instructor notes to accompany - pegasus web …pegasus.cc.ucf.edu/~zarzeski/zar3101.doc · web...

Instructor Notes to AccompanyIntermediate Financial Accounting

ACG 3101Fall 1997

Marilyn T. Zarzeski, Ph.D., CPA(Cocoa) Room 347 / 632-0098 x65578

(Orlando) BA 466 / 823-2150 [email protected]

ZAR3101.doc 1

Review of Accounting Basics (Chapters 3, 4, & 5)

USING THE VARIOUS TYPES OF ACCOUNTS

To Increase

Assets , DEBITLiabilities , CREDIT Balance Sheet AccountsOwners' Equity , CREDIT

Revenue/Income , CREDITExpenses , DEBIT Income Statement Accounts

Dividends , DEBIT Statement of Retained Earnings Account

To Decrease any of the above, do the opposite.

Try to become friends with ALICE; she will help you to recall the normal balance of the six types of accounts. Question: What is the sixth type of account that is not shown below?

D Assets

Liabilities C

Income/Revenue C

Capital/Stk. Equity C

D Expenses

To Do: Draw a large stomach on ALICE so that you now see a large “D” on the above diagram.

ZAR3101.doc 2

HOW TO DO DEBITS AND CREDITS

Step 1: Remember that there is only one meaning of a DEBIT and one meaning of a CREDIT: (In accounting, that is!)

a) DEBIT means LEFT SIDEb) CREDIT means RIGHT SIDEc) And.....DEBITS must equal CREDITS in an entry

Step 2: Read the transaction given in words and numbers.What accounts (Accts) are involved?

* Example: Buy equipment for $10,000 and sign a promissory note for $7,000.

Accts: EQUIPMENT, NOTE PAYABLE, CASH ($10,000) ($7,000) ($3,000)

Step 3: What TYPE of Account is each?* EQUIP Asset NP Liability CASH Asset

Step 4: What is the NORMAL BALANCE of above account TYPES?* EQUIP Asset DEBIT Think of: A NP Liability CREDIT L CASH Asset DEBIT I

CE

Step 5: Are we INCREASING or DECREASING each account?* EQUIP + (increase) DEBIT NP + (increase) CREDIT CASH - (decrease) CREDIT

Step 6: To INCREASE any account, do its NORMAL BALANCE Equip 10,000To DECREASE any account, do opposite of NORMAL BALANCE NP 7,000

Cash 3,000

ZAR3101.doc 3

Understanding the Effect of Accounting Entries

When the accountant records payment of the telephone bill that just arrived today, what effect is there on the following items? (Note: be sure that someone has not already accrued the expense and liability.)

Your Thought Process

1. What is the entry? Telephone ExpenseCash

• Revenue or Gain• Expense or Loss 2. What kind of account is each Telephone Expense is an • Dividend part of the entry? EXPENSE• Asset Cash is an ASSET current• Liability• Stk. Eqty.

3. Answer the above questions. Always start with NI first . . . since NI affects Stk. Eqty.

HINT: Make up some numbers, if it helps you to understand the situation better.

a) Net Income? Decreases because expenses are higher NI is lower now.

b) Assets? Decreases because cash is being given away

c) Liabilities? No Effect (neither account is a Liability)

d) Stockholders’ Equity? Decreases because NI decreases

e) Current Ratio? CA = Decr. = Decrease( CA ) CL NE( CL ) No Effect

ZAR3101.doc 4

ADJUSTING JOURNAL ENTRIES (AJE'S)

WHY? Because GAAP requires ACCRUAL BASIS of accounting. In order to show proper revenue earned during a period and proper expenses which helped to earn the revenue.

a) Revenue Principle - Normally recognize revenue when the service is rendered or when the title to the product is transferred from seller to buyer.

b) Matching Principle - Within the same time period, recognize the expenses that helped the company to earn the revenues.

WHAT? AJE's are journal entries usually prepared at the end of the each month, prior to preparation of the monthly financial statements. True AJE's contain either an expense or a revenue. NOTE: In the text and on exams, annual AJE's are often required, so read carefully.

TYPES?

I. Accruals (Revenue has been earned or Benefit has been received BUT NO CASH has yet been exchanged.)

Examples:

AJE's A) Salary Expense B) Interest ReceivableSalary Payable Interest Revenue

Subsequent A) Salary Payable B) Cashentries Cash Interest Receivablewhen CASHis exchanged

ZAR3101.doc 5

II. Deferrals (Cash has been exchanged prior to the AJE BUT the revenue or expense has NOT been journalized until the AJE is written).

Examples:

Cash A) Prepaid Insurance B) Cashexchanged Cash Unearned RevenuePRIOR togetting use or giving a service

AJE's A) Insurance Expense (Benefit) B)Unearned RevenuePrepaid Insurance Revenue

(Service Rendered)

NOTE to Students: The accountant may not record the original entry into prepaid (asset) or unearned (liab.). The accountant may just expense it all or revenue it all at the receipt of CASH.

CASH Y) Insurance Expense Z) Cashexchanged Cash RevenuePRIOR togetting use orgiving a service

AJE Y) Prepaid Insurance (not used) Z) RevenueInsurance Expense Unearned

Revenue(service

owed)

III. Allocations of Cost (As a long-lived asset is used, some expense must be recognized.)

Examples:

Purchase A) Equipment B) Franchiseof Asset Cash Note Payable

AJE's A) Depreciation Expense B) Amortization ExpenseAccumulated depreciation Franchise or Accum.

Amort. (contra asset)

ZAR3101.doc 6

STEPS IN THE CLOSING PROCESS

WHAT? A closing entry is an entry that makes an account balance ZERO.

1. Close all revenue-type accounts into the income summary account.

2. Close all expense-type accounts into the income summary account.

3. Close the income summary account into the retained earnings account.

4. Close dividends account into the retained earnings account.

WHY? To start a new operating period with a clean slate, it is necessary to start with zero balances in the revenue and expense and dividends accounts.

Note: • Closing entries are usually prepared annually.

• Only the temporary (nominal) accounts are closed.

• The post-closing trial balance should contain only assets, liabilities, and equity accounts (the permanent accounts).

Note: Many companies do not use the Income Summary Account;they merely close all temporary accounts directly to the RetainedEarnings account (if a Corporation) or the Capital account(s) (if a Sole Proprietorship or Partnership).

ZAR3101.doc 7

PROBLEM 3 - 7Beg. = Unadjusted Balance

CASH Unexpired Insurance _____Utilities Exp.___ Beg. 15,000 Beg. 9,000 Beg. 54,000

Dues Receivable Salaries Payable ___Bad Debt Expenses Beg. 13,000

Rent Receivable Unearned Rev. Salaries Exp. Beg. 80,000

Allowance for Doubtful Accounts Common Stock Maintenance Exp.

1,100 Beg . 400,000 Beg. Beg. 24,000

Land R.E. Depr. Exp. - Bldg. Beg. 350,000 72,400 Beg.

Buildings Revenues - Dues Depr. Exp. - Equip Beg. 120,000 200,000 Beg.

Accum. Depr.-Bldg Revenues - Green Fees Insurance Exp. 48,000 Beg. 8,100 Beg.

Equipment Accum. Depr.-Equip Rental Revenue Beg. 150,000 70,000 Beg 15,400Beg

ZAR3101.doc 8

ERROR CORRECTIONS

Situation: We purchase machinery for $10,000 on March 1, 1995. We anticipate using the machinery for three years and then hope to sell it for $1,000.

I. If Error is discovered prior to closing the books:(This is NOT a Prior-Period Adjustment.)

Error DoneAsk yourself: "What is Wrong?"

3/17/95 Machinery Expense 10,000 IncorrectCash 10,000 OK

Should Be Ask yourself: "What should have

been the entry?"Machinery 10,000

Cash 10,000

CORRECTION OF ERROR Correct only the mistake

9/28/95 Machinery 10,000 to debit correct accountMachinery expense 10,000 to reverse error to zero

(Assumed that depreciation entry is done at year-end.)

II. If Error is discovered after the 1995 books are closed: Two different situations may occur - Situation A or B on next page.

Error Done

3/1 Machinery expense 10,000 IncorrectCash 10,000 OK

Should Have Been

Machinery 10,000 The difference from aboveCash 10,000

Note: Ask yourself: 1) "Have any adjusting entries been done?" 2) "Did the error affect the income statement?"

For the above example:

1) No adjusting entries were done, but they would have been if MACHINERY had been debited.2) Yes, there is too much money in the expenses; therefore, NI is understated until we correct the

error.

ZAR3101.doc 9

II. (continued)

3) If done correctly, the following would have occurred:

3/1 Machinery 10,000 Assume: 3-yr. life 10,000Cash 10,000 1,000 salvage -1,000

9,000 9,000 x 1/3 = 3,000/yr.

199512/31 Dep. Exp. 2,500

Accum. Dep. 2,500 3,000 x 10/12 = 2,500 (10 months' usage)

Machinery Exp Cash Error 10,000 10,000 OK

SITUATION A:Correcting Entries (after the 1995 closing process occurred, BUT before the financial statements are released.) (This is NOT a prior-period adjustment.)

Correcting (for 1995):in Machinery 10,000 These entries should be back- early Retained Earnings 10,000 dated to 12/31/95.1996

Dep. Exp. 2,500 This situation is NOT a Prior-Accum. Dep. 2,500 Period Adjustment

Closing (for 1995):RE 2,500 _

Dep. Exp. 2,500

SITUATION B:

Correcting entries (after the 1995 financial statements are released; in other words, during the next year). THIS IS A PRIOR-PERIOD ADJUSTMENT (PPA) that is placed on the statement of Retained Earnings in 1996.

inmid Machinery 10,000 NOTE: Do not debit an expense this

(1996)year if1996 Retained Earnings-PPA 10,000 the dep. expense relates to last year!

Date the entries with July, 1996 date.

Retained Earnings-PPA 2,500 The NI was understated due to overstatedAccum. Dep. (1995) 2,500 EXPENSES.

RE is understated because Mach. Exp. was closed into RE.

1996 Dep. Exp. 1,500 (Assuming you discover the error at the beginning of July 1996.)

Accum. Dep. 1,500 (First half year of usage)

ZAR3101.doc 10

Chapter 3 -- AppendixIA. To find ONLY cash revenue or ONLY cash expense

Accrual to Cash

Revenue Expense

If A , then - If A , then +

If A , then + If A , then -

If L , then + If L , then -

If L , then - If L , then +

EXAMPLE:

Given: Accrual Revenue is $1,400,000 for 1996Required: What is the Cash Revenue for 1996?

a) What ASSET and/or LIABILITY accounts relate to revenue?

