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Chapter 07 Review Atef Abuelaish

Accounting for Receivables
Chapter 07 Accounting for Receivables Atef Abuelaish

1) Accounts Receivable Atef Abuelaish

Sales on Credit On July 1, TechCom had a credit sale of $950 to CompStore and a collection of $720 from RDA Electronics from a prior credit sale. To see how accounts receivable from credit sales are recognized in the accounting records, we look at two transactions on July 1 between TechCom and its credit customers—shown on this slide. The first is a credit sale of $950 to CompStore. A credit sale is posted with both a debit to the Accounts Receivable account in the general ledger and a debit to the customer account in the accounts receivable ledger. The second transaction is a collection of $720 from RDA Electronics from a prior credit sale. Cash receipts from a credit customer are posted with a credit to the Accounts Receivable account in the general ledger and flow through to credit the customer account in the accounts receivable ledger. (Posting debits or credits to Accounts Receivable in two separate ledgers does not violate the requirement that debits equal credits. The equality of debits and credits is maintained in the general ledger. The accounts receivable ledger is a supplementary record providing information on each customer.) C1 Atef Abuelaish

Sales on Credit This slide shows the general ledger and the accounts receivable ledger after recording the two July 1 transactions. The general ledger shows the effects of the sale, the collection, and the resulting balance of $3,230. These events are also reflected in the individual customer accounts: RDA Electronics has an ending balance of $280, and CompStore’s ending balance is $2,950. The $3,230 sum of the individual accounts equals the debit balance of the Accounts Receivable account in the general ledger. C1 Atef Abuelaish

Credit Card Sales Advantages of allowing customers to use credit cards: Customers’ credit is evaluated by the credit card issuer. Sales increase by providing purchase options to the customer. Many companies allow their customers to pay for products and services using third-party credit cards such as Visa, MasterCard, or American Express, and debit cards (also called ATM or bank cards). This practice gives customers the ability to make purchases without cash or checks. Once credit is established with a credit card company or bank, the customer does not have to open an account with each store. Customers using these cards can make single monthly payments instead of several payments to different creditors and can defer their payments. Many sellers allow customers to use third-party credit cards and debit cards instead of granting credit directly for several reasons. First, the seller does not have to evaluate each customer’s credit standing or make decisions about who gets credit and how much. Second, the seller avoids the risk of extending credit to customers who cannot or do not pay. This risk is transferred to the card company. Third, the seller typically receives cash from the card company sooner than had it granted credit directly to customers. Fourth, a variety of credit options for customers offers a potential increase in sales volume. The risks of extending credit are transferred to the credit card issuer. Cash collections are quicker. C1 Atef Abuelaish

Credit Card Sales On July 15, TechCom has $100 of credit card sales with a 4% fee, and its $96 cash is received immediately on deposit. To illustrate, if TechCom has $100 of credit card sales with a 4% fee, and its $96 cash is received immediately on deposit, the entry is a credit to Sales for the entire amount of the sale of $100. However, TechCom will debit Cash for $96, which represents how much cash they will collect from the bank. The difference of $4 is the 4% fee that TechCom must pay for allowing customers to use the third-party credit card. The $4 will be debited to Credit Card Expense. C1 Atef Abuelaish

Credit Card Sales If instead TechCom must remit electronically the credit card sales receipts to the credit card company and wait for the $96 cash payment, we will make the first entry on July 15, and the second entry on July 20, when the cash is received. However, if instead TechCom must remit electronically the credit card sales receipts to the credit card company and wait for the $96 cash payment, the first entry on the date of sale is a credit to Sales for the entire amount of the sale of $100 and a debit to Accounts Receivable for $96, which represents how much cash it will ultimately collect from the credit card company, and a debit of $4 to Credit Card Expense. The $4 fee is what TechCom must pay for allowing customers to use the third-party credit card. When cash is later received from the credit card company, usually through electronic funds transfer, the entry is a debit to Cash and a credit to Accounts Receivable for $96. C1 Atef Abuelaish

NEED-TO-KNOW A small retailer allows customers to use two different credit cards in charging purchases. With the AA Bank Card, the retailer receives an immediate credit to its account when it deposits sales receipts. AA Bank assesses a 5% service charge for credit card sales. The second credit card that the retailer accepts is the VIZA Card. The retailer sends its accumulated receipts to VIZA on a weekly basis and is paid by VIZA about a week later. VIZA assesses a 3% charge on sales for using its card. Prepare journal entries to record the following selected credit card transactions for the retailer. (The retailer uses the perpetual inventory system for recording sales.) Jan. 2 Sold merchandise for $1,000 (that had cost $600) and accepted the customer’s AA Bank Card. The AA receipts are immediately deposited in the retailer’s bank account. Jan. 6 Sold merchandise for $400 (that had cost $300) and accepted the customer’s VIZA Card. Jan. 16 Received VIZA’s check for the January 6 billing, less the service charge. A small retailer allows customers to use two different credit cards in charging purchases. With the AA Bank Card, the retailer receives an immediate credit to its account when it deposits sales receipts. AA Bank assesses a 5% service charge for credit card sales. The second credit card that the retailer accepts is the VIZA Card. The retailer sends its accumulated receipts to VIZA on a weekly basis and is paid by VIZA about a week later. VIZA assesses a 3% charge on sales for using its card. Prepare journal entries to record the following selected credit card transactions for the retailer. (The retailer uses the perpetual inventory system for recording sales.) C1 Atef Abuelaish

NEED-TO-KNOW A small retailer allows customers to use two different credit cards in charging purchases. With the AA Bank Card, the retailer receives an immediate credit to its account when it deposits sales receipts. AA Bank assesses a 5% service charge for credit card sales. The second credit card that the retailer accepts is the VIZA Card. The retailer sends its accumulated receipts to VIZA on a weekly basis and is paid by VIZA about a week later. VIZA assesses a 3% charge on sales for using its card. Prepare journal entries to record the following selected credit card transactions for the retailer. (The retailer uses the perpetual inventory system for recording sales.) Jan. 2 Sold merchandise for $1,000 (that had cost $600) and accepted the customer’s AA Bank Card. The AA receipts are immediately deposited in the retailer’s bank account. Date General Journal Debit Credit Jan. 2 Cash 950 Credit card expense ($1,000 x .05) 50 Sales 1,000 Jan. 2 Cost of goods sold 600 Merchandise inventory 600 On Jan. 2 - Sold merchandise for $1,000 (that had cost $600) and accepted the customer’s AA Bank Card. The AA receipts are immediately deposited in the retailer’s bank account. We record the $1,000 sale by crediting Sales for $1,000. This revenue is immediately matched with an expense, Credit card expense, equal to 5% of the sales, $50. And because the amount is immediately deposited in the retailer's bank account, we debit Cash for the balance, $950. The retailer is using the perpetual inventory system, so cost of goods sold is calculated at the time of the sale; debit Cost of goods sold, $600, and credit Merchandise inventory. C1 Atef Abuelaish

NEED-TO-KNOW A small retailer allows customers to use two different credit cards in charging purchases. With the AA Bank Card, the retailer receives an immediate credit to its account when it deposits sales receipts. AA Bank assesses a 5% service charge for credit card sales. The second credit card that the retailer accepts is the VIZA Card. The retailer sends its accumulated receipts to VIZA on a weekly basis and is paid by VIZA about a week later. VIZA assesses a 3% charge on sales for using its card. Prepare journal entries to record the following selected credit card transactions for the retailer. (The retailer uses the perpetual inventory system for recording sales.) Jan. 6 Sold merchandise for $400 (that had cost $300) and accepted the customer’s VIZA Card. Jan. 16 Received VIZA’s check for the January 6 billing, less the service charge. Date General Journal Debit Credit Jan. 2 Cash 950 Credit card expense ($1,000 x .05) 50 Sales 1,000 Jan. 2 Cost of goods sold 600 Merchandise inventory 600 On Jan. 6 - Merchandise was sold for $400 (that had cost $300) and accepted the customer's VIZA card. Again we credit Sales for the amount of the sale, $400. Credit card expense is recorded at the time of the sale, equal to the fee; 3% of sales; or $12. But unlike the January 2 journal entry, where the remainder was debited to the Cash account, we debit Accounts receivable - VIZA, as the amount will be received about a week later. Cost of goods sold is recorded at the time of the sale, debiting Cost of goods sold, $300, and crediting Merchandise inventory. On Jan VIZA’s check was received for the January 6 billing, less the service charge. The journal entry is the collection of an account receivable; debit Cash for the balance due, $388, and credit Accounts Receivable. Jan. 6 Accounts Receivable - VIZA 388 Credit card expense ($400 x .03) 12 Sales 400 Jan. 6 Cost of goods sold 300 Merchandise inventory 300 Jan. 16 Cash 388 Accounts Receivable - VIZA 388 C1 Atef Abuelaish

Valuing Accounts Receivable
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Valuing Accounts Receivable
Some customers may not pay their account. Uncollectible amounts are referred to as bad debts. There are two methods of accounting for bad debts: Direct Write-Off Method Allowance Method When a company directly grants credit to its customers, it expects that some customers will not pay what they promised. The accounts of these customers are uncollectible accounts, commonly called bad debts. The total amount of uncollectible accounts is an expense of selling on credit. Why do companies sell on credit if they expect some accounts to be uncollectible? The answer is that companies believe that granting credit will increase total sales and net income enough to offset bad debts. Companies use two methods to account for uncollectible accounts: (1) direct write-off method and (2) allowance method. P1 Atef Abuelaish

Valuing Accounts Receivable—Direct Write-Off Method
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Direct Write-Off Method
TechCom determines on January 23 that it cannot collect $520 owed to it by its customer J. Kent. Notice that the specific customer is noted in the transaction so we can make the proper entry in the customer’s Accounts Receivable subsidiary ledger. The direct write-off method of accounting for bad debts records the loss from an uncollectible account receivable when it is determined to be uncollectible. No attempt is made to predict bad debts expense. To illustrate, if TechCom determines on January 23 that it cannot collect $520 owed to it by its customer J. Kent, it recognizes the loss using the direct write-off method as shown in this slide. The debit in this entry charges the uncollectible amount directly to the current period’s Bad Debts Expense account. The credit removes its balance from the Accounts Receivable account in the general ledger (and its subsidiary ledger). P1 Atef Abuelaish

Direct Write-Off Method – Recovering a Bad Debt
On March 11, J. Kent was able to make full payment to TechCom for the amount previously written-off. Although uncommon, sometimes an account written off is later collected. This can be due to factors such as continual collection efforts or a customer’s good fortune. If the account of J. Kent that was written off directly to Bad Debts Expense is later collected in full, the two entries in this slide record this recovery. P1 Atef Abuelaish

Matching vs. Materiality
The matching (expense recognition) principle requires expenses to be reported in the same accounting period as the sales they helped produce. Materiality states that an amount can be ignored if its effect on the financial statements is unimportant to users’ business decisions. The matching (expense recognition) principle requires expenses to be reported in the same accounting period as the sales they helped produce. This means that if extending credit to customers helped produce sales, the bad debts expense linked to those sales is matched and reported in the same period. The direct write-off method usually does not best match sales and expenses because bad debts expense is not recorded until an account becomes uncollectible, which often occurs in a period after that of the credit sale. To match bad debts expense with the sales it produces therefore requires a company to estimate future uncollectibles. The materiality constraint states that an amount can be ignored if its effect on the financial statements is unimportant to users’ business decisions. The materiality constraint permits the use of the direct write-off method when bad debts expenses are very small in relation to a company’s other financial statement items such as sales and net income. Review what you have learned in the following NEED-TO-KNOW Slide. The direct write-off method usually does not best match sales and expenses. P1 Atef Abuelaish

NEED-TO-KNOW A retailer applies the direct write-off method in accounting for uncollectible accounts. Prepare journal entries to record the following selected transactions. Feb. 14 The retailer determines that it cannot collect $400 of its accounts receivable from a customer named ZZZ Company. Apr. 1 ZZZ Company unexpectedly pays its account in full to the retailer, which then records its recovery of this bad debt. Date General Journal Debit Credit Feb. 14 Bad Debts Expense 400 Accounts Receivable - ZZZ Co. 400 Apr. 1 Accounts Receivable - ZZZ Co. 400 Bad Debts Expense 400 Apr. 1 Cash 400 Accounts Receivable - ZZZ Co. 400 A retailer applies the direct write-off method in accounting for uncollectible accounts. Prepare journal entries to record the following selected transactions. Feb The retailer determines that it cannot collect $400 of its accounts receivable from a customer named ZZZ Company. Under the direct write-off method, when an account is determined to be uncollectible, the journal entry debits the expense account, Bad debts expense, and credits Accounts receivable for the amount that's uncollectible; in this case, $400. Apr. 1 - ZZZ Company unexpectedly pays its account in full to the retailer, which then records its recovery of this bad debt. On April 1, we reinstate the account receivable, reversing the write-off from February 14; debit Accounts receivable and credit Bad debts expense. Now that the account has been reestablished, we collect the account receivable, debiting Cash and crediting Accounts receivable. The advantage of the direct write-off method is simply that it's easy. If the amount of bad debts expense is material, Generally Accepted Accounting Principles do not allow the use of the direct write-off method. P1 Atef Abuelaish

