1 Chapter9 Inventory and Cost Inventory/Merchandise Inventory = Goods that are hold in stock (Classification as Current Assets) For merchandiser or inventory firm, inventory is the goods which purchased and held in condition to resale. Source = Beginning inventory + Net purchase Ending inventory For manufacturer inventory is consisted of raw materials, work in process and finished goods that were produced with the aim for sales. Source = Beginning finished goods + Cost of goods manufactured Ending, finished goods Raw materials 1. Direct materials 2. Indirect materials Direct labor, Manufacturing overhead Cost of goods sold(manufacturing) = Beginning, finished goods + Cost of goods manufactured Ending, finished goods Cost of goods manufactured Manufacturing cost (Direct materials + Direct labor + Manufacturing overhead) + Beginning, work in process - Ending, work in process * Direct materials = Beginning, raw materials + Purchased Ending, raw materials Indirect material
2 Manufacturer Schedule of cost of goods manufactured For, 20xx Direct materials : Raw materials, beginning Add : Raw materials purchased Total material available for used Less : Raw materials, ending Less : Indirect material Direct material used Direct labor Manufacturing overhead Total manufacturing cost Add : Work in process, beginning Total work in process Less : Work in process, ending Cost of goods manufactured Inventory valuation Gross profit rate = (Gross profit / Sales) x 100
4 Inventory valuation 1. Specific identification 2. FIFO 3. Average cost = Total cost / Total unit Lower of cost or market Ceiling = Sales price Selling expense Floor = Sales price Selling expense Normal Profit = Ceiling Normal profit Reported adjustment 1. Direct method 2. Allowance method Loss from decline in value of inventory (Dr) Inventory/Allowance for decline in value of inventory (Cr)
5 Chapter 10 Property, Plant, and Equipment and Intangible Assets Property, plant, and equipment Assets of a durable nature used in the regular operations of a business. Also called fixed assets and plant assets. Plant assets Assets of a durable nature used in the regular operations of a business. Also called property, plant, and equipment and fixed assets. Fixed Assets Assets of a durable nature used in the regular operations of a business. Also called property, plant, and equipment and plant assets. The major characteristics of property, plant, and equipment are as follows. 1. They Are Acquired for Use in Operations and Not for Resale. Only assets used in normal business operations are classified as property, plant, and equipment. For example, an idle building is more appropriately classified separately as an investment. Land developers or subdividers classify land as inventory. 2. They Are Long-term in Nature and Usually Depreciated. Property, plant, and equipment yield services over a number of years. Companies allocate the cost of the investment in these assets to future periods through periodic depreciation charges. The exception is land, which is depreciated only if a material decrease in value occurs, such as a loss in fertility of agricultural land because of poor crop rotation, drought, or soil erosion. 3. They Possess Physical Substance. Property, plant, and equipment are tangible assets characterized by physical existence or substance. This differentiates them from intangible assets, such as patents or goodwill. Unlike raw material, however, property, plant, and equipment do not physically become part of a product held for resale. Historical cost The cash or cash equivalent price of obtaining an asset and bringing it to the location and condition necessary for its intended use. Most companies use historical cost as the basis for valuing property, plant,
6 and equipment. Historical cost typically includes the purchase price, freight costs, sales taxes, installation costs, and any related costs incurred after the asset's acquisition (such as additions or improvements) if they provide future service potential. Historical cost is allocated to future periods through depreciation. Write-ups Subsequent to acquisition, companies should not write up property, plant, and equipment to reflect fair value when it is above cost. The main reasons for this position are as follows. 1. Historical cost involves actual, not hypothetical, transactions and so is the most reliable. 2. Companies should not anticipate gains and losses but should recognize gains and losses only when the asset is sold. Write-downs if the fair value of the property, plant, and equipment is less than its carrying amount, the asset may be written down. These situations occur when the asset is impaired (discussed in Chapter 11) and in situations where the asset is being held for sale. A long-lived asset classified as held for sale should be measured at the lower of its carrying amount or fair value less cost to sell. In that case, a reasonable valuation for the asset can be obtained, based on the sales price. A long-lived asset is not depreciated if it is classified as held for sale. This is because such assets are not being used to generate revenues. Cost of Land All expenditures made to acquire land and ready it for use are considered part of the land cost. Thus, when Wal-Mart or Home Depot purchases land on which to build a new store, its land costs typically include (1) the purchase price; (2) closing costs, such as title to the land, attorney's fees, and recording fees; (3) costs incurred in getting the land in condition for its intended use, such as grading, filling, draining, and clearing; (4) assumption of any liens, mortgages, or encumbrances on the property; and (5) any additional land improvements that have an indefinite life. Cost of Buildings The cost of buildings should include all expenditures related directly to their acquisition or construction. These costs include (1) materials,
7 labor, and overhead costs incurred during construction, and (2) professional fees and building permits. Generally, companies contract others to construct their buildings. Companies consider all costs incurred, from excavation to completion, as part of the building costs. But how should companies account for an old building that is on the site of a newly proposed building? Is the cost of removal of the old building a cost of the land or a cost of the new building? Recall that if a company purchases land with an old building on it, then the cost of demolition less its salvage value is a cost of getting the land ready for its intended use and relates to the land rather than to the new building. In other words, all costs of getting an asset ready for its intended use are costs of that asset. Cost of Equipment The term "equipment" in accounting includes delivery equipment, office equipment, machinery, furniture and fixtures, furnishings, factory equipment, and similar fixed assets. The cost of such assets includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special foundations if required, assembling and installation costs, and costs of conducting trial runs. Costs thus include all expenditures incurred in acquiring the equipment and preparing it for use. Self-constructed asset An asset that a company constructs on its own. Without a purchase price or contract price, the company must allocate costs and expenses to arrive at the cost of the self-constructed asset. Materials and direct labor used in construction come directly from work and material orders related to the asset. To account for indirect overhead costs for the constructed asset, the company assigns a portion of all overhead to the construction process. Indirect costs Indirect costs - Also called overhead or administrative costs, these are expenses not directly related to the event. They can include power, heat, light, insurance, property taxes on factory buildings and equipment, factory supervisory labor, depreciation of fixed assets, and supplies.
