ACCT6293 INTERMEDIATE ACCOUNTING ODD 2021/2022

Week 6 session 24

1. Why are companies reluctant to use the revaluation model to value their PPEs? Relate your answer with the
impact of revaluation on financial statements’ elements and financial ratios (e.g., ROA, asset turnover, ROE).
Give examples where appropriate.
- Companies are reluctant in using the revaluation method because of several disadvantages that the
revaluation method has. Firstly, in revaluation method, there are some cases that assets cannot be
depreciated making the data or the value of asset might be misleading or miscalculated. Secondly, it might
be hard to value the depreciation as there are no steady pattern as in cost method. Thirdly, the
implementation of revaluation method might be costly as other than it is harder in being measured, it even
needs experts’ assistance which lead to higher cost. Besides, revaluation method might affect much in the
financial statement. If there are gain of revaluation in the asset when counted, the company need to make
changes in the balance sheet equity section as the gain on revaluation should enter the OCI section of equity.
While on the other hand, if the company make up a loss of revaluation, the company must make record in
the profit/loss section in the income statement, which means there will be a reduce in net income.

Also, the revaluation method will have certain changes in the financial ratio elements. There is various
financial ratio which includes ROA (Formula: Net Income divided by Total assets), indicator of how profitable
a company is relative to its total asset, Assets Turnover (Formula: Sales divided by Total assets), indicator of
the efficiency with which a company is using assets to generate revenue and ROE (Formula: Net income
divided by Total Equity), indicator to determine how effective management is at utilizing equity financing
provided by shareholders.

For instance, if assuming there is a gain on revaluation, ROA will be lower because, if the net income stays
the same, but due to gain in revaluation the asset increases, it means that the denominator will be bigger
causing ROA value lower. Besides, to the asset turnover ratio, with gain in revaluation, there will be a
decrease in the asset turnover ratio because with the same value of sales, but the denominator assets
increase, it will result to the to a decrease in ratio. Further, for the ROE, having a gain on revaluation, the
value of ROE will decrease because, with the same net income, but the value of ROE increases, it will cause
the denominator to increase making the ROE lower. On the other hand, if assuming there is a loss in
revaluation, ROA will be higher because, if the net income stays the same, but the assets decrease, the ROA
will be higher because the denominator will be smaller. Besides, for the asset turnover ratio, with loss in
revaluation, there will be a higher in the asset turnover ratio because with the same value sales, but the
denominator assets decrease, it will result to the increase in ratio. Further, for the ROE, having a loss in
revaluation, the value of ROE will increase because with the same net income, but the value of ROE
decrease, it will cause the denominator to decrease making the ROE higher.

2. Discuss the judgements and uncertainties surrounding the implementation of LCNRV method in inventory
valuation.
- The purpose of using the LCNRV method is to reflect the decline of inventory value below its original cost.
There is certain judgement for the implementation of LCNRV method in inventory valuation. The first
judgement in using the LCNRV method are only if cost is difficult to be determined, so in the case, companies
will use lower cost valuation method to find the current value for the current inventory if the cost can’t be
determined. Secondly, the LCNRV method are used if the items are readily marketable at quoted market
price. Quoted market price itself is representing the latest price of the value price of inventory in the market.
Lastly, the LCNRV method can be used when the units of products are interchangeable. However, there are
certain uncertainties in using the LCNRV method, Firstly, there can be an inconsistent situation in recognition
that can lead to the misleading in the presentation of income data. In which, the decrease and increase of
assets are recognize at different time. Secondly, it would be difficult to determine the market value. Prices
can change anytime due to certain situation for example during a period of price floor and price ceiling. If the
company decides to lower down the cost, it will likely miscalculate the period income and further future
 periods because the inventory should keep on moving for the sales to work. Lastly, there are still lacking
accounting theory that justify the lower cost realisable rule making it more to calculate based on the LCNRV
method.