Accounts Receivable

b) What is the NET change in the Accounts Receivable account--from the beginning of the year to the end of the year?

Accounts Receivable (AR) Beg. 410,000

_______________ End. 520,000

The NET change is an increase of $110,000.

c) Reasoning: Since AR is an asset and it increased, then subtract $110,000 from the accrual revenue of $1,400,000. Therefore, the CASH revenue is $1,290,000.

BEWARE: Name of accounts can be misleading.

Asset accounts: Liability accounts:a) Receivables a) Payablesb) Prepaids b) Unearned Revenuesc) Deferred Expenses c) Accrued Expenses

ZAR3101.doc 11

IB. To find ONLY accrual revenue or ONLY accrual expense

Cash to Accrual

Revenue Expense

If A , then + If A , then -

If A , then - If A , then +

If L , then - If L , then +

If L , then + If L , then -

EXAMPLE: (Ex 3-23 -- Cash expenses only)

Given: Cash expenses are $55,470 for 1995.Required: What are the Accrual expenses for 1995?

a) What ASSET and/or LIABILITY accounts relate to the expenses?

Accrued Expenses (miscellaneous payables)Prepaid Expenses (miscellaneous assets that are paid in advance of usage)

b) What is the NET change in each of the accounts?

Accrued Expenses DECREASED by $1,327 from beginning to end of year.Prepaid Expenses DECREASED by $142 from beginning to end of year.

c) Reasoning:Since Accrued Expenses is a liability and it decreased, then subtract $1,327

from Cash expenses.Since Prepaid Expenses is an asset and it decreased, then add $142 to Cash

expenses.

Therefore, $55,470 (cash expenses) - 1,327 (net change in Accrued Liabilities) + 142 (net change in Prepaid Expenses) = $ 54,285 (EXPENSES based upon ACCRUAL ACCOUNTING

ZAR3101.doc 12

IIA. To find cash NET INCOME

Accrual to Cash

Revenues and Expenses

If A , then -

If A , then +

If L , then +

If L , then -

EXAMPLE: Statement of Cash Flows (Indirect Method)

The CASH FLOWS FROM OPERATING ACTIVITIES must be prepared from the Accrual Income Statement. In other words, the accountant converts the Accrual Net Income to Cash Net Income (also known as Cash Flows from Operating Activities).

a) Start with Net Income per accrual accounting.

b) Determine whether related current assets and current liabilities have increased or decreased from the beginning to the end of the year (accounting period). Calculate the NET CHANGE for each related account.

c) Use chart above to determine whether to add or subtract the NET CHANGE to the Net Income per accrual accounting.

d) The ACCRUAL Net Income plus or minus the NET CHANGES equals the CASH Net Income (Cash flows from operating activities).

IIB. To find accrual NET INCOME

Do the opposite of IIA Chart.Start with CASH Net Income and adjust to ACCRUAL Net Income.

ZAR3101.doc 13

From CASH BASIS to ACCRUAL BASIS

Example:

(Cash to Accrual Basis) Joan E. Robinson, M.D., maintains the accounting records of Robinson Clinic on a cash basis. During 1997, Dr. Robinson collected $142,600 from her patients and paid $55,470 in expenses. At January 1, 1997, and December 31, 1997, she had fees receivable, unearned fees, accrued expenses, and prepaid expenses as follows (all long-lived assets are rented):

January 1, 1997 December 31, 1997

Fees receivable $9,250 $16,100Unearned fees 2,840 1,620Accrued expenses 3,435 2,200Prepaid expenses 2,000 1,775

Instructions

Prepare a schedule that converts Dr. Robinson "excess of cash collected over cash disbursed" for the year 1997 to net income on an accrual basis for the year 1997.

ZAR3101.doc 14

Solution to Example:

Dr. Robinson does CASH Accounting Cash Rev $142,600

Cash Exp 55,470

Cash NI 87,130

IF she did ACCRUAL BASIS, her GL Accounts would be as follows:

Cash Rev Fees Rec. Unearned Fee Rev.

B 9250 2840 B

1 142,600 2 x 142,6001 3

4

E 16100 1620 E

Rev. 149,450 2 9250 + X - 142,600

= 16,100

3 X = 16,100 + 142,600 - 9,520X = 149,450

- 9250

4

$150,670

Per Solutions Manual:

Cash Rev. Add Subtract Accrual Rev.149,450 = 142,600 16,100 9250 150,670

2,840 1620

the net change affects Revenue in the Accrual-Basis

ZAR3101.doc 15

INCOME STATEMENT ITEMSExercise 4 - 13

Thought Process: Income before tax IBT- Income Tax Expense IBT x Tax Rate= Net Income IBT x (1.00 - Tax Rate)

(3) 100% Inc. before tax (4) IBT x 100% = 50 mil (5) IBT 50,000,000(2) 30% Inc. Tax Exp. IBT x 30% =_15 mil_(1) 70% NI IBT x 70% = 35 milSTART HERE Loss of 18,000,000

(before tax) is included in the IBT (50 mil + 18 mil)

(6) IBT before E/O Item = $68 mil.

Partial Income Statement

(7) Inc. from cont. opns $68,000,000 (8) Inc. tax expense 20,400,000 (68 mil. x 30%) (9) Inc. before E/O Loss 47,600,000(10) E/O Loss

(net $5.4 mil. tax benefit) 12,600,000 (18 mil. x 30% = $5.4 mil.)

(11) NI $35,000,000(12) Preferred Dividends: Per Share Data:

$ 12,600,000 (14)Inc.Bef. E/O $4.72$4,500,000 x 8% 10,000,000 sh.= $360,000 div. (13)E/O Loss (1.26)

NI $3.46 EPS = NI - Pref. Div = $35 mil. - $360,000 = $3.46

# COMMON Shares 10 mil. sh.Outstanding

ZAR3101.doc 16

Company NameStatement of Cash Flows

FYE 12/31/97INDIRECT METHOD Note:

Do Not use +'s and -'s on the formal statement.

Use parentheses for CASH outflows.

Not the deprec exp.

Not the int. income and Not the dividend income

Obtain from Balance Sheet

Cash Flows from Operating Activities:

Net Income± _'s in CA and CL, excluding S.T. Rec. and S.T. NP

+ Deprec. Exp., Amortiz. Exp., Depletion Exp.

+ Losses

- Gains

± Other non-cash flows related to operations

Net Cash Flows from Operating Activities $ A

Cash Flows from Investing Activities:

± Property, Plant, and Equip.

± Other Operating Assets, e.g., Intangibles

± Investments in Stocks, Bonds, Mutual Funds, etc.Short-term AND

Long-term± Notes Receivable, Loans Receivable, etc.

Net Cash Flows from Investing Activities $ B

Cash Flows from Financing Activities:

± Common Stock, Preferred Stock (including Paid in Capital Accts.)± Treasury Stock

Short term± Bonds Payable, Notes Payable and

Long term- Dividends, DrawingsNet Cash Flows from Financing Activities $ C

Net Increase (or Decrease) in Cash $ (A+B+C)

Cash Balance, Jan. 1 $

Cash Balance, Dec. 31 $ Place this onthe Balance Sheet

ZAR3101.doc 17

Statement of Cash FlowsDIRECT METHOD

Problem 24-6

(Revenue) (Expense)Cash In Cash OutCA , - CA , +CA , + CA , -CL , + CL , -CL , - CL , +

OPERATING ACTIVITIES:

ACCRUAL CASH

RelatedInc. Stmt CA / CL Am't (000) SCF

Sales 1,007,500 AR 34 -34 973,500

CGS 403,000 Inven 60 + +35

AP 25 438,000

S & A Exp. 222,000 Dep. Exp. - 40-25GW Exp. - 2Prepaids 6 -6Supplies 3 -3Accrued Liab. 9.62 -9.62 136,380

* L.T. Invest. Rev See T-Account*

115,000 (Not on exam) L.T. Invest 75 -75 40,000 55,000 S.T. Invest Rev. 15,000 No Related Acct. 15,000

Intrest Exp. 99,000 Bond Discount 13.88 -13.88 85,120 "Contra-liability"

Inc. Tax Exp. 154,000 Tax Pay 11 -11 143,000

Note 1: Gain on Sale of Equipment is NOT a cash flow; therefore, ignore it in the DIRECT METHOD.

Note 2: Dividends that our company gives are NOT an Operating activity.

Note 3: The "Cash IN" scheme is also used to prepare the Cash Flow from Operating Activities for the INDIRECT METHOD.

ZAR3101.doc 18

SCF - DIRECT METHOD (PROBLEM 24-6)

INVESTING ACTIVITIES:

Land Bldg Equip L.T. Investments *500,000 1,300,000 550,000 700,000

50,000 115,00040,000cash div

645,000 1,300,000 500,000 775,000

S.T. Investment Accum. Dep.- Bldg Accum. Dep.- Equip 325,000 360,000 135,000

5,000 25,000 40,000

350,000 155,000 400,000

_____Goodwill______ _Dividends Payable__65,000 80,000

63,000 _0_

FINANCING ACTIVITIES:

LTNP BP P. Stk C Stk T Stk ____ 50,000 1,000,000 500,000 600,000 40,000

45,000 1,000,000 600,000 600,000 20,000

Discount on BP PIC - P. Stk PIC- C Stk RE 64,630 100,000 550,000 749,630

Dividends 274,500 NI 150,000

50,750 115,000 550,000 874,130

ZAR3101.doc 19

Time Value of MoneyChapter 6

INTEREST is the time value of money.

In accounting records, we do NOT record the interest earned or owed UNTIL TIME HAS PASSED from the time that we loaned the money or borrowed the money.

Examples:

a) Interest REVENUE cannot be recognized until the “lending service” that we have provided has occurred over at least one month’s time. At the end of each month, we can recognize some interest revenue.

b) Interest EXPENSE cannot be recognized until we receive some “benefit” from the cash that we borrowed...over at least one month’s time. At the end of each month, we can recognize some interest expense.

Interest CALCULATION: Interest = Principal x Rate x Time

To use the PRESENT VALUE TABLES, you must know two items:

1) time period (n): the number of time periods that the interest compounds (Beware: the n does not necessarily mean the number of years that the interest compounds).

2) interest rate (i): the interest involved within each time period of compounding

======================================================

ZAR3101.doc 20

There are three kinds of PRESENT VALUE situations.

