, the company’s balance sheet included a restructuring accrual of $29,643 thousand.

The cash flow effect of Acadia’s restructuring during fiscal 2017 was: A) $205,899 thousand B) $235,542 thousand C) $265,185 thousand D) $ 29,643 thousand E) None of the above Answer: A Rationale: The total restructuring charge accrued was $235,542 thousand of which $29,643 thousand was still unpaid (a liability) at the end of the year. The difference of $205,899 thousand must have been paid in cash during the year. The cash flow effect is $205,899 thousand.

Topic: Computing PPE Turnover (Numerical calculations required) LO: 6 21. The 2016 financial statements for BNSF Railway report the following information:

(In millions) Revenues Property and equipment, net Total assets

Year ended December 31, 2016 2015 $19,829 $21,967 61,250 59,510 84,122 81,703

The 2016 property, plant and equipment turnover is: A) 0.39 B) 2.38 C) 0.33 D) 0.70 E) None of the above Answer: C Rationale: Turnover = Revenues / Average PPE, net = $19,829 / [($61,250 + $59,510) / 2] = 0.32843 = 0.33

© Cambridge Business Publishers, 2018 6-13

Financial Statement Analysis & Valuation, 5th Edition

Topic: Computing Estimated Percent Used Up (Numerical calculations required) LO: 6 22. The 2016 financial statements for Leggett & Platt, Inc., report the following information:

(In millions) Depreciation expense Property and equipment, net Land Accumulated depreciation

Year ended December 31, 2016 2015 $86.8 $83.5 565.5 540.8 37.7 40.0 1,165.4 1,146.5

Which of the following estimates the property and equipment’s percent-used-up at December 31, 2016?

A) 68.8% B) 45.4% C) 16.9% D) 42.3% E) None of the above Answer: A Rationale: Percent used up = Accumulated depreciation / Depreciable asset cost = $1,165.4 / ($565.5 + $1,165.4 – $37.7) = 68.8%

Topic: Computing Average Useful Life (Numerical calculations required) LO: 6 23. The 2016 financial statements of Willamette Valley Vineyards, Inc. include the following footnote: Note 4. Property and Equipment Construction in progress Land Winery buildings and hospitality center Equipment Less accumulated depreciation Depreciation expense

December 31, 2016 $ 449,409 8,063,716 14,458,309 10,122,593 33,094,027 (12,897,082) $20,196,945 $ 1,254,455

December 31, 2015 $ 482,284 5,089,472 13,756,320 9,055,987 28,384,063 (11,654,901) 16,729,162 $ 1,194,191

The average useful life of Willamette’s depreciable assets at the end of fiscal 2016 is: A) 14.2 years B) 19.6 years C) 2.4 years D) 21.7 years E) None of the above Answer: B Rationale: Average useful life = Depreciable asset cost / Depreciation expense = ($33,094,027 – $449,409 – $8,063,716) / $1,254,455 = 19.59 = 19.6 years.

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-14

Exercises Topic: Cost of Goods Sold Using FIFO and LIFO Methods LO: 1 1. Aiello, Inc. had the following inventory in fiscal 2016. Compute the company’s cost of goods sold for fiscal 2016 assuming the company used a) FIFO and b) LIFO methods of accounting for inventory: Beginning Inventory, January 1, 2016: 130 units @ $15.00 Purchase 200 units @ $18.00 Purchase 50 units @ $13.50 Purchase 110 units @ $15.75 Ending Inventory, December 31, 2016: 120 units Answer: a) FIFO: Costs of goods available for sale* Less Ending Inventory (110 units @ $15.75) Less Ending Inventory (10 units @ $13.50) Cost of goods sold

$ 7,957.50 1,732.50 135.00 $ 6,090.00

*Cost of goods available for sale: (130 units × $15) + (200 units × $18) + (50 units × $13.50) + (110 units × $15.75) = $7,957.50

b) LIFO: Costs of goods available for sale* Less Ending Inventory (120 units @ $15) Cost of goods sold

$7,957.50 1,800.00 $6,157.50

*Cost of goods available for sale (130 units × $15) + (200 units × $18) + (50 units × $13.50) + (110 units × $15.75) = $7,957.50

Topic: Cost of Goods Sold and Ending Inventory Using Average Cost Method LO: 1 2. Everett Company uses the average cost method to account for inventory and has the following activity during the month of March 2017.

Beginning inventory Purchase #1 Purchase #2

Units 350 650 250

Unit cost $22.50 18.00 15.00

During March, Everett sold 850 units.

Compute the cost of goods sold for March and the ending inventory balance at March 31, 2017.

© Cambridge Business Publishers, 2018 6-15

Financial Statement Analysis & Valuation, 5th Edition

Answer: Beginning inventory Purchase #1 Purchase #2 Total goods available for sale

Units 350 650 250 1,250

Unit cost $22.50 18.00 15.00

Total cost $ 7,875 11,700 3,750 $23,325

Average unit cost = $23,325 / 1,250 = $18.66 Cost of goods sold = $18.66 × 850 = $15,861 Ending inventory = $18.66 × 400 = $7,464

Topic: LIFO and FIFO Inventory LO: 2 3. Leggett and Platt reported total inventory of $519.6 million on their 2016 balance sheet along with a LIFO reserve of $33.8 million.

What would the company have reported on its balance sheet for inventory if it had used the FIFO method of accounting for inventory?

Answer: FIFO inventory = LIFO inventory + LIFO reserve $519.6 million + $33.8 million = $553.4 million

Topic: LIFO and FIFO Cost of Goods Sold LO: 2 4. Leggett and Platt uses the LIFO method of accounting for inventory. The company reported a LIFO reserve of $22.6 million at the beginning of the 2016 fiscal year and a LIFO reserve of $33.8 million at the end of the 2016 fiscal year. Cost of goods sold reported on the 2016 income statement was $2,850.7 million.

What would the company have reported for cost of goods sold had they used FIFO to account for inventory costs?