3. Read the following excerpt. Do you think securitisation of receivables is good or bad? Explain your answer.

Securitizations—Good or Bad?
A popular form of sale (transfer) of receivables is securitization. Securitization takes a pool of assets, such as
credit card receivables, mortgage receivables, or car loan receivables, and sells shares in these pools of
interest and principal payments. This, in effect, creates securities backed by these pools of assets. Virtually
every asset with a payment stream and a long-term payment history is a candidate for securitization. What
are the differences between factoring and securitization? Factoring usually involves sale to only one
company, fees are high, the quality of the receivables is low, and the seller afterward does not service the
receivables. In a securitization, many investors are involved, margins are tight, the receivables are of
generally higher quality, and the seller usually continues to service the receivables. Securitizations can be a
positive force in the mortgage market by increasing liquidity that banks need for mortgage lending. This
improved accounting supports positive outcomes from securitizations in the mortgage market. However,
securitizations got a black eye in the booming mortgage market leading up to the financial crisis of 2008. In
that setting, mortgage loans to high-risk (subprime) borrowers were securitized with lenders selling the loans
to investment banks or trusts (special purpose entities) at a gain. Investors in the securities issued by the
trusts were happy because they earned a return that they believed was excellent, given the risk they took.
However, due to lax regulatory oversight of the mortgage lending process, many of the securitizations
resulted in lenders having to take back the loans when subprime borrowers could not make the payments as
the economy and the housing market slowed. The costs of these bad securitizations were still being felt by
banks several years after the mortgage market meltdown. The moral of the story is that accounting matters.
Lenders had strong incentives to want to report upfront gains on sales of loans. But, in most cases, these
gains should never have been booked. Standard setters have since issued new rules to tighten up “gain-on-
sale” accounting for securitizations and loan losses. With these new rules, lenders have to keep the loans on
their statements of financial position. Under these conditions, lenders would be much less likely to lend so
much money to individuals with poor credit ratings.

Sources: M. Hudson, “How Wall Street Stoked the Mortgage Meltdown,” Wall Street Journal (June 27, 2007), p. A10;
Associated Press, “Legal Costs Weigh Down U.S. Banks Earnings,” The New York Times (February 24, 2015); and B.
Conerly, “Why Borrowers Need Securitization,” Forbes (June 5, 2018)

- Securitization is the process of transforming an illiquid asset into a form of security which is a financial asset.
For some company, having a securitization can be a debated thing in whether they are good or bad. At first,
the advantage of having a securitization is that it can help company with debt to remove its debt from
balance sheet and acquire new funding in place of the debt. Then further, after the debt is remove, the
company itself can gain liquid funds on the specific time for the company usage. Besides, the other
advantage through securitization is that the debts that the company own can be divided into different
tranches. Tranches itself are the assets that are divided into layers of securities and bonds (ratings). Through
this tranche, it helps investors to make choice on which company are they going to choose to risk in and
invest. Lastly, the securitization also has advantage for borrowers. Since securitization are making debt of
company more valuable and attractive, various companies are competing to provide various advantageous
benefits to attract borrowers in making loan. On the other hand, as mentioned, securitization also have
certain disadvantages. Firstly, securitization brings great complexity as it leads to a huge risk. In processing a
securitization, it would be hard even if there are intervention from government, politics, and social problem.
It is hard to measure the risk of securitization as there are no fix guarantee that the receivables will be paid
on time by the borrowers hence making the investors at risk in holding the receivables. Moreover, those
who have put their money on lower traches to obtain higher interest might have the higher risk in
securitization especially considering if the economy is getting low. Hence in conclusion, securitization is good
in a way that this is an excellent process in building companies with debt to keep on moving and moreover it
 helps company to take off the balance sheet and replaces the liquidity. But, for this to continue, of course it
would be much safer is there are accounting standards made for securitization itself. For instance, as
mentioned in the excerpt, it would be better if the standard setters would issue new rule to tighten up the
gain on sale accounting for securitization and loan losses. Moreover, with the new rules, it would be better if
lenders would still have to keep the loans on their financial statement. Lastly, there must be an assurance to
lenders to follow in investing to a company with good traches to prevent fraud while investing and that
company must make sure to keep their traches in good rating.