1. PRESENT VALUE OF $1: This is used when you know the LUMP SUM future amount and you are trying to determine the LUMP SUM present amount of money.

________________________ Present Value of Future Value of Lump Sum Lump Sum

Formula: PV$ = future value x table factor = fv x tf

To obtain table factor: 1) determine the number of time periods of compounding of the interest2) determine the interest rate earned for each period of compounding

Example of PV$: You want to know how much money you have to deposit in your local bank at the beginning of 1996 in order to have $10,000 in the account by the end of 1999. The bank gives 6% interest compounded annually.

Solution:

a) Draw a time line of the situation: ____________________________________ ??? $10,000

1/1/96 12/31/99

b) Decide whether it is a PV$ situation: Yes, it is. The lump sum that we are trying to find

is at the beginning of the time period (in the present). Also, there is another lump sum nvolved at the end of the time period.

c) Determine n and i :1) n = 4 because there are four years of compounding of annual interest2) i = 6% because interest is compounded annually and 6% is the annual

interest.

d) Find the table factor in the PV$ tables. Table 6-2 in the textbook. tf = .79209

e) Use the PV$ formula and calculate the answer:PV$ = $10,000 x .79209 = $7,920.90

ZAR3101.doc 21

2. PRESENT VALUE OF ORDINARY ANNUITY: This is used when you have EQUAL amounts of money involved, over EQUAL intervals of time AND the amounts of money are at the END of the period AND you want to find the present value of those amounts.

_________________________________________________ Present Value Am’t Am’t Am’t Am’t of the amounts

Formula: PVoa = Amount x table factor = A x tf

(Note that the Amount is the equal amount of money over equal intervals of time).

To obtain table factor:1) determine the number of time periods of compounding of the interest2) determine the interest rate earned for each period of compounding

Example of PVoa: You want to know how much money you can pay today for new machinery if you expect that the net cash inflows that the machinery manufacturer tells you are $5,000 at the END of each year for the next four years. The interest rate that your money can earn is 8%.

Solution:

a) Draw a time line of the situation: _________________________________________????? $5,000 $5,000 $5,000 $5,000

b) Decide what kind of present value problem it is: PV of ordinary annuity. The number we are trying to find is in the present AND there are equal amounts of money over equal intervals of time in the future AND the amounts are at the END of the period.

c) Determine n and i :1) n = 4 because there are four amounts of money2) i = 8% because interest is discounted backwards at an 8% rate.

d) Find the table factor in the PVoa tables. Table 6-4 in the textbook. tf = 3.31213

e) Use the PVoa formula and calculate the answer.PVoa = $5,000 x 3.31213 = $16,561 (rounded to nearest dollar)

ZAR3101.doc 22

3. PRESENT VALUE OF ANNUITY DUE: This is used when you have EQUAL amounts of money involved, over EQUAL intervals of time AND the amounts of money are at the BEGINNING of the period AND you want to find the present value of those amounts.

_____________________________________________ Am’t Am’t Am’t Am’t

Present Value of the Amounts

Formula: PVad = Amount x tfad

(Note that the Amount is the equal amount of money over equal intervals of time).

For the exams, you will only be given the present value tables for PV$ and PVoa. Therefore, you will need to convert the PVoa to PVad in order to work the annuity due problems. To do the conversion, obtain the table factor for the present value of an ordinary annuity, refer to #2 example above. Then multiply the tfoa x (1.00 + interest rate in decimals) to obtain the tfad.

ZAR3101.doc 23

Example of PVad: You want to know how much money you must have saved in your bank and investments when you retire in order to buy an annuity contract from your insurance agent, such that you will receive $50,000 at the BEGINNING of each year of your retirement and continuing for 20 years. The anticipated interest rate that the insurance company thinks will be in effect when you retire is 6%. How much money must you have at retirement?

Solution:

a) Draw a time line of the situation: _________________________________________ $50,000 $50,000 $50,000 $50,000 .....$50,000

(twenty payments)

Retirement Savings?????

b) Decide what kind of present value problem it is: PV of annuity due. The number we are trying to find is in the present AND there are equal amounts of money over equal intervals of time in the future AND the amounts are the BEGINNING of the period.

c) Determine n and i :1) n = 20 because there are twenty amounts of money2) i = 6% because interest is expected to be earned on the funds at this rate

during your retirement years.

d) Find the table factor in the PVoa tables and multiply it by 1.06 (Table 6-4 in textbook).

tfoa = 11.46992 Then, multiply 11.46992 x 1.06 to obtain the tfad

tfad = 12.15812 (For your homework, you can check whether you havecalculated this table factor correctly. Look at Table 6-5

for n=20 and I=6% and you will find 12.15812!)

e) Use the PVad formula and calculate the answer.PVad = $50,000 x 12.15812 = $607,906 (rounded to nearest dollar)

ZAR3101.doc 24

SHORT-TERM RECEIVABLES

A. Difference Between Accounts Receivable and Short-Term Receivables

• AR = receivables which arise from selling goods and services to customers because cash is owed; normally collectible in 30 to 60 days, therefore no interest is usually paid by customer. AR are called open accounts.

Accrual AccountingSale of Service Sale of Product

AR AR Service Rev. Sales

Collection of AR Cash Caution: PV Concept not used on

AR AR because time to collection is so short.

• S.T. Note Receivable = receivables which involve promissory notes; often easier to enforce than open accounts (AR)

\Principal Interest Maturity Date

How notesget on the STNR STNR STNR STNRbooks Cash Fee Revenue Sales AR

B. Cash Discounts = given to customer to encourage prompt payment of AR

Examples

2/10, n/30 2% discount if paid within 10 days of invoice date, otherwise, pay net (all the AR) within 30 days

(Note: n = gross amount)

n/10, EOM net amount of sale is due no later than 10 days after the end of the month

Quantity Discounts a reduction in per unit prices if a large quantity is purchased;

quantity discounts are NOT reflected in accounting record.

Markdowns reductions in sale prices normally due to decreased demand; e.g., retail stores' sales; markdowns are NOT reflected in the accounting records

ZAR3101.doc 25

Accounting for Cash Discounts

$1,000 Gross Method Net Method3/10, n/60 (1) More practical (1) Theoretically better

(2) Bkkping more tedious(3) Better internal control,especially for AP (buyer)

Entry at Sales Date: AR 1,000 AR 970

Sales 1,000 Sales 970

Case 1: Cash 970 Cash 970Payment Received Cash Discount 30 AR 970within 30 days AR 1,000

Case 2: Cash 1,000 Cash 1,000Payment received AR 1,000 AR 970after 10 days Cash 30but ‹ 60 days Discount not taken

Rev. acct. that becomes part of "Other Rev. & Exp."

Difference in Methods are usually immaterial, per auditors; therefore, use either method.

Note: Sales Economic value of transaction is $970 because - Cash Discounts (Purchase Discounts) that would be the cash price.= Net Sales

$30 is a potential finance charge (Expense) to customer fin. chg. revenue to the seller

NOTE: Missing cash discounts costs heavily to the buyer.

ZAR3101.doc 26

C. Accounts Receivable

• Two Possible ALLOWANCE METHODS:

(A) Percentage of Credit Sales (Adheres to Matching Principle Income Statement)(B) Percentage of Receivables (Adheres to Net Realizable Value Balance Sheet)

(Aging Method)

• Five Basic Entries:

(1) Sale on Credit AR AR Sale Sales (1) Sales Collection (2) Sales (1)

W/O (3)

(2) Collection on AR Cash (4) Recovery AR Recovery (4)

(3) Write-off of an account Allowance Allowance

AR (3) W/O Recovery (4)

AJE (5)

(4) Recovery of a AR write-off Allowance

Cash Bad Debt. Exp. Cash

AR (5) AJE (2) Collect

(4) Recovery

(5) AJE (at end (Bad Debt Exp.) of period) Uncollectible Accts. Exp.

Allowance for Doubtful Accts.

ZAR3101.doc 27

Allowance Method for ReceivablesExamples

Note: Assume that the unadjusted Balance = $1,000 credit

(A) % of Sales (B) % of Receivables AR

NET CREDIT SALES END-OF-PERIOD for the period Balance in Accts. Rec. 40,000

2% x 300,000 = $6,000 10% x 40,000 = $4,000 Allowance __

1,000 Unadjusted

4,000 Adjusted

The calculated am't Allowance 3,000 AJEgoes in the AJE. 1,000 Beg. The calculated am't goes

Unadjusted in the End-of-Period 6,000 AJE balance: the adjusted balance

7,000 Adjusted

AJE for A: AJE for B: (depends on unadjusted balanceof allowance account)

Bad Debt Expense 6,000 Bad Debt Exp. 3,000Allowance 6,000 Allowance 3,000

NOTE: The AJE is the calculated amount CAUTION: The AJE is NOT thein the % of Sales Method. calculated amount in the % of Receivables

Method.

ZAR3101.doc 28

Theoretical View (minus)

1. Net Realizable Value (NRV) = AR - Allowance for Doubtful Acc'ts (contra asset account) The Allowance is the amount that is estimated to go "bad."

2. Recognizing Bad Debt Expense PRIOR to the actual write-off is consistent with the MATCHING PRINCIPLE. Match this year's sales with the % of this year's sales that are expected to be uncollectible in the future (Bad Debt Expense).

Over or underestimated Bad Debt Expense can eventually cause a significant debit or credit accumulation in the Allowance account; in such cases, the company should change the estimating formula and ajust the Allowance account to a reasonable value.

causeOverestimates credit balance in Allowance Account of bad debts

and vice versaAging Schedule Method good management tool for the collection department; this method is a more specific type of % of Receivables Method.

• DIRECT WRITE-OFF METHOD

GAAP says to use this in the following cases ONLY:- unable to reasonably and objectively estimate bad debts

CASE 1: only a few high dollar accounts of receivablesCASE 2: all customers are companies, which usually pay their debts

Accounting for Direct Write-Off Method:1) NO AJE is needed at end of accounting period2) Only prepare entry when an account is written off

Bad Debt ExpenseAR

Why not recommended:

1) No use of matching principle2) AR may be overstated

Accounting for Sales Returns:

Returns result in:1) removal of AR or2) granting of future credit

1) Sales Returns 2) Sales Returns AR AR or Allowance for Returns

ZAR3101.doc 29

D.NOTES RECEIVABLE (NR)

Two Methods for Accounting of NR:

1. a) Record the principal into the NR account.b) Accrue1 interest receivable and interest revenue as time passes.