8 Handling Indirect Costs Companies can handle indirect costs in one of two ways: 1. Assign No Fixed Overhead to the Cost of the Constructed Asset. The major argument for this treatment is that indirect overhead is generally fixed in nature; it does not increase as a result of constructing one's own plant or equipment. This approach assumes that the company will have the same costs regardless of whether it constructs the asset or not. Therefore, to charge a portion of the overhead costs to the equipment will normally reduce current expenses and consequently overstate income of the current period. However, the company would assign to the cost of the constructed asset variable overhead costs that increase as a result of the construction. 2. Assign a Portion of All Overhead to the Construction Process. This approach, called a full-costing approach, is appropriate if one believes that costs attach to all products and assets manufactured or constructed. Under this approach, a company assigns a portion of all overhead to the construction process, as it would to normal production. Advocates say that failure to allocate overhead costs understates the initial cost of the asset and results in an inaccurate future allocation. - Companies should assign to the asset a pro rata portion of the fixed overhead to determine its cost. Companies use this treatment extensively because many believe that it results in a better matching of costs with revenues. If the allocated overhead results in recording construction costs in excess of the costs that an outside independent producer would charge, the company should record the excess overhead as a period loss rather than capitalize it. This avoids capitalizing the asset at more than its probable fair value. Interest Costs During Construction The proper accounting for interest costs has been a long-standing controversy. Three approaches have been suggested to account for the interest incurred in financing the construction of property, plant, and equipment: 1. Capitalize No Interest Charges During Construction. Under this
9 approach, interest is considered a cost of financing and not a cost of construction. Some contend that if a company had used stock (equity) financing rather than debt, it would not incur this cost. The major argument against this approach is that the use of cash, whatever its source, has an associated implicit interest cost, which should not be ignored. 2. Charge Construction With All Costs of Funds Employed, Whether Identifiable or Not. This method maintains that the cost of construction should include the cost of financing, whether by cash, debt, or stock. Its advocates say that all costs necessary to get an asset ready for its intended use, including interest, are part of the asset's cost. Interest, whether actual or imputed, is a cost, just as are labor and materials. A major criticism of this approach is that imputing the cost of equity capital (stock) is subjective and outside the framework of a historical cost system. 3. Capitalize Only the Actual Interest Costs Incurred During Construction. This approach agrees in part with the logic of the second approach that interest is just as much a cost as are labor and materials. But this approach capitalizes only interest costs incurred through debt financing. (That is, it does not try to determine the cost of equity financing.) Under this approach, a company that uses debt financing will have an asset of higher cost than a company that uses stock financing. Some consider this approach unsatisfactory because they believe the cost of an asset should be the same whether it is financed with cash, debt, or equity. Interest Costs During Construction The proper accounting for interest costs has been a long-standing controversy. Three approaches have been suggested to account for the interest incurred in financing the construction of property, plant, and equipment: 1. Capitalize No Interest Charges During Construction. 2. Charge Construction With All Costs of Funds Employed, Whether Identifiable or Not. 3. Capitalize Only the Actual Interest Costs Incurred During Construction. GAAP requires the third approach capitalizing actual interest (with modification). This method follows the concept that the historical
10 cost of acquiring an asset includes all costs (including interest) incurred to bring the asset to the condition and location necessary for its intended use. The rationale for this approach is that during construction, the asset is not generating revenues. Therefore, a company should defer (capitalize) interest costs.  Once construction is complete, the asset is ready for its intended use and a company can earn revenues. At this point the company should report interest as an expense and match it to these revenues. It follows that the company should expense any interest cost incurred in purchasing an asset that is ready for its intended use. Interest Costs During Construction Underlying Concepts The objective of capitalizing interest is to obtain a measure of acquisition cost that reflects a company's total investment in the asset and to charge that cost to future periods benefited. Capitalizing actual interest (with modification) To implement this general approach, companies consider three items: 1. Qualifying assets. 2. Capitalization period. 3. Amount to capitalize. Qualifying Assets To qualify for interest capitalization, assets must require a period of time to get them ready for their intended use. A company capitalizes interest costs starting with the first expenditure related to the asset. Capitalization continues until the company substantially readies the asset for its intended use. Assets that qualify for interest cost capitalization include assets under construction for a company's own use (including buildings, plants, and large machinery) and assets intended for sale or lease that are constructed or otherwise produced as discrete projects (e.g., ships or real estate developments). NOT Qualifying Assets