Valuing Accounts Receivable—Allowance Method
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Two advantages to the allowance method:
At the end of each period, estimate total bad debts expected to be realized from that period’s sales. Two advantages to the allowance method: It records estimated bad debts expense in the period when the related sales are recorded. It reports accounts receivable on the balance sheet at the estimated amount of cash to be collected. The allowance method of accounting for bad debts matches the estimated loss from uncollectible accounts receivable against the sales they helped produce. We must use estimated losses because when sales occur, management does not know which customers will not pay their bills. This means that at the end of each period, the allowance method requires an estimate of the total bad debts expected to result from that period’s sales. This method has two advantages over the direct write-off method: it records estimated bad debts expense in the period when the related sales are recorded and it reports accounts receivable on the balance sheet at the estimated amount of cash to be collected. P2 Atef Abuelaish

Recording Bad Debts Expense
TechCom had credit sales of $300,000 during its first year of operations. At the end of the first year, $20,000 of credit sales remained uncollected. Based on the experience of similar businesses, TechCom estimated that $1,500 of its accounts receivable would be uncollectible. The allowance method estimates bad debts expense at the end of each accounting period and records it with an adjusting entry. TechCom, for instance, had credit sales of $300,000 during its first year of operations. At the end of the first year, $20,000 of credit sales remained uncollected. Based on the experience of similar businesses, TechCom estimated that $1,500 of its accounts receivable would be uncollectible. This estimated expense is recorded with the adjusting entry shown in this slide. The estimated bad debts expense of $1,500 is reported on the income statement (as either a selling expense or an administrative expense) and offsets the $300,000 credit sales it helped produce. The Allowance for Doubtful Accounts is a contra asset account. A contra account is used instead of reducing accounts receivable directly because at the time of the adjusting entry, the company does not know which customers will not pay. After the bad debts adjusting entry is posted, TechCom’s account balances (in T-account form) for Accounts Receivable and its Allowance for Doubtful Accounts are as shown at the bottom of this slide. P2 Atef Abuelaish

Balance Sheet Presentation
TechCom had credit sales of $300,000 during its first year of operations. At the end of the first year, $20,000 of credit sales remained uncollected. Based on the experience of similar businesses, TechCom estimated that $1,500 of its accounts receivable would be uncollectible. The Allowance for Doubtful Accounts credit balance of $1,500 has the effect of reducing accounts receivable to its estimated realizable value. Realizable value refers to the expected proceeds from converting an asset into cash. Although credit customers owe $20,000 to TechCom, only $18,500 is expected to be realized in cash collections from these customers. (TechCom continues to bill its customers a total of $20,000, the amounts from the subsidiary ledger.) In the balance sheet, the Allowance for Doubtful Accounts is subtracted from Accounts Receivable and is often reported as shown here. P2 Atef Abuelaish

TechCom has determined that J. Kent’s $520 account is uncollectible.
Writing Off a Bad Debt TechCom has determined that J. Kent’s $520 account is uncollectible. When specific accounts are identified as uncollectible, they are written off against the Allowance for Doubtful Accounts. To illustrate, TechCom decides that J. Kent’s $520 account is uncollectible and makes the above entry to write it off. Posting this write-off entry to the Accounts Receivable account removes the amount of the bad debt from the general ledger (it is also posted to the accounts receivable subsidiary ledger). The general ledger accounts now appear as shown (assuming no other transactions affecting these accounts). P2 Atef Abuelaish

Writing Off a Bad Debt The write-off does not affect the realizable value of accounts receivable. The write-off does not affect the realizable value of accounts receivable as shown in this slide. Neither total assets nor net income is affected by the write-off of a specific account. Instead, both assets and net income are affected in the period when bad debts expense is predicted and recorded with an adjusting entry. P2 Atef Abuelaish

Recovering a Bad Debt To help restore credit standing, a customer sometimes volunteers to pay all or part of the amount owed on an account even after it has been written off. On March 11, Kent pays in full his $520 account previously written off. When a customer fails to pay and the account is written off as uncollectible, his or her credit standing is jeopardized. To help restore credit standing, a customer sometimes volunteers to pay all or part of the amount owed. A company makes two entries when collecting an account previously written off by the allowance method. The first is to reverse the write-off and reinstate the customer’s account. The second entry records the collection of the reinstated account as illustrated here. Review what you have learned in the following NEED-TO-KNOW Slides. P2 Atef Abuelaish

NEED-TO-KNOW A retailer applies the allowance method in accounting for uncollectible accounts. Prepare journal entries to record its following selected transactions. 12/31/20X1 The retailer estimates $3,000 of its accounts receivable are uncollectible. 2/14/20X2 The retailer determines that it cannot collect $400 of its accounts receivable from a customer named ZZZ Company. 4/1/20X2 ZZZ Company unexpectedly pays its account in full to the retailer, which then records its recovery of this bad debt. A retailer applies the allowance method in accounting for uncollectible accounts. Prepare journal entries to record its following selected transactions. P2 Atef Abuelaish

NEED-TO-KNOW A retailer applies the allowance method in accounting for uncollectible accounts. Prepare journal entries to record its following selected transactions. 12/31/20X1 The retailer estimates $3,000 of its accounts receivable are uncollectible. 2/14/20X2 The retailer determines that it cannot collect $400 of its accounts receivable from a customer named ZZZ Company. 4/1/20X2 ZZZ Company unexpectedly pays its account in full to the retailer, which then records its recovery of this bad debt. Date General Journal Debit Credit 12/31/20X1 Bad Debts Expense 3,000 Allowance for Doubtful Accounts 3,000 2/14/20X2 Allowance for Doubtful Accounts 400 Accounts Receivable - ZZZ Co. 400 4/1/20X2 Accounts Receivable - ZZZ Co. 400 Allowance for Doubtful Accounts 400 12/31/20X1 - The retailer estimates $3,000 of its accounts receivable are uncollectible. Under the allowance method, as a year-end adjusting entry, we debit the income statement account, Bad debts expense, for the estimated amount that's uncollectible, $3,000, and we credit the contra asset account, Allowance for doubtful accounts. This transaction reduces the net realizable value of the receivables to be reported on the December 31, 20X1 balance sheet and records an expense, Bad debts expense, in the same time period as the sale. On February 14, 20X2, the retailer determines that it cannot collect $400 of its accounts receivable from a customer named ZZZ Company. Under the allowance method, when an account is deemed uncollectible, we debit Allowance for doubtful accounts for the uncollectible amount, $400, and credit Accounts receivable. The journal entry for the write-off has no effect on the carrying value of the receivables, as we're debiting one portion of accounts receivable, and crediting another. 4/1/20X2 - ZZZ Company unexpectedly pays its account in full to the retailer, which then records its recovery of this bad debt. The first step whenever a bad debt is collected is to reverse the write-off. The journal entry on April 1 is a debit to Accounts receivable and a credit to Allowance for doubtful accounts. This journal entry, just like the write-off, has no affect on the net realizable value of the receivables. The second step is to record the collection of the account receivable; debit Cash and credit Accounts receivable. 4/1/20X2 Cash 400 Accounts Receivable - ZZZ Co. 400 P2 Atef Abuelaish

Estimating Bad Debts Expense
Two Methods Percent of Sales Method Accounts Receivable Methods Percent of Accounts Receivable Aging of Accounts Receivable The allowance method requires an estimate of bad debts expense to prepare an adjusting entry at the end of each accounting period. There are two common methods. One is based on the income statement relation between bad debts expense and sales. The second is based on the balance sheet relation between accounts receivable and the allowance for doubtful accounts. P2 Atef Abuelaish

1) Percent of Sales Method
Bad debts expense is computed as follows: The percent of sales method, also referred to as the income statement method, is based on the idea that a given percent of a company’s credit sales for the period is uncollectible. When using the Percent of Sales Method, the estimate at the end of the period is determined by taking current period sales and multiplying by an established bad debt percentage. The bad debt percentage is determined based on past history of the company and current economic trends. Also, the sales transactions included in this computation are typically only the credit sales. There are no collection issues to consider for cash sales transactions. P2 Atef Abuelaish

Percent of Sales Method
Musicland has credit sales of $400,000 in It is estimated that 0.6% of credit sales will eventually prove uncollectible. Let’s look at recording Bad Debts Expense for 2015. Musicland’s accountant computes estimated Bad Debts Expense of $2,400. The percent of sales method, also referred to as the income statement method, is based on the idea that a given percent of a company’s credit sales for the period is uncollectible. To illustrate, assume that Musicland has credit sales of $400,000 in year Based on past experience, Musicland estimates 0.6% of credit sales to be uncollectible. This implies that Musicland expects $2,400 of bad debts expense from its sales (computed as $400,000 x 0.006). The adjusting entry to record this estimated expense is shown here. The allowance account ending balance on the balance sheet for this method would rarely equal the bad debts expense on the income statement. This is because unless a company is in its first period of operations, its allowance account has a zero balance only if the prior amounts written off as uncollectible exactly equal the prior estimated bad debts expenses. (When computing bad debts expense as a percent of sales, managers monitor and adjust the percent so it is not too high or too low.) P2 Atef Abuelaish

2) Accounts Receivables Method
Compute the estimate of the Allowance for Doubtful Accounts. Year-end Accounts Receivable x Bad Debt % Bad Debts Expense is computed as: 2. Total Estimated Bad Debts Expense – Previous Balance in Allowance Account = Current Bad Debts Expense The accounts receivable methods, also referred to as balance sheet methods, use balance sheet relations to estimate bad debts—mainly the relation between accounts receivable and the allowance amount. The goal of the bad debts adjusting entry for these methods is to make the Allowance for Doubtful Accounts balance equal to the portion of accounts receivable that is estimated to be uncollectible. The estimated balance for the allowance account is obtained in one of two ways: (1) computing the percent uncollectible from the total accounts receivable or (2) aging accounts receivable. The percent of accounts receivable method assumes that a given percent of a company’s receivables is uncollectible. This percent is based on past experience and is impacted by current conditions such as economic trends and customer difficulties. The total dollar amount of all receivables is multiplied by this percent to get the estimated dollar amount of uncollectible accounts—reported in the balance sheet as the Allowance for Doubtful Accounts. P2 Atef Abuelaish

Percent of Receivables Method
Musicland has $50,000 in accounts receivable and a $200 credit balance in Allowance for Doubtful Accounts on December 31, Past experience suggests that 5% of receivables are uncollectible. Desired balance in Allowance for Doubtful Accounts. Musicland has $50,000 of accounts receivable on December 31, Experience suggests 5% of its receivables is uncollectible. This means that after the adjusting entry is posted, we want the Allowance for Doubtful Accounts to show a $2,500 credit balance (5% of $50,000). We are also told that its beginning balance is $2,200, which is 5% of the $44,000 accounts receivable on December 31, 2014. During 2015, accounts of customers are written off on February 6, July 10, and November 20. Thus, the account has a $200 credit balance before the December 31, 2015, adjustment. The adjusting entry to give the allowance account the estimated $2,500 balance is shown on this slide. P2 Atef Abuelaish

Aging of Receivables Method
Classify each receivable by how long it is past due. Each age group is multiplied by its estimated bad debts percentage. The aging of accounts receivable method uses both past and current receivables information to estimate the allowance amount. Specifically, each receivable is classified by how long it is past its due date. Then estimates of uncollectible amounts are made assuming that the longer an amount is past due, the more likely it is to be uncollectible. Classifications are often based on 30-day periods. After the amounts are classified (or aged), experience is used to estimate the percent of each uncollectible class. These percents are applied to the amounts in each class and then totaled to get the estimated balance of the Allowance for Doubtful Accounts. Estimated bad debts for each group are totaled. P2 Atef Abuelaish

Aging of Accounts Receivable
This aging of accounts lists each customer’s individual balances assigned to one of five classes based on its days past due. The amounts in each class are totaled and multiplied by the estimated percent of uncollectible accounts for each class. The percents used are regularly reviewed to reflect changes in the company and economy. Musicland has $3,700 in accounts receivable that are 31 to 60 days past due. Its management estimates 10% of the amounts in this age class are uncollectible, or a total of $370 (computed as $3,700 x 10%). Similar analysis is done for each of the other four classes. The final total of $2,270 ($740 + $ $475 + $360) shown in the first column is the estimated balance for the Allowance for Doubtful Accounts. P2 Atef Abuelaish

Aging of Accounts Receivable
Musicland has an unadjusted credit balance of $200 in the allowance account. We estimated the proper balance to be $2,270. Notice that the allowance account has an unadjusted credit balance of $200, the required adjustment to the Allowance for Doubtful Accounts is $2,070. (We could also use a T-account for this analysis as shown in the slide.) This yields the following end-of-period adjusting entry shown above. P2 Atef Abuelaish

Summary of Methods This diagram summarizes the principles guiding all three estimation methods and their focus of analysis. Percent of sales, with its income statement focus, does a good job at matching bad debts expense with sales. The accounts receivable methods, with their balance sheet focus, do a better job at reporting accounts receivable at realizable value. Review what you have learned in the following NEED-TO-KNOW Slides. P2 Atef Abuelaish