2. a) Record the principal and the interest into NR. Record interest in a DISCOUNT ON NOTE RECEIVABLE account.

b) Recognize interest revenue as time passes, by amortizing the DISCOUNT ON NOTE RECEIVABLE. (Amortizing means tospread the Discount over the future time period.)

Journal entries vary BUT. . . . . . . . .there is NO difference between the Balance Sheet and Income Statement Values.

Note 1: Note 2:1. Note Rec. 10,000 2. Note Rec. 11,200

Less Discount on NR 1,20010,000

NOTE: INTEREST is the time value of money.

I = Principal x Rate x Time

* * * DO NOT recognize interest revenue or interest expense until TIME PASSES.

CASH Interest = Principal x Stated Rate x Time

EFFECTIVE Interest = Carrying Value2 x Effective Rate x Time

1 ACCRUE means to come into existence as a legally enforceable claim. (For example, a receivable or a payable arises.)2 Carrying Value = Note Receivable Minus Discount on Note Receivable.

ZAR3101.doc 30

NOTES RECEIVABLE

Note 1: Note 2:

Interest Bearing Note

Note A

$10,000

Due in one year 12%

12% Ratefor each note

Non-Interest-Bearing Note

Note B

$11,200

Due in one year

No interest typed on the note, but interest is implied in the deal.

• Issue Date 1/2/91 Note Rec.10,000 Note Rec. 11,200

Cash 10,000 Cash 10,000 "Interest"Disc. on NR 1,200

• • 12 Monthly AJEs Interest Rec. 100 Disc. on NR 100 Interest Rev. 100 Interest Rev. 100

• • • Maturity Date 12/31/91 Cash 11,200 Cash 11,200

Note Rec. 10,000 Note Rec. 11,200Interest Rec. 1,200

Notes Payable would have mirror-image entries:

• Cash •CashN Pay Disc. on NP

NP • • Int. Exp. • • Int. Exp.

Int. Pay Disc. on NP

• • • N Pay • • •N PayInt. Pay Cash

Cash

ZAR3101.doc 31

Interest Bearing Note

Chapter 7Page 335, Textbook

1/1/95 N. Rec 10,000 Supporting CalculationsDisc. on NR 480Cash 9,520

CV x ER = Int. Rev.12/31/95 Cash 1,000 9,520 x 12% = 1,142

Disc. on NR 142 + 142Int. Rev 1,142

12/31/96 Cash 1,000 9,662 x 12% = 1,159Disc. on NR 159 + 159

Int. Rev. 1,159

12/31/97 Cash 1,000 9,821 x 12% = 1,179Disc. on NR 179 + 179

Int. Rev. 1,179

Cash 10,000 C.V. = 10,000=Note Rec. - Disc.N. Rec. 10,000

= 10,000 -0

ZAR3101.doc 32

UNDERSTANDING THE EFFECT OF ACCOUNTING ENTRIES

If accountant forgets to amortize the DISCOUNT ON NOTES RECEIVABLE, what effect is there on the following items: assets, liabilities, stockholders’ equity, and profit margin.

Thought Process

1. What is the entry? Disc. on NRInt. Rev

2. What kind of account is each part of the entry? Disc. on NR is a Contra-assetInterest Rev. is a Revenue

3. Answer the above questions.

Hint: Make up some numbers for the entry, if it helps you to understand the situation better.

a) Profit Margin? Understated because NI is understated but sales is correct

b) Total Assets? Understated because too much DISC. On REC. NOTES REC. will be understated

c) T. Liabilities? No effect because no liability account is involved

d) Stockholders’ Equity? Understated because not enough rev and NI went into Retained Earning

ZAR3101.doc 33

Non-Interest Bearing Note

Chapter 7Page 337, Textbook

Present Value Future Value20,000 35,247

“IF” sold for cash, entry is: Cash 20,000

Land 14,000 (orig. cost)“Interest” Gain 6,000= 15,247 place it into Disc. on NR

PV$1 = FV x Table Factor (tf) n = 520,000 = 35,247 x tf i = ? .5674 = tf

Go into PV$1 table to find the interest rate. (12% is the implied rate)

1/1/95 Note Rec. 35,247 Supporting CalculationsDisc. on NR 15,247Land 14,000Gain 6,000

CV x ER = Int. Rev.

12/31/95 Disc. on NR 2,400 20,000 x 12% = 2,400Int. Revenue 2,400 +2,400

12/31/96 Disc. on NR 2,688 22,400 x 12% = 2,688Int. Revenue 2,688 + 2,688




Cash 35,247Note Rec. 35,247 C.V. = 35,247

ZAR3101.doc 34

Notes ReceivableImplied Interest Rate versus Incremental Interest Rate

Situation: On January 2, 1995, our company receives a non-interest-bearing note for $20,000 to be paid to us at the end of 1999. In exchange, our company gives a one-month-old truck with book value of 15,000. As the accountant, you are to prepare the journal entries for January 2, 1995, and every fiscal year-end until the note matures. The fiscal year is the calendar year. (Assume that you only depreciate assets that you have had for at least six months).

Question: At what value do we record the Note?

Answer: a) If we know the fair market value of the truck ($15,670), use that value. In this case, we compute the IMPLIED interest rate that is evident in the situation. See the timeline below.

1/2/95 12/31/99 ___________________________________________ $15,670 $20,000 Fair Value of Truck Maturity Value of Note

(This includes principal & interest)

Because there are TWO lump sums on the timeline, this is a present value of a dollar problem.

n= 5 and i = ? You must compute the implied rate.

Present value of $1 formula: PV = FV x table factor (tf)

$15,670 = $20,000 x tf

$15,670/$20,000 = .7835 = tf

Go the present value of $1 tables at n=5 and go ACROSS the line until you find a table factor that is close to .7835; then go UP from .7835 until you find the interest rate of 5%. That is the IMPLIED INTEREST RATE, implied by the facts of this transaction.

ZAR3101.doc 35

Journal Entries:

1/2/95 Note Receivable 20,000Discount on NR 4,330Truck 15,000Gain on Sale 670

The present value (carrying value) of the note is 20,000-4,330=15,670.

12/31/95 Discount on NR 784Interest Revenue 784

(Effective interest=Carrying Value x effective rate (implied rate)(784 = 15,670 x 5%)

The new carrying value is 15,670 + 784 = 16,454.

12/31/96 Discount on NR 823Interest Revenue 823

(823 = 16,454 x 5%)

YOU, the accountant, complete the remaining items:

The new carrying value of the note is _____________________________.

Entry for 12/31/97:

Calculation of interest revenue 12/31/97:

The new carrying value of the note is____________________________.

Entry for 12/31/98:


The new carrying value of the note is_____________________________.

ZAR3101.doc 36

Entry for 12/31/99: (Hint: It may help to prepare two different entries. On entry will recognize the interest accumulated since last year-end. The other entry will recognize the maturity of the note.)


Note Receivable Discount on N.R. C.V.

1/2/95 20,000 4330 15670

12/31/95 7843546 16464

12/31/96 8232723 17277

12/31/97 8641859 18141

12/31/98 907 952 19048

12/31/99 952 0 20000

============================================================== C.V. = carrying value = net of the two accounts

ZAR3101.doc 37

“Imputed” Interest

Answer: b) If we do NOT know the fair market value of the truck, then we must use the borrrower’s INCREMENTAL BORROWING rate. That is the rate at which that company could obtain a bank loan of approximately $20,000 for five years. How do you find this out? Ask the local bank loan officer. Every company should always have at least two banking relationships in town.

Solution for the journal entries to the problem are similar to the above situation, if we assume that the INCREMENTAL BORROWING RATE is 5%. The THOUGHT PROCESS, though, is different when you are trying to determine the present value of the note receivable.

Show your thought processes here: (Hint: Say what you KNOW in this situation and show how to obtain the unknown present value).

?

present value 20,000 of $1 n = 5 I = 5% (imputed rate)

ZAR3101.doc 38

Exercise 7-20Situation 1: Entries for 12/31 continued through maturity of note.

12/31/96 Discount on NR 42,000 700,000 x 12% x ½ = 42,000 Interest Revenue 42,000 (one-half year)

……………………………………………………………………………………………..6/30/97 Same accounts 700,000 x 12% x ½ = 42,00012/31/97 784,000 x 12% x ½ = 47,040……………………………………………………………………………………………..6/30/98 784,000 x 12% x ½ = 47,04012/31/98 878,080 x 12% x ½ = 52,685……………………………………………………………………………………………..6/30/99 878,080 x 12% x ½ = 52,68512/31/99 983,450 x 12% x ½ = 59,005 (rounded $2 off)……………………………………………………………………………………………..

983,450 x 12% x ½ = 59,005 (rounded $2 off)

6/30/00 Discount on NR 59,005 Interest Revenue 59,005

Cash 1,101,460 Note Receivable 1,101,460

+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

Exercise 7-20Situation 2: Entries for 12/31 for first two years, assuming that the note was signed on 1/1/96.

Supporting Calculations12/31/96 Cash 9,000 300,000 x 3% = 9,000

Interest Rev. 19,905 165,873 x 12% = 19,905Disc. on NR 10,905 *

12/31/97 Cash 9,000 300,000 x 3% = 9,000 Interest Rev. 21,213 176,778 x 12% = 21,213Disc. on NR 12,213

etc.

ZAR3101.doc 39

Impairment of Loan

Creditor still hopes for payment, but thinks it is probable that some of the PRINCIPAL (or interest) will not be paid. Therefore, the Creditor sets up an allowance account. The debtor does not do an impairment entry!

Bad Debt Exp. Allowance for Bad Debt

12/31/97310,460 500,000

Step 1: Total

Principal12/31/95 1 2 3 4 5

Impairment Date CV375,657

225,3 96 300,000Step 2: Expected

Principal 12/31/97 Payment

CV n = 3 =PV i= 10%

Step 3: Find the difference (Step 1 - Step 2) Loss due to impairment $150,261

Restructuring of Loan

Reduce Principal owed Entries sometimes are needed

Reduce Interest owed at restructure date

Increase Time to maturity

That is, the debtor gets a “good deal.”

ZAR3101.doc 40

Chapters 8 & 9

MERCHANDISE INVENTORY

A. DEF'N OF INVENTORY: items held for sale in the ordinary course of business (going concern).

Company wants to ensure a demand for its inventory; should carry enough inventory to satisfy demands, but should not overstock because it is costly.

Why accounting methods for inventory are important:

1) Large dollar amounts are usually involved

ROI2) Methods affect CGS = > NI EPS

and Ending Inventory Bal. Sheet CA WC CR etc.