Reference: https://medium.com/@analytics_92512/securitization-pros-cons-2910509f5414

4. Discuss the differences between cash flow from operating activities and free cash flow. Why do you think
free cash flow is important?
- Free cash flow is the cash that a company generate from its normal business operations before interest
payments and after subtracting any money spent on capital expenditure (Fixed asset). While operating
activities cash flow refers to the cash generated from normal business operations or activities. Operating
cash flow only focuses on showing whether the company generates enough positive cash flow to run its
business and grow its operations. Free cash flow on the other hand focuses to a wider branch which includes
looking on whether the cash flow is available to all investors before cash is paid out to make debt payments,
dividends, or share repurchases. In free cash flow it can by directly by investor and creditor to determine
whether the company have enough cash flow to pay even after being deducted from their various capital
expenditure (financing operations). Operating cash flow mainly just focuses on the net income section that
are listed in the income statement.

Free cash flow is important because as mentioned above, it can be used to check the availability of cash for
wider range that benefit investors and creditors. For instance, in dividend payment, free cash flow can show
whether the company have enough funds to pay the dividend. Even further, if the free cash flow show that
the cash left is high, it can be a source to determine that the company can give higher dividend payment to
investors in the future. In which, this will help attract investors to invest more in the company. Moreover,
free cash flow is also important to creditors since, banks are likely to prefer in giving loans only to companies
that generate a positive cash flow because by then bank will have lower risk of the company not being able
to pay back in the maturity date.

Reference: https://www.investopedia.com/ask/answers/111314/whats-difference-between-free-cash-flow-
and-operating-cash-flow.asp

5. Find an annual report from a sample company, then:

a. Evaluate the company’s performance based on the statement of cash flow.
b. Explain how the cash flow is different from the reported profit.

- PT Ultrajaya Milk Industry & Trading Company Tbk.

- Financial Statement Link: https://www.ultrajaya.co.id/uploads/ULTJ-AR-2019.pdf
- Compares of the year between 2018 and 2019

a. From the statement of cash flow of PT Ultrajaya Milk Industry Tbk, the company shows an improvement in
terms of cash flow when compared between the year 2018 to 2019. The company shows a positive or an
increase cash and cash equivalent by the year 2019. From the previous year 2018, the company have a loss
of cash and cash equivalent amounting to Rp. -676,090 and changes in the year 2019 to an increase up to
positive Rp. 596,281. The operating activates shows the most improvement among all the cash flow section.
It seems that PT Ultrajaya Milk Industry Tbk is obtaining an improvement in the payment of their receivables
and improvement in their receipt of interest income. The receivable itself is increasing to an amount of Rp.
778,992. Besides, for the investing activities cash flow section, PT Ultrajaya Milk Industry Tbk have been
obtaining an increase in the non-current asset in 2019, improving from a decrease in the previous year.
 Moreover, by the year 2019, PT Ultrajaya Milk Industry Tbk have not been purchasing government bonds
and invest a join venture but instead the company have decided to invest on livestock.

b. The value of the cash flow and the income statement are different because, first, cash flow focuses on the
money flows in the company that involves the cash transaction. Cash flow does not the money that are being
owed from debtors (payable) or the money that is on the bank. While in the other hand the value for the
profit is the amount obtain from the income statement after the revenue is being deducted by the expenses.
Profit that are obtained from the income statement are used to measure the success of business or financial
health while cash flow is mainly to use to show the company financial outlook. Besides, in some cases there
are possibility that a company might be profitable, but they have poor cash flow. For instance, as seen on PT
Ultrajaya Milk Industry Tbk, the company is making profit by the end of 2018 with the amount of Rp. 702,345
shown from its comprehensive income of the year. However, if we then compare it with cash flow
statement, we could see that the company is making a decrease/loss in their cash and cash equivalent by the
end of 2018 amounting to Rp. -676,090. While in the year 2019, even both make up a profit, the value will be
different. As shown from the financial statement, the comprehensive income in the year 2019 amounted to
Rp. 1,030,191 while in the cash and cash equivalent, there is only an increase amounting to Rp. 596,281