NEED-TO-KNOW At its December 31 year-end, a company estimates uncollectible accounts using the allowance method. It prepared the following aging of receivables analysis. Days Past Due Total 1 to 30 31 to 60 61 to 90 Over 90 Accounts receivable $2,600 $2,000 $300 $80 $100 $120 Percent uncollectible 1% 2% 5% 7% 10% 1. (a) Estimate the balance of the Allowance for Doubtful Accounts using the aging of accounts receivable method. (b) Prepare the adjusting entry to record Bad Debts Expense using the estimate from part a. Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $10 debit. Date General Journal Debit Credit Dec. 31 Bad Debts Expense Income St. Allowance for Doubtful Accounts Bal. Sheet Adjusting entries: 3-step process: Step 1) Determine what the account balance equals. Step 2) Determine what the account balance SHOULD equal. Step 3) Make an adjusting entry to get from Step 1 to Step 2. At its December 31 year-end, a company estimates uncollectible accounts using the allowance method. It prepared the following aging of receivables analysis. 1. (a) Estimate the balance of the Allowance for Doubtful Accounts using the aging of accounts receivable method. (b) Prepare the adjusting entry to record Bad Debts Expense using the estimate from part (a). Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $10 debit balance. This adjusting entry, like all adjusting entries, affects one income statement account and one balance sheet account. The journal entry to estimate bad debts using the allowance method is always a debit to Bad debts expense, the income statement account, and a credit to Allowance for doubtful accounts, the balance sheet account. Preparing adjusting entries is a three-step process: Step 1: Determine what the account balance equals. Step 2: Determine what the account balance SHOULD equal. Step 3: Make an adjusting entry to get from step 1 to step 2. The entry to estimate bad debts is always a debit to Bad debts expense and a credit to Allowance for doubtful accounts, regardless of the method used. In this case, the company is estimating their bad debts based on an aging of accounts receivable. P2 Atef Abuelaish

NEED-TO-KNOW P2 Days Past Due Total 1 to 30 31 to 60 61 to 90 Over 90
1 to 30 31 to 60 61 to 90 Over 90 Accounts receivable $2,600 $2,000 $300 $80 $100 $120 Percent uncollectible 1% 2% 5% 7% 10% Uncollectible amount $49 $20 $6 $4 $7 $12 Step 1: Determine what the current account balance equals. When the estimate is based on receivables (Balance Sheet Approach) the account is the Balance sheet portion of the adjusting entry, Allowance for Doubtful Accounts. The existing balance is a debit of $10. Allowance for Doubtful Accounts Unadjusted 10 Adjustment 59 Adjusted 49 Step 2: Determine what the current account balance SHOULD BE. The balance should equal the amount calculated, $49. Step 1: Determine what the current account balance equals. When the estimate is based on receivables, this is the balance sheet approach. The account is the balance sheet portion of the adjusting entry, Allowance for doubtful accounts. The existing balance is a debit of $10. Step 2: Determine what the current account balance SHOULD BE. When a company uses an aging of accounts receivable, they look at the number of days past due and then multiply by the historical percentage of uncollectible items. For accounts that are current, not yet past due, 1% are uncollectible. 1% of $2,000 is $20. 2% of accounts that are 1 to 30 days past due are uncollectible; 2% of $300 is $6. 5% of the accounts that are 31 to 60 days past due are uncollectible; $80 multiplied by 5% is $4. 7% of the accounts that are 61 to 90 days past due are uncollectible; 7% of $100 is $7. And accounts that are over 90 days past due have a 10% chance of becoming uncollectible; 10% of $120 is $12. Total accounts receivable is $2,600. The total amount that's estimated to be uncollectible is $49. The balance in Allowance for doubtful accounts should equal the amount calculated, $49. Remember, Allowance for doubtful accounts is a contra asset account and has a normal credit balance. Step 3: Make an adjusting entry to get from step 1 to step 2. In order to go from a debit balance of $10 to a credit balance of $49, we need to credit the Allowance account for the total, $59. The adjusting entry debits Bad debts expense and credits Allowance for doubtful accounts for $59. Step 3: Make an adjusting entry to get from step 1 to step 2. Date General Journal Debit Credit Dec. 31 Bad Debts Expense 59 Allowance for Doubtful Accounts 59 P2 Atef Abuelaish

NEED-TO-KNOW 2. (a) Estimate the balance of the Allowance for Doubtful Accounts assuming the company uses 2% of total accounts receivable to estimate uncollectibles, instead of the aging of receivables method in number 1. (b) Prepare the adjusting entry to record Bad Debts Expense using the estimate from part a. Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $4 credit. Step 1: Determine what the current account balance equals. When the estimate is based on receivables, the Balance Sheet Approach, the account is the Balance sheet portion of the adjusting entry, Allowance for Doubtful Accounts. The existing balance is a credit of $4. Allowance for Doubtful Accounts Unadjusted 4 Adjustment 48 Adjusted 52 Step 2: Determine what the current account balance SHOULD BE. The balance should be 2% of Accounts Receivable. $2,600 x .02 = $52. 2. (a) Estimate the balance of the Allowance for Doubtful Accounts assuming the company uses 2% of total accounts receivable to estimate uncollectibles, instead of the aging of accounts receivables method in number 1. (b) Prepare the adjusting entry to record Bad Debts Expense using the estimate from part a. Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $4 credit. The process stays the same. The adjusting entry to estimate Bad debts expense is always a debit to Bad debts expense and a credit to Allowance for doubtful accounts. The company is estimating that 2% of total accounts receivable are uncollectible. When the estimate is based on receivables, we're using the balance sheet approach. The account is the balance sheet portion of the adjusting entry, Allowance for doubtful accounts. The existing balance is a credit of $4. Step 2: Determine what the current account balance SHOULD BE. Total accounts receivable of $2,600 multiplied by 2% is $52. The allowance for doubtful accounts should have an ending credit balance of $52. Step 3: Make an adjusting entry to get from step 1 to step 2. To go from a credit of $4 to a credit a $52, we need to credit Allowance for doubtful accounts for $48. Step 3: Make an adjusting entry to get from step 1 to step 2. Date General Journal Debit Credit Dec. 31 Bad Debts Expense 48 Allowance for Doubtful Accounts 48 P2 Atef Abuelaish

NEED-TO-KNOW 3. a) Estimate the balance of the uncollectibles assuming the company uses 0.5% of annual credit sales (annual credit sales were $10,000). (b) Prepare the adjusting entry to record Bad Debts Expense using the estimate from part a. Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $2 credit. Step 1: Determine what the current account balance equals. When the estimate is based on sales, the Income Statement Approach, the account is the Income Statement portion of the adjusting entry, Bad Debts Expense. The existing balance in the expense account is always $0, as it is closed every period. Bad Debts Expense Unadjusted Adjustment 50 Adjusted 50 Step 2: Determine what the current account balance SHOULD BE. The balance should be .5% of net credit sales. $10,000 x .005 = $50. 3. (a) Estimate the balance of the uncollectibles assuming the company uses 0.5% of annual credit sales (annual credit sales were $10,000). (b) Prepare the adjusting entry to record Bad Debts Expense using the estimate from part a. Assume the unadjusted balance in the Allowance for Doubtful Accounts is a $2 credit. Step 1: Determine what the current account balance equals. The adjusting entry will be the same, debiting Bad debts expense and crediting Allowance for doubtful accounts. When the estimate is based on sales, we're using the income statement approach; the account is the income statement portion of the adjusting entry, Bad debts expense. The existing balance in the expense account is always $0, as it's closed every period. Step 2: Determine what the current account balance SHOULD BE. The balance in bad debts expense should equal 0.5% of net credit sales. $10,000 multiplied by equals $50. Remember, Bad debts expense has a normal debit balance, as expenses decrease equity. Step 3: Make an adjusting entry to get from step 1 to step 2. To go from an unadjusted balance of $0 to an adjusted debit balance of $50, we need to debit Bad debts expense for $50. Notice that we did not need to consider the existing balance in Allowance for doubtful accounts to solve this question, because we were using the income statement approach, not a balance sheet approach, and Allowance for doubtful accounts is a balance sheet account. Step 3: Make an adjusting entry to get from step 1 to step 2. Date General Journal Debit Credit Dec. 31 Bad Debts Expense 50 Allowance for Doubtful Accounts 50 P2 Atef Abuelaish

2) Notes Receivable Atef Abuelaish

Notes Receivable A promissory note is a written promise to pay a specified amount of money, usually with interest, either on demand or at a definite future date. A promissory note is a written promise to pay a specified amount of money, usually with interest, either on demand or at a definite future date. Promissory notes are used in many transactions, including paying for products and services, and lending and borrowing money. Sellers sometimes ask for a note to replace an account receivable when a customer requests additional time to pay a past-due account. For legal reasons, sellers generally prefer to receive notes when the credit period is long and when the receivable is for a large amount. If a lawsuit is needed to collect from a customer, a note is the buyer’s written acknowledgment of the debt, its amount, and its terms. The note illustrated on this slide shows a simple promissory note dated July 10, For this note, Julia Browne promises to pay TechCom or to its order (according to TechCom’s instructions) a specified amount of money ($1,000), called the principal of a note, at a definite future date (October 8, 2015). As the one who signed the note and promised to pay it at maturity, Browne is the maker of the note. As the person to whom the note is payable, TechCom is the payee of the note. To Browne, the note is a liability called a note payable. To TechCom, the same note is an asset called a note receivable. This note bears interest at 12%, as written on the note. Interest is the charge for using the money until its due date. To a borrower, interest is an expense. To a lender, it is revenue. C2 Atef Abuelaish

Computing Maturity and Interest
The maturity date of a note is the day the note (principal and interest) must be repaid. On July 10, TechCom received a $1,000, 90-day, 12% promissory note as a result of a sale to Julia Browne. The maturity date of a note is the day the note (principal and interest) must be repaid. The period of a note is the time from the note’s (contract) date to its maturity date. Many notes mature in less than a full year, and the period they cover is often expressed in days. When the time of a note is expressed in days, its maturity date is the specified number of days after the note’s date. As an example, a five-day note dated June 15 matures and is due on June 20. A 90-day note dated July 10 matures on October 8. This October 8 due date is computed as shown in this slide. The period of a note is sometimes expressed in months or years. When months are used, the note matures and is payable in the month of its maturity on the same day of the month as its original date. A nine-month note dated July 10, for instance, is payable on April 10. The same analysis applies when years are used. The note is due and payable on October 8. C2 Atef Abuelaish

Even for maturities less than one year, the rate is annualized.
Interest Computation Even for maturities less than one year, the rate is annualized. If the note is expressed in days, base a year on 360 days using the “banker’s rule.” Interest is the cost of borrowing money for the borrower or, alternatively, the profit from lending money for the lender. Unless otherwise stated, the rate of interest on a note is the rate charged for the use of the principal for one year. The formula for computing interest on a note is shown in the slide. It is calculated as Principal times Rate times Time. To simplify interest computations, a year is commonly treated as having 360 days (called the banker’s rule in the business world and widely used in commercial transactions). We treat a year as having 360 days for interest computations in the examples and assignments. Using the promissory note in the earlier slide where we have a 90-day, 12%, $1,000 note, the total interest is computed as $30. C2 Atef Abuelaish

Recognizing Notes Receivable
Notes receivable are usually recorded in a single Notes Receivable account to simplify recordkeeping. The original notes are kept on file, including information on the maker, rate of interest, and due date. To illustrate the recording for the receipt of a note, we use the $1,000, 90-day, 12% promissory note from Julia Browne to TechCom. TechCom received this note at the time of a product sale to Julia Browne. Notes receivable are usually recorded in a single Notes Receivable account to simplify record-keeping. The original notes are kept on file, including information on the maker, rate of interest, and due date. (When a company holds a large number of notes, it sometimes sets up a controlling account and a subsidiary ledger for notes. This is similar to the handling of accounts receivable.) To illustrate the recording for the receipt of a note, we use the $1,000, 90-day, 12% promissory note we discussed in a prior slide. TechCom received this note at the time of a product sale to Julia Browne. This transaction is recorded as shown above. C2 Atef Abuelaish

Valuing and Settling Notes
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Recording an Honored Note
The principal and interest of a note are due on its maturity date. J. Cook has a $600, 15%, 60-day note receivable due to TechCom on December 4. The principal and interest of a note are due on its maturity date. The maker of the note usually honors the note and pays it in full. To illustrate, when J. Cook pays the note above on its due date, TechCom records the journal entry shown. Interest revenue, also called interest earned, is reported on the income statement. P3 Atef Abuelaish

Recording a Dishonored Note
The act of dishonoring a note does not relieve the maker of the obligation to repay the principal and interest due. J. Cook has a $600, 15%, 60-day note receivable due to TechCom on December 4. When a note’s maker is unable or refuses to pay at maturity, the note is dishonored. The act of dishonoring a note does not relieve the maker of the obligation to pay. The payee should use every legitimate means to collect. How do companies report this event? The balance of the Notes Receivable account should include only those notes that have not matured. Thus, when a note is dishonored, we remove the amount of this note from the Notes Receivable account and charge it back to an account receivable from its maker. To illustrate, assume that J. Cook dishonors the note above at maturity. The journal entry to record the dishonoring of the note is shown. P3 Atef Abuelaish

Recording End-of-Period Interest Adjustments
On December 16, TechCom accepts a $3,000, 60-day, 12% note from a customer in granting an extension on a past-due account. When TechCom’s accounting period ends on December 31, $15 of interest has accrued on the note. $3,000 x 12% x 15/360 = $15 When notes receivable are outstanding at the end of a period, any accrued interest earned is computed and recorded. To illustrate, on December 16, TechCom accepts a $3,000, 60-day, 12% note from a customer in granting an extension on a past-due account. When TechCom’s accounting period ends on December 31, $15 of interest has accrued on this note ($3,000 x 12% x 15/360). The adjusting entry shown records this revenue. P3 Atef Abuelaish