• Purchase inventory on account (never pay CASH until due)

Inventory 10,000AP 10,000

• Sale of inventory (½ of above sold at 60% markup) 5,000 x 160% = $8000 sales price

Two entries CGS 5000 AR/Cash 8000if perpetual Inventory 5000 Sales 8000inventory (only this entry, if periodic)

Sales $8000-CGS 5000Gross Profit/Gross Margin 3000 Mark-up on Cost

B. FOUR MAIN ISSUES in Accounting for Inventories:units?

1. Acquiring Inven. What costs are capitalized? costs?

perpetual2. Carrying Inven. Which timing method to use? periodic

FIFO3. Selling Inven. What Cost Flow assumption? Wt. Av.

LIFO

units4. Ending Inven. Applying LCM Rule categories

totals

ZAR3101.doc 41

asset expense

C. ACQUIRING INVENTORY (PFEB) Sold Inventory CGS (B = Benefit)Note: PFEB = probable future economic benefit CGS = cost of goods sold

General Rule: Include costs if inventory is held for resale and ownership is unrestricted co. bears complete loss if items are lost, (unless there is insurance coverage) etc. and co. owns all rights to the benefits

Variations in the Real World:

• consignments inventory items held by an entity which does not hold legal title to the goods (consignor is the owner). The entity holding the inventory is the consignee.NOTE: the inventory belongs on the owner's Balance Sheet

• goods in transit at end of accounting period, these items belong to the legal owner, per shipping terms:

FOB Shipping Point title passes to buyer at the shipping pointFOB Destination title passes to buyer at the destination

NOTE: Auditors do special audit procedures to ensure Sales and Purchases of Inventory are recorded in the proper accounting period!

Costs to be Capitalized:· manufacturing costs· acquisition costs· storage· preparation for sale· packaging· transportation IN costs(Note: Trans. OUT is a selling expense)

ZAR3101.doc 42

Accounting for CASH Discounts (similar to the AR discounts)

1/10, n/30 Perpetual Method

Gross Method Net Method(economically more accurate) (better internal control)

PurchaseInven 10,000 Inven. 9900

AP 10,000 AP 9900

Case 1 AP 10,000 AP 9900Pay within Cash 9900 Cash 990010 days Inven. 100

Purch. Dis. Lost* 100Case 2 AP 10,000 AP 9,900Paid after Cash 10,000 Cash 10,00010 days (*similar to "Interest Expense")

Freight Costs In: Inven 200

Cash 200

Mfg. Cos. have several inventory accounts that hold all necessary costs incurred to get the product ready for sale:

· materials· labor· overhead (misc. costs)

D. CARRYING INVENTORY (2 timing methods possible periodic and perpetual))Ask: Should we credit inventory as we sell it daily, or should we do an AJE at

end of accounting period?

Closing Entries:• Periodic CGS

Inventory (end) Purchases

Inventory (beg.)

• Perpetual (None required because Inventory is debited as we buy it and credited as we sell it.)

ZAR3101.doc 43

COST OF GOODS SOLD

BeParticularlyCareful of the GASolineEmptyCars Go Slow

Beginning Inventory +

Purchase +Purchases Purchase Returns and Allowances -

Purchase Discounts -Freight IN +

Cost of Goods Available for Sale =

Ending Inventory -

Cost of Goods Sold =

Example of Gross Margin Method(How to find the cost of the goods lost or stolen)

Income Statement

Beg. Inven $120 Sales $330Net Purchases 200 CGS 220*Purchases P.R.&A (10)

P. Disc (20) Gross Profit 110 (Mark-up on Cost)Freight IN 30 200CGAS 320 Operating Exp. 40 Freight OUT goes

here

End. Inven (100) Net Income 70 CGS *220

Note: Purchase Discounts Lostgoes in "other rev. and expenses"

(50% Mark-up on COST = 220 x (50% = $110)(Cost of $220 + Mark-up of $110 = Selling price of $330)

ZAR3101.doc 44

INVENTORY

E. TIMING METHODS - how often entries are made to the Inventory Account

a) Periodic- Inventory account is not touched until end of period use PURCHASES account

b) Perpetual- should equal inventory on hand at all times (except for damages and theft)

F. COSTING METHODS - how the dollar values flow through the general ledger accounts

a) First In First Outb) Weighted Averagec) Last In First Outd) Specific Identification

G. END-OF-MONTH METHOD - how much value should go on Balance Sheet

LOWER OF COST OR MARKET RC NRV NRV -normal profit

Purpose is to value the Ending Inventory conservatively by valuing one of the following:a) Individual Itemsb) Class of Itemsc) Total Inventory

H. ESTIMATION OF INVENTORYa) Gross Margin Methodb) Retail Inventory Method

ZAR3101.doc 45

E. TIMING METHODS

Perpetual* PeriodicInventory Purchases

Purchase AP AP

CGS Cash/AR Inventory Sales

Sales Cash/AR Sales

Closing None CGS (plug figure)Inven. (Ending) Purchases Inven. (Beg.)NOTE: Inventory Losses get buried

in the CGS account

Inventory Inventory Shortage (a separate expense on I/S)Shortage Inventory

CGS = BI + Purchases - EI

OR Use T-Account: Inventory CGS BI CGS CGS Purchases EI

NOTE: A physical count must be taken once a year per SEC, no matter which method the co. uses.

* Use if computer system is available with details daily.

** For accounting purposes, a physical count must be taken to determine this entry.

ZAR3101.doc 46

F. INVENTORY COSTING METHODS

1) FIFO (perpetual is same as periodic) Information Given: 2) Wt. Av. (perpetual and periodic differ ) Wt. Av. LIFO3) LIFO(perpetual and periodic differ) B C4) Specific Identification (Physical Flow always matches Cost Flow)

FIFO Spec. Iden. A D

Specific Oranges Sold Day Purchases PERIODIC (this example)

4 Mon. 5 Oranges @ $1 ea. = 5 4 Tues. 4 Oranges @ $2 ea. = 8 Weekly Sales 5 Thurs. 6 Oranges @ $4 ea. = 24 17 oranges 4 Fri. 5 Oranges @ $7 ea. = 35 Sale Price = $10 ea.17 20 Oranges $72 CGAS

Wt. Av. Cost = $ units

= $72 = $3.60/orange 20 oranges

A B C D Inc. Stmts Sales $170 $170.00 $170 $170

CGS 51 61.20 69 60 GP $119 $108.80 $101 $110

Bal. Sheets M. Inven. $21 $10.80 $3 $123 x $7 3x$3.60 3x$1

(FIFO) (Wt. Av.) (LIFO) (Spec. Inden.)CGS: CGS: CGS: CGS: 5 x $1= 5 5 x 7=35 4 x 1=4 4 x 2= 8 17 x $3.60 6 x 4=24 4 x 2 =8 6 x 4=24 = $61.20 4 x 2= 8 5 x 4=20 2 x 7=14 CGS 2 x 1= 2 4 x 7=28

Sold 17 $51 17 $69 17 $60

ZAR3101.doc 47

EFFECTS OF INVENTORY COST FLOW ASSUMPTIONS (CFA'S)

1. All 3 CFAs allocate entire capitalized inventory cost* to either

CGS or EI

2. Rising per unit prices affect the CGS and EI differently than if inventory prices varied or were falling

Assume INFLATION (rising prices):

· FIFO largest balance sheet inventorysmallest CGS highest NI

· Wt. Av. medium value - EImedium value - CGS

· LIFO smallest balance sheet inventorylargest CGS lowest NI

vice versa for DEFLATION (re: LIFO and FIFO)

Income Taxes

LIFO Conformity Rule: If a company uses LIFO for its tax return, it must also use LIFO to prepare its financial statements.

(LIFO achieves lowest NI during INFLATION)

Beware: The COST FLOW of the goods used does not necessarily coincide with the PHYSICAL FLOW of the goods!

* Also called cost of goods available for sale

ZAR3101.doc 48

Tradeoffs due to Cost Flow Assumptions:

1. Income and Asset Measurement

LIFO -- better for matching principle

FIFO -- better for Balance Sheet valuation of Inventory

2. Economic Consequencesa) Income taxes and liquidity (cash position) --LIFO reduces cash sent to IRS if

possible, but it reduces NI on financial statements. However it improves LIQUIDITY of the company.. Note: FIFO gives paper profits.

b) Bookkeeping CostsLIFO more costly

c) LIFO LiquidationIf inventory levels are grossly cut back, the old, old inventory costs might end up in CGS low CGS high NI

(Care should be taken with inventory purchases)

d) Debt and Compensation ContractsFIFO higher NI good for bonus plansLIFO lower EI debt covenants usually are less severe for FIFO cos.

e) Capital MarketsThe Stock Market is not dumb: analysts understand the different effects of accounting method options.

Since LIFO company saves taxes, it should be valued more highly.

G. END-OF-MONTH VALUATION METHOD:Apply the Lower-of-Cost-or-Market Rule (LCM)

At end of accounting period, after the timing method and cost flow method have been applied, the accountant has to ask one more question:

Is the ENDING BALANCE of inventory overvalued with respect to its current REPLACEMENT COST?

·Replacement Cost·NRV·NRV - minus profit 3 potential market values

If so, an AJE is needed to write down the inventory:LOSS on Inventory

Inventory

ZAR3101.doc 49

INVENTORY ERRORS

(A) A purchase of inventory NOT recorded AND NOT counted in ending inventory:_________Inventory_________ NI: NE* Ok

CGAS U CGS TA: U_________________________ TL: U

EI U SE: NE

Current Ratio = _CA_ = _U_* CL U *

________ AP___________ * understated by equal am’ts BUT cannot U determine the overall effect

____________________U Ending

S/B DoneBI 5 5Purch _U_ 13 12CGAS 18 17EI ( U ) (4) (3)CGS 14 *14

(B) A purchase of inventory NOT recorded AND ending inventory is properly stated:

_______Inventory_________ NI: O

CGS TA: NECGS

U U TL: U_______________________

SE: OEI Ok

_________AP__________ Current Ratio = _CA_ =_NE_ = O CL U

U______________________ Profit Margin =_NI_ = _O_ = O

Sales NEU Ending

ZAR3101.doc 50

ERRORS IN THE INVENTORY COUNT:

(a) If EI is overstated, CGS is understated

NI is overstated

1991 RE is overstated

(b) If EI is understated, CGS is overstated

NI is understated

RE is understated

THEN. . . . . . . .the EI becomes the BI for the next year (1992).