11 Examples of assets that do not qualify for interest capitalization are (1) assets that are in use or ready for their intended use, and (2) assets that the company does not use in its earnings activities and that are not undergoing the activities necessary to get them ready for use. Examples of this second type include land remaining undeveloped and assets not used because of obsolescence, excess capacity, or need for repair. Capitalization period The period of time during which a company must capitalize interest. The period lasts for as long as three conditions are present: expenditures for the asset have been made, activities needed to prepare the asset for its intended use are in progress, and interest cost is being incurred. The capitalization period is the period of time during which a company must capitalize interest. It begins with the presence of three conditions: 1. Expenditures for the asset have been made. 2. Activities that are necessary to get the asset ready for its intended use are in progress. 3. Interest cost is being incurred. - Interest capitalization continues as long as these three conditions are present. The capitalization period ends when the asset is substantially complete and ready for its intended use. Avoidable interest The amount of interest cost in a period that a company could theoretically avoid if it had not made expenditures for an asset. When a company capitalizes interest expense, the amount of interest to capitalize is limited to the lower of actual interest cost incurred during the period or the amount of avoidable interest. Amount to Capitalize - The amount of interest to capitalize is limited to the lower of actual interest cost incurred during the period or avoidable interest. - In no situation should interest cost include a cost of capital charge for stockholders' equity. Furthermore, GAAP requires interest capitalization for a qualifying asset only if its effect, compared with
12 the effect of expensing interest, is material. - To apply the avoidable interest concept, a company determines the potential amount of interest that it may capitalize during an accounting period by multiplying the interest rate(s) by the weighted-average accumulated expenditures for qualifying assets during the period. Weighted-average accumulated expenditures A measure used in determining the amount of interest that can be capitalized. Computed by weighting construction expenditures by the amount of time (e.g., fraction of a year) that a company can incur interest cost on the expenditure. Weighted-average accumulated expenditures calculation To compute the weighted-average accumulated expenditures, a company weights the expenditures by the amount of time that it can incur interest cost on each one. For the March 1 expenditure, the company associates 10 months' interest cost with the expenditure. For the expenditure on July 1, it incurs only 6 months' interest costs. For the expenditure made on November 1, the company incurs only 2 months of interest cost. Interest Rates. Companies follow these principles in selecting the appropriate interest rates to be applied to the weighted-average accumulated expenditures: 1. For the portion of weighted-average accumulated expenditures that is less than or equal to any amounts borrowed specifically to finance construction of the assets, use the interest rate incurred on the specific borrowings. 2. For the portion of weighted-average accumulated expenditures that is greater than any debt incurred specifically to finance construction of the assets, use a weighted average of interest rates incurred on all other outstanding debt during the period. Weighted average interest rate Weighted average interest rate = Total interest / Total principal
13 Avoidable interest Avoidable interest = Weighted-average accumulated expenditures * Interest rate Special Issues Related to Interest Capitalization Two issues related to interest capitalization merit special attention: 1. Expenditures for land. 2. Interest revenue. Expenditures for Land. When a company purchases land with the intention of developing it for a particular use, interest costs associated with those expenditures qualify for interest capitalization. If it purchases land as a site for a structure (such as a plant site), interest costs capitalized during the period of construction are part of the cost of the plant, not the land. Conversely, if the company develops land for lot sales, it includes any capitalized interest cost as part of the acquisition cost of the developed land. However, it should not capitalize interest costs involved in purchasing land held for speculation because the asset is ready for its intended u Interest Revenue. Companies frequently borrow money to finance construction of assets. They temporarily invest the excess borrowed funds in interest-bearing securities until they need the funds to pay for construction. During the early stages of construction, interest revenue earned may exceed the interest cost incurred on the borrowed funds. - In general, companies should not net or offset interest revenue against interest cost. Temporary or short-term investment decisions are not related to the interest incurred as part of the acquisition cost of assets. Therefore, companies should capitalize the interest incurred on qualifying assets whether or not they temporarily invest excess funds in short-term securities. Some criticize this approach because a company can defer the interest cost but report the interest revenue in the current period.