Recording End-of-Period Interest Adjustments
Recording collection on note at maturity. When the December 16 note is collected on February 14, TechCom’s entry to record the cash receipt is shown. Total interest earned on the 60-day note is $60. The $15 credit to Interest Receivable on February 14 reflects the collection of the interest accrued from the December 31 adjusting entry. The $45 interest earned reflects TechCom’s revenue from holding the note from January 1 to February 14 of the current period. Review what you have learned in the following NEED-TO-KNOW Slide. P3 $3,000 x 12% x 60/360 = $60 Atef Abuelaish

NEED-TO-KNOW a. AA Company purchases $1,400 of merchandise from ZZ on December 16, 20X1. ZZ accepts AA’s $1,400, 90-day, 12% note as payment. ZZ’s accounting period ends on December 31, and it does not make reversing entries. Prepare entries for ZZ on December 16, 20X1, and December 31, 20X1. b. Using the information in part a, prepare ZZ’s March 16, 20X2, entry if AA dishonors the note. c. Instead of the facts in part b, prepare ZZ’s March 16, 20X2, entry if AA honors the note Date General Journal Debit Credit 12/16/20X1 Notes Receivable 1,400 Sales 1,400 12/31/20X1 Interest Receivable 7 Interest Revenue ($1,400 x .12 x 15/360) 7 03/16/20X2 Accounts Receivable 1,442 Interest Receivable 7 Interest Revenue ($1,400 x .12 x 75/360) 35 Notes Receivable 1,400 AA Company purchases $1,400 of merchandise from ZZ on December 16, 20X1. ZZ accepts AA’s $1,400, 90-day, 12% note as payment. ZZ’s accounting period ends on December 31, and it does not make reversing entries. Prepare entries for ZZ on December 16, 20X1, and December 31, 20X1. On December 16, we record the sale, debiting Notes receivable, $1,400, and we credit Sales. On December 31, we accrue the interest, debiting Interest receivable and crediting Interest revenue. The company has earned 15 days of interest in the current year. $1,400 multiplied by 12% multiplied by 15 days divided by 360 is $7 of accrued interest. (b) Using the information in part a, prepare ZZ’s March 16, 20X2, entry if AA dishonors the note. On March 16, 20X2, ZZ will bill AA for the balance due. The amount due as of March 16 is equal to the interest receivables, the 15 days of interest that were accrued in 20X1, $7, plus an additional 75 days of interest from January 1 through March 16. $1,400 multiplied by 12% multiplied by 75 divided by 360 is $35 of interest. $1,400 multiplied by 12% multiplied by 75 divided by 360 is $35 of interest. We credit Notes receivable for the principal amount, and debit Accounts receivable for principal plus 90 days of interest, $1,442. (c). Instead of the facts in part b, prepare ZZ’s March 16, 20X2, entry if AA honors the note. If they honor the note, they make full payment on the maturity date. The entire journal entry is the same as we had previously; the only difference is that rather than debiting Accounts receivable, we debit Cash. 03/16/20X2 Cash 1,442 Interest Receivable 7 Interest Revenue ($1,400 x .12 x 75/360) 35 Notes Receivable 1,400 P3 Atef Abuelaish

Disposal of Receivables
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Disposal of Receivables
Companies can convert receivables to cash before they are due. Selling Receivables Pledging Receivables Companies can convert receivables to cash before they are due. Reasons for this include the need for cash or the desire not to be involved in collection activities. Converting receivables is usually done either by (1) selling them or (2) using them as security for a loan. A recent survey shows that about 20% of companies obtain cash from either selling receivables or pledging them as security. In some industries such as textiles, apparel, and furniture, this is common practice. A company can sell all or a portion of its receivables to a finance company or bank. The buyer, called a factor, charges the seller a factoring fee and then the buyer takes ownership of the receivables and receives cash when they come due. By incurring a factoring fee, the seller receives cash earlier and can pass the risk of bad debts to the factor. The seller can also choose to avoid costs of billing and accounting for the receivables. A company can raise cash by borrowing money and pledging its receivables as security for the loan. Pledging receivables does not transfer the risk of bad debts to the lender because the borrower retains ownership of the receivables. If the borrower defaults on the loan, the lender has a right to be paid from the cash receipts of the receivable when collected. Since pledged receivables are committed as security for a specific loan, the borrower’s financial statements disclose the pledging of them. Inventory and accounts receivable are two assets commonly demanded by bankers as collateral when making business loans. C3 Atef Abuelaish

10) Accounts Receivable Turnover
This ratio provides useful information for evaluating how efficient management has been in granting credit to produce revenue. Accounts receivable turnover is a measure of both the quality and liquidity of accounts receivable. It indicates how often, on average, receivables are received and collected during the period. The formula for this ratio is shown above. Accounts receivable turnover also reflects how well management is doing in granting credit to customers in a desire to increase sales. A high turnover in comparison with competitors suggests that management should consider using more liberal credit terms to increase sales. A low turnover suggests management should consider stricter credit terms and more aggressive collection efforts to avoid having its resources tied up in accounts receivable. Dell’s 2013 turnover is 8.7, computed as $56,940/$6,553 ($ millions). This means that Dell’s average accounts receivable balance was converted into cash 8.7 times in Its turnover declined in 2013 (8.7) compared with 2012 (9.6) and 2011 (10.0). However, Dell’s turnover exceeds that for HP in each of the past four years. Is either company’s turnover too high? Since sales are relatively flat over this time period, neither company’s turnover rate appears to be too high. Instead, both Dell and HP seem to be doing an adequate job of managing receivables. A1 Atef Abuelaish

Welcome Back Atef Abuelaish

Welcome Back Time for Any Question Atef Abuelaish

Chapter 08 Accounting for Atef Abuelaish

Accounting for Long-term assets
Chapter 08 Accounting for Long-term assets Atef Abuelaish

Long-term assets I Plant Assets S62 – S112.
II Natural Resources S113 – S118. III Intangible Assets S119 - S122. Atef Abuelaish

Cost Determination Atef Abuelaish

Asset Accounts Asset Accounts Cash Accounts Receivable Land
Notes Receivable Buildings Here is a listing of common asset accounts we are likely to find in all businesses. Prepaid accounts may be new to you. Think about your auto insurance. Many of us pay our auto insurance semi-annually or annually. The payment is made in advance and is referred to as a prepaid amount. Prepaid amounts will turn into expenses as they are used up. Prepaid Accounts Equipment Supplies C 2 Atef Abuelaish

1) Plant Assets Tangible in Nature Actively Used in Operations
Expected to Benefit Future Periods Plant assets are tangible assets used in a company’s operations that have a useful life of more than one accounting period. Plant assets are also called plant and equipment; property, plant, and equipment; or fixed assets. For many companies, plant assets make up the single largest class of assets they own. Called Property, Plant, & Equipment C 1 Atef Abuelaish

PLANT ASSETS The four main issues in accounting for plant assets: (1) computing the costs of plant assets, (2) allocating the costs of most plant assets (less any salvage amounts) against revenues for the periods they benefit, (3) accounting for expenditures such as repairs and improvements to plant assets, and (4) recording the disposal of plant assets. C 1 Atef Abuelaish

Cost Determination Acquisition Cost Purchase price
All expenditures needed to prepare the asset for its intended use Acquisition Cost Plant assets are recorded at cost when acquired. This is consistent with the cost principle. Cost includes all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use. The cost of a factory machine, for instance, includes its invoice cost less any cash discount for early payment, plus any necessary freight, unpacking, assembling, installing, and testing costs. Examples are the costs of building a base or foundation for a machine, providing electrical hookups, and testing the asset before using it in operations. Finance charges are not included in the cost of an asset. If we elect to finance the purchase over a period of time, the interest cost is charged as an expense when incurred. Acquisition cost excludes financing charges and cash discounts C 1 Atef Abuelaish

Machinery and Equipment
Purchase price Taxes Machinery and Equipment Transportation charges The costs of machinery and equipment consist of all costs normal and necessary to purchase them and prepare them for their intended use. These include the purchase price, taxes, transportation charges, insurance while in transit, and the installing, assembling, and testing of the machinery and equipment. Installing, assembling, and testing Insurance while in transit C 1 Atef Abuelaish

Cost of purchase or construction
2) Buildings Cost of purchase or construction Title fees Buildings Brokerage fees Attorney fees A Building account is charged for the costs of purchasing or constructing a building that is used in operations. When purchased, a building’s costs usually include its purchase price, brokerage fees, taxes, title fees, and attorney fees. Its costs also include all expenditures to ready it for its intended use, including any necessary repairs or renovations such as wiring, lighting, flooring, and wall coverings. When a company constructs a building or any plant asset for its own use, its costs include materials and labor plus a reasonable amount of indirect overhead cost. Overhead includes the costs of items such as heat, lighting, power, and depreciation on machinery used to construct the asset. Costs of construction also include design fees, building permits, and insurance during construction. Taxes C 1 Atef Abuelaish

3) Land Improvements Parking lots, driveways, fences, walks, shrubs, and lighting systems. Depreciate over useful life of improvements. Land improvements are additions to land and have limited useful lives. Examples are parking lot surfaces, driveways, walkways, fences, landscaping, and sprinkling and lighting systems. Costs of land improvements include expenditures necessary to make those improvements ready for their intended use. While the costs of these improvements increase the usefulness of the land, they are charged to a separate Land Improvement account so that their costs can be allocated to the periods they benefit. C 1 Atef Abuelaish

4) Land Land is not depreciable. Land Title insurance premiums
Purchase price Delinquent taxes Land Real estate commissions Surveying fees Land is the earth’s surface and has an indefinite (unlimited) life. Costs of land include expenditures necessary to make that property ready for its intended use. When land is purchased for a building site, its cost includes the total amount paid for the land, including any real estate commissions, title insurance fees, legal fees, and any accrued property taxes paid by the purchaser. Payments for surveying, clearing, grading, and draining also are included in the cost of land. Other costs include government assessments, whether incurred at the time of purchase or later, for items such as public roadways, sewers, and sidewalks. These assessments are included because they permanently add to the land’s value. Land purchased as a building site sometimes includes structures that must be removed. In such cases, the total purchase price is charged to the Land account as is the cost of removing the structures, less any amounts recovered through sale of salvaged materials. Title search and transfer fees Land is not depreciable. C 1 Atef Abuelaish

Depreciation Methods Atef Abuelaish

Lump-Sum Purchase The total cost of a combined purchase of land and building is separated on the basis of their relative fair market values. CarMax paid $90,000 cash to acquire a group of items consisting of land appraised at $30,000, land improvements appraised at $10,000, and a building appraised at $60,000. The $90,000 cost will be allocated on the basis of appraised values as shown: Plant assets sometimes are purchased as a group in a single transaction for a lump-sum price. This transaction is called a lump-sum purchase, or group, bulk, or basket purchase. When this occurs, we allocate the cost of the purchase among the different types of assets acquired based on their relative market values, which can be estimated by appraisal or by using the tax-assessed valuations of the assets. To illustrate, assume CarMax paid $90,000 cash to acquire a group of items consisting of a building appraised at $60,000, land improvements appraised at $10,000, and land appraised at $30,000. The $90,000 cost is allocated on the basis of these appraised values as shown in this slide. Review what you have learned in the following NEED-TO-KNOW Slide. P 1 Atef Abuelaish

NEED-TO-KNOW Compute the amount recorded as the cost of a new machine given the following payments related to its purchase: gross purchase price, $700,000; sales tax, $49,000; purchase discount taken, $21,000; freight cost—terms FOB shipping point, $3,500; normal assembly costs, $3,000; cost of necessary machine platform, $2,500; cost of parts used in maintaining machine, $4,200. Measurement Principle (Cost Principle) requires that assets be valued at all necessary costs to get the asset ready for its intended purpose. Gross purchase price $700,000 Sales tax 49,000 Purchase discount taken (21,000) Freight cost (FOB shipping point) 3,500 Normal assembly costs 3,000 Necessary machine platform 2,500 Costs of parts used in maintaining machine Cost of new machine $737,000 Compute the amount recorded as the cost of a new machine given the following payments related to its purchase: gross purchase price, $700,000; sales tax, $49,000; purchase discount taken, $21,000; freight cost - terms FOB shipping point, $3,500; normal assembly costs, $3,000; cost of necessary machine platform, $2,500; cost of parts used in maintaining machine, $4,200. The Measurement Principle (Cost Principle) requires that assets be valued at all necessary costs to get the asset ready for its intended purpose. The purchase price of $700,000 is obviously a necessary cost. We can't buy the machine without paying the sales tax; we add the sales tax into the cost of the machine. The purchase discount taken reduces the cost of the machine. It's not necessary to spend all $700,000 if a sales discount is offered; we subtract the purchase discount taken. The freight cost is a necessary cost because it was shipped to us FOB shipping point. The machine became ours as soon as it was shipped. Normal assembly costs are unavoidable. This machine required a special platform; we add the $2,500 to the cost of the machine. The costs of parts used in maintaining the machine, while necessary, are not required to get the asset ready for its intended purpose. As soon as the company starts to use the machine, the capitalization process ends. The maintenance costs will be expensed as incurred, and are not included in the cost of the machine. The total cost of the new machine is $737,000. P 1 Atef Abuelaish

Depreciation Depreciation is the process of allocating the cost of a plant asset to expense in the accounting periods benefiting from its use. Acquisition Cost (Unused) Balance Sheet (Used) Income Statement Expense Cost Allocation Depreciation is the process of allocating the cost of a plant asset to expense in the accounting periods benefiting from its use. Depreciation does not measure the decline in the asset’s market value each period, nor does it measure the asset’s physical deterioration. Since depreciation reflects the cost of using a plant asset, depreciation charges are only recorded when the asset is actually in service. P 1 Atef Abuelaish