Answer: FIFO COGS = LIFO COGS – Increase in LIFO reserve.

FIFO COGS = $2,850.7 million – ($33.8 million – $22.6 million) = $2,839.5 million

Topic: Average Days Inventory Outstanding LO: 3 5. Note 3 to the 2016 financial statements of Willamette Valley Vineyards reports that Inventories consist of the following:

Winemaking and packaging materials Work-in-process Finished goods Total inventories

2016 $ 817,836 6,634,014 4,518,806 $11,970,656

2015 $ 690,292 6,058,701 3,883,469 $10,632,462

The company reported cost of goods sold of $7,204,884 in 2016 and $7,092,111 in 2015. At December 31, 2014, Total inventories were $ 9,910,570.

Compute average days inventory outstanding for both years. the ratios.

Test Bank, Module 6

What does this ratio mean? Interpret © Cambridge Business Publishers, 2018 6-16

Answer: 2016: [365 x (($11,970,656 + $10,632,462) / 2)] / $7,204,884 = 572.5 days 2015: [365 x (($10,632,462 + $9,910,570) / 2)] / $7,092,111 = 528.6 days The ratio indicates the average number of days it takes a company to sell its inventory. Willamette Valley Vineyards average days inventory outstanding increased by almost 44 days, taking approximately 1.57 years to sell its inventory. Further analysis of the industry is needed to determine whether this is typical for the industry due to the aging process of wine.

Topic: Days Inventory Outstanding LIFO versus FIFO LO: 2, 3 6. The January 28, 2017 (fiscal year 2016) financial statements of Caleres, Inc. reported the following information (in thousands): Caleres, Inc. Cost of sales Inventories, net LIFO reserve

2016 $1,517,397 585,764 4,345

2015 $1,529,527 546,745 4,094

The footnotes to the 2016 financial statements of Skechers U.S.A., Inc., a competitor of Caleres, Inc., reported that the company uses the FIFO method of accounting for inventories. Financial statements reported the following (in thousands): Skechers U.S.A., Inc. Cost of sales Inventories, net

2016 $1,928,715 700,515

2015 $1,723,315 620,247

Compare the two companies’ days-inventory-outstanding ratios for 2016. To do this properly, you will need to convert the companies’ cost of sales and inventories to a common inventory costing method.

Which company is more efficient with its inventory?

Answer: Caleres, Inc.: Caleres uses LIFO. The year-end inventory and COGS must be first converted to FIFO. FIFO Inventory 2016 = $585,764 thousand + $4,345 thousand = $590,109 thousand FIFO Inventory 2015 = $546,745 thousand + $4,094 thousand = $550,839 thousand FIFO COGS = $1,517,397 – ($4,345 thousand – $4,094 thousand) = $1,517,146 thousand FIFO days inventory outstanding = [($590,064 + 550,839) / 2] x 365 / $1,517,146 = 137.2 days Skechers U.S.A., Inc : FIFO days inventory outstanding = [($700,515 + $620,247)/2] x 365 / $1,928,715 = 125.0 days When we compare these ratios we see that both companies hold inventory for a long time. However, Skechers is more efficient with its inventory than Caleres. Skechers holds inventory on average 125 days compared to Caleres’ 137 days.

© Cambridge Business Publishers, 2018 6-17

Financial Statement Analysis & Valuation, 5th Edition

Topic: Inventory Turnover LO: 3 7. Abercrombie & Fitch has inventory levels of $399,795 thousand and $436,701 thousand at the end of fiscal-year ending 2016 and 2015 respectively. Cost of goods sold for 2016 is $1,298,172 thousand. a. Calculate the inventory turnover ratio and the average days inventory outstanding for 2016. b. Suggest three ways that Abercrombie & Fitch might improve inventory turnover.

Answer: a. Inventory turnover = COGS / Average inventory. = $1,298,172 / [($399,795 + $436,701) / 2] = 3.10 times Average days inventory outstanding = (365 x Average inventory) / COGS = [365 x (($399,795 + $436,701) / 2)] / $1,298,172 = 117.6 days. b. Abercrombie & Fitch might improve inventory turnover by: • Reducing the number of sizes and colors of garments manufactured • Monitoring sales by color/ size and putting slow-moving items on sale more quickly • Dropping the price (increasing turnover needs to be weighed against decrease in gross profit margin) • Ordering / manufacturing inventory for just-in-time delivery to stores • Closing or reducing the size of stores that don’t turn inventory as quickly.

Topic: Depreciation Expense – Double-Declining-Balance Method LO: 4 8. Central Supply purchased a new printer for $72,000. The printer is expected to operate for ten (10) years, after which it will be sold for salvage value (estimated to be $7,200).

How much is the first and second year’s depreciation expense if the company uses the doubledeclining-balance method?

Answer: Depreciation base: Net book value = Cost – Accumulated depreciation Depreciation rate: 2 × straight-line rate (1 / useful life) = 2 × (1/10) = 2/10 Depreciation expense: Year 1 Year 2

$72,000 × 2/10 = $14,400 ($72,000 – $14,400) × 2/10 = $11,520

Topic: Depreciation Expense – Straight Line and Double-Declining-Balance Methods LO: 4 9. The Rialto Theatre purchased a new projector costing $123,000 on January 1, 2017. Because of changing technologies, the projector is estimated to last four years after which it will be obsolete and have a salvage value of $6,000 as a collectors’ item.

Compute the depreciation expense for 2017 using: a. The straight-line method b. Double-declining-balance method

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-18

Answer: a. Depreciation base = Cost – Salvage value Straight-line depreciation = ($123,000 - $6,000) / 4 = $29,250 b. Depreciation rate: 2 × straight-line rate (1 / useful life) = 2 × (1/4) = 2/4 Double-declining-balance depreciation = $123,000 × (2/4) = $61,500

Topic: Analyzing and Computing an Asset Impairment LO: 5 10. Plastix Inc. bought a molding machine for $555,000 on June 1, 2016. The company expected to use this machine to extrude plastic toys for the next eight (8) years, when the machine would be sold for $45,000. On June 1, 2018, their major customer, Wal-Mart, gave notification that they were terminating Plastix Inc. as a supplier. Plastix Inc.’s accountants estimate that the machine will generate $390,000 in future cash inflows from other customers and the fair value of the machine is $345,000. Plastix uses straight-line depreciation. a. Is this asset impaired on June 1, 2018? Show your calculation. b. If the equipment is impaired, what is the impairment loss on June 1, 2018?