14 Valuation of Property, Plant, and Equipment Like other assets, companies should record property, plant, and equipment at the fair value of what they give up or at the fair value of the asset received, whichever is more clearly evident. However, the process of asset acquisition sometimes obscures fair value. For example, if a company buys land and buildings together for one price, how does it determine separate values for the land and buildings? We examine these types of accounting problems in the following sections. Cash Discounts price reductions given to buyers for prompt payment or cash payment Impute attribute (responsibility or fault) to a cause or source Lump-sum price A single amount paid for a group of plant assets. To determine the cost for the individual assets acquired in a lump-sum purchase, the company allocates the total cost among the various assets on the basis of their relative fair values. Issuance of Stock When companies acquire property by issuing securities, such as common stock, the par or stated value of such stock fails to properly measure the property cost. If trading of the stock is active, the market price of the stock issued is a fair indication of the cost of the property acquired. The stock is a good measure of the current cash equivalent price. - If the company cannot determine the market price of the common stock exchanged, it establishes the fair value of the property. It then uses the value of the property as the basis for recording the asset and issuance of the common stock. Exchanges of Nonmonetary Assets Ordinarily companies account for the exchange of nonmonetary assets on the basis of the fair value of the asset given up or the fair
15 value of the asset received, whichever is clearly more evident.  Thus, companies should recognize immediately any gains or losses on the exchange. The rationale for immediate recognition is that most transactions have commercial substance, and therefore gains and losses should be recognized. Nonmonetary assets Fixed assets such as property, plant, and equipment. Ordinarily, companies account for the exchange of nonmonetary assets by recognizing immediately any gains or losses on the exchange, using the fair value of the asset given up or the fair value of the asset received, whichever is clearly more evident. The accounting for exchanges of nonmonetary assets with a gain involves assessing whether the transaction has commercial substance. Commercial substance In accounting for exchanges of nonmonetary assets, the basis for measuring the gain or loss on an exchange. If the future cash flows change (if the two parties' economic positions change) as a result of the transaction, the transaction is said to have commercial substance, and the parties to the exchange recognize a gain or loss on the exchange. Commercial substance Companies immediately recognize losses they incur on all exchanges. The accounting for gains depends on whether the exchange has commercial substance. If the exchange has commercial substance, the company recognizes the gain immediately. However, the profession modifies the rule for immediate recognition of a gain when an exchange lacks commercial substance: If the company receives no cash in such an exchange, it defers recognition of a gain. If the company receives cash in such an exchange, it recognizes part of the gain immediately. Exchanges loss Situation When a company exchanges nonmonetary assets and a loss results, the company recognizes the loss immediately. The rationale: Companies should not value assets at more than their cash
16 equivalent price; if the loss were deferred, assets would be overstated. Therefore, companies recognize a loss immediately whether the exchange has commercial substance or not. Exchanges gain Situation Now let's consider the situation in which a nonmonetary exchange has commercial substance and a gain is realized. In such a case, a company usually records the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset at the fair value of the asset given up, and immediately recognizes a gain. The company should use the fair value of the asset received only if it is more clearly evident than the fair value of the asset given up. Gain on disposal Gain (credit) if proceeds of sale exceed net book value; loss on disposal if proceeds of sale are less than the net book value Lacks Commercial Substance some Cash Received. When a company receives cash (sometimes referred to as "boot") in an exchange that lacks commercial substance, it may immediately recognize a portion of the gain. -The portion of the gain a company recognizes is the ratio of monetary assets (cash in this case) to the total consideration received. Lacks Commercial Substance some Cash Received. (calculation) Recognized gain = Cash Received (boot) / (Cash received + Fair Value of other Asset Received) Total gain = Fair value of machine exchanged - Book value of machine exchanged Rationale for the treatment of a partial gain The rationale for the treatment of a partial gain is as follows: Before a nonmonetary exchange that includes some cash, a company has an unrecognized gain, which is the difference between the book value and the fair value of the old asset. When the exchange occurs, a
17 portion of the fair value is converted to a more liquid asset. The ratio of this liquid asset to the total consideration received is the portion of the total gain that the company realizes. Thus, the company recognizes and records that amount. Nonreciprocal transfers Contributions (donations or gifts of cash, securities, land, buildings, or use of facilities) that transfer assets in only one direction. Companies that receive contributions should record the transferred asset at its fair value. In general, companies should recognize contributions as revenue in the period received. Accounting for Contributions The FASB's position is that in general, companies should recognize contributions received as revenues in the period received. When a company contributes a nonmonetary asset, it should record the amount of the donation as an expense at the fair value of the donated asset. If a difference exists between the fair value of the asset and its book value, the company should recognize a gain or loss. Other Asset Valuation Methods The exception to the historical cost principle for assets acquired through donation is based on fair value. Another exception is the prudent cost concept. This concept states that if for some reason a company ignorantly paid too much for an asset originally, it is theoretically preferable to charge a loss immediately. For example, assume that a company constructs an asset at a cost much greater than its present economic usefulness. It would be appropriate to charge these excess costs as a loss to the current period, rather than capitalize them as part of the cost of the asset. In practice, the need to use the prudent cost approach seldom develops. Companies typically either use good reasoning in paying a given price or fail to recognize that they have overpaid. What happens, on the other hand, if a company makes a bargain purchase or internally constructs a piece of equipment at a cost savings? Such savings should not result in immediate recognition of a gain under any circumstances.
