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UF / Accounting / ACG 2021 / What is the objective of merchandising and manufacturing companies?

What is the objective of merchandising and manufacturing companies?

What is the objective of merchandising and manufacturing companies?

Description

School: University of Florida
Department: Accounting
Course: Introduction to Financial Accounting
Professor: Jill Goslinga
Term: Fall 2020
Tags: financial accounting
Cost: 50
Name: ACG2021 Exam 2 Study Guide
Description: These notes cover what will be on Exam 2, including the formulas and journal entries.
Uploaded: 10/29/2020
25 Pages 59 Views 5 Unlocks
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ACG2021 Exam 2 Study Guide 


What is the objective of merchandising and manufacturing companies?



Chapter 6 

Incorrect Financial Statements

• Inventory includes items a company intends for sale to customers in the ordinary course  of business

o Inventory also includes items that are not yet finished products

▪ Example: Steel at a construction firm

o Generally reported as a current asset in the balance sheet 

▪ It is a resource with a future benefit

• Cost of goods sold is the cost of the inventory sold

o At the end of the period, the amount that the company reports for  


What is the role of inventory on balance sheet?



inventory is the cost of inventory that has not yet been sold by the company

▪ The company will then report the cost of inventory sold  

during the period of the goods sold

o Reported as an expense in the income statement 

What Goes into Inventory Cost?

The cost of any asset, such as inventory, is the sum of all the costs incurred to bring the asset to its  intended use, less any discounts Don't forget about the age old question of How did andy warhol enter the world of art?

• Intended use of inventory is to sell the inventory

Cost Includes: We also discuss several other topics like How do sensory neurons detect stimulus?

Purchase price

Freight in


What are the various inventory cost methods?



Insurance while in transmit

Fees or taxes paid to get the inventory ready to sell

• Then you would subtract off any returns, allowances, and discounts If you want to learn more check out What is required for idea to be facilitated?

A better definition of the inventory cost is the sum of all costs incurred to bring the inventory to salable  condition

• For any cost, ask yourself: can I sell this inventory without incurring any costs? o If the answer is no: it gets included in the cost of inventory

o If the answer is yes: it would NOT get included in the cost of inventory

▪ Might still be an expense, but not in cost of inventory

- Salable condition – theoretical

• Is this item capable of being sold?

• Example: advertising cost would not be included in cost of inventory because  you don’t need to incur that cost in order to sell your inventory

• Freight in: the shipping cost that you pay to get the inventory from the supplier  to you would be included in the cost of the inventory, because you cannot sell  

the inventory unless you have it

• Inventory costs affect gross profit

• Gross profit = net revenue - cost of goods sold

• Note: Net revenue = sales revenue - sales allowance/returns/discounts

Interest would not be included because it hasn’t been incurred yet

Manufacturing and Merchandising Companies If you want to learn more check out How do religions function according to dirkham?

Manufacturing companies produce the inventory that they sell rather than buying them in finished form from suppliers

• Buy inputs for products they manufacture

• Raw materials - cost of the component that will go in to make the actual inventory • Work in process - the inventory that has been started in the production process but are  not yet complete at the end of the period

o The total cost in work in process include some of raw materials that have  

been put into a product so far, direct labor (allocation of labor costs that go  

into producing products), and indirect manufacturing cost called overhead  

(portion of building rent, utilities, supervisor salaries, etc.)

• Finished goods - consists of items in which the manufacturing process is complete and  items are ready for sale Don't forget about the age old question of What causes hemineglect?

Merchandising company don’t manufacture any goods (can be wholesalers or retailers); buy finished  goods and put that in their inventory

• Don’t have different categories, simply have inventory

Service companies perform services for the end user (No inventory)

Recall: Inventory is an asset on balance sheet. When we sell inventory, the inventory move from asset  on balance sheet to an expense (cost of goods sold) on the income statement

Below explains the inventory equation (will show up throughout the chapter) 

Beginning Inventory (asset) + Purchases During the Year (asset)

Total Inventory Available for Sale

Inventory Not Sold Inventory Sold

Ending Inventory + Cost of Goods Sold

Asset in the balance sheet Expense in the income statement

 Goods Available for Sale

Cost of Goods Sold = Beginning Inventory + Purchases During the Year - Ending Inventory Multi-step income statement

• Breaks the income statement into different parts

• By separating revenues and expenses into different categories, investors are better able to  determine the company's source of profitability

**A multiple-step income statement reports multiple levels of profitability. Gross profit equals net  revenues (or net sales) minus cost of goods sold. Operating income equals gross profit minus operating  expenses. Income before income taxes equals operating income plus nonoperating revenues and minus  nonoperating expenses. Net income equals all revenues minus all expenses. If you want to learn more check out What are the arguments of the interparadigm debate?

Inventory Cost Methods

• Accounting uses four generally accepted inventory methods

1. Specific unit cost

2. Average cost

3. First-in, first-out (FIFO) cost

- For accounting purposes, Publix can still record their inventory with LIFO

4. Last-in, first-out (LIFO) cost

-- Inventory cost flow assumptions

- Company can use any of these methods

- Methods can have very different effects on reported:

o Profits

o Income taxes

o Cash flow

- If you have high COGS and low income, you will pay less taxes.  

