Cash and Inventory: Financial Accounting Study Notes

Cash and Inventory in Financial Accounting

Session Overview

This session covers essential topics in financial accounting related to cash management and inventory. The main questions addressed include profit manipulation, cash management, accounts receivable, settlement discounts, cost of goods sold (COGS), and handling bad inventory.

Profit Manipulation Techniques

Earnings Management

Earnings management refers to the deliberate adjustment of financial statements by management to achieve desired profit figures. This can involve timing revenue recognition or expense reporting to smooth earnings or meet targets.

• Definition: The use of accounting techniques to produce financial reports that present an overly positive view of a company's business activities and financial position.

• Example: Shifting expenses to future periods or accelerating revenue recognition.

Income Smoothing

Income smoothing is a form of earnings management where managers attempt to reduce fluctuations in earnings over time, making profits appear more stable.

• Key Point: Smoother earnings can lead to higher stock market valuations, as investors prefer predictability.

• Example: Deferring revenue or accelerating expenses in high-profit years.

Big Bath and Cookie Jar Accounting

These are two specific strategies for manipulating profits:

• Big Bath: In a year of loss, managers may take extra write-offs or provisions to "clean up" the balance sheet, making future results look better.

• Cookie Jar: In profitable years, managers may set aside reserves for future periods, smoothing out future earnings.

Capex Manipulation

Capex manipulation involves booking operating expenses as capital expenditures (investments), which are then depreciated over time rather than expensed immediately.

• Result: Higher reported profits in the short term.

• Classic Examples: Worldcom, Satyam, Comverse, Penn West Petroleum.

Cash Management

Growth Drains Cash Faster Than It Creates It

Rapid growth often requires significant cash outflows before revenue is realized. Companies must manage cash carefully to avoid liquidity problems.

Year	Revenue	Net Profit Margin	Operating Cash Flow	Inventory	Accounts Receivable	Machines (At Cost)
2024	100	10%	10	10	15	100
2025 (10% growth)	110	10%	11	11	16.5	110

Additional cash needed for growth:

• Increase in inventory: -1

• Increase in receivables: -1.5

• New machine (capacity investment): -10

• Total additional cash outflow: -12.5

• Net cash impact: +10 (2024), -1.5 (2025)

The Double Burden of Growth

Cash Today	Confidence in Tomorrow
Invest in long-term capacity now: datacenters, machines, people	Investors must believe demand will persist to justify that investment
Cash outflow happens before revenue inflow	Growth assumptions drive valuation and access to capital
Without cash, you can't grow	Without investor confidence, you can't fund that growth

When Cash Drags Down Return

Holding excess cash can reduce a company's overall return on assets.

Scenario	Non-current assets	Cash	Return on non-current assets	Return on cash	Blended return
A – Low cash	€80m	€20m	20%	1%	16.2%
B – Moderate cash	€60m	€40m	20%	1%	12.1%
C – High cash	€40m	€60m	20%	1%	8.1%

Buy Back Shares or Invest In the Future?

Companies must decide whether to use excess cash for share buybacks or invest in future growth (e.g., capex for data centers).

• Share buybacks: Can increase earnings per share and shareholder value.

• Capex investment: May drive long-term growth and competitiveness.

Accounts Receivable

What Happens to Accounts Receivable?

Event	Accounts Receivable	What next?	Why?
Signing Sales Order	No impact	Nothing	Neither the firm nor the customer have performed
Goods are delivered / services performed	No impact	Recognize revenue and accounts receivable to be invoiced	Firm performed, but customer can't pay yet, invoice not sent
Invoice is sent	Increase	Amount to be invoiced is transferred to accounts receivable	Customer has to pay
A customer pays	Decrease	Cash increases	Balance is settled
Doubt whether customer will pay	No impact	An allowance (negative asset) counteracts accounts receivable and equals estimated loss	Since we no longer believe the customer will pay, we recognize expected loss
Confirm the customer will not pay	Decrease	The allowance is deducted from accounts receivable	No expense, just reclassification

Percentage of Unpaid Amounts Receivable

Accounts receivable can become overdue, and the percentage of unpaid amounts increases with the length of delinquency.

