SOUTH EASTERN UNIVERSITY OF SRI LANKA

FACULTY OF MANAGEMENT AND COMMERCE

DEPARTMENT OF ACCOUNTANCY AND FINANCE
Tutorial - 02
Analyzing Investing Activities
FINANCIAL STATEMENT ANALYSIS- FIM 41073

BBA Degree Programme Final Year - Semester I

Lecturer in Charge
A L Sarifudeen
B.Com (Hons) Spl, in Acc & Fin. Mgt (SEUSL),
MBA (WUSL) , MAAT (SL) , ACPM (SL), CTHE (CMB), SEDA (UK)

1) a) Explain the concept of a company’s operating cycle and its meaning.

b) Discuss the significance of the operating cycle to classification of current versus noncurrent
items in a balance sheet. Cite examples.
c) Is the operating cycle concept useful in measuring the current debt-paying ability of a company
and the liquidity of its working capital components?
d) Describe the impact of the operating cycle concept for classification of current assets in the
following industries: (1) tobacco, (2) liquor, and (3) retailing.

2) a) Identify the main concerns in analysis of accounts receivable.

b) Describe information, other than that usually available in financial statements that we should
collect to assess the risk of non-collectability of receivables.

3) a) What is meant by the factoring or securitization of receivables?

b) What does selling receivables with recourse mean? What does it mean to sell them without
recourse?
c) How does selling receivables (particularly with recourse) potentially distort the balance sheet?

4) a) Discuss the consequences for each of the acceptable inventory methods in recording costs of
inventories and in determination of income.

b) Comment on the variation in practice regarding the inclusion of costs in inventories. Give
examples of at least two sources of such cost variations.

5) On December 31, Year 1, Carme Company reports its accounts receivable from credit sales to
customers. Carme Company uses the allowance method, based on credit sales, to estimate bad
debts. Based on past experience, Carme fails to collect about 1% of its credit sales. Carme expects
this pattern to continue.

Required:
a) Discuss the rationale for using an allowance method based on credit sales to estimate bad
debts. Contrast this method with an allowance method based on the accounts receivable
balance.
b) How should Carme report its allowance for bad debts account on its balance sheet at
December 31, Year 1? Describe the alternatives, if any, for presentation of bad debt expense
in Carme’s Year 1 income statement.
c) Explain the analysis objectives when evaluating the reasonableness of Carme’s allowance for
bad debts.

6) A balance sheet, which is intended to present fairly the financial position of a company, frequently
is criticized for not reflecting all assets under the control of a company.
Required:
Cite five examples of assets that are not presently included on the balance sheet. Discuss the
implications of unrecorded assets for financial statement analysis.

7) An analyst must be familiar with the determination of income. Income reported for a business entity
depends on proper recognition of revenues and expenses. In certain cases, costs are recognized as
expenses at the time of product sale; in other situations, guidelines are applied in capitalizing costs
and recognizing them as expenses in future periods.

Required:
a) Under what circumstances is it appropriate to capitalize a cost as an asset instead of expensing
it? Explain.
b) Certain expenses are assigned to specific accounting periods on the basis of systematic and
rational allocation of asset cost. Explain the rationale for recognizing expenses on such a basis.
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8) Which of the following items are classified as assets on a typical balance sheet?
a) Depreciation. b) CEO salary. c) Cash. d) Deferred income taxes.
e) Installment receivable (collectible in 3 years). f) Capital withdrawal (dividend).
g) Inventories. h) Prepaid expenses. j) Deferred charges. k) Work-in-process inventory.
l) Depreciation expense. m) Bad debts expense. n) Loan to officers. o) Loan from officers.
p) Fully trained sales force. q) Common stock of a subsidiary. s) Trade name purchased.
t) Internally developed goodwill. u) Franchise agreements obtained at no cost.
v) Internally developed e-commerce system

9) K2 Sports, a wholesaler that has been in business for two years, purchases its inventories from
various suppliers. During these two years, each purchase has been at a lower price than the previous
purchase. K2 uses the lower-of-(FIFO)-cost-or-market method to value its inventories. The original
cost of the inventories exceeds its replacement cost, but it is below the net realizable value (also,
the net realizable value less a normal profit margin is lower than replacement cost for he
inventories).