Inventory Cost Methods

• Specific identification

o Matches each unit of inventory with its actual cost

▪ Can only be used for certain companies

▪ Example: an expensive jewelry store that only has one thing  

of that particular item that they can know which item they  

sold and find out that specific cost

• Target CANNOT go back and determine the  

specific cost of a certain product (like paper  

towels)

• FIFO (first in, first out)

o Assumes first units purchased are first units sold

• LIFO (last in, first out)

o Assumes last units purchased are first ones sold

• Weighted-average cost

o Assumes each unit of inventory has a cost equal to the weighted-average  

unit cost of all inventory items

Weighted-Average Cost

• Under this method, we assume:

o Both cost of goods sold and ending inventory consist of a random mixture of  all the goods available for sale

o Each unit of inventory has a cost equal to the weighted-average unit cost of  all inventory items

o The weighted-average cost is calculated as:

▪ Cost of goods available for sale / number of units available for  

sale

Note: weighted average will always be in the middle of LIFO and FIFO

• LIFO will be larger, FIFO will be smaller (assuming prices increase)

Key Point

Companies are allowed to report inventory costs by assuming which specific units of inventory are sold  and not sold, even if this does not match the actual flow. The three major inventory cost flow  assumptions are FIFO, LIFO, and weighted-average cost.

Choice of Inventory Reporting Methods

Accounting method selected affects the:

• Profits to be reported

• Amounts of income tax to be paid

• Values of inventory turnover and gross profit ratios derived from the financial statements

FIFO Method

• Matches physical flow for most companies

• Ending inventory reflects current cost

• Balance-sheet approach

o The older costs go into cost of goods sold, the newer costs are inventory  

(assets on balance sheet)

LIFO Method

• Cost of goods sold reflects current cost

• Income-statement approach

o Current cost will go on income statement as cost of goods sold

LIFO Conformity Rule

• Companies that use LIFO for tax reporting must also use LIFO for financial reporting

When COGS is higher (under LIFO), income will be lower which means less income taxes. That is why  companies like this option better. However, the LIFO conformity rule prevents you from reporting  higher income with lower taxes.  

• Although you will get the advantage of lower taxes, you must report lower income on  your financial statements (which are available to investors and creditors)

NOTE: if prices are declining, FIFO would have higher COGS and lower income. If prices are rising, FIFO  would have lower COGS and higher income

The choice of inventory methods affects:

• Reported ending inventory (asset)

• Reported cost of goods sold (expense, therefore profit)

**Generally, FIFO more closely resembles the actual physical flow of inventory. When inventory costs  are rising, FIFO results in higher reported inventory in the balance sheet and higher reported income in  the income statement. Conversely, LIFO results in lower reported inventory and net income, reducing  the company's income tax obligation.

**Look at whether the cost of the inventory is increasing or decreasing to determine which method  would produce tax savings

**The internal revenue service (IRS) requires all US companies to use the same method of costing  inventories for tax purposes as they use for financial statement purposes (LIFO Conformity Rule)

Perpetual Inventory System and Periodic Inventory System

Perpetual Inventory System

Periodic Inventory System

Maintains a continual record of inventory

Does not maintain a continual record of  inventory

Helps a company better manage inventory  levels

Periodically adjusts for purchase and sale of  inventory

Most often used in practice

Perpetual is simpler and generally more cost effective for companies

• When a store scans a barcode from an item, the company takes that item out of the  inventory available. Thus, it is constantly being updated. 

Periodic determines how much inventory is sold at the end of the period

LIFO Adjustment

• Companies generally maintain their own inventory records on a FIFO basis

• To report using LIFO, a year-end adjustment to inventory needs to be made (LIFO  adjustment)

• The difference in reported inventory when using LIFO instead of FIFO is commonly  referred to as the LIFO reserve

FIFO Amount - LIFO Adjustment = Ending LIFO Amount

When the LIFO inventory balance is greater than the FIFO inventory balance (when prices are declining)  the LIFO adjustment would be debited. If prices are rising, the LIFO inventory balance would be credited.

Additional Inventory Transactions

• Freight charges

o Freight in (shipment from suppliers)

▪ Included in Cost of Inventory - needed to get item in salable  

condition

o Freight out (shipments to customers)

• If you pay for shipping, it could be selling cost or COGS (depends)

• Purchase discounts

o Discount offered by seller to buyer for quick payment

▪ Subtracted from purchase

• Purchase returns

o Buyer returns unwanted or defective inventory

▪ Subtracted when calculating purchases

Shipping Terms

1. FOB Shipping Point - title passes at shipping point (when inventory leaves the supplier's  warehouse).  

2. FOB Destination - title passes at destination (when inventory arrives to consumer).  Period Inventory System

• Does not continually modify inventory amounts

• Periodically adjust for purchases and sales of inventory

o At the end of the reporting period

o Based on a physical count of inventory on hand

• No running record of inventory and cost of goods sold is kept

o When inventory is purchased, a temporary account purchases is debited

o When inventory is sold only the revenue is recorded (COGS is NOT updated) ▪ Unlike perpetual, we had two journal entries. However, we  

will only have one (to record revenue)

• Ending inventory and cost of goods sold is determined at the end of the period from a  physical count

o COGS = BI + P - EI

• Big limitation compared to perpetual - perpetual would adjust for a sudden loss of  inventory, but period would not catch this sudden loss

Purchase inventory on account

Perpetual

Periodic

Inventory 2700

Account Payable 2700

Purchases 2700

Account Payable 2700

Sell Inventory on Account

Perpetual

Periodic

Account Receivable 4500

Sales Revenue 4500

Account Receivable 4500 Sales Revenue 4500

Cost of Goods Sold 2500

Inventory 2500

NO ENTRY

Freight In Charges

Perpetual

Periodic

Inventory 300

Cash 300

Freight in 300

Cash 300

Pay on account with 2% purchase discount of $54; return inventory previously purchased on account