• Current: 0%

• 1 Month: 7.4%

• 2 Months: 16.8%

• 3 Months: 28.8%

• 6 Months: 43.9%

• 12 Months: 59.7%

• 24 Months: 88.3%

Allowance for Doubtful Accounts

Companies estimate the amount of receivables that may not be collected and create an allowance for doubtful accounts.

• Example: If 50% of receivables overdue by more than 90 days are expected to be uncollectible, the allowance is set accordingly.

Analysing Accounts Receivable

• Accounts Receivable Turnover (ART): Measures how quickly receivables are collected.

$\text{Accounts receivable turnover (ART)} = \frac{\text{Sales revenue}}{\text{Average accounts receivable}}$

• Average Collection Period (ACP): Indicates the average number of days it takes to collect receivables.

$\text{Average collection period (ACP)} = \frac{\text{Average accounts receivable}}{\text{Average daily sales}} = \frac{365\ \text{days}}{\text{Accounts receivable turnover}}$

Settlement Discounts

2/10 Net 30

2/10 net 30 is a common settlement discount offered to customers. It means the customer can deduct 2% of the invoice amount if payment is made within 10 days; otherwise, the full amount is due in 30 days.

• Paying 20 days earlier for a 2% discount is equivalent to an annualized interest rate of 36%.

$\text{Annualized rate} = \frac{2\%}{20/365} \approx 36\%$

• Recommendation: Only offer this discount if in urgent need of cash, as factoring receivables may be a better alternative.

Cost of Goods Sold (COGS)

Definition and Measurement

Cost of Goods Sold (COGS) represents the direct costs attributable to the production of goods sold by a company. It includes the cost of raw materials, labor, and manufacturing overhead.

• Example: For a cheese company, COGS includes the cost of milk, additives, factory labor, and depreciation of production equipment.

COGS vs. Period Costs

COGS	Period Cost
Cost of raw milk	Cost of advertising
Cost of additives	Cost of sales staff
Cost of transportation to factory	Cost of transfer to customer
Depreciation of factory building/equipment	Depreciation of head office
Labour cost of factory personnel	Labour cost of HR and Finance departments
Storage costs during curing of cheese	Storage costs of packaged cheese

Inventory Flow

Goods move from raw materials to finished goods inventory before being recognized as COGS upon sale.

• Raw Material (Asset) → Labour/Machine/Production Cost → Finished Goods (Asset) → COGS (Income Statement)

Cost Formulas

When determining COGS, companies must decide which inventory cost flow assumption to use:

• Specific Identification: Used for unique items (e.g., art, jewelry).

• FIFO (First-In, First-Out): Assumes oldest inventory is sold first.

• Average Cost: Uses weighted average cost of inventory.

• LIFO (Last-In, First-Out): Assumes newest inventory is sold first (not allowed under IFRS, often used for tax purposes).

Effect of Costing Method

Method	COGS (Increasing Prices)	Ending Inventory (Increasing Prices)
FIFO	Low COGS, high profit	High
LIFO	High COGS, low profit	Low
Average	In between	In between

Method	COGS (Decreasing Prices)	Ending Inventory (Decreasing Prices)
FIFO	High COGS, low profit	Low
LIFO	Low COGS, high profit	High
Average	In between	In between

Bad Inventory and Net Realizable Value (NRV)

Net Realizable Value (NRV)

NRV is the estimated selling price of inventory in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.

• NRV = Estimated sales price - Cost to complete - Sales cost

When Might NRV Fall Below Cost?

• Increase in costs to complete or selling costs

• Fall in selling price

• Decision to manufacture and sell products at a loss

• Errors in production or purchasing

• Obsolescence of products

Obsolescence

• Functional obsolescence: Product no longer meets customer needs.

• Economic obsolescence: Product is no longer profitable due to market changes.

• Physical deterioration: Product is damaged or spoiled.

Example: International Cheese Company

• If the market price of milk drops below the average inventory cost, the company may need to write down inventory to NRV, even if overall sales are profitable.

Additional info: These notes expand on the original slides by providing definitions, formulas, and examples for each topic, ensuring a comprehensive understanding suitable for exam preparation.