Answer: a. Yes, the asset is impaired. An asset is impaired if its net book value (purchase cost minus accumulated depreciation) exceeds the sum of all expected future cash inflows.

Net book value = $555,000 – [2 years × ($555,000 - $45,000) / 8 years] = $427,500 Expected future cash flows, given = $390,000 b. Impairment loss is the difference between the asset’s NBV and the fair value.

Loss = $427,500 – $345,000 = $82,500

Topic: Restructuring Charges (Numerical calculations required) LO: 5 11. Aiello Industries recorded a restructuring charge of $37.8 million during fiscal 2017 related entirely to the closing of its operations based in Orlando, Florida. The company’s financial statement footnotes indicated that expected employee separation payments amounted to $29.4 million and that fixed asset write-downs accounting for the remainder. Aiello had never before incurred restructuring charges. At the end of the year, the company’s balance sheet included a restructuring accrual of $6,300,000.

Calculate the cash flow effect of Nickolas’s restructuring during fiscal 2017.

Answer: The total restructuring charge accrued was $29.4 million because asset write-downs are not accrued.

That is there is no credit to a liability account for write-downs, the assets are credited (reduced).

Thus, the company must have paid $29,400,000 - $6,300,000 = $23,100,000 in cash during fiscal 2017.

© Cambridge Business Publishers, 2018 6-19

Financial Statement Analysis & Valuation, 5th Edition

Topic: Restructuring Charges (Numerical calculations required) LO: 5 12. Dow Chemical included the following information in footnotes to its 2016 Form 10-K: 2016 Restructuring On June 27, 2016, the Board of Directors of the Company approved a restructuring plan that incorporates actions related to the recent ownership restructure of Dow Corning Corporation ("Dow Corning"). These actions, aligned with Dow’s value growth and synergy targets, will result in a global workforce reduction of approximately 2,500 positions, with most of these positions resulting from synergies related to the Dow Corning transaction. These actions are expected to be substantially completed by June 30, 2018.

As a result of these actions, the Company recorded pretax restructuring charges of $449 million in the second quarter of 2016 consisting of severance charges of $268 million, asset write-downs and writeoffs of $153 million and costs associated with exit and disposal activities of $28 million. a. Reconcile the various parts of Dow Chemical’s “Restructuring charges” of $449 million. b. How should Dow Chemical report the restructuring charges in its income statement and on its balance sheet? c. The SEC has expressed concern about abuses surrounding restructuring charges. What is the nature of the SEC’s concerns?

Answer: a. (in millions) Asset write-downs and write-offs Exit or disposal activities Severance costs Total

$153 28 268 $449

b. Under GAAP, the restructuring charges require enhanced disclosure and should be reported as a separate line item in the income statement or as a footnote. In Dow Chemical’s case, the $449 million restructuring charge is material and is reported a separate line item in the income statement. Additionally, any accrued liabilities resulting from the restructuring are reflected on the balance sheet. The footnotes detail the change in the accrual (liability) account each period. c.

The timing and magnitude of restructuring costs is subject to management’s discretion. Thus, some companies might overestimate such costs, especially if earnings are already low, a practice which is referred to as a “big bath.” Overestimating the restructuring costs creates a cushion for adjusting future earnings. On the other hand, because materiality is also discretionary, management could deem these costs to be immaterial in order to avoid recording them as separate items. Either tactic would impair the quality of the companies’ financial reports.

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-20

Topic: Computing PPE Turnover and PPE Ratios LO: 6 13. The 2016 financial statements for BNSF Railway report the following information: Year ended December 31, (In millions) Revenues Property and equipment, net Total assets

2016

2015

$19,829 61,250 84,122

$21,967 59,510 81,703

a. Compute the common-size amount for property and equipment, net for 2016. Does this ratio seem high or low to you? Explain. b. Compute property, plant and equipment turnover for 2016. Interpret the ratio.

Answer: a. $61,250/ $84,122= 72.8% The ratio is high but not surprising – the company has huge investment in track and rolling stock.

It is a very capital intensive (old economy) company. The company has no inventory – it is a service company. b. Turnover = Revenues / Average PPE, net = $19,829 / [($61,250 + $59,510) / 2] = 0.33 The interpretation of this ratio is that for every dollar of PPE in 2016, BNSF had an average of $0.33 of sales.

Topic: Computing and Evaluating Estimated Useful Life and Percent Used Up LO: 6 14. The 2016 financial statements for Leggett & Platt, Inc. report the following information: Year ended December 31, (In millions) Depreciation Property and equipment, net Land Accumulated depreciation and amortization

2016

2015

$86.8 565.5 37.7 1,165.4

$83.5 540.8 40.0 1,146.5

a. By what percentage are the assets ‘used up’ at the year-end 2016? What implication does this ratio have for future cash flows at Leggett & Platt? b. Estimate the useful life on average for the Leggett & Platt depreciable assets.