Perpetual

Periodic

A/P 2700

Inventory 54

Cash 2646

A/P 2700

Purchase Discounts 54 Cash 2646

A/P 550

Inventory 550

A/P 550

Purchase Returns 550

Period-end adjustment

• Needed only under the periodic system

Perpetual

Periodic

NO ENTRY

Inventory (ending) - 1650

COGS - 8046

Purchase discounts - 54

Purchase returns - 550

Purchases - 9300 Freight in - 300 Inventory (beginning) - 700

Purchase discounts and returns were credited, so they must be debited to be closed • Refer to previous tables. The purchase discounts were originally credited as they relate to  the asset (inventory)

Purchase and freight in - to take it off the books, they must be credited because they were originally  debited

• Period-end adjustments under the periodic system:

1. Adjusts the balance of inventory to its proper ending balance

2. Records the cost of goods sold for the period

3. Closes (or zeros out) the temporary purchases accounts

COGS will be different

• Just understand that if you use LIFO or weighted average cost or perpetual, you will get a  different COGS

• Very few companies use a LIFO perpetual system

• Most companies maintain their records on a FIFO basis and then adjust for the LIFO  difference before preparing financial statements

The period system and perpetual system will always produce the same amount for cost of goods sold  (and ending inventory) when FIFO is used.

• A periodic system does not maintain a continuously updated inventory account nor a  continuously updated cost of goods sold on account

If you use LIFO or weighted-average, you will have a different amount of cost of goods sold whether it is  perpetual or periodic

During the year 

Record inventor purchases at cost

At the end of the year 

Cost - specific identification, FIFO, or weighted-average

• No year-end adjustment needed

• Reporting ending inventory as purchase cost

Net realizable value - estimated selling price minus cost to sell

• Reduce inventory from cost to net realizable value

• Report an expense for reduction

Which is lower for unsold inventory?

• Report the lower value

o If it is cost, leave it as is

o If it is net realizable value, reduce inventory from cost to net realizable value

When adjusting for the adjustment in net realizable value

• Debit cost of goods sold (expense)

• Credit inventory

The lower of cost or market (NVR) concept is based on the principle of relevance and faithful  representation 

− If the current market value of inventory (NVR, which is selling price minus cost of completion,  disposal and transportation) is lower than the cost, the inventory must be written down by  recording a debit to cost of goods sold and credit to inventory 

o A decrease in value is always recorded in COGS and is not shown as a loss.

− If the NVR is higher than the cost, we do not increase the value of inventory on the company's  book due to the principle of conservatism

Inventory Turnover Ratio

• Inventory turnover ratio

o Shows the number of times the firm sells its average inventory balance  

during a reporting period

• Cost of goods sold / average inventory

• Average inventory = (Beginning inventory + Ending inventory) / 2

• Average Days in Inventory

o Indicates the approximate number of days the average inventory is held.

▪ 365 / Inventory turnover ratio

• When this is lower, that means the company sells its inventory quickly

• You should only compare these ratios based on the inventory

Gross Profit Ratio

• Indicator of the company's successful management of inventory

• Measures the amount by which the sale price of inventory exceeds its cost per dollar of  sales

o Gross profit / net sales

▪ Gross profit = net sales - cost of goods sold

**Inventory turnover ratio indicates the number of times the firm sells, or turns over, its average  inventory balance during a reporting period. The gross profit ratio measures the amount by which the  sale of inventory exceeds its cost per dollar of sales.

Analyze Effects of Inventory Errors

Inventory error

Cost of goods sold

Gross profit

Net income

Retained earnings

Overstate ending inventory

Understate

Overstate

Overstate

Overstate

Understate ending inventory

Overstate

Understate

Understate

Understate

Chapter 7 

Tangible Assets

Intangible Assets

Land

Land improvements

Buildings

Equipment

Natural resources

• Physical substance

Patents

Trademarks

Copyrights

Franchises

Goodwill

• Lack of physical substance

• Existence often based on legal contract

*Long-term assets are very important because they make up a large percentage on the balance sheet

Property, Plant, and Equipment

Recorded at:

• The original cost of the asset + all expenditures necessary to get the asset ready for use Inventory refers to salable condition

Property, plant, and equipment refers to getting the asset to its intended use

Land

• Land includes cost of the land and all expenditures necessary to get the land ready for its  intended use

o Represents land company is using in its operations

▪ Not land used for investment purposes

• Capitalize all land expenditures

o Capitalize means to add to cost of an asset

▪ Capitalize all costs needed to get that asset to its intended use

• Cost to get the land ready for use include items such as:

o Real estate commission and fees

o Back property taxes or other obligations

o Clearing, filling, and leveling the land

o Cash received from selling salvaged building materials reduces the cost of  

land

• Land includes the initial purchase price plus all expenditures (net of salvaged materials)  necessary to get the land ready for use.