Factors in Computing Depreciation
The calculation of depreciation requires three amounts for each asset: 1. Cost 2. Salvage Value 3. Useful Life Factors that determine depreciation are (1) cost, (2) salvage value, and (3) useful life. Cost - The cost of a plant asset consists of all necessary and reasonable expenditures to acquire it and to prepare it for its intended use. Salvage Value - The total amount of depreciation to be charged off over an asset’s benefit period equals the asset’s cost minus its salvage value. Salvage value, also called residual value or scrap value, is an estimate of the asset’s value at the end of its benefit period. This is the amount the owner expects to receive from disposing of the asset at the end of its benefit period. If the asset is expected to be traded in on a new asset, its salvage value is the expected trade-in value. Useful Life - The useful life of a plant asset is the length of time it is productively used in a company’s operations. Useful life, also called service life, might not be as long as the asset’s total productive life. For example, the productive life of a computer can be eight years or more. Some companies, however, trade in old computers for new ones every two years. In this case, these computers have a two-year useful life, meaning the cost of these computers (less their expected trade-in values) is charged to depreciation expense over a two-year period. P 1 Atef Abuelaish

Depreciation Methods Straight-line [ST. L.] Units-of-production
Double Declining-balance [D.D. BAL.] Asset we will depreciate in future screens Depreciation methods are used to allocate a plant asset’s cost over the accounting periods in its useful life. The most frequently used method of depreciation is the straight-line method. Another common depreciation method is the units-of-production method. We explain both of these methods in this section. This section also describes accelerated depreciation methods, with a focus on the declining-balance method. The computations in this section use information about a machine that inspects athletic shoes before packaging. Manufacturers such as Converse, Reebok, Adidas, and Fila use this machine. Data for this machine are presented in this slide. We will use this to illustrate depreciation using the three methods listed. Let’s begin by looking at straight-line depreciation. P 1 Atef Abuelaish

1) Straight-Line Method
Straight-line depreciation charges the same amount of expense to each period of the asset’s useful life. A two-step process is used. We first compute the depreciable cost of the asset, also called the cost to be depreciated. It is computed by subtracting the asset’s salvage value from its total cost. Second, depreciable cost is divided by the number of accounting periods in the asset’s useful life. If this machine is purchased on December 31, 2014, and used throughout its predicted useful life of five years, the straight-line method allocates an equal amount of depreciation to each of the years 2015 through We make the adjusting entry shown above at the end of each of the five years to record straight-line depreciation of this machine. The $1,800 Depreciation Expense is reported on the income statement among operating expenses. The $1,800 Accumulated Depreciation is a contra asset account to the Machinery account in the balance sheet. P 1 Atef Abuelaish

Balance Sheet Presentation
Straight-Line Method Balance Sheet Presentation Machinery $ 10,000 Less: accumulated depreciation 1,800 $ 8,200 The graph on the left in this slide shows the $1,800 per year expenses reported in each of the five years. The graph on the right shows the amounts reported on each of the six December 31 balance sheets. The net balance sheet amount is the asset book value, or simply book value, and is computed as the asset’s total cost less its accumulated depreciation. For example, at the end of year 2 (December 31, 2016), its book value is $6,400 and is reported in the balance sheet as shown. P 1 Atef Abuelaish

Straight-Line Depreciation Schedule
Note three points in this exhibit. First, depreciation expense is the same each period. Second, accumulated depreciation is the sum of current and prior periods’ depreciation expense. Third, book value declines each period until it equals salvage value at the end of the machine’s useful life. P 1 Atef Abuelaish

2) Units-of-Production Method
Depreciation Per Unit = Cost - Salvage Value Total Units of Production Step 1: Step 2: Depreciation Expense = Per Unit × Number of Units Produced in the Period When equipment use varies from period to period, the units-of-production depreciation method can better match expenses with revenues. Units-of-production depreciation charges a varying amount to expense for each period of an asset’s useful life depending on its usage. A two-step process is used to compute units-of-production depreciation. We first compute depreciation per unit by subtracting the asset’s salvage value from its total cost and then dividing by the total number of units expected to be produced during its useful life. Units of production can be expressed in product or other units such as hours used or miles driven. The second step is to compute depreciation expense for the period by multiplying the units produced in the period by the depreciation per unit. P 1 Atef Abuelaish

Units-of-Production Method
Assume that 7,000 units were inspected during the first year. Depreciation would be calculated as follows: Depreciation Per Unit = Cost - Salvage Value Total Units of Production Step 1: $9,000 36,000 = $0.25/unit Using data on the number of shoes inspected by the machine, we can compute the units-of- production depreciation schedule shown in this slide. For example, depreciation for the first year is $1,750 (7,000 shoes at $0.25 per shoe). Step 2: Depreciation Expense = Per Unit × Number of Units Produced in the Period = $0.25 × 7,000 = $1,750 P 1 Atef Abuelaish

Units-of-Production Depreciation Schedule
Units produced and sold during the period. Depreciation for the second year is $2,000 (8,000 shoes at $0.25 per shoe). Other years are similarly computed. This graphic shows that depreciation expense depends on unit output, (2) accumulated depreciation is the sum of current and prior periods’ depreciation expense, and (3) book value declines each period until it equals salvage value at the end of the asset’s useful life. P 1 Atef Abuelaish

3) Double-Declining-Balance Method
An accelerated depreciation method yields larger depreciation expenses in the early years of an asset’s life and less depreciation in later years. The most common accelerated method is the declining-balance method of depreciation, which uses a depreciation rate that is a multiple of the straight-line rate and applies it to the asset’s beginning- of-period book value. The amount of depreciation declines each period because book value declines each period. To illustrate, let’s apply the double- declining-balance method to compute depreciation expense for our $10,000 machine with a 5-year useful life. This slide shows the first-year depreciation computation for the machine. The three-step process is to (1) divide 100% by five years to determine the straight-line rate of 20%, or 1/5, per year, (2) double this 20% rate to get the declining-balance rate of 40%, or 2/5, per year, and (3) compute depreciation expense as 40%, or 2/5, multiplied by the beginning-of-period book value. P 1 Atef Abuelaish

Double-Declining-Balance Method
The double-declining-balance depreciation schedule is shown here. The schedule follows the formula except for year 2019, when depreciation expense is $296. This $296 is not equal to 40% x $1,296, or $ If we had used the $ for depreciation expense in 2019, the ending book value would equal $777.60, which is less than the $1,000 salvage value. Instead, the $296 is computed by subtracting the $1,000 salvage value from the $1,296 book value at the beginning of the fifth year (the year when DDB depreciation cuts into salvage value). P 1 Atef Abuelaish

Comparing Depreciation Methods
Methods Used by Companies This first table show depreciation expense for each year of the machine’s useful life under each of the three depreciation methods. While depreciation expense per period differs for different methods, total depreciation expense of $9,000 is the same over the machine’s useful life. The book value of the asset when using straight-line is always greater than the book value from using double-declining-balance, except at the beginning and end of the asset’s useful life, when it is the same. Also, the straight-line method yields a steady pattern of depreciation expense while the units-of-production depreciation depends on the number of units produced. Each of these methods is acceptable because it allocates cost in a systematic and rational manner. As shown in the above graph, about 85% of companies use straight-line depreciation for plant assets, 5% use units-of-production, and 4% use declining- balance. Another 6% use an unspecified accelerated method—most likely declining-balance. P 1 Atef Abuelaish

Depreciation for Tax Reporting
Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. MACRS depreciation provides for rapid write-off of an asset’s cost in order to stimulate new investment. The records a company keeps for financial accounting purposes are usually separate from the records it keeps for tax accounting purposes. This is so because financial accounting aims to report useful information on financial performance and position, whereas tax accounting reflects government objectives in raising revenues. Differences between these two accounting systems are normal and expected. Depreciation is a common example of how the records differ. For example, many companies use accelerated depreciation in computing taxable income. Reporting higher depreciation expense in the early years of an asset’s life reduces the company’s taxable income in those years and increases it in later years, when the depreciation expense is lower. The company’s goal here is to postpone its tax payments. P 1 Atef Abuelaish

Partial-Year Depreciation
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Partial-Year Depreciation
When a plant asset is acquired during the year, depreciation is calculated for the fraction of the year the asset is owned. Cost $ ,000 Salvage value 1,000 Depreciable cost $ ,000 Useful life Accounting periods 5 years Units inspected 36,000 units Assume our machinery was purchased on October 8, Let’s calculate depreciation expense for 2014, assuming we use straight-line depreciation. Plant assets are purchased and disposed of at various times. When an asset is purchased (or disposed of) at a time other than the beginning or end of an accounting period, depreciation is recorded for part of a year. This is done so that the year of purchase or the year of disposal is charged with its share of the asset’s depreciation. To illustrate, assume that the shoe machine is purchased and placed in service on October 8, 2014, and the annual accounting period ends on December 31. Since this machine is purchased and used for nearly three months in 2014, the calendar-year income statement should report depreciation expense on the machine for that part of the year. Normally, depreciation assumes that the asset is purchased on the first day of the month nearest the actual date of purchase. In this case, since the purchase occurred on October 8, we assume an October 1 purchase date. This means that three months’ depreciation is recorded in Using straight-line depreciation, we compute three months’ depreciation of $450 as shown in this slide. C 2 Atef Abuelaish

Changes in Estimates for Depreciation
Predicted salvage value Predicted useful life Depreciation is an estimate Depreciation is based on estimates of salvage value and useful life. During the useful life of an asset, new information may indicate that these estimates are inaccurate. If our estimate of an asset’s useful life and/or salvage value changes, what should we do? The answer is to use the new estimate to compute depreciation for current and future periods. This means that we revise the depreciation expense computation by spreading the cost yet to be depreciated over the remaining useful life. This approach is used for all depreciation methods. Over the life of an asset, new information may come to light that indicates the original estimates were inaccurate. C 2 Atef Abuelaish

Changes in Estimates for Depreciation
Let’s look at our machinery from the previous examples and assume that at the beginning of the asset’s third year, its book value is $6,400 ($10,000 cost less $3,600 accumulated depreciation using straight-line depreciation). At that time, it is determined that the machinery will have a remaining useful life of 4 years, and the estimated salvage value will be revised downward from $1,000 to $400. Let’s return to the machine described in Exhibit 8.8 using straight-line depreciation. At the beginning of this asset’s third year, its book value is $6,400, computed as $10,000 minus $3,600. Assume that at the beginning of its third year, the estimated number of years remaining in its useful life changes from three to four years and its estimate of salvage value changes from $1,000 to $400. Straight-line depreciation for each of the four remaining years is computed as shown above. Thus, $1,500 of depreciation expense is recorded for the machine at the end of the third through sixth years—each year of its remaining useful life. . C 2 Atef Abuelaish

Reporting Depreciation
Both the cost and accumulated depreciation of plant assets are reported on the balance sheet or in its notes. Dale Jarrett Racing Adventure, for instance, reports the amounts shown in this slide. Many companies also show plant assets on one line with the net amount of cost less accumulated depreciation. When this is done, the amount of accumulated depreciation is disclosed in a note. Review what you have learned in the following NEED-TO-KNOW Slides. C 2 Atef Abuelaish

NEED-TO-KNOW Part 1. A machine costing $22,000 with a five-year life and an estimated $2,000 salvage value is installed on January 1. The factory manager estimates the machine will produce 1,000 units of product during its life. It actually produces the following units: Year 1, 200; Year 2, 400; Year 3, 300; Year 4, 80; and Year 5, 30. The total number of units produced by the end of Year 5 exceeds the original estimate—this difference was not predicted. (The machine must not be depreciated below its estimated salvage value.) Prepare a table with the following four-column headings: Year; Straight-Line; Units-of- Production; Double-Declining-Balance; and then compute depreciation for each year (and total depreciation for all years combined) under each depreciation method. Year Straight-Line Units-of-Production Double-Declining-Balance Year 1 Year 2 Year 3 Year 4 Year 5 Total $20,000 $20,000 $20,000 Part 1. A machine costing $22,000 with a five-year life and an estimated $2,000 salvage value is installed on January 1. The factory manager estimates the machine will produce 1,000 units of product during its life. It actually produces the following units: Year 1, 200; Year 2, 400; Year 3, 300; Year 4, 80; and Year 5, 30. The total number of units produced by the end of Year 5 exceeds the original estimate - this difference was not predicted. We're reminded that the machine must not be depreciated below its estimated salvage value. Prepare a table with the following four-column headings: Year; Straight-Line; Units-of-Production; Double-Declining-Balance; and then compute depreciation for each year (and total depreciation for all years combined) under each depreciation method. Regardless of the depreciation method used, total depreciation expense over the life of the asset will equal $20,000; the $22,000 cost minus the $2,000 salvage value. C 2 Atef Abuelaish

NEED-TO-KNOW Part 1. A machine costing $22,000 with a five-year life and an estimated $2,000 salvage value is installed on January 1. The factory manager estimates the machine will produce 1,000 units of product during its life. It actually produces the following units: Year 1, 200; Year 2, 400; Year 3, 300; Year 4, 80; and Year 5, 30. The total number of units produced by the end of Year 5 exceeds the original estimate—this difference was not predicted. (The machine must not be depreciated below its estimated salvage value.) Year Straight-Line Units-of-Production Double-Declining-Balance Year 1 $4,000 Year 2 4,000 Year 3 4,000 Year 4 4,000 Year 5 4,000 Total $20,000 $20,000 $20,000 Straight-Line Cost - Salvage $22,000 - $2,000 $4,000 per year EUL (years) 5 years The formula for straight-line depreciation is: (Cost minus Salvage) divided by the estimated useful life expressed in terms of years. The $22,000 cost minus the $2,000 salvage value divided by five years is depreciation expense of $4,000 per year. Depreciation of $4,000 per year for five years is a total of $20,000, and will reduce the book value from its $22,000 cost to its salvage value of $2,000. C 2 Atef Abuelaish