Answer: a. Percent used up = Accumulated depreciation / Depreciable asset cost = $1,165.4 / ($565.5 + $1,165.4 – $37.7) = 68.8% On average, we expect a company’s assets to be about 50% used up (if the company replaces assets evenly over their lives). Leggett & Platt’s percent used up exceeds the average. The implication is that the company will probably soon have to replace these assets. b. Average useful life = Depreciable asset cost / Depreciation expense ($565.5 + $1,165.4 – $37.7) / $86.8 = 19.5 years

© Cambridge Business Publishers, 2018 6-21

Financial Statement Analysis & Valuation, 5th Edition

Topic: Fixed Asset Analysis and Impairment Charge LO: 5, 6 15. The 2016 financial statements of Willamette Valley Vineyards include the following footnote: Note 4. Property and Equipment

Construction in progress Land Winery building and hospitality center Equipment Less accumulated depreciation

Depreciation expense

2016 $ 449,409 8,063,716 14,458,309 10,122,593 33,094,027 (12,897,082) $20,196,945

2015 $ 482,284 5,089,472 13,756,320 9,055,987 28,384,063 (11,654,901) $16,729,162

$ 1,254,455

$ 1,194,191

a. Estimate the useful life on average for Willamette’s depreciable assets at the end of fiscal 2016.

What assets does a wine producer such as Willamette Valley Vineyards own that would explain the useful life you calculated? b. Assume that on January 1, 2017 the company determined that a building with a net book value of $950,000 had a fair value of $400,000. How would this affect the company’s balance sheet and income statement in 2017?

Answer: a. Average useful life = Depreciable asset cost / Depreciation expense = ($33,094,027 – $449,409 – $8,063,716) / $1,254,455 = 19.6 years.

The company has buildings for wine production and storage as well as offices and showrooms that have long useful lives, perhaps as long as 20 years. b. The asset appears to be impaired because the net book value exceeds the fair value. To accurately determine impairment, we would need to know the expected future cash flows and compare those to the net book value. If the impairment is permanent, the company will reduce the asset’s carrying cost on the balance sheet. To do this, the company will expense $550,000 (calculated as $950,000 - $400,000) on the 2017 income statement and add the same amount to the accumulated depreciation of this building. This will reduce both assets and retained earnings in 2017.

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-22

Problems Topic: Inventories LO: 1, 2, 3 1. The asset side of the 2016 balance sheet for Leggett & Platt follows. The company reported cost of sales of $2,850.7 million in 2016 and $2,994.0 million in 2015. Use this information to answer the requirements.

LEGGETT & PLATT, INCORPORATED Consolidated Balance Sheets (excerpts) (in millions) Current Assets Cash and cash equivalents Trade receivables, net of allowance $7.2 and $9.3, at December 31, 2016 and 2015, respectively Other receivables, net Total receivables, net Inventories Finished goods Work in process Raw materials and supplies LIFO reserve Total inventories, net Prepaid expenses and other current assets Total current assets Property, plant and equipment – at cost Machinery and equipment Buildings and other Land Total property, plant and equipment Less accumulated depreciation Net property, plant and equipment Other Assets Goodwill Other intangibles, less accumulated amortization of $137.0 and $139.8 at December 31, 2016 and 2015, respectively Sundry Total other assets Total assets

Dec. 31, 2016

Dec. 31, 2015

$281.9

$ 253.2

450.8 35.8 486.6

448.7 71.5 520.2

255.7 52.6 245.1 (33.8) 519.6 36.8 1,324.9

242.8 42.6 241.8 (22.6) 504.6 33.2 1,311.2

1,133.8 559.4 37.7 1,730.9 (1,165.4) 565.5

1,099.1 548.2 40.0 1,687.3 (1,146.5) 540.8

791.3

806.1

164.9 137.5 1,093.7 $2,984.1

188.4 117.2 1,111.7 $2,963.7

Continued next page

© Cambridge Business Publishers, 2018 6-23

Financial Statement Analysis & Valuation, 5th Edition

Required: a. Calculate the common-size amount for inventories for both years and comment on any differences that you note. Given that the company is in the furniture manufacturing industry, does this ratio seem appropriate? b. Compute inventory turnover for both years and interpret any change. At December 31, 2014, Total inventories, net were $481.4 million. c. Leggett & Platt uses LIFO for at least some of its inventory method. What would the company have reported as inventory in 2016 and 2015 if the company had used the FIFO method? (LIFO reserve balances: $33.8 million in 2016; $22.6 million in 2015; and $73.0 million in 2014.) d. Recalculate cost of goods sold (COGS) under the FIFO method. e. Recompute the inventory turnover ratios for 2016 and 2015 under the FIFO method. What difference do you notice between the FIFO-based ratios and the LIFO-based ratios?

Answer: a. (in millions) Total inventories, net Total assets Common-size inventory

2016 $519.6 $2,984.1 17.4%

2015 $504.6 $2,963.7 17.0%

The company likely has such significant inventories on hand in order to quickly ship to distributors and avoid stock-outs. We should compare this level of inventory to other companies in the industry and to manufacturers in general before we decided if the levels seemed appropriate. b. (in millions) (LIFO) Cost of goods sold Total inventories, net Average total inventories, net Inventory turnover

2016 $2,850.7 $519.6 $512.1 5.57

2015 $2,994.0 $504.6 $493.0 6.07

2014 $481.4

The inventory turnover rate has decreased from 2015 to 2016. The company’s inventory efficiency is declining. c.

(in millions)

Total inventories, net LIFO reserve FIFO inventories = LIFO inventories + LIFO reserve d. (in millions) LIFO reserve Increase (decrease) in reserve LIFO Cost of goods sold FIFO COGS = LIFO COGS – increase (+ decrease) in LIFO reserve

Test Bank, Module 6

2016 $519.6 $33.8 $553.4

2015 $504.6 $22.6 $527.2

2014 $481.4 $73.0 $554.4

2016 $33.8 $11.2 $2,850.7

2015 $22.6 $(50.4) $2,994.0

$2,839.5

$3,044.4

2014 $73.0

© Cambridge Business Publishers, 2018 6-24

e. (in millions) (FIFO) Cost of goods sold Total inventories, net Average total inventories, net Inventory turnover

2016 $2,839.5 $553.4 $540.3 5.26

2015 $3,044.4 $527.2 $540.8 5.63

2014 $554.4

The inventory turnover rate has decreased slightly from 2015 to 2016, consistent with the pattern using LIFO numbers. However, we see that turnover is lower when we use FIFO because inventory is higher.