Land Improvements

• Land improvements are amounts spent to improve the land

• Land improvements have limited useful lives and are recorded separately from the Land  account

o Land, however, has an unlimited useful life. It does not decline or  

deteriorate (for accounting purposes)

o That is why land and land improvements are in separate categories

Buildings

• Buildings: administrative offices, retail stores, manufacturing facilities, and storage  warehouses

• Cost of getting a building ready for use include items such as:

o Realtor commissions and legal fees

• Remodeling costs

• Unique accounting issues arise when a firm constructs a building rather than purchasing it  (capitalize interest cost)

o If you took out a note payable to purchase the building, the interest wasn’t included in the cost of the building

o If you construct a building, the interest that you incurred during the  

construction period would be included  

▪ Once the construction ends, if you continue to incur interest,  

that would not be included (like a building you purchased)

Equipment

• Equipment: machinery used in manufacturing, computers, and other office equipment,  vehicles, furniture, and fixtures

• The cost of equipment might include sales tax, shipping, assembly, and any other costs to  prepare the asset for use

• Recurring costs such as annual property insurance and annual property taxes on vehicles  are expensed as incurred

Total cost of equipment includes the initial purchase price plus all expenditures necessary to get the  equipment ready for use

Basket Purchase

• Purchase of more than one asset at the same for one purchase price

• Because we need to record land, building, and equipment in separate accounts, we must  allocate the total purchase price based on the relative fair value of the individual assets o We must take the fair value of each individual asset, divide it by the fair  

value of all assets purchased, then multiply it by the purchase price

Natural Resources

Natural Resources: oil, natural gas, timber, and salt

• Distinguished from other assets by the fact that they are physically used up, or depleted • Recorded at cost plus all other costs necessary to get the natural resource ready for its  intended use

*** Tangible assets, such as land, land improvements, buildings, equipment, and natural resources are  recorded at cost plus all costs necessary to get the asset ready for its intended use.

Intangible Assets

• Intangible assets: patents, copyrights, trademarks, franchises, and goodwill • Lack physical substance but can be very valuable

• Existence often based on legal contract

• Acquired in two ways

o Purchased

o Developed internally

Recording and Reporting Intangible Assets

• Purchased intangibles: record at their original cost plus all other costs necessary to get  the asset ready for use

o Similar to reporting purchased property, plant, and equipment

• Intangible assets developed internally: expense in the income statement most of the  costs for internally developed intangible assets in the period we incur those costs o Difficult to determine portion of the expense that benefits future periods

o GAAP says this research and development cost is not close enough to  

intangible assets

Patents

• Exclusive right to manufacture a product or to use a process

• Granter for a period of 20 years

• When purchased

o Capitalize the purchase price plus legal and filing fees

• When developed internally

o Capitalize legal and filing fees only (Research and Development costs are  

expensed as incurred)

The cost of successfully defending a patent (attorney fees)

• To successfully defend patent in court after being sued

o If it is not successfully defended, these costs would not be included

Copyrights

• Exclusive right of protection given to the creator of a published work

• Granted for the life of the creator plus 70 years

o Usually has shorter useful life (textbook - always has a new edition, so old  edition won’t be as helpful)

• Allows holder to pursue legal action against anyone who tries to infringe the copyright • Accounting is virtually identical to that of patients

Trademark

• Word, slogan, or symbol that distinctively identifies a company, product, or service • Renewable for an indefinite number of 10 year periods

• Capitalize legal, registration, and design fees

o Advertising costs expensed as incurred

Franchises

• Local outlets that pay for the exclusive right to use the franchisor's name and to sell its  products within a specified geographical area

• The franchise records the initial fee as an intangible asset

• Additional periodic payments to the franchisor are usually expensed as incurred Good Will

• Goodwill is the portion of the purchase price that exceeds the fair value of identifiable net  assets

o The value you attribute to the company

• Recorded only when one company acquires another company

• Most companies also create goodwill to some extent through advertising, employee  training, and other efforts. However, as it does for other internally generated intangibles,  a company must expense costs incurred in the internal generation of goodwill

**Intangible assets are recorded at purchase price plus all costs necessary to get the asset ready for use • Internally generated intangible assets are expensed as incurred

o Exceptions are legal and filing fees, and successfully defending the  

intangible asset

• Goodwill = purchase price of a company - FMV of net assets purchased

o FMV Net Assets = FMV assets - liabilities

Expenditures After Acquisition

• Repairs and maintenance

• Additions

• Improvements

• Litigation costs

For all expenditures after acquisition

Expense

If they benefit only the current period

Capitalize

If they benefit future periods as well

If the cost is before asset can be used, capitalize all costs.

If cost is after the asset can be used, capitalize or expense according to criteria: - Capitalize increases useful life, capacity (usefulness) or successful litigation

- Expense if ordinary repair or maintenance or unsuccessful litigation cost

Materiality

• An item is said to be material if it is large enough to influence a decision

• When an expenditure is not material, the item is typically recorded as an expense  regardless of its expected period of benefit

• Companies generally have policies regarding amounts that are not material. They will  expense all costs under a certain dollar amount, say $1000, regardless of whether future  benefits are increased

*If a company capitalizes instead of expensed, overstated net income and understated expenses − You will have a depreciation allocated, and it will be less than the expense

Assume Nation Airlines repaired a Boeing 777 aircraft at a cost of $1.5 million, which Nation paid in  cash. Further, assume the Nation accountant erroneously capitalized this expense as part of the cost of  the plane.

Show the effects of the accounting error on Nation Airline's income statement. To answer this question,  determine whether revenues, total expenses, and net income were overstated or understated by the  accounting error.

Recorded 

Equipment 1.5 Million

Cash 1.5 Million

Depreciation expense (less then 1.5 million)

Accumulated depreciation (less than 1.5 million)

What Should Have Been Recorded 

Repair Expense 1.5 Million

Cash 1.5 Million

Assets are overstated

Revenue is overstated

Expense is understated

Net income is overstated

Depreciation

- Allocation of an asset's cost to expense over time

We need a way to take the cost and expense it over the period that the assets are going to be used

Recording Depreciation

Depreciation expense xx

Accumulated depreciation xx

**Recall accumulated depreciation is a contra-asset account

Equipment – accumulated depreciation = book value

*Book value is what is recorded in the balance sheet

Depreciation in accounting is not a valuation process. Rather, depreciation in accounting is an allocation  of an asset's cost to expense overtime

Factors Used in Calculating Depreciation

• Service life (or useful life) - the estimated use of the company expects to receive from the  asset before disposing of it

• Residual value (or salvage value) - the amount the company expects to receive from  selling the asset at the end of its service life

o Useful life is how long the asset will be used.