18 Costs Subsequent to Acquisition After installing plant assets and readying them for use, a company incurs additional costs that range from ordinary repairs to significant additions. The major problem is allocating these costs to the proper time periods. In general, costs incurred to achieve greater future benefits should be capitalized, whereas expenditures that simply maintain a given level of services should be expensed. Capitalizing Costs Subsequent to Acquisition In order to capitalize costs, one of three conditions must be present: 1. The useful life of the asset must be increased. 2. The quantity of units produced from the asset must be increased. 3. The quality of the units produced must be enhanced. Capital expenditure Expenditure whose purpose is to create a new asset or to increase an asset's future benefits. Such expenditures are to be capitalized, rather than expensed. Revenue expenditure (expense) Expenditure whose purpose is to maintain a given level of services (or revenues generated from these expenditures). Ordinary repairs are an example. Revenue expenditures are expensed in the period in which they take place. MAJOR TYPES OF EXPENDITURES: - Additions - Improvements and Replacements Additions Increase or extension of existing assets, such as adding a wing to a hospital. Companies capitalize any addition to plant assets because a new asset is created. Improvements and Replacements - Improvement (betterments) The substitution of a better asset for the one currently used (say, a
19 concrete floor in a factory for a wooden floor). If the expenditure for an improvement increases future service potential of an asset, the company capitalizes the cost of the improvement. - Replacements The substitution of a similar asset for an existing asset (e.g., a new wooden floor for an old wooden floor). If the expenditure for the replacement increases the service potential, a company should capitalize the cost of the replacement. Improvements and Replacements Many times improvements and replacements result from a general policy to modernize or rehabilitate an older building or piece of equipment. The problem is differentiating these types of expenditures from normal repairs. Does the expenditure increase the future service potential of the asset? Or does it merely maintain the existing level of service? Frequently, the answer is not clear-cut. Good judgment is required to correctly classify these expenditures. If the expenditure increases the future service potential of the asset, a company should capitalize it. The accounting is therefore handled in one of three ways, depending on the circumstances: 1. Use the Substitution Approach. 2. Capitalize the New Cost. 3. Charge to Accumulated Depreciation. Use the Substitution Approach. Conceptually, the substitution approach is correct if the carrying amount of the old asset is available. It is then a simple matter to remove the cost of the old asset and replace it with the cost of the new asset. Capitalize the New Cost. Another approach capitalizes the improvement and keeps the carrying amount of the old asset on the books. The justification for this approach is that the item is sufficiently depreciated to reduce its carrying amount almost to zero. Although this assumption may not always be true, the differences are often insignificant. Companies usually handle improvements in this manner.
20 Charge to Accumulated Depreciation. In cases when a company does not improve the quantity or quality of the asset itself, but instead extends its useful life, the company debits the expenditure to Accumulated Depreciation rather than to an asset account. The theory behind this approach is that the replacement extends the useful life of the asset and thereby recaptures some or all of the past depreciation. The net carrying amount of the asset is the same whether debiting the asset or accumulated depreciation. Rearrangement and reinstallation costs The costs of moving assets from one location to another. Companies incur such costs to benefit future periods. If a company can determine or estimate the original installation cost and the accumulated depreciation to date, it handles the rearrangement and reinstallation cost as a replacement. If not, the company capitalizes the new costs. If these costs are immaterial or if they cannot be separated from other operating expenses, the company should immediately expense them. Ordinary repairs Routine expenditures to maintain plant assets in operating condition. Examples are replacing minor parts, lubricating and adjusting equipment, repainting, and cleaning. Companies treat ordinary repairs as operating expenses and charge these amounts to an expense account in the period incurred Major repairs Significant expenditures, such as an overhaul, whose purpose it to maintain assets in operating condition. Several periods benefit from major repairs, and companies should depreciate the cost of such repairs as they would the costs for an addition, improvement, or replacement. Involuntary conversion The termination of an asset's service as a result of some type of unwanted or unexpected event, such as fire, flood, theft, or
21 condemnation. Companies report the difference between the amount recovered from the involuntary conversion, if any, and the asset's book value as a gain or loss. In rare cases, these gains or losses are reported as extraordinary items in the income statement. GAAP requires "that a gain or loss be recognized when a nonmonetary asset is involuntarily converted to monetary assets even though an enterprise reinvests or is obligated to reinvest the monetary assets in replacement nonmonetary assets." Miscellaneous Problems If a company scraps or abandons an asset without any cash recovery, it recognizes a loss equal to the asset's book value. If scrap value exists, the gain or loss that occurs is the difference between the asset's scrap value and its book value. If an asset still can be used even though it is fully depreciated, it may be kept on the books at historical cost less depreciation. Companies must disclose in notes to the financial statements the amount of fully depreciated assets in service. Describe Property, Plant, and Equipment. The major characteristics of property, plant, and equipment are as follows. (1) They are acquired for use in operations and not for resale. (2) They are long-term in nature and usually subject to depreciation. (3) They possess physical substance. Identify the Costs to Include in Initial Valuation of Property, Plant, and Equipment. The costs included in initial valuation of property, plant, and equipment are as follows. Cost of land: Includes all expenditures made to acquire land and to ready it for use. Land costs typically include (1) the purchase price; (2) closing costs, such as title to the land, attorney's fees, and recording fees; (3) costs incurred in getting the land in condition for its intended use, such as grading, filling, draining, and clearing; (4) assumption of any liens, mortgages, or encumbrances on the property; and (5) any additional land improvements that have an indefinite life. Cost of buildings: Includes all expenditures related directly to their acquisition or construction. These costs include (1) materials, labor,