Topic: Inventories LO: 1, 2, 3 2. The asset side of the 2016 balance sheet for Willamette Valley Vineyards is below. The company reported cost of goods sold of $7,204,884 in 2016 and $7,092,111 in 2015. Use this information to answer the requirements.

WILLAMETTE VALLEY VINEYARDS, INC. Balance Sheet (excerpts) CURRENT ASSETS Cash and cash equivalents Restricted cash Accounts receivable, net Inventories Prepaid expenses & other current assets Income tax receivable Total current assets Investment in Kore Wine Company Vineyard development costs, net Property and equipment, net TOTAL ASSETS

Dec. 31, 2016

Dec. 31, 2015

$ 5,706,351 0 1,871,450 11,970,656 399,740 0 19,948,197 59,186 4,666,794 20,196,945 $44,871,122

$ 4,010,664 1,476,232 1,684,502 10,632,462 131,173 204,513 18,139,546 60,000 3,699,947 16,729,162 $38,628,655

Note 3 to the financial statement reports that Inventories consist of: Willamette Valley Vineyards, Inc. Inventories 12 Months Ended Dec. 31, 2016 December 31, 2016 Winemaking and packaging materials Work-in-process (costs relating to unprocessed and/or unbottled wine products) Finished goods (bottled wine and related products) Current inventories

$

817,836

$

6,634,014 4,518,806 11,970,656

December 31, 2015 $

690,292

$

6,058,701 3,883,469 10,632,462 Continued next page

© Cambridge Business Publishers, 2018 6-25

Financial Statement Analysis & Valuation, 5th Edition

Required: a. Explain in layman’s terms what each of the three types of inventories comprises. b. Compute average days inventory outstanding for both years and interpret any change. At December 31, 2014, Total inventories, net, were $ 9,910,570. What does this ratio mean? Is the year-over-year change good news? c. It is typical in the winemaking industry for wine to stay in “process” for more than a year. How is such inventory classified in Willamette’s balance sheet?

Answer: a. Winemaking and packaging materials would include grapes that have not yet been harvested or placed into production, along with bottles and corks and labels. Work-in-process includes costs relating to unprocessed and/or unbottled wine products. This would be the barrels of wine in the store rooms. This category would include the cost of materials (grapes) as well as direct labor and overhead costs. Finished goods are bottled wine and related products. b. 2016: [(($11,970,656 + $10,632,462)/2) x 365] / $7,204,884 = 572.5 days 2015: [(($10,632,462 + $9,910,570)/2) x 365] / $7,092,111 = 528.6 days The days inventory outstanding increased 43.9 days in 2016. The wine is sitting on the shelves for more than 1.5 years. c.

Willamette classifies all wine inventories as current on the balance sheet. The definition of a current asset is one that will be converted to cash within one operating cycle, which is ordinarily a year. In the case of this industry, the ordinary operating cycle is more than a year. This meets the definition of current for this industry.

Topic: Inventories LO: 1, 2, 3 3. The asset side of the 2017 balance sheet for CarMax Inc. is below.

Consolidated Balance Sheets – USD $ in Thousands (excerpts) CURRENT ASSETS: Cash and cash equivalents Restricted cash from collections on auto loan receivables Accounts receivable, net Inventory Other current assets TOTAL CURRENT ASSETS Auto loan receivables, net Property and equipment, net Deferred income taxes Other assets TOTAL ASSETS

Feb. 28, 2017

$

38,416

Feb. 29, 2016

$

37,394

380,353

343,829

152,388 2,260,563 41,910 2,873,630 10,596,076 2,518,393 150,962 140,295 $16,279,356

132,171 1,932,029 26,358 2,471,781 9,536,892 2,161,698 161,862 127,678 $14,459,911

Continued next page

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-26

The footnotes to the annual report include the following: Inventory is primarily comprised of vehicles held for sale or currently undergoing reconditioning and is stated at the lower of cost or market. Vehicle inventory cost is determined by specific identification. Parts, labor and overhead costs associated with reconditioning vehicles, as well as transportation and other incremental expenses associated with acquiring and reconditioning vehicles, are included in inventory.

Required: a. Does CarMax use the LIFO or the FIFO method of inventory costing? Explain. b. Calculate the common-size amount for inventories for both years and comment on any differences that you note. Given that the company is an automotive retailer, does this ratio seem appropriate? c. At February 28, 2015, Inventory was $2,086,874 thousand. CarMax reports cost of sales of $13,691,824 thousand for the year ended February 28, 2017 and $13,130,915 thousand for the year ended February 29, 2016. Compute inventory turnover and average days inventory outstanding for both years. Do the two ratios tell the same story? Why or why not? d. CarMax reports revenue of $15,875,118 thousand for the year ended February 28, 2017 and $15,149,675 thousand for the year ended February 29, 2016. Calculate gross profit margins for both years. e. What is your opinion about the financial health of CarMax? Use the ratios you calculated above to support your opinion.

Answer: a. CarMax uses neither the LIFO nor FIFO method of accounting for inventory cost. The company uses the specific identification method. Under this method, the serial number of each vehicle is used to track the vehicles original cost. Any repairs or shipping costs are allocated to the specific vehicle – no averaging is done. When the vehicle is sold, its specific cost is transferred to the income statement as cost of sales. b. February 2017: $2,260,563 thousand / $16,279,356 thousand = 13.9% February 2016: $1,932,029 thousand / $14,459,911 thousand = 13.4% This ratio seems appropriate given that CarMax sells automobiles, which are a high-priced inventory. We may even expect the ratio to be higher, but it is kept at this level due to the large amount of auto loans receivable included in total assets. c. $ in thousands Cost of sales Inventory Average Inventory Inventory turnover = COGS / Average inventory Days inventory outstanding = (365 x Average inventory) / COGS

Feb 28, 2017 $13,691,824 $2,260,563

Feb 29, 2016 $13,130,915 1,932,029

$2,096,296

$2,009,451.5

6.53 times

6.53 times

55.9 days

55.9 days

Feb 28, 2015 $2,086,874

Both ratios tell the same story. There was no change in either ratio from 2016 to 2017.