(a) If BI is overstated, CGS is overstated

NI is understated

1992 RE is understated

(b) If BI is understated, CGS is understate

NI is overstated

RE is overstated

NOTE: If correct physical count is taken in second year (1992), then the error self-corrects itself. The ending RE is finally ok.

EI = Ending Inventory

BI = Beginning Inventory

ZAR3101.doc 51

DOLLAR-VALUE LIFOTextbook, page 394

Path: From Total Current $

To Total Base $

To Layers of Base $

To Layers of Current $

Step 1 From Total Current $ Step 2 To Layers of Base $To Total Base $ To Layers of Current $

1993 ____ Inventory__________________ ______________Inventory________________

1993* 1993 cont’dT. Current Index Total Base Current Base200,000 100 = 200,000 200,000 200,000

---------------------------------------Base Current

*Base Year when we Layers Layersfirst adopted Dollar Value ‘93 200,000 x 1 200,000

LIFOEI at Current $Total Layers(Dollar Value LIFO)

___________Inventory____________________ _________ Inventory __________________

1994 1995T. Current T. Base T. Current T. Base299,000 115 260,000 300,000 120,000 250,000

--------------------------------------------- --------------------------------------------- Base Current Base Current Layers Layers Layers Layers‘93 200,000 x 100 200,000 ‘93 200,000 x 100 200,000 ‘94 60,000 x 115 69,000 ‘94 50,000 x 115 57,500

269,000 257,000

EI at Current $ (Dollar Value LIFO) EI at Current $ (Dollar Value LIFO)

ZAR3101.doc 52

Determining Market Value for Lower-of-Cost-or-Market Rule:

Cost Designated Market

"Ceiling" "Floor"Historical Cost (HC) RC NRV NRV-normal profit

Step 1 (SHORT-CUT)

From the three values on the right-hand side of the DOUBLE DOTTED LINE, select the middle value for DESIGNATED MARKET VALUE ("MV").

Step 2 Compare HC to "MV" selected in Step 1.

Step 3 (a) If "MV" is lower than historical cost (HC), then prepare an AJE.(b) If "MV" is higher than HC, you MIGHT need an AJE, if there is

a balance in the Allowance Account.

Typical AJE: Unrealized LOSS due to LCM (Inc. Stmt account) Allowance for LCM Inventory (Balance Sheet account)

ZAR3101.doc 53

Chapters 10, 11, & 12

Overview of LONG-LIVED ASSETS

Method of ExpensingA. Property, Plant, and Equipment DEPRECIATE

B. Natural Resources (mineral deposits) DEPLETE

C. Intangible Assets AMORTIZE· patent · lease· copyright · leasehold improvements· franchise · goodwill know the entry· trademark • NOT research & development

D. Things to know about above assets

1. Acquisition—Use Fair Value · single asset

· basket purchase WhyHow

· making the asset· replacing a part

2. Usage· 4 Depreciation Methods· 1 Depletion Method (units of production)· 1 Amortization Method (usually straight-line)

3. Disposal *· scrap (no cash received)· sale· exchange

* Always remember to update the depreciation expense for usage up to the date of disposal

ZAR3101.doc 54

Long-Lived Assets (LLA)

A. Definition of LLA: assets that are used in the operations of the business and that provide benefits beyond the current operating period.

No Depreciation • Land(Depreciate) • Fixed Assets - Bldg, Machinery, Autos, etc.(Deplete) • Natural Resources - oil wells, coal mines, etc.(Amortize) • Intangible Assets - patents, goodwill, trademarks, etc.(Amortize) • Deferred Costs - L.T. prepaids, organizational costs

Matching Principle: expenses should be matched against revenues in the period when the revenues are recognized; i.e., when the expenses give benefit to the company.

B. Three Major Questions

1. What $ amount should be capitalized?2. Over what time period should this cost be expensed?3. At what rate should this cost be expensed?

VeryImportant Note LLA are large dollar values; therefore, the

income statement and balance sheet can be greatly affected by the way the company answers the above 3 questions.

ZAR3101.doc 55

C. Costs to be capitalized: debit the asset for all necessary costs required to get the LLA into serviceable condition and location.

• Acquisition of Land- debit the LAND account for:

·purchase price·closing costs·razing old bldgs, grading, clearing, etc.·assumptions of back taxes, liens, mortgages·permanent land improvements landscaping

street lights sewers drainage systems

LAND has an indefinite life: DO NOT depreciate it.

Notes:

• Land improvements with limited lives are debited to a separate account and amortized.

e.g. driveways, fences, parking lots

• Lump-Sum Purchases-if two or more LLA are purchased for one lump sum, use the RELATIVE FMV (fair market value) to allocate the cost to the separate asset accounts.

"Why do we need to use separate asset accounts?"(Because land is not depreciated and because the various depreciable assets may

have different economic lives.)

• Construction of Long-lived Assets-include materials, labor, and overhead and interest expense on borrowed funds in

the LLA account. Depreciation (expensing) occurs when the asset starts to be used.

ZAR3101.doc 56

Exercise 10 - 15Notes Payable with Principal Installments

(textbook)

15,000 15,000 15,000 15,000 15,000 15,000Down

______________________________________________________PVOA

n = 5I = 10% 90,000

-15,000 75,000 5 = 15,000

cash installment per year-endPVOA = A x tf

= 15,000 x 3.79079= 56,862

56,862 Carrying Value+15,000 Down Payment$71,862 Total Present Value of Computer

(a) Dec. 31, 1994 Computer 71,862Disc. on NP 18,138

NP 75,000 Cash 15,000

12/31/94 CV = NP - Disc. on NP = 56,86256,862 x 10% x 1 CV x ER x T

(b) Dec. 31, 1995 Int. Exp. 5,686 + 5,686

Discount on NP 5,686NP 15,000 Cash 15,000 - 15,000

12/31/95 47,54847,548 x 10% x 1

(c) Dec. 31, 1996 Int. Exp. 4,755 Disc. on NP 4,755 + 4,755NP 15,000 Cash 15,000 - 15,000

12/31/96 37,303

ZAR3101.doc 57

D. Post-acquisition expenditures:

(A) Betterments (B) Maintenance

improves the quality or quantity of benefits \f1 simply maintains the asset in working condition

CAPITALIZE (make it an asset) EXPENSE AT ONCE (maintenance expense)

What is a Betterment? What is a Maintenance Expense?1) Increase of useful life 1) Tune-up and service2) Quality Improvements 2) Muffler replacement3) Increase of Quantity 3) Paint Job4) Reduction of operating costs

E. Cost Allocation: Expensing Capitalized Costs

NOTE: There are no set guidelines in accounting standards/rules.

3 Steps:

1) Estimate the USEFUL LIFE

2) Estimate the SALVAGE VALUE (amount that is expected to be obtained after our company has used the asset, i.e., the cash we estimate that we'll collect when we sell the LLA)

3) Choose an ALLOCATION METHOD

IMPORTANT: Financial statement effect of the above choices can be significant.

ZAR3101.doc 58

Revision of Useful-Life Estimate

• if a company changes its estimate of life, do the following:

1) Determine the Accum. Dep. up to the date of change of estimate (therefore, you may need to record depreciation expense first).

2) Calculate the Book Value (Orig. cost minus Accum. Dep.)3) Book value at date of change

- Salvage value still anticipated= Depreciable Amount (to be depreciated over the est. REMAINING years of life)

F. Miscellaneous Issues

1) How Management chooses an Acceptable Depreciation Method

• desired effect on important financial ratios• desired effect on NI

bonus plans debt covenants (agreements)

2) Depreciation Methods for INCOME TAX purposes (Note: Corporations pay income tax.)

• Company may use different depreciation for financial accounting versus tax accounting• For IRS, use MACRS (modified accelerated cost-recovery system) -- very specific

guidelines for dep. tax deduction calculation.ASSET DEPRECIATION RANGE specifies allowable dep'n method for specific lives

of assetsTo reduce taxes, use accelerated methods and shorter estimated lives minimize the present value of tax payments

ZAR3101.doc 59

3) DEPLETION of natural resources (use the units-of-production method). Following are typical entries.

Purchase an oil well: Oil Reserves $10 mil.Cash 10 mil.

Extract Oil: Depletion Exp. $2 mil. Accum. Depletion $2 mil.

Sale of one fourth of oil: AR $1.5 mil.(with 200% mark-up on cost) Sales $1.5 mil.

CGS $ .5 mil. Depl. Exp. $ .5 mil. Sold

Mineral Inventory $1.5 mil. Depl. Exp $1.5 mil. Unsold

Note: Depletion Expense itself does NOT appear on the financial statements.Depletion Expense becomes cost of goods sold if the minerals are sold.Depletion Expense becomes inventory if the minerals are NOT sold.

ZAR3101.doc 60

G. Disposal of LLA:

(1) Retirement -- discontinue use of the asset(2) Sale - exchange LLA asset for cash or a receivable(3) Trade-ins -- exchange LLA or LLA and cash for other LLA or LLA and cash

Note: For each of the three disposal examples, always remember to update the depreciation expense to the date of disposal.

(1) Retirement — company no longer can use the asset and no cash is received (no sale is made)

• remove asset’s original cost and its accumulated depreciation; therefore, will result in either

no gain or loss a loss

if asset has been if asset has NOT beenNo salvage fully depreciated fully depreciated value

(2) Sale — cash is received when we sell the asset

• Remove the asset orig. cost and the accum. depn. and debit the cash. The "PLUG FIGURE" to balance the entry will be a gain or loss.

(3) Trade-ins -- two or more assets are exchanged; they can be SIMILAR assets (NO GAIN recognized) whereby the earnings process is NOT yet complete, OR DISSIMILAR assets (treated like an actual sale). The GAIN or LOSS recognized

ZAR3101.doc 61

COST ALLOCATION METHODS FOR LONG-LIVED ASSETS(Depreciation Methods for Partial Year )

Situation:Purchase

Equipment

Straight Line

(SLD)

Sum of Years’

Digits (SYD)

DoubleDeclining

Balance(DDB)

Unitsof

ProductionOrig.Cost=

$10,000

PurchaseDate: 9/1/90

EntryEquip.10,000 Cash 10,000

EstimatesLife = 3 yearsResidual Value=$1,000Total Products= 90,000

O.C. 10,000-R.V. 1,000=DepreciableAm’t of 9,000

SLD rate = 1/life

Dep.Expense =Deprec.Am’t xSLD rate x time

9,000 x 1/3 x 4/12= 1,000 for 1990

9,000 x 1/3 x 12/12= 3,000 for a year

Entries

12/31/90Dep.Exp. 1,000 Acc.Dep. 1,000

12/31/91Dep. Exp. 3,000 Acc.Dep. 3,000

12/31/92Dep. Exp. 3,000 Acc.Dep. 3,000

8/31/93Dep. Exp. 2,000 Acc.Dep. 2,000

O.C. 10,000-R.V. 1,000=DepreciableAm’t of 9,000

Sum the years:1+2+3=6

Year 1 is largestfraction =>3/6Year 2 =>2/6Year 3 =>1/6(Note: Year 1 means the first12 months, Year 2 means the next 12,etc.)