• Depreciation method - the pattern in which the asset's depreciable cost (original cost - residual value) is allocated overtime

• Cost - you can have changes to cost when having capital expenditures

Depreciation Methods

• In determining how much of an asset's cost to allocate to each year, a company should  choose a depreciation method that corresponds to the pattern of benefits received from  using the asset

• Three common methods

o Straight line

o Declining balance

o Activity based

Straight-Line Depreciation

Depreciation expense = (asset's cost - residual value)/service life  

Partial-Year Depreciation

• What if the delivery truck was purchased during the year, say on March 1, and then used  for 5 years? (annual depreciation = 7000)

• Depreciate for portion of the year held:

o Year 1 = (10/12)*7000 = 5833

o Years 2 - 5 = 7000*4 = 28000  

o Year 6 = (2/12)*7000 = 1167

▪ Total depreciation over life: 5833+28000+1167 = 35000  

Steps for Change in Estimate:

1. Calculate the book value

2. Use book value as "cost" and depreciate over remaining useful life

• Use it as the cost in the depreciation calculation

Steps for Capital Expenditure:

1. Calculate book value

2. Add capital expenditure to book value

3. Use book value + capital expenditure as the cost and depreciate over remaining useful life 4.

Double Declining Balance

• Depreciation will be higher in earlier years and lower in ending years

• All depreciation methods will result in the same amount of total depreciation Book Value * 2 / useful life

• Using book value (not depreciable cost)

• Must be careful our book value doesn’t fall below residual value each year, or we have  recorded too much depreciation

Activity-Based Depreciation

Depreciation rate per unit = (asset’s cost – residual value) / total units expected to be produced

Depreciation rate = This rate * activity measured per year

o This gives you the depreciation expense

• Subtract each of these rate from the cost to get the book value

Under each method, the total depreciation is the same under each method

• How those allocations for each one differs

• Straight line is the straight line method

• Decreasing is the double declining balance

• Variation is the activity based

Tax Depreciation

• Accelerated methods reduce taxable income more in the earlier years of an asset's life.

o High depreciation means lower taxes

• Most companies use

o Straight line for financial reporting

o Accelerated for tax reporting

▪ Called MACRS (Modified Accelerated Cost Recovery System)

• Accelerated method used for tax purposes

• Straight line = (cost - residual) / useful

• Double declining = book value*2 / useful life

o You must check that book value does not drop below residual value

• Activity based = Depreciation rate per unit = (cost - residual value) / useful life in units

• Partial year depreciation must be used for the first year of the asset's life if purchased on a  date other than January 1 and the last year of the asset's life if sold on a date other than  

December 31 (for a calendar year company)

• Partial year depreciation = depreciation for full year * # months / 12

• Steps when there is a change in useful life / residual value of an asset

o Calculate book value on the date of change

o Depreciate this book value over the remaining useful life

• Steps when there is a capital expenditure

o Calculate book value on the date change

o Add the capital expenditure to the book value

o Depreciate this book value + capital expenditure over remaining useful life

Amortization of intangible assets

• Allocating the cost of most tangible assets to expense is called depreciation

• Allocating the cost of intangible assets to expense is called amortization

• Most intangible assets have a finite useful life that can be estimated

• Most companies use straight line amortization for intangibles

Amorization Expense xx

Intangible Asset xx

Intangible Assets

Subject to Amorization (those with useful life)

Intangible Assets

Not subject to Amorization (those with indefinite useful life)

Patents

Copyright

Trademarks (with finite life)

Franchises

Goodwill

Trademarks (with infinite life)

Amortization is a process similar to depreciation in which we allocate the cost of intangible assets over  their estimated service lives. Intangible assets with an indefinite useful life (goodwill and most  trademarks) are not amortized

Sale

Retirement

Exchange

Most common method to dispose  of long-term asset

Occurs when a long-term asset it no  longer useful but cannot be sold

Occurs when two companies  trade long-term assets

Sale for Gain 

Cash xx

Accumulated depreciation xx

Equipment xx

 Gain xx

Sold for Loss 

Cash xx

Accumulated depreciation xx

Loss xx

Equipment xx

Retired 

Accumulated depreciation xx

Loss xx

Equipment xx

- When selling in first year, the lower book value gives highest gain

The double declining balance would result in the most depreciation in the first year, which results in  lowest book value. Assuming that the asset is used uniformly, approximately the same amount of  depreciation would be recorded each year of the asset's life under the straight line or activity based  method

Exchanged 

Equipment (new) xx

Accumulated depreciation xx

{Loss xx}

Cash xx

Equipment xx

{Gain xx}

Gain/loss on exchange of old asset = FMV old asset - book value of old asset

If we dispose of an asset for more than its book value, we record a gain. If we dispose of an asset for less than its book value, we record a loss.