Required:
a) What criteria should be used in determining costs to include in inventory?
b) Why is the lower-of-cost-or-market rule used in valuing inventory?
c) At what amount should K2 report its inventories on the balance sheet? Explain the application
of the lower-ofcost-or-market rule in this situation.
d) What would be the effect on ending inventories and net income for the second year had K2
used the lower-of- (average) cost-or-market inventory method instead of the lower-of-(FIFO)-
cost-or-market inventory method? Explain.
10)

11)

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12) Cost for inventory purposes should be determined by the inventory cost flow method best
reflecting periodic income.
Required:
a) Describe the inventory cost flow assumptions of (1) average-cost, (2) FIFO, and (3) LIFO.
b) Discuss management’s usual reasons for using LIFO in an inflationary economy.
c) When there is evidence the value of inventory, through its disposal in the ordinary course of
business, is less than cost, what is the accounting treatment? What concept justifies this
treatment?

13) Trimax Solutions develops software to support e-commerce. Trimax incurs substantial computer
software development costs as well as substantial research and development (R&D) costs related
to other aspects of its product line. Under GAAP, if certain conditions are met, Trimax capitalizes
software development costs but expenses the other R&D costs. The following information is taken
from Trimax’s annual reports ($ in thousands):

Required:

a) Compute the total expenditures for software development costs for each year.
b) R&D costs are expensed as incurred. Compare and contrast computer software development
costs with the R&D costs and discuss the rationale for expensing R&D costs but capitalizing
some software development costs.
c) Based on the information provided, when do successful research efforts appear to produce
income for Trimax?
d) Discuss how income and equity are affected if Trimax invests more in software development
versus R&D projects (focus your response on the accounting, and not economic, implications).
e) Compute net income, return on assets, and return on equity for year 2006 while separately
assuming (1) Software development costs are expensed as incurred and (2) R&D costs are
capitalized and amortized using straight line over the following four years.
f) Discuss how the two accounting alternatives in ewould affect cash flow from operations for
Trimax.

14) Inventory and cost of goods sold figures prepared under the LIFO cost flow assumption versus
the FIFO cost flow assumption can differ dramatically.

Required:
a) Would an analyst consider ending inventory asset value more useful if computed using LIFO
or FIFO? Explain.

b) Would an analyst consider cost of goods sold more useful if computed using LIFO or FIFO?
Explain.
c) Assume a company uses the LIFO cost flow assumption. Identify any FIFO-computed values
that are useful for analysis purposes, and explain how they are determined using financial
statement information.

15) Sports Biz, a profitable company, built and equipped a Rs.2,000,000 plant brought into operation
early in Year 1. Earnings of the company (before depreciation on the new plant and before income
taxes) is projected at: Rs.1,500,000 in Year 1; Rs. 2,000,000 in Year 2; Rs.2,500,000 in Year 3;
Rs.3,000,000 in Year 4; and Rs. 3,500,000 in Year 5. The company can use straight-line, double
declining-balance, or sum-of-the-years’-digits depreciation for the new plant. Assume the plant’s
useful life is 10 years (with no salvage value) and an income tax rate of 50%.
Required:
Compute the separate effect that each of these three methods of depreciation would have on:
a) Depreciation
b) Income taxes

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 c) Net income
d) Cash flow (assumed equal to net income before depreciation)

16) Jay Manufacturing, Inc., began operations five years ago producing probos, a new medical
instrument it hoped to sell to doctors and hospitals. The demand for probos far exceeded initial
expectations, and the company was unable to produce enough probos to meet demand. The
company was manufacturing this product using self-constructed equipment at the start of
operations. To meet demand, it needed more efficient equipment. The company decided to design
and self-construct this new, more efficient equipment. A section of the plant was devoted to
development of the new equipment and a special staff was hired. Within six months, a machine
was developed at a cost of $170,000 that successfully increased production and reduced labor costs
substantially. Sparked by the success of this new machine, the company built three more machines
of the same type at a cost of $80,000 each

