Modules 6 to 7
Module 6: Inventory and Plant Assets
1. Inventory Costing: FIFO vs. LIFO
Key idea: FIFO and LIFO can produce different inventory values and different cumulative income effects when prices change.
Important points:
- FIFO inventory is generally higher than LIFO inventory when costs are rising.
- LIFO reserve = FIFO inventory - LIFO inventory
- Using LIFO during rising prices usually: lowers inventory, lowers pretax income, and lowers taxes.
What to know:
- How to interpret the LIFO reserve.
- Why LIFO can create tax savings.
- Why FIFO inventory is often closer to current replacement cost.
2. Inventory Write-Downs / Write-Offs
Key idea: If inventory is not worth its recorded amount, it must be written down.
Effects of a write-down: Inventory decreases, Expense increases, Pretax income decreases, Total assets decrease.
What to know:
- Why firms write down inventory.
- How a write-down affects the income statement and balance sheet.
- Why ignoring a write-down would overstate assets and income.
3. Inventory Turnover and DIO
Key idea: These ratios measure how quickly inventory moves.
Interpretation: Higher turnover usually means inventory is moving faster. Lower DIO usually means inventory is held for fewer days. Inventory write-downs can affect both ratios.
What to know:
- How to calculate average inventory.
- How changes in COGS or inventory affect turnover and DIO.
- Why ratio interpretation matters more than just calculation.
4. PPE Turnover
Key idea: Measures how efficiently the company uses property, plant, and equipment to generate sales.
Interpretation: Higher PPE turnover suggests more efficient use of plant assets. Must be interpreted in context of the industry.
5. Average Useful Life
Key idea: Estimates how long depreciable assets last on average.
What to know: A longer useful life means lower annual depreciation relative to the asset base. Note: In real-world analysis, strictly non-depreciable assets like Land and Construction in Progress (CIP) must be excluded from the gross PPE base before calculating this metric. Compare across firms carefully.
6. Percent Used Up
Key idea: Shows how much of a company’s depreciable asset base has already been used.
Interpretation: Higher percentage = older assets. Lower percentage = newer assets. Note: As with average useful life, exclude non-depreciable assets like Land and CIP from your denominator.
Module 7: Warranties, Debt, and Bonds
1. Warranty Expense and Warranty Liability
Key idea: Expected warranty costs are recognized when products are sold, not when cash is later paid.
What to know:
- Why warranty expense follows accrual accounting.
- Difference between expense recognition and later cash payment.
- How liability changes when actual repairs occur (Rollforward method).
2. Reformulating Warranty Expense
Key idea: Analysts may adjust warranty expense to make performance more comparable across years.
What to know: Why reported warranty expense may not reflect normal operations in one year, and how adjusting warranty expense affects pretax income, income tax expense, and net income.
3. Accrued Liabilities
Key idea: Expenses are recorded when incurred, even if not yet paid.
Examples: Interest payable, Bonus payable, Warranty liability.
What to know: How to prorate interest for part of a year, why accrued liabilities appear at year-end, and how accruals affect both expense and liabilities.
4. Bond Pricing
Key idea: Bond issue price equals the present value of future cash flows.
Interpretation:
- Coupon rate < market rate → bond sells at a discount
- Coupon rate > market rate → bond sells at a premium
- Coupon rate = market rate → bond sells at par
What to know: Why bond prices move inversely to market interest rates, and how present value determines issue price.
5. Interest Expense on Bonds
Key idea: Interest expense is based on the effective interest method, not simply the cash paid.
What to know:
- Discount bonds: interest expense is greater than cash interest.
- Premium bonds: interest expense is less than cash interest.
- Carrying value changes over time.
- Crucial Step: The market rate used must match the payment period. For example, if a bond pays interest semi-annually, an 8% annual market rate becomes 4% per period. Compounding frequency directly impacts the bond's present value and periodic amortization.
6. Financial Statement Effects of Bonds
Key ideas:
- Issue at par: cash up, bonds payable up
- Interest payment: cash down, interest expense up
- Retirement of bonds: debt removed, gain or loss may occur
What to know: How bond issuance affects balance sheet accounts, why early retirement can create a gain or loss, and how interest expense flows through retained earnings.
7. Average Interest Rate on Debt
Key idea: Helps estimate the effective cost of borrowing.
What to know: Why interest paid may differ from interest expense, and how premium/discount amortization affects the effective borrowing rate.
8. Bond Prices, Yields, and Interest Rates
Key relationship: Bond price and yield move in opposite directions.
Interpretation: Bond price above par → yield below coupon rate. Bond price below par → yield above coupon rate.
What to know: Why changes in market rates affect bond prices, and why longer-maturity bonds often carry different yields than shorter-maturity bonds.