- Procedures for selling a plant asset

• Record depreciation up to the date of sale (partial year depreciation)

• Record disposal

• Remove the asset and associated accumulated depreciation from the books

• Record how the asset was paid for (cash or notes receivable)

• Record a gain or loss on sale if needed (amount received - book value of asset)

o Exchange of plant asset

▪ Cost of new asset = FMV old asset + any cash paid (or notes  

payable) OR FMV of new asset

▪ Gain or loss on exchange = FMV old asset - Book Value old  

asset

Return on Assets

• Indicates the amount of net income generated for each dollar invested in assets Return on assets = net income / average total assets

• Income statement account vs. balance sheet account

o Thus, you must collect the average amount since the balance sheet is for a  specific period on time

• A company might have a larger net income and net sales, but the return on assets might  be lower compared to another company

Components of Return on Assets

Return on assets = profit margin x asset turnover

 Net income = Net Income x Net Sales 

Average total asset Net Sales Average total assets • Profit margin: indicates the earnings per dollar of sales

• Asset turnover = measures the sales per dollar of assets invested

Impairment

Step 1: Test for Impairment

• Assets are impaired when the estimated future cash flows are less than the book value If it isn't impaired, no further steps are needed

Step 2: If Impaired, record impairment loss  

• Loss = book value - FMV value

o Write asset down to FMV

Journal Entry 

Loss xx

Asset xx

Appendix D 

Why Companies Invest in Other Companies 

1. To receive dividends, earn interest, and gain from the increase in the value of their  investment

2. To temporarily invest excess cash created by operating in seasonal industries 3. To build strategic alliances, increase market share, or enter new industries • Companies raise revenue with additional activities: Issuing activity securities (common  stock and preferred stock) or debt securities (bonds, notes)

o Purchased by investors, mutual funds, and other companies

Debt securities and earning interest revenue has nothing to do with equity investments • If you own less than 20% of voting shares, you have insignificant influence, so you use fair  value method

• If you own less than 50% but more than 20%, you have significant influence, so you use  the equity method

• If you own more than 50%, you have controlling influence, so you use consolidated  financial statements

Equity Investments with Insignificant Influence

• Often indicated by ownership of less than 20% of the voting stock

• Use the fair value method

o Securities are reported as assets in the balance sheet at their fair value.  

They are classified as current or long-term depending on the length of time  

management intends to hold them

▪ If you intend to turn that investment into cash within the  

operating cycle or one year, it would be current.

▪ If you intend to hold it longer than one year or one operating  

cycle, it would be long-term

o Changes in fair value from one period to the next are reported as gains and  losses in the income statement

▪ At the end of the period, we will adjust to the current market  

value

The critical events over the life of an equity investment in another company, such as shares of common  stock, include the following:

1. Purchasing the equity security

2. Receiving dividends (for some equity services)

3. Holding the investment during periods in which investment's fair value changes  (unrealized holding gains and losses)

4. Selling the investment (realized gains and losses)

Journal Entries

Purchase Stock 

Investment xx

Cash xx

Dividends 

Cash xx

Dividend Revenue xx

Rise/Fall in Stock Price 

Unrealized Holding Loss xx

Investment xx

OR

Investment xx

Unrealized Holding Gain xx

Selling Investment 

Cash xx

{Loss xx}

Investment xx

{Gain xx}

Use the journal entry to determine the gain/loss

• Realized gain/loss = cash received - fair value investment on the last balance sheet date **We report investments at fair value when a company has an insignificant influence over another  company in which it invests, often indicated by an ownership interest of less than 20%. Unrealized  holding gains and losses are included in net income.

Equity Investments with Significant Influence

• When the investor own between 20% to 50% of the common stock, it is presumed that  the investing company exercises significant

• Use the equity method

o Under the equity method, the investor accounts for the investments as if  

the investee is part of the investor company

Journal Entries

Purchase 

Investment xx

Cash xx

Net Income Reported 

Investment xx

Equity income xx

Dividends (Cash) 

Cash xx

Investment xx

**We initially record equity investments at cost. Under the equity method, the balance of the  investments account increases for the investor's share of the investee's net income and decreases for  the investor's share of the investee's cash dividends. Equity income reflects the investor's share of the  investee's net income

Fair value method

Equity method

Investment  

balance

Current market value * number of  shares

Original balance + % investee net income - % dividends received

Investment  

income

Dividends received (+-) unrealized  gains and losses

% investee's net income

Equity Investments with Controlling Influence

• Assumes a controlling influences (> 50% ownership of voting stock)

• Prepare consolidated financial statements

o Used when a company purchases more than 50% of the voting stock

o Combine the parent's subsidiary's financial statements as if the two  

companies were a single reporting company

**Investments involving one company (parent) purchasing more than 50% of the voting stock of another  company (subsidiary) require the parent company to prepare consolidated financial statements. These  statements combine the parent's and subsidiary's financial statement as if the two companies were a  single reporting company.

**Combine everything in the statement (eliminate any inner company accounts) PART B: DEBT INVESTMENTS

LO D-5: Account for investments in debt securities

What Are Bonds?

• Formal debt instrument that obligates the borrower to repay a stated amount, referred to  as the principal or face amount, at a specified maturity date

• The borrower also agrees to pay interest over the life of the bond

• Traditionally, interest on bonds is paid twice a year (semiannually) on designated interest  dates, beginning six months after the original bond issue date

Bond Terminology  

• Face value, maturity value, par value

o All mean the same thing

o Amount paid at the end of the period

• Maturity date

o When maturity value is paid

• Face (stated or coupon) interest rate

o Stated rate of interest

o What is actually paid by the bond

• Market (effective) interest rate

o Rate of interest paid by similar-risk bonds in the market

o It will affect the purchase price

o Will discuss later

• Interest payment dates

o Does this bond pay annually, semiannually, etc.?