NEED-TO-KNOW Part 1. A machine costing $22,000 with a five-year life and an estimated $2,000 salvage value is installed on January 1. The factory manager estimates the machine will produce 1,000 units of product during its life. It actually produces the following units: Year 1, 200; Year 2, 400; Year 3, 300; Year 4, 80; and Year 5, 30. The total number of units produced by the end of Year 5 exceeds the original estimate—this difference was not predicted. (The machine must not be depreciated below its estimated salvage value.) Year Straight-Line Units-of-Production Double-Declining-Balance Year 1 $4,000 $4,000 Year 2 4,000 8,000 Year 3 4,000 6,000 Year 4 4,000 1,600 Year 5 4,000 400 Total $20,000 $20,000 $20,000 Units-of-Production Cost - Salvage $22,000 - $2,000 $20 per unit For first 1,000 units produced! EUL (units) 1,000 units Units Depreciation The formula for units-of-production depreciation is similar. The numerator is cost minus salvage, and we divide by the estimated useful life. But under the units-of-production method, the estimated useful life is expressed in terms of units of output. $20,000 divided by 1,000 total units is depreciation expense of $20 per unit. Actual units produced: Year 1, 200; Year 2, 400; Year 3, 300; Year 4, 80; and Year 5, 30. A total of 1,010 units are produced. If depreciation expense of $20 per unit is recorded for each of the 1,010 units produced, total depreciation expense equals $20,200, this is more than the actual amount and would bring the book value to an amount less than salvage. So it's important to remember that we're depreciating $20 per unit, but only for the first 1,000 units produced. As soon as the machine produces 1,000 units, the depreciation process stops! In Year 1, total depreciation expense is $4,000; 200 units produced at $20 per unit. In Year 2, they produce twice as many units; depreciation expense is twice as much; $8,000. In Year 3, 300 units produced at $20 per unit is $6,000. In Year 4, 80 units at $20 per unit, $1,600, and in Year 5, 20 units at $20 per unit is depreciation expense of $400. Total depreciation expense is $20,000; cost minus salvage. Actual Depreciable Expense Year 1 200 200 $20 per unit $4,000 Year 2 400 400 $20 per unit 8,000 Year 3 300 300 $20 per unit 6,000 Year 4 80 80 $20 per unit 1,600 Year 5 30 20 $20 per unit 400 Total 1,010 1,000 $20,000 C 2 Atef Abuelaish

NEED-TO-KNOW Part 1. A machine costing $22,000 with a five-year life and an estimated $2,000 salvage value is installed on January 1. The factory manager estimates the machine will produce 1,000 units of product during its life. Year Straight-Line Units-of-Production Double-Declining-Balance Year 1 $4,000 $4,000 Year 2 4,000 8,000 Year 3 4,000 6,000 Year 4 4,000 1,600 Year 5 4,000 400 Total $20,000 $20,000 $20,000 Double-Declining-Balance Step 1: Straight-line rate 100% 100% 20% EUL (years) 5 years x 2 Step 2: Double the Straight-line rate 200% 200% 40% EUL (years) 5 years The final method is called "Double-Declining-Balance" (DDB). Double-declining- balance (DDB) is a three-step process. First, we calculate the straight-line rate. 100% divided by the estimated useful life of five years is a straight-line rate of 20% per year. Since this is the double-declining-balance method, we double the straight line rate; 20% multiplied by 2 is 40%. Alternatively, you can combine the two steps by taking 200% and dividing by five years; 200% divided by five years is 40%. Step three calculates the depreciation expense. Depreciation expense is calculated by taking the double-declining-balance rate, and multiplying by the beginning-of-year book value. Step 3: Depreciation expense = DDB rate x Beginning-period book value C 2 Atef Abuelaish

NEED-TO-KNOW Part 1. A machine costing $22,000 with a five-year life and an estimated $2,000 salvage value is installed on January 1. The factory manager estimates the machine will produce 1,000 units of product during its life. Year Straight-Line Units-of-Production Double-Declining-Balance Year 1 $4,000 $4,000 $8,800 Year 2 4,000 8,000 5,280 Year 3 4,000 6,000 3,168 Year 4 4,000 1,600 1,901 Year 5 4,000 400 851 Total $20,000 $20,000 $20,000 Double-Declining-Balance Book Value = Cost – Accumulated Depreciation Beginning DDB Depreciation Accumulated Book Book Value Rate Expense Depreciation Value Year 1 $22,000 40% $8,800 $8,800 $13,200 Year 2 13,200 40% 5,280 14,080 7,920 Year 3 7,920 40% 3,168 17,248 4,752 The book value declines over time. The maximum book value is always the asset's cost, $22,000, and the minimum book value is salvage value. Total depreciation expense over the five-year period must equal $20,000. The declining balance is the book value, cost minus accumulated depreciation. In Year 1, the beginning book value is the cost of $22,000. We multiply by the DDB rate, 40%, to calculate depreciation expense in the first year, $8,800. The journal entry is a debit to Depreciation expense and a credit to Accumulated depreciation, bringing the end-of-year balance in Accumulated depreciation to $8,800. As the balance in Accumulated depreciation increases, the book value decreases. Cost of $22,000 minus accumulated depreciation of $8,800 is an end-of-year book value of $13,200. The book value at the end of Year 1 becomes the beginning book value for Year 2. $13,200 multiplied by 40% is $5,280. The balance in Accumulated depreciation increases to $14,080, reducing the book value to $7,920. $7,920 multiplied by 40% is depreciation expense of $3,168. This increases the balance in Accumulated depreciation to $17,248, and reduces the book value to $4,752. $4,752 multiplied by 40% is $1,901. Accumulated depreciation at the end of Year 4 is $19,149, dropping the book value to $2,851. In Year 5, if we continue the process, $2,851multiplied by 40%; depreciation expense is $1,140. This brings the balance in Accumulated depreciation to $20,289; more than the $20,000 maximum. If we depreciate $1,140 in Year 5, the book value drops to less than salvage, $1,711. So rather than using the rate in Year 5, we calculate depreciation expense to be $851. This brings the balance in Accumulated depreciation up to $20,000 and reduces the book value to its minimum, $2,000 salvage value. Year 4 4,752 40% 1,901 19,149 2,851 Year 5 2,851 40% 1,140 851 20,000 20,289 1,711 2,000 Total $20,000 C 2 Atef Abuelaish

NEED-TO-KNOW Part 2. In early January 20X1, a company acquires equipment for $3,800. The company estimates this equipment to have a useful life of three years and a salvage value of $200. Early in 20X3, the company changes its estimates to a total four-year useful life and zero salvage value. Using the straight-line method, what is depreciation expense for the year ended December 31, 20X3? Straight-Line Depreciation - Original Cost minus Salvage $3,800 - $200 $3,600 Estimated Useful Life (years) 3 years 3 Depreciation expense = $1,200 per year Straight-Line Depreciation - Revised Book Value minus Revised Salvage $1,400 - $0 $1,400 Estimated Remaining Years 2 remaining years 2 Depreciation expense = $700 per year Year Beginning Annual Year-End Book Value Depreciation Book Value Part 2. In early January 20X1, a company acquires equipment for $3,800. The company estimates this equipment to have a useful life of three years and a salvage value of $200. Early in 20X3, the company changes its estimates to a total four-year useful life and zero salvage value. Using the straight-line method, what is depreciation expense for 20X3? Straight-line depreciation was originally calculated as cost minus salvage divided by the estimated useful life in terms of years. $3,800 minus $200 divided by three years is depreciation expense of $1,200 per year. The beginning book value was $3,800, the equipment's cost. In 20X1, depreciation of $1,200 reduced the book value to $2,600. In 20X2, an additional $1,200 of depreciation reduced the book value to $1,400. At the beginning of 20X3, when the book value is $1,400, the company changes their estimates, so the amount of depreciation must also be changed. The book value minus the revised salvage value is divided by the estimated remaining years. Total depreciation of $1,400 must be reported over the remaining two years; depreciation expense is $700 per year. In 20X3, $700 of depreciation reduces the book value at the end of the year to $700. In 20X4, an additional $700 of depreciation expense reduces the book value to $0. Total depreciation over the four-year period is $3,800, cost minus salvage. 1 $3,800 $1,200 $2,600 2 2,600 1,200 1,400 3 1,400 700 700 4 700 700 Total $3,800 C 2 Atef Abuelaish

Additional Expenditures
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Additional Expenditures
After a company acquires a plant asset and puts it into service, it often makes additional expenditures for that asset’s operation, maintenance, repair, and improvement. In recording these expenditures, it must decide whether to capitalize or expense them (to capitalize an expenditure is to debit the asset account). The issue is whether these expenditures are reported as current- period expenses or added to the plant asset’s cost and depreciated over its remaining useful life. Revenue expenditures, also called income statement expenditures, are additional costs of plant assets that do not materially increase the asset’s life or productive capabilities. They are recorded as expenses and deducted from revenues in the current period’s income statement. Examples of revenue expenditures are cleaning, repainting, adjustments, and lubricants. Capital expenditures, also called balance sheet expenditures, are additional costs of plant assets that provide benefits extending beyond the current period. They are debited to asset accounts and reported on the balance sheet. Capital expenditures increase or improve the type or amount of service an asset provides. Examples are roofing replacement, plant expansion, and major overhauls of machinery and equipment. After a plant asset is purchased, the company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, upgrading the asset, and similar expenditures. In recording these expenditures, it must decide whether to capitalize or expense them (to capitalize an expenditure is to debit the asset account). The issue is whether these expenditures are reported as current period expenses or added to the plant asset’s cost and depreciated over its remaining useful life. One way to handle these types of expenditures is to treat them as a capital expenditure and charge the amount to a balance sheet account like the asset or accumulated depreciation. In most cases, the capital expenditure represents an additional cost of plant assets that provide benefits extending beyond the current period. In some cases, the expenditures may be treated as a revenue expenditure and charged to current period income as an expense. For each expenditure subsequent to acquisition of a plant asset, we must decide if the expenditure is to be treated as a capital or revenue expenditure. If the amounts involved are not material, most companies expense the item. C 3 Atef Abuelaish

Revenue and Capital Expenditures
Ordinary repairs are expenditures to keep an asset in normal, good operating condition. They are necessary if an asset is to perform to expectations over its useful life. Ordinary repairs do not extend an asset’s useful life beyond its original estimate or increase its productivity beyond original expectations. Examples are normal costs of cleaning, lubricating, adjusting, oil changing, and replacing small parts of a machine. Ordinary repairs are treated as revenue expenditures. This means their costs are reported as expenses on the current-period income statement. Accounting for betterments and extraordinary repairs is similar—both are treated as capital expenditures. Betterments (Improvements) Betterments, also called improvements, are expenditures that make a plant asset more efficient or productive. A betterment often involves adding a component to an asset or replacing one of its old components with a better one and does not always increase an asset’s useful life. An example is replacing manual controls on a machine with automatic controls. One special type of betterment is an addition, such as adding a new wing or dock to a warehouse. Since a betterment benefits future periods, it is debited to the asset account as a capital expenditure. The new book value (less salvage value) is then depreciated over the asset’s remaining useful life. Extraordinary repairs are expenditures extending the asset’s useful life beyond its original estimate. Extraordinary repairs are capital expenditures because they benefit future periods. Their costs are debited to the asset account (or to accumulated depreciation). C 3 Atef Abuelaish

Disposals of Plant Assets
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Disposals of Plant Assets
Update depreciation to the date of disposal. Journalize disposal by: Recording cash received (debit) or paid (credit). Recording a gain (credit) or loss (debit). Plant assets are disposed of for several reasons. Some are discarded because they wear out or become obsolete. Others are sold because of changing business plans. Regardless of the reason, disposals of plant assets occur in one of three basic ways: discarding, sale, or exchange. The general steps in accounting for a disposal of plant assets are described in this slide. After we dispose of a plant asset, the first thing we do is update depreciation to the date of disposal. After completing the update, we can prepare the journal entry. We do so by recording a debit to the cash account, if cash was received, or credit the cash account, if cash was paid by the company. In addition, we must determine whether a gain or loss is associated with the disposal. A gain is recorded with a credit, just like revenue, and a loss is recorded with a debit, just like an expense account. We complete the entry by removing the plant asset’s cost from our books with a credit, and remove the related accumulated depreciation with a debit. Let’s see how we calculate the gain or loss associated with the disposal. Removing accumulated depreciation (debit). Removing the asset cost (credit). P 2 Atef Abuelaish

Discarding Plant Assets
If Cash > BV, record a gain (credit). If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss. Update depreciation to the date of disposal. Journalize disposal by: Recording a gain (credit) or loss (debit). Recording cash received (debit) or paid (credit). If the amount of cash received is greater than the book value of the asset (cost less accumulated depreciation), a gain is associated with the disposal. If the cash received is less than the book value of the asset, a loss will be recorded. When the amount of cash is exactly equal to the book value of the asset, there will be no gain or loss in connection with the disposal. Now let’s look at a specific example of disposal of a plant asset. Removing accumulated depreciation (debit). Removing the asset cost (credit). P 2 Atef Abuelaish