© Cambridge Business Publishers, 2018 6-27

Financial Statement Analysis & Valuation, 5th Edition

d. (in thousands) Sales Cost of sales Gross profit Gross profit margin %

Feb. 28, 2017 $ 15,875,118 13,691,824 2,183,294 13.8%

Feb. 29, 2016 $ 15,149,675 13,130,915 2,018,760 13.3%

e. CarMax ratios appear to be stable and includes a slight improvement in its gross profit margin ratio from 2017 to 2016.

Topic: Restructuring Costs (Numerical calculations required) LO: 5 4. The Dow Chemical Corporation announced a restructuring plan in 2016 which incorporated actions related to the recent ownership restructure of Dow Corning Corporation. The following footnote (excerpted) of the Company comes from the December 31, 2016 financial statements: 2016 Restructuring On June 27, 2016, the Board of Directors of the Company approved a restructuring plan that incorporates actions related to the recent ownership restructure of Dow Corning Corporation ("Dow Corning"). These actions, aligned with Dow’s value growth and synergy targets, will result in a global workforce reduction of approximately 2,500 positions, with most of these positions resulting from synergies related to the Dow Corning transaction. These actions are expected to be substantially completed by June 30, 2018.

As a result of these actions, the Company recorded pretax restructuring charges of $449 million in the second quarter of 2016 consisting of severance charges of $268 million, asset write-downs and writeoffs of $153 million and costs associated with exit and disposal activities of $28 million. The impact of these charges is shown as "Restructuring charges (credits)" in the consolidated statements of income and reflected in the Company's segment results in the table that follows. The table also summarizes the activities related to the Company's 2016 restructuring reserve, which is included in "Accrued and other current liabilities" and "Other noncurrent obligations" in the consolidated balance sheets.

The following table summarizes the activities related to the Company’s restructuring reserve (liability):

2016 Restructuring Charges (in millions) Consumer Solutions Infrastructure Solutions Performance Plastics Corporate 2016 restructuring charges Charges against the reserve Cash payments Reserve balance at December 31, 2016

Impairment of Long-Lived Assets and Other Assets $ 23 74 10 46 $153

Costs Associated with Exit and Disposal Activities $ 5 23 — — $428

Total $ 28 97 10 314 $449

—

(156)

—

(153)

(67)

— $—

(1)

(68)

$ 27

$228

Severance Costs $ — — — 268 $268

$201

Continued next page

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-28

Required: a. Explain why Dow Chemical planned this restructuring. When did the company record the restructuring expense? When will the restructuring take place? Explain the difference. b. What are the three types of restructuring costs for Dow Chemical for 2016? c. Explain why no cash is involved in settling the impairment of long-lived assets portion of the restructuring reserve. d. Dow Chemical managers estimated all of the charges above. What would be the incomestatement consequences next year (in 2017) if only $100 million of additional cash payments were necessary to completely settle the employee severance costs? Assume that Dow Chemical did not intentionally overestimate these severance costs.

Answer: a. On June 27, 2016, the Board of Directors of the Dow Chemical Corporation approved a restructuring plan that incorporated actions related to the recent ownership restructure of Dow Corning Corporation ("Dow Corning"). Because the board of directors passed a motion to restructure in 2016, GAAP allows Dow to accrue the costs in 2016. The restructuring was started in 2016 and some of the cash was paid out during 2016. However, the restructuring continues into 2018, but the expenses were recorded in 2016. b. Asset impairment charges relate to the write-down of assets to fair values. This likely represents plants that will be shuttered, equipment that will be scrapped, and office locations that will be closed. Costs associated with exit or disposal relate to the costs that will arise as the company tries to sell off long-term assets, charges of early termination of leases, legal fees, closure and relocation of manufacturing and administrative facilities etc. Employee severance costs represent accrued costs for the termination of employees whose jobs are to be eliminated under the restructuring. This includes layoff packages, pension payouts, and any other costs paid to or on behalf of, the laid-off employees. c.

Asset write-offs are noncash charges. The income statement shows the $153 million as part of the total restructuring expense, and assets (property, land, equipment, etc.) are reduced on the balance sheet.

d. If only $100 million additional severance costs will be paid, Dow Chemical has an excess liability on its balance sheet for $101 ($201 – $100) and this will never be paid. The consequence is that the charge will be reversed. This reversal will reduce expenses, which will increase net income 2016.

© Cambridge Business Publishers, 2018 6-29

Financial Statement Analysis & Valuation, 5th Edition

Topic: Property, Plant and Equipment LO: 6 5. The 2016 income statement and balance sheet (excerpts) for BNSF Railway are below.

BNSF RAILWAY Consolidated Statements of Income (in millions) Revenues Operating expenses: Compensation and benefits Purchased services Depreciation and amortization Fuel Equipment rents Materials and other Total operating expenses Operating income Interest expense Other expense, net Income before income taxes Income tax expense Net income

(in millions)

Dec. 31, 2016

Dec. 31, 2015

Dec. 31, 2014

$ 19,829

$ 21,967

$ 23,239

4,769 2,418 2,128 1,934 766 1,129 13,144 6,685 992 0 5,693 2,124 $ 3,569

5,043 2,546 2,001 2,656 801 1,196 14,243 7,724 928 21 6,775 2,527 $ 4,248

5,023 2,592 2,123 4,478 867 1,143 16,226 7,013 833 11 6,169 2,300 $ 3,869

BNSF RAILWAY Consolidated Balance Sheets Dec. 31, 2016

Current assets: Cash and cash equivalents Accounts receivable, net Materials and supplies Current portion of deferred income taxes Other current assets Total current assets Property and equipment, net of accumulated depreciation of $6,130 and $4,845, respectively Goodwill Intangible assets, net Other assets Total assets