22 and overhead costs incurred during construction, and (2) professional fees and building permits. Cost of equipment: Includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special foundations if required, assembling and installation costs, and costs of conducting trial runs. Describe the Accounting Problems Associated With Selfconstructed Assets. because companies cannot easily trace these costs directly to work and material orders related to the constructed assets. Companies might handle these costs in one of two ways: (1) Assign no fixed overhead to the cost of the constructed asset, or (2) assign a portion of all overhead to the construction process. Companies use the second method extensively. Describe the Accounting Problems Associated With Interest Capitalization. Only actual interest (with modifications) should be capitalized. The rationale for this approach is that during construction, the asset is not generating revenue and therefore companies should defer (capitalize) interest cost. Once construction is completed, the asset is ready for its intended use and revenues can be earned. Any interest cost incurred in purchasing an asset that is ready for its intended use should be expensed. Understand Accounting Issues Related to Acquiring and Valuing Plant Assets. The following issues relate to acquiring and valuing plant assets: (1) Cash discounts: Whether taken or not, they are generally considered a reduction in the cost of the asset; the real cost of the asset is the cash or cash equivalent price of the asset. (2) Deferred-payment contracts: Companies account for assets purchased on long-term credit contracts at the present value of the consideration exchanged between the contracting parties. (3) Lump-sum purchase: Allocate the total cost among the various assets on the basis of their relative fair values. (4) Issuance of stock: If the stock is actively traded, the market price of the stock issued is a fair indication of the cost of the property acquired. If the market price of the common stock
23 exchanged is not determinable, establish the fair value of the property and use it as the basis for recording the asset and issuance of the common stock. (5) Exchanges of nonmonetary assets. The accounting for exchanges of nonmonetary assets depends on whether the exchange has commercial substance. See Illustrations and for summaries of how to account for exchanges. (6) Contributions: Record at the fair value of the asset received, and credit revenue for the same amount. Describe the Accounting Treatment for the Disposal of Property, Plant, and Equipment. Regardless of the time of disposal, companies take depreciation up to the date of disposition, and then remove all accounts related to the retired asset. Gains or losses on the retirement of plant assets are shown in the income statement along with other items that arise from customary business activities. Gains or losses on involuntary conversions, if unusual and infrequent, may be reported as extraordinary items.
24 Chapter 11 Investment in Noncurrent operating assets Utilization and retirement 1. Use straight-line, accelerated, use-factor, and group depreciation methods to compute annual depreciation Factors Affecting the Periodic Depreciation Charge - Asset cost - Residual or salvage value - Useful life - Pattern of use Recording Periodic Depreciation Depreciation expense xx Accumulated depreciation xx Methods of depreciation 1. Time-factor methods 1.1. Straight-line depreciation. The difference between asset cost and residual value is divided by the useful life of asset. Annual Depreciation Expense = (Cost salvage value)/useful life 1.2. Sum-of-the-Years -Digits Depreciation. The depreciable asset cost is multiplied a fraction; the numerator is the number of years remaining in the asset life as of the beginning of the year, and the denominator is the sum of or the digits from one to the original useful life. Annual Depreciation Expense = (Cost Salvage value) x Remaining year/sum of the years
25 1.3. Declining-Balance Depreciation. The asset book value is multiplied by a constant percentage rate derived from the useful life. The most commonly used percentage is double the straight-line rate. Double-declining rate = (Cost Accumulated depreciation) x 2/Useful life 2. Use-Factor methods 2.1. Service-hours depreciation. Depreciation cost is divided by total expected lifetime service hours to compute a per-hour depreciation rate. The number of service hours in a period multiplied by the rate yields the periodic depreciation charge Productive-output depreciation. This is similar to service-hours depreciation except the rate is based on expected number of output units during the life of the asset. Annual Depreciation Expense = (Cost Salvage value) x Number of used/total unit available 3. Group and Composite Methods. A collection of assets is depreciated as one group. A group rate, derived from an initial analysis of the type of assets in the group, is multiplied by the total cost of group assets to compute periodic depreciation expense. Gains and losses resulting from normal variations in asset lives are not recognized. 2. Apply the productive-output method to the depletion of natural resources. The depletion rate is based on total development cost of the natural resource divided by the estimated amount of resource units to be removed. Periodic depletion expense is the depletion rate multiplied by the number of units removed during the period. Structures and improvements related specifically to removal of the natural resource
26 should be depreciated based on the fraction of natural resources extracted during the period. Depletion model = Productive output depreciation 3. Incorporate changes is estimates and methods into the computation of depreciation for current and future periods. A change in estimate impacts the current and future periods and is not used to adjust amounts reported in prior periods. The undepreciated book value is allocated over the remaining life based in the revised estimates. Changed in depreciation method are accounted for as changes in estimates and are reflected in the current and future periods. Change in estimated useful life Annual Depreciation Expense = (Book value - Salvage)/Remaining useful life 4. Identify whether an asset is impaired, and measure the amount of the impairment loss using both U.S. GAAP and IASB standards Under U.S. GAAP, assets are reviewed for possible impairment whenever there is a significant change in operations or in the way an asset is used. An impaired when the undiscounted sum of future cash flows from the asset is less than the reported book value. IASB standards differ from U.S. GAAP in that the discounted sum of future cash flows rather than the undiscounted sum is used to determine whether an impairment loss exists. International standards also allow for the upward revaluation of long-term operating assets that have increased in value. Accounting for Asset Impairment Guidance on the accounting for asset impairment addresses the following four questions. 1. When should an asset be reviewed for possible impairment?