Dep. Expense =Deprec.Am’t x fraction x time

12/31/909,000x3/6x 4/12 = 1,500

12/31/919000x3/6 x 8/12 plus 9000 x 2/6 x 4/12 =4,000

12/31/929,000x2/6x 8/12plus 9000 x 1/6x4/12 = 2,500

8/31/939,000x1/6x8/12= 1,000

O.C. 10,000 and Deprec. Am’tm=$9,000DDB rate= 2 x SLD rate

Dep.Expense =Step 1: O.C. balance x DDB rate x time

Step 2: Declinethe O.C. balance before calculating next year’s dep.exp.

Step 3: Never depreciate the residual==>sobeware of O.C.balance 12/31/9010,000 x 2/3 x4/12 = 2,200(10,000-2,200 =OC bal 7,800) 12/31/917,800 x 2/3 x 1= 5,200(7,800-5,200=OC bal 2,600)12/31/922,600 x 2/3 x 1=1,733 BUT the RV must be1,000 \f1 only depreciate 1,600

O.C. 10,000-R.V. 1,000= DepreciableAm’t of 9,000

$/unit = Deprec.Am’t /Total Units Estimated

$9,000 / 90,000 units =$ .10/unit

Dep.Expense = Units produced x $/unit

12/31/90

11,000 units x $ .10/u = $1,100

12/31/91

32,000 units x $ .10/u = $3,200

12/31/92

30,500 units x $ .10/u = $3,050

etc.

Beware: Do notdepreciate beyond thedepreciable amount of$9,000

ZAR3101.doc 62

ZAR3101.doc 63

Similar and Dissimilar Exchanges of Nonmonetary AssetsInformation:

OUR company owns a used truck: Original cost is $30,000Accum. dep. is 20,000Book value is 10,000 Fair value is $11,000

The new truck has Fair value of $15,000

Rule to remember: When trying to determine the dollar value to debit to the asset received, following sequence of thinking should occur. First, compare FAIR VALUE GIVEN to BOOK VALUE to determine gain or loss.If FV GIVEN is not known, then second, compare FAIR VALUE RECEIVED to BOOK VALUE to determine gain or loss.If neither FV is known, then third, compare BOOK VALUE to BOOK VALUE which results in no gain or loss recorded.<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>The following examples show SIMILAR EXCHANGES because these are the situations for which the accountant must determine whether any of the determined “gain” is recorded in the accounting records. Theoretically, in an exchange of similar assets, the earnings process of the old asset (given) is not complete; therefore, if a gain arises, the company must defer recognition of it until the new asset (received) is sold at some future time.

A. Situations with NO CASH or OTHER MONETARY ASSET

1) OUR company knows the fair value given

Worksheet EntryFV given 11,000 Accum. Dep. 20,000BV given 10,000 Truck 30,000GAIN 1,000 Truck (new) 10,000

2) OUR company knows the fair value received

Worksheet EntryFV rec’d 15,000 Accum. Dep. 20,000BV given 10,000 Truck 30,000GAIN 5,000 Truck (new) 10,000

3) OUR company knows neither fair value

NO gain or loss; Accum. Dep. 20,000The old BV becomes Truck 30,000 the new BV. Truck (new) 10,000

ZAR3101.doc 64

B. Situations with CASH RECEIVED (Our company receives $1,000)

1) OUR company knows the fair value given 1

Worksheet EntryFV given 11,000 Accum. Dep. 20,000BV given 10,000 Truck 30,000PossibleGain 1,000 Cash 1,000

Gain 83 *Truck (new) 9,083

Calculate the portion of the “Possible Gain”That will be recorded, because this exchange has a “partial sale” (the cash portion).* ____1,000___ 1 (portion of “Possible Gain” to be recognized 1,000 + 11,000 12 = Cash/Cash+FV of Exchange)

1/12 x $1,000 = $83 (Gain to be recorded = above fraction x “Possible Gain”)


Worksheet EntryFV rec’d 16,000 Accum. Dep. 20,000BV given 10,000 Truck 30,000Possible Gain 6,000 Cash 1,000


= Similar to prior example

(1,000/1,000 +16,000) x $6,000 = 375


NO gain or loss; Accum. Dep. 20,000The old BV becomes Truck 30,000 The new BV. Cash 1,000

Truck (new) 9,000

1 On your worksheet, be sure to consider the CASH in the fair value or book value, as appropriate.

ZAR3101.doc 65

C. Situations with CASH GIVEN (Our company gives $3,000)


Worksheet EntryFV given 14,000 Accum. Dep. 20,000BV given 10,000 Truck 30,000Possible Gain 4,000 Cash 3,000

Truck 13,000

Determine whether ALL or NONE of the Possible Gain will be recorded; use the 25% Rule of the Emerging Issues Task Force (EITF).

25% Rule: If Cash is greater than or equal to 25% of the fair value of the exchange (refer to your worksheet), then the transaction is considered by GAAP to be an outright purchase of the asset received and an outright sale of the asset given. Therefore, ALL of the GAIN is recorded, as it would be with an outright sale.

25% Rule applied: Is 3,000 25% x 14,000? NO; therefore, no gain is recorded.


Worksheet EntryFV received 15,000 Accum. Dep. 20,000BV given 13,000 Truck 30,000Possible Gain 2,000 Cash 3,000

Truck (new) 13,000

Similar to prior example

Is 3,000 25% x 15,000? NO, therefore, no gain is recorded.



Truck (new) 13,000

-----------------------------------------------------------------------------------------------------------NOTE: For all of the exchange transactions, do one final check:

Be sure that the value recorded in the Asset RECEIVED is not greater than its fair market value on the date of the exchange.

ZAR3101.doc 66

SALES AND EXCHANGES OF LONG-LIVED ASSETS

MAJOR QUESTION:How do we value the asset RECEIVED?

Equipment Acc. Dep. 9/1/90 10,000 1000 12/31/90 3yr. Life

3000 AJE $1,000 Salvage4000 12/31/91 3000 AJE7000 12/31/92

A. SALE on 12/31/92 for:

Situation a: $4,200 cash received Situation b: $2,300 cash receivedCash 4,200 Cash 2,300Acc. Dep. 7,000 Acc. Dep. 7,000

Equip. 10,000 Loss 700Gain 1,200 Equip. 10,000

B. EXCHANGES on 12/31/92 Two Acceptable Methods for New Asset:1. Dissimilar: For a Truck FMV of Asset Given Or

FMV of Asset Received

Situation a: FMV of Truck = $4,200 Situation b: FMV of Truck= $2,300(received) (received)

Truck 4,200 Truck 2,300Acc. Dep. 7,000 Acc. Dep. 7,000

Equip. 10,000 Loss 700Gain 1,200 Equip 10,000

2. Similar: For another machine (NO GAINS recognized)Equip. or Machinery 3000* Machinery 2,300Acc. Dep 7000 Acc. Dep 7,000

Equip 10,000 Loss 700Equip 10,000

DISSIMILAR ASSETS ONLY: Value the asset received with the following order of preferences: (1) market value of asset given or (2) market value of asset received or (3) if neither is known, use the book value of asset given. We always know book value!

SIMILAR ASSETS ONLY:* The highest value debited for what we receive is the B.V. given or F.V. received,

whichever is LOWER.

EXCHANGES OF LONG-LIVED ASSETS (continued)

ZAR3101.doc 67

C. EXCHANGES WITH BOOT on 12/31/92

In general, to determine the value of the asset we receive:1) Use FMV of assets given;2) If 1 is not known, then use FMV of assets received;3) If 1 & 2 are not known, then use the BV of assets given.

1. Situation c: FMV of truck=$4,200 Situation d: FMV of truck=$2,300

Dissimilar: Receive a truck and $500 cash (boot)

Entry: Cash 500 Cash 500Truck 4200 Truck 2300Acc.Dep. 7000 Acc.Dep. 7000

Equip. 10000 Equip. 10000Gain 1700 Loss 200

2. Situation c: FMV of new equip.=$4200 Situation d:FMV of new eq.=$2300

Similar: Receive new equipment and $500 cash (boot)

(FMV total of $4700) (FMV total of $2800)PARTIAL GAIN will be recognized. TOTAL LOSS will be recognized.

FMV received 4700 FMV received 2800BV given 3000 BV given 3000Total Gain 1700 Total Loss 200

Partial Gain = (500/4700) x 1700 = Recognize total loss of $20010.6% x 1700 = $180

Entry: Cash 500 Cash 500Acc.Dep. 7000 Acc.Dep. 7000

Equip. 10000 Equip. 10000Gain 180 Loss 200

Machinery 2680 Machinery 2300

(Do the above entry in the order of (Do NOT have to do the entry inaccounts given. The balancing the above order.)figure should be the ASSETRECEIVED.)

ZAR3101.doc 68

D. CORRESPONDING ENTRIES ON OTHER COMPANY’S BOOKS (for the “gain” situations only): The capital letters below refer to the first company’s entries on the prior two pages.

A. Sale on 12/31/92 is a PURCHASE for Other Co.

Entry: Equip. 4200Cash 4200

________________________________________________________________

For the remaining situations, use the following data:Other Co. receives equipment and gives a truck with original cost of $20,000 and acc. dep. of $16,000. The FMV of the truck ($4,200) is known by both companies.

B. 1. Dissimilar EXCHANGE without boot:Worksheet

BV given 4000FMV given 4200 GAIN 200

And, these are dissimilar; therefore,recognize total gain.

Entry: Acc. Dep. 16000Truck 20000Gain 200

Equipment 4200

2. Similar EXCHANGE without boot: WorksheetSame as prior, but now the assets aresimilar; therefore, NO gain is recorded.

Entry: Acc. Dep. 16000Truck 20000

Equipment 4000

Note: The old book value becomes the new book value. And, the gain is deferred until Other Co. sells the equipment at some future date.