Dec. 31, 2015

$ 3,218 1,272 825 0 235 5,550

$ 2,329 1,198 829 245 337 4,938

61,250

59,510

14,845 430 2,047 $84,122

14,845 468 1,942 $81,703

Continued next page

Test Bank, Module 6

© Cambridge Business Publishers, 2018 6-30

The footnotes to the financial statements included the following: Property and equipment, net (in millions), and the corresponding ranges of estimated useful lives were as follows:

Land for transportation purposes Track structure Other roadway Locomotives Freight cars and other equipment Computer hardware, software and other Construction in progress Total cost Less accumulated depreciation and amortization Property and equipment, net

December 31, 2016

December 31, 2015

$

$

6,063 22,287 25,990 8,338 2,755 982 965 67,380 (6,130)

$

61,250

6,037 21,200 24,767 7,794 2,629 897 1,031 64,355

2016 Range of Estimated Useful Life — 15–50 years 7–100 years 7–35 years 8–40 years 6–9 years —

(4,845) $

59,510

Required: a. What proportion of total assets, does BNSF hold as property and equipment in 2016 and 2015?

Does this surprise you? b. Compute property and equipment turnover for 2016 and 2015. Property and equipment, net for 2014 was $55,806 million. Explain this ratio. c. By what percentage are the assets ‘used up’ at year-end 2016? What implication does this ratio have for future cash flows at BNSF? d. Estimate the useful life on average for the BNSF depreciable assets at year-end 2016. Which of the assets listed in the footnote explain this estimated useful life?

Answer: a. 2016: $61,250 / $84,122 = 72.8% 2015: $59,510 / $81,703 = 72.8% This is not surprising – the company has huge investment in track and rolling stock. It is a very capital-intensive (old economy) company. The company has no inventory—it is a service company. b. (in millions) Revenues Property and equipment, net Average PPE PPE turnover

2016 $ 19,829

2015 $ 21,967

2014

$61,250 $60,380 0.33

$59,510 $57,658 0.38

$55,806

The interpretation of this ratio is that for every dollar of PPE in 2016, BNSF had an average of $0.33 of sales,

© Cambridge Business Publishers, 2018 6-31

Financial Statement Analysis & Valuation, 5th Edition

c.

2016: $6,130 / ($67,380 - $6,063 - $965) = 10.2% On average, we expect a company’s assets to be about 50% used up (if the company replaces assets evenly over their lives). A few years ago, BNSF went through a merger. At that time, all assets were revalued and depreciation began new and since the useful lives of most of their assets are many years, they are about 10% depreciated on average. The implication is that the company will not soon have to replace these assets.

d. 2016: ($67,380 - $6,063 - $965) / $2,128 = 28.4 years The company has track improvements and other roadways that could have useful lives of 7 to 100 years. Train cars and locomotives likely last up to 35 to 40 years. The only short-lived assets are the computers and these do not account for a significant proportion of total PPE.

Topic: Fixed Asset Analysis LO: 6 6. Following are selected disclosures from Cabela’s Inc. (an outdoor adventure superstore): Property and equipment consisted of the following at the years ended:

(in thousands) Land Buildings and improvements Furniture, fixtures, and equipment Assets held under capital lease Property and equipment Less accumulated depreciation and amortization

Depreciable Life in Years — 7 to 40 3 to 15 Up to 30

$

Construction in progress $

2016

2015

364,694 $ 1,311,941 905,739 12,979 2,595,353 (833,956) 1,761,397 45,812 1,807,209 $

325,576 1,181,704 834,656 12,979 2,354,915 (707,183) 1,647,732 163,570 1,811,302

Required: a. Compute the PPE turnover for 2016 (Total revenue in 2016 is $4,129,359 thousand). Does the level of its PPE turnover suggest that Cabela’s is capital intensive? (Hint: The median PPE turnover for all publicly traded companies is approximately 1.3.) b. Cabela’s reported depreciation expense of $150,163 thousand in 2016. How much of this related to Land? How much of this expense related to Construction in progress? Explain. c. Assuming that Cabela’s uses straight-line depreciation, estimate the useful life of its depreciable PPE assets. d. By what percentage are Cabela’s assets “used up” at year-end 2016? What implication does the assets-used-up ratio have for forecasting Cabela’s cash flows?

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Answer: a. PPE turnover for 2016 = $4,129,359 / [($1,807,209 + $1,811,302) / 2] = 2.28 This company does not seem to be capital intensive because its asset turnover of 2.28 is greater than the median of 1.3. b. None of the depreciation expense for the year relates to land or construction in progress. Land is never depreciated because its value does not atrophy over time, that is, you can’t use land up.

Construction in progress represents assets that the company has not begun using. Thus, they can’t be depreciated. c.

Depreciable assets = $2,595,353 thousand - $364,694 thousand = $2,230,659 thousand.

Average asset life = $2,230,659 / $150,163 = 14.9 years

d. Percent used up = $833,956 / $2,230,659 = 37.4% If property and equipment were replaced at a constant rate, those assets would be about 50% “used up”, on average. Cabela’s Inc.’s depreciable assets are only about 37% used up, so there will not be reason to assume significant cash outflows in the near future to replace these assets.

Topic: Fixed Asset Analysis LO: 5, 6 7. The asset side of the 2016 balance sheet for Willamette Valley Vineyards is as follows: WILLAMETTE VALLEY VINEYARDS, INC. Balance Sheet (excerpts) CURRENT ASSETS Cash and cash equivalents Restricted cash Accounts receivable, net Inventories Prepaid expenses & other current assets Income tax receivable Total current assets Investment in Kore Wine Company Vineyard development costs, net Property and equipment, net TOTAL ASSETS

Dec. 31, 2016

Dec. 31, 2015

$ 5,706,351 0 1,871,450 11,970,656 399,740 0 19,948,197 59,186 4,666,794 20,196,945 $44,871,122

$ 4,010,664 1,476,232 1,684,502 10,632,462 131,173 204,513 18,139,546 60,000 3,699,947 16,729,162 $38,628,655

Continued next page

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Financial Statement Analysis & Valuation, 5th Edition

The following footnotes are from the annual report for Willamette Valley Vineyards for 2016.