27 Companies are required to conduct impairment tests whenever there has been a material change in the way an asset is used or in the business environment. 2. When is an asset impaired? Undiscounted sum of estimated future cash flows from an asset is less than the book value of the asset. 3. How should an impairment loss be measured? The difference between the book value of the asset and fair value. 4. What information should be disclosed about an impairment? Description of the impaired asset, reasons for the impairment, a description of the measurement assumptions, and the business segment or segments affected. Book value < Net cash flows = Not impairment Book value > Net cash flows = Impairment Accumulated depreciation Loss on impairment asset Asset xxx xxx xxx
28 Chapter 14 Investment in debt and equity There are three reasons for investment 1. Carry the excess cash until needs 2. Earning from investment s income 3. To meet strategic goals There are two types of investment 1. Debt investment a. Bond investment b. Return on interest c. Maturity 2. Equity investment a. Stock investment b. Return on dividend c. No maturity From the two types of investment, it can be divided in four purposes 1. Trading securities (Debt and Equity) 2. Available for sales securities (Debt and Equity) 3. Held to maturity securities (Debt) 4. Equity method securities (Equity)
29 Invest for securities Purchased of debt securities Date Account title Dr. Cr. Investment in securities Company s name $ Cash Calculate $ 1. Percentage of investment 2. Different between interest at contract and yield Example: Jan 1, 2014 AP company purchased $105,000 7% OK bonds, paying for 103. In addition, AP also paid brokerage fee$470. AP has classified as trading securities Date Account title Dr. Cr. Jan1 Investment in securities OK Company $108, Cash $108,620 Purchase of equity securities Date Account title Dr. Cr. Investment in securities Company s name $ Cash $ Example: Oct 1, 2014 GD Company purchased 4,500 ordinary shares of BB company included brokerage fee of $500. The stock is classified as available for sales securities. Date Account title Dr. Cr. Investment in securities BB Company $225,000 Cash $225,000 Revenue from investment securities Revenue from debt securities Date Account title Dr. Cr.
30 Cash Interest receivable Interest revenue $ Example: Jan1, 2014 $50,000 bonds were purchased under terms of interest 12% semiannually. The transaction for July 1, Dec 31 is Date Account title Dr. Cr. July 1 Cash $3,000 Interest revenue $3,000 Dec31 Interest receivable $3,000 Interest revenue $3,000 $ $ Revenue from equity securities % of holding Method Revenue Less than 20% Trading or Dividend Revenue Available for sales 20%-50% Equity Dividend Revenue from investment More than 50% Equity and Consolidates - Less than 20% holding Date Account title Dr. Cr. Cash $ Dividend revenue $ Example: The 500 stocks are held, entries are required for any cash dividend received. If $2 per share dividend is received by Sand Company The transaction on Dec 31 is
31 Date Account title Dr. Cr. Dec31 Cash $1,000 Dividend revenue $1,000 Between 20%-50% Date Account title Dr. Cr. Cash $ Investment in Investment in $ Income from investment in $ $ Example: LL Company had invested in AA Company in common stock with 40% ownership. At the year ended, LL reported net income at $20,000 and declare cash dividend to 10,000. The transaction on Dec 31 is Date Account title Dr. Cr. Cash $4,000 Investment in AA company $4,000 Investment in AA company Income from investment in AA company $8,000 $8,000 Sales of investment securities Date Account title Dr. Cr. Cash $ Investment in securities-company s $ name Example: GY Company sold 50% trading securities that were invested in PP company with total costs of 5,500 at 3,000 Date Account title Dr. Cr.