Account for Investment in Debt Securities

3 Categories of Investments in Debt Securities 

• Trading - the company intends to hold for less than a year

• Available for sale - the company intends to hold for more than a year, but less than until  maturity  

• Held to maturity - the company intends to hold until maturity

o Fair value method

Held to Maturity Securities

• Reported by amortized cost method

• Interest received semi-annually

• Usually issued in $1,000 denominations

• Prices quotes as a percentage of par value

• Fluctuate with market interest rates

o Market rate > face rate --> discount

▪ Purchase price is less than maturity value

o Market rate < face rate --> premium

▪ Purchase price is more than the maturity value

o Market rate = face rate --> issued at par value

Debt Investments

• The critical events over the life of a debt investment in another company, such as a bond,  include the following:

1. Purchasing the debt security

2. Receiving interest for some debt securities

3. Holding the investment during periods in which the investment's fair value changes  (unrealized holding gains and losses which are only reported for debt investment classified  as trading or available for sale)

• We will kind of skip over part three since we are focused on held to maturity securities

4. Either selling the investment before maturity (realized gains and losses) or receiving  principal payment at maturity

Purchase (put on books at cost)

Investment xx

Cash xx

Interest Entry 

Discount

Par

Premium

Cash xx

Investment xx

Interest revenue xx

Cash xx

Investment xx

Interest Revenue xx

Cash xx

Investment xx

Interest revenue xx

Interest*caring value of interest*  market rate revenue

Interest payment = maturity value * stated rate interest per period

Interest revenue = CV investment (investment income) * market rate interest per period

Discount/premium = plug (whatever you need for debits to equal credits)

Maturity 

Cash xx (maturity value)

Investment xx

Analyze and Report Investments in Held to Maturity Debt Securities

• Initially recorded at cost

• Interest revenue recorded at semiannual interest payment date

• Premium or discount is amortized

o Carrying value (CV) is adjusted towards face value

• Face value received at maturity

**Bond investments are the flip side of bonds payable. Bond investments are long-term assets that earn  interest revenue, while bonds payable are long-term liabilities that incur interest expense • Investment in bonds are recorded at cost

• Bond discount/premium is amortized directly to the long-term investment in bonds account

• Amortization of a discount on a bond increases the amount of interest revenue recorded • Amortization of a premium on a bond investment decreases the amount of interest  revenue recorded

Chapter 8 

Liabilities

• Liabilities have three essential characteristics

o Probable future sacrifices of economics benefits

o Arising from present obligations  

• Recall that assets represent probable future benefits. In contrast, liabilities represent  probable future sacrifices of benefits

• What benefits are sacrificed?

o Most liabilities require the future sacrifice of cash (accounts payable, notes  payable, and salaries payable)

o Deferred revenue is a liability that requires giving up inventory or services

Current versus Long-Term Liabilities

Current

Long-Term

Usually payable within  one year from the  

balance sheet date

Payable in more than  one year from the  

balance sheet date

Operating cycle: the time it takes to produce revenue. If a company has an operating cycle longer than 1  year, its current liabilities are defined by the operating cycle rather than by the length of a year. For  some companies, it takes longer than a year to perform the activities that produce revenue

Notes Payable

• Note signed by a firm promising to repay the amount borrowed plus interest • Interest on notes is calculated as:

o Interest = face value x annual interest rate x fraction of the year

Journal Entry for Notes Payable 

Cash xxx

Notes payable xxx

• Do not include interest at the time the note has been issued

• You may have to adjust for the interest at the end of the year  

Interest expense xx

Interest payable xx

Repayment of note 

Notes payable xx

Interest expense xx

Interest payable xx

Cash xx

Line of Credit & Commercial Paper

Line of Credit: 

• Informal agreement

• Permits a company to borrow up to a prearranged limit

• Recorded similar to notes payable

Commercial Paper: 

• Borrowing from another company rather than a bank

• Sold with maturities ranging from 30 to 270 days

• Interest rate is usually lower than a bank loan

Many short term loans are arranged under an existing line of credit with a bank, or for larger  corporations in the form of commercial paper, a loan from one company to another Accounts Payable

• Amounts owed to suppliers of merchandise or services

• Sometimes called trade accounts payable

• Most accounts payable are current liabilities, but they could be long term liabilities  depending on the due date

Employee Costs

Employer Costs

Federal and state income taxes

• Employer takes it out of the employee paychecks to  pay the taxes

Federal and state unemployment  taxes

Employee portion of Social Security and Medicare (FICA taxes) • Another amount held from employee tax

Employer matching portion of Social  Security and Medicare

Employee contributions for health, dental, disability, and life  insurance

Employer contributions for health,  dental, disability, and life insurance

Employee investments in retirement or savings plans

Employer contributions to  

retirement or savings plans

Employee Costs

• Federal and state income taxes

• FICA taxes

o 7.65% (6.2% + 1.45%)

o Collectively, Social Security and Medicare taxes

• Federal Insurance Contributions Act

- Requires employers to withhold security tax of 6.2% social security tax up to a maximum  base plus 1.45% Medicare tax with no maximum)

▪ This is on income with a base amount of $128,400

• Past the base amount, you will have the  

Medicare tax of 1.45%  

• Employees may have additional amounts withheld from their paychecks for health, dental,  disability, and life insurance

• Employees may also have amounts deducted for retirement or employee savings plans Employer Costs

• Additional (matching) FICA tax on behalf of the employee

• Employers also have federal and state unemployment taxes on behalf of employees o FUTA and SUTA