Vineyard Development Costs Vineyard development costs consist primarily of the costs of the vines and expenditures related to labor and materials to prepare the land and construct vine trellises. The costs are capitalized until the vineyard becomes commercially productive, at which time annual amortization is recognized using the straight-line method over the estimated economic useful life of the vineyard, which is estimated to be 30 years. Accumulated amortization of vineyard development costs aggregated $1,185,823 and $1,109,406 at December 31, 2016 and 2015, respectively.

Amortization of vineyard development costs are included in capitalized crop costs that in turn are included in inventory costs and ultimately become a component of cost of goods sold. For the years ending December 31, 2016 and 2015, approximately $76,417 and $75,669, respectively, was amortized into inventory costs.

Note 4. Property and Equipment December 31, 2016 Construction in progress Land and improvements Winery buildings and hospitality center Equipment

$

Less accumulated depreciation Depreciation expense

$ $

449,409 8,063,716 14,458,309 10,122,593 33,094,027 (12,897,082) 20,196,945 1,254,455

December 31, 2015 $

$ $

482,284 5,089,472 13,756,320 9,055,987 28,384,063 (11,654,901) 16,729,162 1,194,191

Required: a. Explain the difference between Vineyard development costs and Land and improvements. b. Calculate the percent used up of the Vineyard development costs. c. Calculate the percent used up of the Property and equipment. What does this imply for future cash flows for Willamette Valley Vineyards? d. Assume that on January 1, 2017 the company determined that the Vineyard development costs had a fair value of $4,000,000. How would this affect the company’s balance sheet and income statement in 2017?

Answer: a. The Vineyard development costs include the cost of buying and planting the vines along with the cost of the trellis system upon which the vines grow. All of these costs are depreciated (via cost of goods sold). Land and improvements is the cost of the vineyard land – the original purchase cost – as well as the cost of adding infrastructure such as water and sanitation and roads. The original land cost is not depreciated, but the improvements likely are if the company believes that they are used up. b. Percent used up = Accumulated amortization / Development costs, gross = $1,185,823 / ($4,666,794 + $1,185,823 ) = 20.3%

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c.

Percent used up = Accumulated depreciation / Depreciable asset cost = $12,897,082 / ($33,094,027 – $449,409 – $8,063,716) = 52.5% The assets are getting old – they are on average over 52% used up. The implication is that the Vineyard will need to replace these assets and cash will be required.

d. The asset appears to be impaired because the fair value is less than NBV. To accurately determine whether there is impairment, we would need to know the expected future cash flows of the development costs and compare those to the net book value. If the impairment is permanent, the company will reduce the asset’s carrying cost on the balance sheet. To do this, the company will add $4,666,794 – $4,000,000 = $666,794 to inventory which will flow to the income statement as cost of goods sold when the inventory manufactured in 2017 is sold. This same amount ($666,794) will be added to accumulated amortization, which will reduce the Vineyard development cost, net on the balance sheet.

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Financial Statement Analysis & Valuation, 5th Edition

Essay Questions Topic: Inventory Costing LO: 1, 3 1. When making investment decisions, why is it important to know what type of inventory costing system the company uses? Give two examples of ratios and accounts that may be affected by a company’s inventory costing method choice.

Answer: Inventory costing method affects numbers on both the income statement and the balance sheet. If we want to compare companies to each other, or compare a given company to an industry benchmark, it is important to ensure that we are comparing apples to apples. The accounts affected are: inventory, cost of sales, gross profit, and net income. The ratios affected include: common-size amount for inventory, gross profit margin, inventory turnover, average days inventory outstanding, current ratio, working capital ratios, etc.

Topic: Depreciation Methods LO: 4 2. You are the CFO of a small start-up company and are trying to decide between using the straight-line depreciation method, the double-declining-balance depreciation method, or another use-based depreciation. What should you consider as you make your choice?

Answer: Ideally, depreciation expense should match the using up of the asset. You would want to consider how the asset is used up as it produces products and creates revenue. If the asset is used in the same amount each year, then the simplest way to depreciate it is straight-line. If an asset will be used up more in its early years and less in its later years, it is a good candidate for double-decliningbalance. If it is possible to estimate a total number of uses that is a good estimate of the lifetime production of that asset, it can be beneficial to depreciate based on the number of uses in the period divided by the total number of lifetime uses.

Topic: Asset Impairment LO: 5 3. How do companies test assets for impairment? If an asset is impaired, how do companies write them down?

Answer: Tangible assets are held on the balance sheet at their net book value. The first step to testing for impairment is to estimate the undiscounted future cash flows expected to be generated by the asset.

If the sum of these undiscounted future cash flows is less than the current net book value, the asset is deemed to be impaired. If the expected future cash flows are greater than the net book value, no impairment exists. Once impairment has been identified, the amount of the asset impairment is equal to difference between the asset’s fair value and its net book value. This asset would then appear on the balance sheet at the impaired value and the amount of the impairment would be an expense on the income statement for that year. Asset impairment requires estimates by management.

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Test Bank for Financial Statement Analysis & Valuation, 4th Edition, by Easton, McAnall

Topic: Restructuring Charges LO: 5 4. Firms typically report three categories of restructuring costs. What are they and how do they affect the balance sheet and the income statement?

Answer: Restructuring costs consist of three general categories: asset write-downs, liability accruals for severance and relocation costs, and accruals of other restructuring-related costs. Asset write-downs reduce assets’ net book value and are recognized in the income statement as an expense. Liability accruals for severance and other expenses create a liability, such as for anticipated severance costs and exit costs, and yield a corresponding expense that reduces income and equity.

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Financial Statement Analysis & Valuation, 5th Edition

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