Required:
1. In addition to satisfying a need that outsiders could not meet within the desired time, why might
a company self-construct fixed assets for its own use?
2. Generally, what costs should a company capitalize for a self-constructed fixed asset?
3. Discuss the propriety of including in the capitalized cost of self-constructed assets:
a) The increase in overhead caused by the self-construction of fixed assets.
b) A proportionate share of overhead on the same basis as that applied to goods manufactured
for sale.
4. Discuss the accounting treatment for the $90,000 amount ($170,000 - $80,000) by which the
cost of the first machine exceeded the cost of subsequent machines

17) On June 30, Year 1, your client, the Vandiver Corp., is granted two patents covering plastic cartons
that it has been producing and marketing profitably for the past three years. One patent covers the
manufacturing process, and the other covers related products. Vandiver executives tell you that
these patents represent the most significant breakthrough in the industry in three decades. The
products have been marketed under the registered trademarks Safetainer, Duratainer, and Sealrite.
Your client has already granted licenses under the patents to other manufacturers in the U.S. and
abroad and is receiving substantial royalties. On July 1, Year 1, Vandiver commenced patent
infringement actions against several companies whose names you recognize as those of substantial
and prominent competitors. Vandiver’s management is optimistic that these suits will result in a
permanent injunction against the manufacture and sale of the infringing products and collection of
damages for loss of profits caused by the alleged infringement. The financial vice president has
suggested that the patents be recorded at the discounted value of expected net royalty receipts.

Required:
a) Explain what an intangible asset is.
b) 1) Explain what is meant by “discounted value of expected net royalty receipts.”
2) How would such a value be calculated for net royalty receipts?

c) What basis of valuation for Vandiver’s patents is generally accepted in accounting? Give
supporting reasons for this basis.
d) 1) Assuming no problems of implementation and ignoring generally accepted accounting
principles, what is the preferable basis of evaluation for patents? Explain.

2) Explain what would be the preferable conceptual basis of amortization.

e) What recognition or disclosure, if any, is Vandiver likely to make for the infringement
litigation in its financial statements for the year ending September 30, Year 1? Explain.

17) a) Explain the concept of a company’s operating cycle and its meaning.
b) Discuss the significance of the operating cycle to classification of current versus noncurrent
items in balance sheet. Cite examples.
c) Is the operating cycle concept useful in measuring the current debt-paying ability of a
company and the liquidity of its working capital components?
d) Describe the impact of the operating cycle concept for classification of current assets
in the following industries: (1) tobacco, (2) liquor, and (3) retailing.

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16) Mirage Resorts, Inc., recently completed construction of Bellagio Hotel and Casino in Las

Vegas. Total cost of this project was approximately $1.6 billion. The strategy of the investors is to
build a gambling environment for “high rollers.” As a result, they paid a premium for property in the
“high rent” district of the Las Vegas Strip and built a facility inspired by the drama and elegance of
fine art. The investors are confident that if the facility attracts high volume and high stakes gaming, the
net revenues will justify the $1.6 billion investment several times over. If the facility fails to attract
high rollers, this investment will be a financial catastrophe. Mirage Resorts depreciates its fixed assets
using the straight-line method over the estimated useful lives of the assets.

Assume construction of Bellagio is completed and the facility is opened for business on January 1,
Year 1. Also assume annual net income before depreciation and taxes from Bellagio is $50 million,
$70 million, and $75 million for Year 1, Year 2, and Year 3, and that the tax rate is 25%.

Required:

Compute the return on assets for the Bellagio segment for Year 1, Year 2, and Year 3, assuming

management estimates the useful life of Bellagio to be:

a. 25 years. b. 15 years. c. 10 years. d. 1 year.