• Fringe benefits: additional employee benefits paid for by the employer

o Health, dental, and life insurance

o Contributions to retirement or savings plans

Record employee salary expense and withholdings

Salaries expense xx

Income tax payable xx

FICA tax payable xx

Salaries payable (to balance) xx

• Could have been cash instead of salaries payable

Record employer-provided fringe benefits 

Salaries expense xx

Accounts payable (to Blue Cross) xx

Accounts payable (to Fidelity) xx

Record employer payroll taxes 

Payroll tax expense xx

FICA tax payable

Unemployment tax payable

Salary Expense = the sum of all of these salary expenses

**Employee salaries are reduced by withholdings for federal and state income taxes, FICA taxes, and the  employee portion of insurance and retirement contributions. The employer, too, incurs additional  payroll expenses for unemployment taxes, the employer portion of FICA taxes, and employer insurance  and retirement contributions

Other current liabilities

• Deferred revenue: liability account used to record cash received in advance of the sale or  service

• Sales tax payable: sales taxes collected from customers by the seller

• Current portion of long-term debt: debt that will be paid within the next year When a company receives cash in advance, it debits cash and credits deferred revenue Sales Tax Payable

• In some states, companies are required to collect sales tax when selling goods or services  and then remitting those back to the state or local government

• The collection of cash from the customer creates a liability for the company • Assume you buy lunch in the airport for $15 plus 10% sales tax. The airport restaurant  records the journal entry below:

Cash 16.50

Sales revenue 15

Sales tax payable 1.50

Sales tax payable = revenue * sales tax percentage

**Sales tax collected from customers by the seller are not an expense. They actually represent current  liabilities payable to the government

Current Portion of Long-Term Debt

• Debt that will be paid within the next year

• For example, a 20-year mortgage is split and reported as the portions that are due 1. Within the next year (current liability)

2. After the next year (long-term liability)

• Long-term obligations are reclassified and reported as current liabilities when they become payable within the upcoming year

• For example, a note payable that matures in 10 years is reported as a long term liability  for the first 9 years, but as a current liability in the 10th year

Example: Jan 1, 2020, you borrow $100,000 for 10 years. Pay $10,000 each Dec. 31st

December 31, 2020

Paid: 10,000

Current: 10,000

Long-term: 80,000

December 31, 2021

Paid: 10,000

Current: 10,000

Long-term: 70,000

December 31, 2022

Paid: 10,000

Current: 10,000

Long-term: 60,000

****Pay attention to this chart, use for exam purposes. Most people get these questions wrong!!

Contingent Liability

• An existing uncertain situation that might return in a loss depending on the outcome of a  future event

Criteria for Reporting a Contingent Liability

• The likelihood of payment is

A. Probable (likely to occur)

B. Reasonably possible (more than remote but less than probable)

C. Remote (the chance is slight)

• The amount of payment is

A. Reasonably estimable

B. Not reasonably estimable

• A contingent liability is recorded only if

o A loss is probable AND the amount is reasonably estimable

Record (Accrue) - loss is probable and can be estimated

Disclose - loss is possible or probable but cannot estimate

Do nothing - loss is remote

Contingent Gains

• An existing uncertain situation that might result in a gain

• In a lawsuit, the defendant faces a contingent liability, while the other side (the plaintiff)  has a contingent gain

• Contingent gains are not recorded until gain is certain

o Example of conservatism

Warranty expense = sales * percent of warranty costs in sales

Adjustment to record warranty expense 

Warranty expense xx

Warranty liability xx

Warranty Payments 

Warranty liability xx

Cash xx

**Notice with bad debts, we are only using credit sales. However, we are using total sales for warranty  because every sale comes with a warranty

Liquidity Analysis

• Liquidity: refers to having sufficient cash or other current assets to pay current maturing  debts

• Lack of liquidity can result in financial difficulties or even bankruptcy

Working Capital

• Working capital = current assets - current liabilities

• Measure of current assets remaining after paying current liabilities

• A large positive working capital is an indicator of liquidity  

• Not the best measure of liquidity for comparing across companies because the ratio does  not control for the relative size of each company

Current Ratio

• Current ratio = current assets / current liabilities

o The amount of current assets available for every dollar of current liabilities

• The higher the current ratio, the greater the company's liquidity

• A current ratio of say, 1.5, indicates that for every dollar of current liabilities, the company  has $1.50 of current assets

Acid-Test Ratio

Acid test ratio = (cash + current investments + accounts receivable) / current liabilities • The amount of quick assets available for every dollar of current liabilities

• Quick assets are current assets more readily convertible to cash

o Exclude current assets such as inventory and prepaid rent

• By excluding less liquid current assets, the acid-test ratio may provide a better overall  indication of a company's liquidity

**Remember: working capital doesn't adjust for size, current ratios (including all of our current assets)  might not be able to readily be used to pay our current liabilities.

• Quick ratio is the best measure

Changes that increase the ratio

Changes that decrease the ratio

Current ratio

Increase in current assets

Decrease in current liabilities

Decrease in current assets

Increase in current liabilities

Acid-test ratio

Increase in quick assets

Decrease in current liabilities

Decrease in quick assets

Increase in current liabilities

Liquidity Management

• Management can influence the ratios that measure liquidity to some extent • Example: a company can influence the timing of inventory and accounts payable  recognition by asking suppliers to delay delivery schedules from December to January.  This would reduce the balances in inventory and accounts payable, thus changing the  current ratio

Example of Liquidity Management

• Expected End of Period Current Ratio

o 5 million / 4 million = 1.25

• Company decides to delay receipt of 1 million in goods until the following period • Current assets and current liabilities are now 1 million lower

• New current ratio = 4 / 3 = 1.33

Note: the ratio changes, it does not stay the same

 

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