ZAR3101.doc 69

C. 1. Dissimilar EXCHANGE WITH BOOT:Worksheet

BV given (truck + cash) 4500FMV given (truck + cash) 4700

GAIN 200

Entry: Acc. Dep. 16000Truck 20000Cash 500Gain 200

Equip. 4700

2. Similar EXCHANGE WITH BOOT:Worksheet

Same as prior, but now the assets are similar. The CASH is GIVEN, therefore,use the 25% rule to determine whetherto treat this as DISSIMILAR.

If BOOT GIVEN 25% of FMV of the exchange, then treat as DISSIMILAR and recognize the gain. Otherwise, treat as SIMILAR do not recognize any of the gain. If $500 25% x $4700

If $500 $1175....BUT it is NOT, therefore, treat as SIMILAR, with no gain involved.

Entry: Acc. Dep. 16000Truck 20000Cash 500

Equip. 4500==================================================Reminders:

1. Each company’s “old” asset being exchanged has a different book value, most likely.

2. Always remember to compare the book value (BV) of what the company is exchanging (giving) with one of the following values (in this order):

a) FMV of asset GIVEN, but not always known.b) If a is not known, then use FMV of asset RECEIVED.c) if a and b are not known, then use the BV of asset given. (We always

know this because we are the accountants of the company!)3. The amount of cash involved is at book value and at fair market value. 4. If there is a loss, ALWAYS record the entire loss. This is done because of

conservatism.

ZAR3101.doc 70

Similar and Dissimilar Exchanges of Nonmonetary AssetsAdditional Example

Information:OUR company owns a used truck: Original cost is $30,000

Accum. dep. is 20,000Book value is 10,000

Fair value is $11,000The new truck has Fair value of $15,000

Rule to remember: When trying to determine the dollar value to debit to the asset received, following sequence of thinking should occur. First, compare FAIR VALUE GIVEN to BOOK VALUE to determine gain or loss.If FV GIVEN is not known, then second, compare FAIR VALUE RECEIVED to BOOK VALUE to determine gain or loss.If neither FV is known, then third, compare BOOK VALUE to BOOK VALUE which results in no gain or loss recorded.

<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>The following examples show SIMILAR EXCHANGES because these are the situations for which the accountant must determine whether any of the determined “gain” is recorded in the accounting records.

D. Situations with NO CASH or OTHER MONETARY ASSET


Worksheet EntryFV given 11,000 Accum. Dep. 20,000BV given 10,000 Truck 30,000GAIN 1,000 Gain 1,000

Truck (new) 11,000


Worksheet EntryFV rec’d 15,000 Accum. Dep. 20,000BV given 10,000 Truck 30,000GAIN 5,000 Gain 5,000

Truck (new) 15,000


NO gain or loss; Accum. Dep. 20,000The old BV becomes Truck 30,000 the new BV. Truck (new) 10,000

ZAR3101.doc 71

E. Situations with CASH RECEIVED (Our company receives $1,000)

4) OUR company knows the fair value given 2

Worksheet EntryFV given 11,000 Accum. Dep. 20,000BV given 10,000 Truck 30,000PossibleGain 1,000 Cash 1,000


Calculate the portion of the “Possible Gain”That will be recorded, because this exchange has a “partial sale” (the cash portion).* ____1,000___ 1 (portion of “Possible Gain” to be recognized 1,000 + 11,000 12 = Cash/Cash+FV of Exchange)

1/12 x $1,000 = $83 (Gain to be recorded = above fraction x “Possible Gain”)


Worksheet EntryFV rec’d 16,000 Accum. Dep. 20,000BV given 10,000 Truck 30,000Possible Gain 6,000 Cash 1,000


= Similar to prior example

(1,000/1,000 +16,000) x $6,000 = 375



Truck (new) 9,000

2 On your worksheet, be sure to consider the CASH in the fair value or book value, as appropriate.

ZAR3101.doc 72

F. Situations with CASH GIVEN (Our company gives $5,000; the fair value of the asset received is now $20,000.


Worksheet EntryFV given 14,000 Accum. Dep. 20,000BV given 10,000 Truck 30,000Possible Gain 4,000 Cash 5,000

Gain 4,000Truck (rec’d) 19,000

Determine whether ALL or NONE of the Possible Gain will be recorded; use the 25% Rule of the Emerging Issues Task Force (EITF).

25% Rule: If Cash is greater than or equal to 25% of the fair value of the exchange (refer to your worksheet), then the transaction is considered by GAAP to be an outright purchase of the asset received and an outright sale of the asset given. Therefore, ALL of the GAIN is recorded, as it would be with an outright sale.

25% Rule applied: Is 5,000 25% x 14,000? YES; therefore, record the entire gain.

5) OUR company knows only the fair value received

Worksheet EntryFV received 20,000 Accum. Dep. 20,000BV given 15,000 Truck 30,000Possible Gain 5,000 Cash 5,000

Gain 5,000Truck (rec’d) 20,000

Similar to prior example

Is 5,000 25% x 20,000? YES; therefore, record the entire gain.



Truck (new) 15,000

NOTE: For all of the above transactions, do one final check:

Be sure that the value recorded in the Asset RECEIVED is not greater than its fair market value on the date of the exchange.

ZAR3101.doc 73

H. ECONOMIC CONSEQUENCES related to Accounting for Long-Lived Assets

• Problems with Historical Cost (HC)1) Fin. Stmt users may find that HC of a LLA is not relevant for decision-making.

They might rather have:a) present value (PV)b) fair market value (PMV) orc) replacement cost (RC)

2) Although HC is more objective than other valuation bases, it still is subjective due to the estimates and choices involved in the accounting process.

• Problems with Cost Allocation1) Difficult to match depreciation of the asset directly with the generation of

revenues because of all the estimates.2) Depending on the choices made by management, financial statement

numbers can vary significantly.

• Clearing up Misconceptions about Cost Allocation1) Book Value is not FMV or PV or RC.2) Depreciation entry does not set cash aside for future replacement of old LLA.

(However, depr. exp. lowers RE (retained earnings) change and could lower dividends, thereby preserving more cash in company.)

I. INTANGIBLE ASSETS and DEFERRED COSTS

Characterized by rights, L.T. Prepaidsprivileges, and benefits OR Start-up Costs RATHER THANby physical substance

RULES FOR AMORTIZATION:(Use Economic Life or Legal Life, whichever is shorter), but not more than 40 years.

Special Rule for companies that develop COMPUTER SOFTWARE:development and production costs can be capitalized and later amortizeddeferment of expenses higher NI

• Goodwill — only arises when one company purchases another company and pays more than the FMV of the net assets (TA-TL = Net Assets = Stockholders' Equity)

• Organization Costs — expenses incurred prior to the start up of the company may be capitalized and amortized over the future years.

For tax purposes, use 5 years of life IRS allows high deductionsFor financial accounting purposes, use more years because company wants lower

expenses on income statement.• R & D — expensed immediately, even though inconsistent with MATCHING PRINCIPLE.

ZAR3101.doc 74

CAPITALIZATION OF INTEREST Worksheet

1) Find the Weighted Average Accumulated Expenditures $

2) Specific Rate is given

Weighted Average Rate must be calculated, but only use the NON-construction debt

Debt A:Principal x SR x T = Interest

Debt B:Principal x SR x T = Interest

Total Principal Total Interest

Total Interest Total Principal = Wt. Avg. Rate(Weighted Average Rate

Calculated)

3) Basic Idea: Avoidable Interest = Wt. Avg. Accum. Expend x Interest Rate

Total Wt. Avg. Accum. Expend (Step 1)- Principal of the Construction Debt x Spec. Rate $- Remainder of Accum. Expend. x Wt. Avg. Rate $

= AVOIDABLE INTEREST 3)

4) Calculate Total “Interest Expense” for the year1:

Principal1 x Rate1 x Time1 = InterestPrincipal2 x Rate2 x Time2 = Interest

etc. __etc. TOTAL INTEREST EXPENSE 4)

5) Compare 3 and 4, and capitalize the LESSER of the two. All remaining interest must be expensed immediately. CAUTION: Be careful about the credit(s) in the entry; at year-end there may be CASH and/or INTEREST PAYABLE credits.

NEXT PERIOD

1. Wt. Avg. Accum. Expend = TOTAL EXPEND. FROM ALL PRIOR PERIODS and add CAPITALIZED INTEREST and add WT. AVG. EXPEND. OF THIS PERIOD

1 A year is usually the time frame for the problems

ZAR3101.doc 75

Impairment of Long-Lived AssetsStatement of Financial Accounting Standards (SFAS) No. 121

Purpose: Provides a systematic procedure for management writedown of long-lived assets. Therefore, it prevents the “big bath” that is often taken when new management arrives at a company.

Application: This standard relates to the loss of value of long-lived assets used and long-lived assets to be disposed.3

a. Both tangible and identifiable intangible long-lived assets are included. Goodwill related to the long-lived assets are included.

b. Which assets apply? Those that have independent identifiable cash flows.Therefore, accounting for impairment is performed only on largesegments or divisions of the company.

Calculation:

Step 1: Compare undiscounted FUTURE CASH FLOWS (FCF) related to the assets to the assets’ CV (carrying value on the books) to determine whether to write the assets down.

Step 2: Write the assets down a) to FAIR VALUE (MARKET VALUE), if known, or otherwise b) to PRESENT VALUE (PV) of future cash flows expected from the assets impaired.

3 Note that SFAS #121 excludes disposal of a segment of a business.

ZAR3101.doc 76

Accountant’s Routine Procedure:

a. Periodically, review events and circumstances for possible asset impairment.

b. If Carrying Value (CV)4 of any long-lived assets may not be recoverable, then apply the Recoverability Test presented below:

1. Estimate the net future cash flows (cash in minus cash out)expected from the use of the asset and its eventual disposition.

2. If the FCF < CV of the asset, then the asset is impaired. And vice versa.

3. If impairment occurred, then compute the loss, per next step (#4).

4. Impairment Loss = CV of asset - FMV of asset

or

Impairment Loss = CV of asset - PV of FCF5

Procedure of Write Down:

Step 1: Reduce goodwill first.

Step 2: Then prorate the remaining impaired value over the tangible assets.

ENTRY: Loss on ImpairmentAccumulated DepreciationGoodwill

Note: Typically, the reduced CV of asset becomes its new cost basis: therefore, you usually do not write up the value, even if FMV increases later.

However, if the asset is held for disposal, its value can be written up to the CV that it was before the impairment.

4 Carrying value is also book value (BV).5 To calculate the present value of the future cash flows, use the company’s market interest rate.

ZAR3101.doc 77

instructor notes to accompany - pegasus web …pegasus.cc.ucf.edu/~zarzeski/zar3101.doc · web...

Documents