A machine costing $9,000, with accumulated depreciation of $9,000 on December 31 of the previous year was discarded on June 5th of the current year. The company is depreciating the equipment using the straight-line method over eight years with zero salvage value. A plant asset is discarded when it is no longer useful to the company and it has no market value. To illustrate, assume that a machine costing $9,000 with accumulated depreciation of $9,000 is discarded. When accumulated depreciation equals the asset’s cost, it is said to be fully depreciated (zero book value). The entry to record the discarding of this asset is shown in this slide. This entry reflects all four steps of Exhibit Step 1 is unnecessary since the machine is fully depreciated. Step 2 is reflected in the debit to Accumulated Depreciation and credit to Machinery. Since no other asset is involved, step 3 is irrelevant. Finally, since book value is zero and no other asset is involved, no gain or loss is recorded in step 4. P 2 Atef Abuelaish

Equipment costing $8,000, with accumulated depreciation of $6,000 on December 31st of the previous year was discarded on July 1st of the current year. The company is depreciating the equipment using the straight-line method over eight years with zero salvage value. Step 1: Bring the depreciation up-to-date. How do we account for discarding an asset that is not fully depreciated or one whose depreciation is not up-to-date? To answer this, consider equipment costing $8,000 with accumulated depreciation of $6,000 on December 31 of the prior fiscal year-end. This equipment is being depreciated using the straight-line method over eight years with zero salvage. On July 1 of the current year it is discarded. Step 1 is to bring depreciation up-to-date. The required entry is shown above. Steps 2 through 4 are reflected in the second (and final) entry. This loss is computed by comparing the equipment’s $1,500 book value ($8,000 - $6,000 - $500) with the zero net cash proceeds. The loss is reported in the Other Expenses and Losses section of the income statement. Discarding an asset can sometimes require a cash payment that would increase the loss. Step 2: Record discarding of asset. P 2 Atef Abuelaish

Selling Plant Assets On March 31st, BTO sells equipment that originally cost $16,000 and has accumulated depreciation of $12,000 at December 31st of the prior calendar year-end. Annual depreciation on this equipment is $4,000 using straight-line depreciation. The equipment is sold for $3,000 cash. Step 1: Update depreciation to March 31st. Step 2: Record sale of asset at book value ($16,000 - $13,000 = $3,000). Companies often sell plant assets when they restructure or downsize operations. To illustrate the accounting for selling plant assets, we consider BTO’s March 31 sale of equipment that cost $16,000 and has accumulated depreciation of $12,000 at December 31 of the prior calendar year-end. Annual depreciation on this equipment is $4,000 computed using straight-line depreciation. Step 1 of this sale is to record depreciation expense and update accumulated depreciation to March 31 of the current year. Steps 2 through 4 can be reflected in one final entry that depends on the amount received from the asset’s sale. In this case $3,000. Sale at Book Value - If BTO receives $3,000 cash, an amount equal to the equipment’s book value as of March 31 (book value = $16,000 - $12,000 - $1,000), no gain or loss occurs on disposal. The entry is shown above. P 2 Atef Abuelaish

Selling Plant Assets On March 31st, BTO sells equipment that originally cost $16,000 and has accumulated depreciation of $12,000 at December 31st of the prior calendar year-end. Annual depreciation on this equipment is $4,000 using straight-line depreciation. The equipment is sold for $2,500 cash. Step 1: Update depreciation to March 31st. Step 2: Record sale of asset at a loss (Book value $3,000 - $2,500 cash received). As before, we must bring the depreciation up-to-date as of March 31st. The journal entry is to debit Depreciation Expense for $1,000 and credit Accumulated Depreciation – Equipment for the same amount. The balance in the accumulated depreciation account is now $13,000. Sale below Book Value - If BTO receives $2,500, an amount that is $500 below the equipment’s $3,000 book value as of March 31, a loss on disposal occurs. The entry is shown above. Review what you have learned in the following NEED-TO-KNOW Slides. P 2 Atef Abuelaish

NEED-TO-KNOW A company pays $1,000 for equipment expected to last four years and have a $200 salvage value. Prepare journal entries to record the following costs related to the equipment. a) During the second year of the equipment’s life, $400 cash is paid for a new component expected to increase the equipment’s productivity by 20% a year. b) During the third year, $250 cash is paid for normal repairs necessary to keep the equipment in good working order. c) During the fourth year, $500 is paid for repairs expected to increase the useful life of the equipment from four to five years. Betterments, also called improvements, are expenditures that make a plant asset more efficient or productive. Extraordinary repairs are expenditures extending the asset’s useful life beyond its original estimate. General Journal Debit Credit Purchase Equipment 1,000 Cash 1,000 a) Equipment 400 Cash 400 A company pays $1,000 for equipment expected to last four years and have a $200 salvage value. Prepare journal entries to record the following costs related to the equipment. Betterments, also called improvements, are expenditures that make a plant asset more efficient or productive. Extraordinary repairs are expenditures extending the asset’s useful life beyond its original estimate. The cost of betterments and extraordinary repairs are capitalized; recorded as assets. At the time the equipment was purchased, the journal entry was a debit to the Equipment account and a credit to Cash. a) During the second year of the equipment’s life, $400 cash is paid for a new component expected to increase the equipment’s productivity by 20% a year. This cost is a betterment; it's making the plant asset more productive. The journal entry is a debit to the Equipment account, $400, and a credit to Cash. b) During the third year, $250 cash is paid for normal repairs necessary to keep the equipment in good working order. This expenditure does not make the plant asset more efficient or productive, or extend the asset's useful life. This cost is expensed as incurred. We debit Repairs expense and credit Cash. c) During the fourth year, $500 is paid for repairs expected to increase the useful life of the equipment from four to five years. This is an extraordinary repair. The journal entry is a debit to the Equipment account and a credit to Cash. b) Repairs expense 250 Cash 250 c) Equipment 500 Cash 500 P 2 Atef Abuelaish

NEED-TO-KNOW A company owns a machine that cost $500 and has accumulated depreciation of $400. Prepare the entry to record the disposal of the machine on January 2 under each of the following independent situations. a) The machine needed extensive repairs, and it was not worth repairing. The company disposed of the machine, receiving nothing in return. b) The company sold the machine for $80 cash. c) The company sold the machine for $100 cash. d) The company sold the machine for $110 cash. Machine Accumulated Depreciation - Machine Cost 500 To date 400 Book Value = $100 General Journal Debit Credit Purchase Machine 500 A company owns a machine that cost $500 and has accumulated depreciation of $400. Prepare the entry to record the disposal of the machine on January 2 under each of the following independent situations. At the time the machine was purchased, the journal entry was a debit to the Machine account and a credit to Cash. Over the life of the asset, $400 has been depreciated, debiting Depreciation expense and crediting Accumulated depreciation. Cash 500 Over life Depreciation expense 400 Accumulated Depreciation - Machine 400 P 2 Atef Abuelaish

NEED-TO-KNOW Machine Accumulated Depreciation - Machine Cost 500
To date 400 Book Value = $100 a) The machine needed extensive repairs, and it was not worth repairing. The company disposed of the machine, receiving nothing in return. b) The company sold the machine for $80 cash. c) The company sold the machine for $100 cash. d) The company sold the machine for $110 cash. General Journal Debit Credit Cash $ rec’d Loss on sale of machine Cash < BV Accumulated Depreciation - Machine $ to date Machine Cost Gain on sale of machine Cash > BV The book value of the equipment on January 2, cost minus accumulated depreciation, is $100. The general format to record the disposal of a depreciable asset is as follows: First we eliminate the book value, crediting the asset account for the original cost, and debiting Accumulated depreciation for the amount recorded to date. We debit Cash for the amount received, and then compare the book value with the amount of cash received. If the amount of cash received is less than book value, we debit Loss on sale of machinery. Atef Abuelaish

NEED-TO-KNOW Machine Accumulated Depreciation - Machine Cost 500
To date 400 Book Value = $100 a) The machine needed extensive repairs, and it was not worth repairing. The company disposed of the machine, receiving nothing in return. b) The company sold the machine for $80 cash. c) The company sold the machine for $100 cash. d) The company sold the machine for $110 cash. General Journal Debit Credit a) Accumulated Depreciation - Machine 400 Loss on disposal 100 Machine 500 b) Cash 80 Loss on sale of machine 20 Accumulated Depreciation - Machine 400 Machine 500 If the amount of cash received is greater than book value, we credit gain on sale of machine. In a) the asset is simply thrown out; no cash is received. We eliminate the book value, crediting the Machine account for $500, and debiting Accumulated depreciation. The amount of cash received is $0. This is $100 less than the book value. We debit Loss on disposal, $100. b) The company sold the machine for $80 cash. We always eliminate the book value, crediting the asset account for the original cost, and debiting accumulated depreciation for the amount recorded to date. The amount of cash received is $80. This is $20 less than the book value. We debit loss on sale of machine for $20. c) The company sold the machine for $100 cash. We eliminate the book value, crediting the asset account for the cost of $500 and debiting Accumulated depreciation for the amount recorded to date, $400. And we debit Cash for the amount received, $100. In this case, the cash received was equal to the book value; there is no gain or loss on the sale. c) Cash 100 Accumulated Depreciation - Machine 400 Machine 500 Atef Abuelaish

NEED-TO-KNOW P 2 Machine Accumulated Depreciation - Machine Cost 500
To date 400 Book Value = $100 a) The machine needed extensive repairs, and it was not worth repairing. The company disposed of the machine, receiving nothing in return. b) The company sold the machine for $80 cash. c) The company sold the machine for $100 cash. d) The company sold the machine for $110 cash. General Journal Debit Credit d) Cash 110 Accumulated Depreciation - Machine 400 Machine 500 Gain on sale of machine 10 d) The company sold the machine for $110 cash. We eliminate the book value, crediting the Machine account, $500, and debiting Accumulated depreciation for $400. Debit Cash for the amount received, $110, and because the amount of cash received is greater than the book value, we credit Gain on sale of machine for the difference, $10. P 2 Atef Abuelaish

II Natural Resources Atef Abuelaish

Examples: oil, coal, gold
Natural Resources Total cost, including exploration and development, is charged to depletion expense over periods benefited. Extracted from the natural environment and reported at cost less accumulated depletion. Natural resources are recorded at cost, which includes all expenditures necessary to acquire the resource and prepare it for its intended use. Depletion is the process of allocating the cost of a natural resource to the period when it is consumed. Natural resources are reported on the balance sheet at cost less accumulated depletion. The depletion expense per period is usually based on units extracted from cutting, mining, or pumping. This is similar to units-of-production depreciation. Examples: oil, coal, gold P 3 Atef Abuelaish

Cost Determination and Depletion
Let’s consider a mineral deposit with an estimated 250,000 tons of available ore. It is purchased for $500,000, and we expect zero salvage value. Let’s consider a mineral deposit with an estimated 250,000 tons of available ore. It is purchased for $500,000, and we expect zero salvage value. The depletion charge per ton of ore mined is $2, computed as $500,000/250,000 tons. If 85,000 tons are mined and sold in the first year, the depletion charge for that year is $170,000. P 3 Atef Abuelaish

Depletion of Natural Resources
Depletion expense in the first year would be: Balance Sheet presentation of natural resources: If the company extracts and sells 85,000 tons during the year, depletion expense will be $170,000 (85,000 tons times $2 per ton). The journal entry to record depletion is to debit Depletion Expense – Mineral Deposit for $170,000, and credit Accumulated Depletion – Mineral Deposit for the same amount. The period-end balance sheet reports the mineral deposit as shown in this slide. Since all 85,000 tons of the mined ore are sold during the year, the entire $170,000 of depletion is reported on the income statement. If some of the ore remains unsold at year-end, however, the depletion related to the unsold ore is carried forward on the balance sheet and reported as Ore Inventory, a current asset. P 3 Atef Abuelaish

Plant Assets Used in Extracting
Specialized plant assets may be required to extract the natural resource. These assets are recorded in a separate account and depreciated. The conversion of natural resources by mining, cutting, or pumping usually requires machinery, equipment, and buildings. When the usefulness of these plant assets is directly related to the depletion of a natural resource, their costs are depreciated using the units-of-production method in proportion to the depletion of the natural resource. For example, if a machine is permanently installed in a mine and 10% of the ore is mined and sold in the period, then 10% of the machine’s cost (less any salvage value) is allocated to depreciation expense. The same procedure is used when a machine is abandoned once resources have been extracted. If, however, a machine will be moved to and used at another site when extraction is complete, the machine is depreciated over its own useful life. Review what you have learned in the following NEED-TO-KNOW Slide. P 3 Atef Abuelaish