32 Cash Investment in securities-pp Company Realized Gain on sales of securities $3,000 $2,750 $250 Valuing and reporting investment The comparing of cost and fair value by investor Example The statement of investment of DD Company on Dec31 Securities Classifications Cost Fair value Unrealized gain(loss) A Trading 50,000 48,000 (2,000) B Trading 20,000 21,000 1,000 C Available for sale 85,000 80,000 (5,000) D Available for sale 90,000 99,000 9, , ,000 3,000 The transaction on Dec31 is Date Account title Dr. Cr. Dec31 Unrealized loss on trading securities Market adjustment Trading securities Market adjustment Available for sales Unrealized increase $1,000 $4,000 $1,000 $4,000
33 CHAPTER 18 EARINING PER SHARE EPS = NET INCOME + COMMON SHARE OUTSTANDING NET INCOME COME FROEM INCOME FROM OPERATION DISCOUNTINUING OPERATION EXTRAORDINARY GAIN/LOSS NET INCOME XXXX XXXX XXXX XXXX COMMON SHARE OUTSTANDING COME FROM COMMON STOCK LESS: TREASURY STOCK COMMON SHARE OUTSTANDING XXXX XXXX XXXX EPS CAN BE CALCULATED 2 WAYS 1. SIMPLE CAPITAL STRUCTURE BASIC FACTOR EFFECT THE CHANGE OF BASIC EPS 1.1 NET INCOME - DIVIDEND P/S (CUMULATIVE) - DIVIDEND P/S (NON-CUMULATIVE) 1.2 WEIGHT AVERAGE C/S OUTSTANDING - PERIOD - ADDITIONAL STOCK - STOCK SPLIT - STOCK DIVIDEND EPS= NET INCOME-DIVIDEND P/S / WEIGHT AVERAGE C/S OUTSTANDING
34 EXAMPLE 1 Jan 1,2010 the company has shares outstanding. The number of share outstanding is the same through of the year. During the year, the company has shares, 6%, $100 par of preferred stock outstanding. However during year 2010, the company did not declare any cash dividend of preferred stock. Net income for the year was $ Compute basic earning per share under the following independent assumptions of preferred stock. Cased 1: Non-cumulative p/s Cased 2: Cumulative p/s Solution - Net income = Dividend p/s per year = 6% of (20000x100) = (but did not declare the year) - Weight average c/s outstanding = Cased 1: Non-cumulative p/s EPS = ( )/50000 = $3 per share Cased 2: Cumulative p/s EPS = ( )/50000 = $0.6 per share 2. COMPLEX CAPITAL STRUCTURE DILUTE FACTOR EFFECT THE CHANGE OF COMPLEX EPS 2.1 NET INCOME - DIVIDEND P/S (CUMULATIVE) & (NON-CUMULATIVE) - INTEREST B/P (AFTER TAXES) 2.2 WEIGHT AVERAGE C/S OUTSTANDING - PERIOD - ADDITIONAL STOCK - STOCK SPLIT - STOCK DIVIDEND - STOCK OPTION
35 - CONVERTED P/S - CONVERTED B/P EPS = NET INCOME-DIVIDEND P/S +/- CHANGE FROM STOCK OPTION AND CONVERTED / WEIGHT AVERAGE C/S OUTSTANDING + STOCK FROM STOCK OPTION AND CONVERTIBLE THERE ARE THREE FACTORS WHICH EFFECT DILUTING OR ANTI- DILUTED. STOCK OPTION - EXERCISE PRICE < STOCK PRICE = DILUTE - EXERCISE PRICE > STOCK PRICE = ANTI-DILUTED CONVERTED P/S TO C/S - DIVIDEND P/S / CONVERTED P/S TO C/S < EPS = DILUTE - DIVIDEND P/S / CONVERTED P/S TO C/S > EPS = ANTI-DILUTE CONVERTED B/P TO C/S - INTEREST AFTER TAXES / CONVERTED B/P TO C/S < EPS = DILUTE - INTEREST AFTER TAXES / CONVERTED B/P TO C/S > EPS = ANTI- DILUTE CASED 1: STOCK OPTION The company had shares common stock outstanding during the year. On Jan.1, the company issued stock option for its employees that allowed them to purchase shares of common share. The exercise price of option stock was $9 per share. There are not other dilute securities. Since the year operation, net income was represented at $ Compute dilute EPS assuming that 1) stock price for the year was $12 and 2) stock price for the year was $6. Instruction: - Compute basic EPS - Determine the short-cut of dilutive securities from above information and classified as dilutive or anti- dilutive. - Compute dilute EPS (2 decimals, if any).
36 Solution Step 1: Find basic earnings per share Net income = , Dividend p/s per year = 0 Weight average c/s outstanding = Basic EPS = ( )/80000 = $1.875 per share Step 2: Short cut Cased 1: Exercise price $9 < Stock price $12 = Dilute Cased 2: Exercise price $9 > Stock price $ 6 = Anti-dilute Step 3: Compute dilutive EPS Cased 1 - $12 stock price Stock option = shares, exercise price = 9 Proceeds from stock option at exercise price = No. of stock reacquired = /12 = shares Incremental c/s outstanding, optional exercise = = 5000 Dilute EPS = ( )/ = $1.154 per share Cased 2 - $6 stock price Stock option = shares, exercise price = 9 Proceeds from stock option at exercise price = No. of stock reacquired = / 6 = shares Incremental c/s outstanding, optional exercise = = (10000) Dilute EPS = ( )/ = $2.143 per share Answer Anti-dilute = $1.875 per share CASED 2: CONVERTED P/S The company had shares c/s outstanding throughout the year operation. On Jan.1, the company has issued 5000 convertible P/S (8% cumulative, $50 par). The company has no other dilute securities. Net income for the year $ Compute diluted
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