NEED-TO-KNOW A company acquires a zinc mine at a cost of $750,000. It incurs additional costs of $100,000 to access the mine, which is estimated to hold 200,000 tons of zinc. The estimated value of the land after the zinc is removed is $50,000. 1) Prepare the entry(ies) to record the cost of the zinc mine. 2) Prepare the year-end adjusting entry if 50,000 tons of zinc are mined, but only 40,000 tons are sold the first year. Depletion - Units-of-Production Cost - Salvage $850,000 - $50,000 $4 per ton EUL (units) 200,000 tons General Journal Debit Credit 1) Zinc mine 850,000 Cash 850,000 2) Depletion expense - Zinc mine 40,000 tons x $4 160,000 Zinc inventory 10,000 tons x $4 40,000 Accumulated depletion - Zinc mine 50,000 tons x $4 200,000 A company acquires a zinc mine at a cost of $750,000. It incurs additional costs of $100,000 to access the mine, which is estimated to hold 200,000 tons of zinc. The estimated value of the land after the zinc is removed is $50,000. 1) Prepare the entry(ies) to record the cost of the zinc mine. To record the purchase, we debit the Zinc mine for the entire cost of $850,000, all necessary costs to get the asset ready for its intended purpose, and we credit Cash. 2) Prepare the year-end adjusting entry if 50,000 tons of zinc are mined, but only 40,000 tons are sold the first year. The year-end adjusting entry is for depletion, which is basically units-of-production depreciation, only for a natural resource. The formula takes (Cost minus Salvage) and divides by the estimated units of production. The $850,000 cost minus the $50,000 salvage value, divided by the total capacity of the mine, 200,000 tons, is depletion of $4 per ton. 50,000 tons are extracted. We credit Accumulated depletion for the number of tons extracted, 50,000, multiplied by the $4 per ton; total depletion is $200, ,000 tons have been sold. Since the revenue has been realized, we match it with an expense; Depletion expense, 40,000 tons at $4 per ton, $160,000. The remaining 10,000 tons are in inventory. We had the depletion to the inventory cost; 10,000 tons at $4 per ton, $40,000. This $40,000 will be expensed at the time those tons are sold. P 3 Atef Abuelaish

III Intangible Assets Atef Abuelaish

Intangible Assets Intangible Assets
Noncurrent assets without physical substance. Often provide exclusive rights or privileges. Intangible Assets Intangible assets are nonphysical assets (used in operations) that confer on their owners long- term rights, privileges, or competitive advantages. Examples are patents, copyrights, licenses, leaseholds, franchises, goodwill, and trademarks. Lack of physical substance does not necessarily imply an intangible asset. Notes and accounts receivable, for instance, lack physical substance, but they are not intangibles. Useful life is often difficult to determine. Usually acquired for operational use. P 4 Atef Abuelaish

Cost Determination and Amortization
Patents Copyrights Franchises and Licenses Trademarks and Trade Names Goodwill Leaseholds Leasehold Improvements Other Intangibles Record at current cash equivalent cost, including purchase price, legal fees, and filing fees. An intangible asset is recorded at cost when purchased. Intangibles are then separated into those with limited lives or indefinite lives. If an intangible has a limited life, its cost is systematically allocated to expense over its estimated useful life through the process of amortization. If an intangible asset has an indefinite life—meaning that no legal, regulatory, contractual, competitive, economic, or other factors limit its useful life—it should not be amortized. (If an intangible with an indefinite life is later judged to have a limited life, it is amortized over that limited life.) Review what you have learned in the following NEED-TO-KNOW Slide. P 4 Atef Abuelaish

NEED-TO-KNOW Part 1. A publisher purchases the copyright on a book for $1,000 on January 1 of this year. The copyright legally protects its owner for 5 more years. The company plans to market and sell prints of the original for 7 years. Prepare entries to record the purchase of the copyright on January 1 of this year, and its annual amortization on December 31 of this year. General Journal Debit Credit Jan. 1 Copyright 1,000 Cash 1,000 Dec. 31 Amortization expense - Copyright $1,000 / 5 years 200 Accumulated amortization - Copyright 200 Part 2. On January 3 of this year, a retailer incurs a $9,000 cost to modernize its store. Improvements include lighting, partitions, and a sound system. These improvements are estimated to yield benefits for 5 years. The retailer leases its store and has 3 years remaining on its lease. Prepare the entry to record (a) the cost of modernization and (b) amortization at the end of this current year. General Journal Debit Credit A publisher purchases the copyright on a book for $1,000 on January 1 of this year. The copyright legally protects its owner for five more years. The company plans to market and sell prints of the original for seven years. Prepare entries to record the purchase of the copyright on January 1 of this year, and its annual amortization on December 31 of this year. The journal entry to record the purchase is a debit to the intangible asset account, Copyright, for the cost of $1,000, and a credit to Cash. On December 31, we debit Amortization expense – Copyright for $1,000 divided by five years. Even though the company plans to market and sell the prints for seven years, the life of the copyright is only five more years. The annual amortization expense is $200. We credit the contra asset account, Accumulated amortization - Copyright. The carrying value of the copyright at the end of the first year is $800. On January 3 of this year, a retailer incurs a $9,000 cost to modernize its store. Improvements include lighting, partitions, and a sound system. These improvements are estimated to yield benefits for five years. The retailer leases its store and has three years remaining on its lease. Prepare the entry to record (a) the cost of modernization and (b) amortization at the end of this current year. The journal entry to record the cost of modernization is a debit to the intangible asset account, Leasehold improvements, $9,000, and a credit to Cash. On December 31, these costs are amortized over the remaining term of the lease. Debit Amortization expense - Leasehold improvements, $9,000 divided by three years remaining on the lease, $3,000, and credit Accumulated amortization - Leasehold improvements. On January 6 of this year, a company pays $6,000 for a patent with a remaining 12-year legal life to produce a supplement expected to be marketable for three years. Prepare entries to record its acquisition and the December 31 amortization entry for the current year. The cost of the patent is a debit to the Patents account, $6,000, and a credit to Cash. In order to adhere to the expense recognition principle, we match the cost with the three years of expected revenues. Debit Amortization expense - Patents, $6,000 divided by three years, $2,000, and credit Accumulated amortization - Patents. Jan. 3 Leasehold improvements 9,000 Cash 9,000 Dec. 31 Amortization expense - Leasehold Improv. $9,000 / 3 years 3,000 Accumulated amortization - Leasehold improvements 3,000 P 4 Atef Abuelaish

Global View Decreases in the Value of Plant Assets
There is one area where notable differences exist, and that is in accounting for changes in the value of plant assets (between the time they are acquired and disposed of). Namely, how does IFRS and U.S. GAAP treat decreases and increases in the value of plant assets subsequent to acquisition? Decreases in the Value of Plant Assets Both U.S. GAAP and IFRS require that an impairment in value be recognized. One area where notable differences exist is in accounting for changes in the value of plant assets (between the time they are acquired and when disposed of). Namely, how do IFRS and U.S. GAAP treat decreases and increases in the value of plant assets subsequent to acquisition? Decreases in the Value of Plant Assets When the value of plant assets declines after acquisition, but before disposition, both U.S. GAAP and IFRS require companies to record those decreases as impairment losses. While the test for impairment uses a different base between U.S. GAAP and IFRS, a more fundamental difference is that U.S. GAAP revalues impaired plant assets to fair value whereas IFRS revalues them to a recoverable amount (defined as fair value less costs to sell). Increases in the Value of Plant Assets U.S. GAAP prohibits companies from recording increases in the value of plant assets. However, IFRS permits upward asset revaluations. Namely, under IFRS, if an impairment was previously recorded, a company would reverse that impairment to the extent necessary and record that increase in income. If the increase is beyond the original cost, that increase is recorded in comprehensive income. Increases in the Value of Plant Assets U.S. GAAP prohibits recording increase in value of plant assets. IFRS permits upward asset revaluation. Atef Abuelaish

Total Asset Turnover Atef Abuelaish

Provides information about a company’s efficiency in using its assets.
11) Total Asset Turnover Total asset turnover = Net sales Average total assets Provides information about a company’s efficiency in using its assets. A company’s assets are important in determining its ability to generate sales and earn income. Managers devote much attention to deciding what assets a company acquires, how much it invests in assets, and how to use assets most efficiently and effectively. One important measure of a company’s ability to use its assets is total asset turnover. Total asset turnover is equal to the net sales for the period divided by the average total assets. The average total assets is computed by taking the beginning balance of total assets, adding the ending balance, and dividing the result by two. To show how we use total asset turnover, let’s look at Molson Coors. We express Molson Coors’s use of assets in generating net sales by saying “it turned its assets over 0.26 times during 2013.” This means that each $1.00 of assets produced $0.26 of net sales. Is a total asset turnover of 0.26 good or bad? It is safe to say that all companies desire a high total asset turnover. Like many ratio analyses, however, a company’s total asset turnover must be interpreted in comparison with those of prior years and of its competitors. Interpreting the total asset turnover also requires an understanding of the company’s operations. Some operations are capital-intensive meaning that a relatively large amount is invested in assets to generate sales. This suggests a relatively lower total asset turnover. Other companies’ operations are labor-intensive, meaning that they generate sales more by the efforts of people than the use of assets. In that case, we expect a higher total asset turnover. Companies with low total asset turnover require higher profit margins (examples are hotels and real estate); companies with high total asset turnover can succeed with lower profit margins (examples are food stores and toy merchandisers). Molson Coors’s turnover is much lower than that for Boston Beer and many other competitors. Total asset turnover for Molson Coors’s competitors, available in industry publications such as Dun & Bradstreet, is generally in the range of 0.5 to 1.0 over this same period. Overall, Molson Coors must improve relative to its competitors on total asset turnover. A1 Atef Abuelaish

Additional Important Equations
12) Straight–Line (ST. L.) Method: [Cost – Salvage Value] / Useful Life in Periods = Depreciation Per Year. 13) Units-of-Production Method: Depreciation Per Unit = [Cost – Salvage Value] / Total Units of Production Depreciation Expenses = Depreciation Per Unit X Number of Units Produced in the Period Atef Abuelaish

Additional Important Equations
14) Double-Declining-Balance (DD. BAL) Method: Straight Line Rate = 100% / Useful Life Double-Declining-Balance Rate = Straight Line Rate X 2 Depreciation Expense = Double-Declining-Balance Rate X Beginning-Period Book Value 15) Natural Resources: [Cost – Salvage Value] / Total Units of Capacity = Depletion Per Unit Depletion Per Unit X Units Extracted & Sold = Depletion Expense Atef Abuelaish

Exchanging Plant Assets
Atef Abuelaish

10A – Exchanging Plant Assets
Many plant assets such as machinery, automobiles, and office equipment are disposed of by exchanging them for newer assets. In a typical exchange of plant assets, a trade-in allowance is received on the old asset and the balance is paid in cash. Accounting for the exchange of assets depends on whether the transaction has commercial substance. Commercial substance implies the company’s future cash flows will be altered. Many plant assets such as machinery, automobiles, and office equipment are disposed of by exchanging them for newer assets. In a typical exchange of plant assets, a trade-in allowance is received on the old asset and the balance is paid in cash. Accounting for the exchange of assets depends on whether the transaction has commercial substance (per SFAS 153, commercial substance implies that it alters the company’s future cash flows). If an asset exchange has commercial substance, a gain or loss is recorded based on the difference between the book value of the asset(s) given up and the market value of the asset(s) received. If an asset exchange lacks commercial substance, no gain or loss is recorded, and the asset(s) received is recorded based on the book value of the asset(s) given up. An exchange has commercial substance if the company’s future cash flows change as a result of the transaction. P5 Atef Abuelaish

Exchange with Commercial Substance: A Loss
A company acquires $42,000 in new equipment. In exchange, the company pays $33,000 cash and trades in old equipment. The old equipment originally cost $36,000 and has accumulated depreciation of $20,000 (book value is $16,000). This exchange has commercial substance. The old equipment has a trade-in allowance of $9,000. A company acquires $42,000 in new equipment. In exchange, the company pays $33,000 cash and trades in old equipment. The old equipment originally cost $36,000 and has accumulated depreciation of $20,000, which implies a $16,000 book value at the time of exchange. We are told this exchange has commercial substance and that the old equipment has a trade-in allowance of $9,000. This exchange yields a loss as computed above. P5 Atef Abuelaish

Exchange with Commercial Substance: A Loss
A company acquires $42,000 in new equipment. In exchange, the company pays $33,000 cash and trades in old equipment. The old equipment originally cost $36,000 and has accumulated depreciation of $20,000 (book value is $16,000). This exchange has commercial substance. The old equipment has a trade-in allowance of $9,000. In our case, the book value of the two assets given up (book value of old equipment plus cash) are greater than the market value of the asset received, so we will recognize a loss of $7,000. The journal entry is debit Equipment for $42,000 (new), debit Loss on Exchange of Assets for $7,000, debit Accumulated Depreciation – Equipment for $20,000, credit Equipment for $36,000 (old), and credit Cash for $33,000. P5 Atef Abuelaish

Exchanges Without Commercial Substance
Let’s assume the same facts as on the previous screen except that the market value of the new equipment received is $52,000 and the transaction lacks commercial substance. Let’s assume the same facts as in the preceding asset exchange involving new equipment received with a market value of $52,000, but let’s instead assume the transaction lacks commercial substance. Because the transaction is without commercial substance, no gain or loss will be recognized. The new equipment received will be recorded at the book value of the asset or assets given up. P5 Atef Abuelaish

Exchanges Without Commercial Substance
Let’s assume the same facts as on the previous screen except that the market value of the new equipment received is $52,000 and the transaction lacks commercial substance. In our example, we gave up an old piece of equipment with a book value of $16,000 plus cash of $33,000. The journal entry to record the exchange is to debit Equipment for $49,000, debit Accumulated Depreciation – Equipment for $20,000, credit Equipment for $36,000 and credit cash for $33,000. Remember, no gain or loss is recognized when the exchange lacks commercial substance. P5 Atef Abuelaish

Happiness is having all homework up to date
Homework assignment Using Connect – 10 Questions for 60 Points For Chapter 8. Prepare chapters 9 “Accounting for Current Liabilities.” Happiness is having all homework up to date Atef Abuelaish

Thank you and See You Next Week at the Same Time, Take Care
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