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Unformatted text preview: Intermediate Accounting 1 Chapter 1-13 Course Notes Prepared By Li Xu School of Accountancy Southern Illinois University at Carbondale Email: [email protected] Phone: 618-453-1407 Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 1 CHAPTER 1 Financial Accounting and Accounting Standards LECTURE OUTLINE In this Chapter, we are trying to answer the following questions: 1. What is accounting and what is financial accounting? 2. Why do we need financial accounting? 3. The challenges facing financial accounting. 4. Objectives of financial reporting. 5. Why do we need to develop standards? 6. Who sets the standards? 7. How to set the standards? 8. What are the standards? 9. Role of pressure groups 10. IFRS vs. GAAP? Section 1: A. What is accounting? 1. Identification, measurement, and communication of financial information a. Financial statements: (1) (2) (3) (4) b. Financial reporting: (1) (2) Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 2 (3) (4) 1. About economic entities. 2. To interested parties. B. Why do we need financial accounting? 1. 2. 3. A world of scarce resources. Capital allocation. Changing user needs. C. What are the challenges facing financial accounting? D. What are the objectives of accounting? Objectives of financial reporting identified in SFAC No. 1, are to provide: 1. 2. 3. Information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. Information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. Information about the economic resources of an enterprise, the claims on those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources. E. Why are standards needed? 1. 2. Need for comparability among the financial statements of different enterprises. Need to minimize bias, ambiguity, inexactness, and misinterpretation. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 3 Section 2: A. Who has authority to set standards? Standard setting in the public sector: Standard setting in the private sector: B. What are the standards? Those principles that have “substantive authoritative support:” 1. Principles established by an authoritative rule-making body. 2. General acceptance over time of accounting practices that have received widespread application. Examples include: Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 4 Section 3: A. Why are pressure groups interested in accounting? B. IFRS vs. GAAP Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 5 CHAPTER 2 Conceptual Framework Underlying Financial Accounting LECTURE OUTLINE Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 6 Section 1. First Level: Basic objectives A. First Level: Objectives. 1. 2. 3. Information that is useful to present and potential investors and creditors in making rational investment, credit, and similar decisions. Information to help present and potential investors and creditors and other users in assessing the amount, timing, and uncertainty of future cash flows. Information about the economic resources of an enterprise, the claims on those resources, and the effects of transactions, events, and circumstances that change its resources and claims to those resources. Section 2. Second Level: Qualitative Characteristics and Elements. A. Qualitative characteristics. The overriding criterion for evaluating accounting information is that it must be useful for decision making. To be useful, it must be understandable. a. Primary qualities of useful accounting information. (1) Relevance. Accounting information is relevant if it is capable of making a difference in a decision. Relevant information has (2) Reliability. Accounting information is reliable to the extent that users can depend on it to represent the economic conditions or events that it purports to represent. Reliable information has . b. Secondary qualities of useful accounting information. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 7 B. Elements. Section 3. Third Level: Recognition and Measurement Concepts.. A. Assumptions. B. Principles. C. Constraints modifying basic theory: a. Cost-benefit b. Materiality c. Industry practice d. Conservatism Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 8 CHAPTER 3 The Accounting Information System LECTURE OUTLINE Section 1 Accounting information system A. Basic Terminology. Read pg 68-69 B. Double-Entry Accounting. Debt: Credit: Normal Balance: C. The Accounting Equation D. Financial Statement and Ownership Structure Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 9 Section 2 Accounting Cycle Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 10 xx Salaries Expense xx Salaries Payable Expense/Liability Subsequent Entry Salaries Payable Cash Adjusting Entry xx Insurance Expense xx Prepaid Insurance Prepaid Insurance Cash Cash is Paid or Received Adjusting Entry Original Entry Asset → Expense xx xx xx xx ACCRUALS AFTER BEFORE PREPAYMENTS xx xx xx xx Cash xx Interest Receivable Interest Receivable xx Interest Revenue Asset/Revenue xx xx An Expense or Revenue is Recognized Unearned Rent Revenue Rent Revenue Cash Unearned Rent Revenue Liability → Revenue A. Journalization. B. Posting to the Ledger. C. Trial Balance. D. Adjusting Entries. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 11 Adjusting entry examples: The business closes its book on October 31. 1. Pioneer purchased advertising supplies costing $25,000 on October 5. Prepare the journal entry to record the purchase of the supplies. An inventory count at the close of business on October 31 reveals that $10,000 of the advertising supplies are still on hand. 2. On Oct. 4th, Pioneer paid $6,000 for a one-year fire insurance policy, beginning October 1. Show the entry to record the purchase of the insurance and the adjusting entry at the close of business on October 31. 3. Pioneer Advertising estimates depreciation on its office equipment to be $400 per month. Accordingly, Pioneer recognizes depreciation for October by the following adjusting entry. 4. Pioneer Advertising received $12,000 on October 2 from KC for advertising services expected to be completed by December 31. Show the journal entry to record the receipt on Oct. 2nd. Analysis reveals that Pioneer earned $4,000 of the advertising services in October. Show the adjusting entry. 5. In October Pioneer earned $2,000 for advertising services that it did not bill to clients before October 31. Thus, Pioneer makes the following adjusting entry. 6. Pioneer signed a three-month, 12%, note payable in the amount of $50,000 on October 1. Prepare the adjusting entry on Oct. 31 to record the accrual of interest. 7. At October 31, the salaries for these days represent an accrued expense and a related liability to Pioneer. Employees receive total salaries of $10,000 for a five-day work week, or $2,000 per day. Prepare the adjusting entry on Oct. 31 to record accrual for salaries. 8. On November 23, Pioneer will again pay total salaries of $40,000. Prepare the entry to record the payment of salaries on November 23. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 12 E. Prepare financial statements. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 13 F. Prepare closing entries. a. Temporary accounts vs. permanent accounts. b. Post-closing trial balance. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 14 CHAPTER 4 Income Statement and Related Information LECTURE OUTLINE Section 1: Income statement limitation and format A. Limitations of the Income Statement. B. Income Statement Format: Disclosure of the Intermediate Components of Income. 1. What are the intermediate components of income? 2. Presentation of items before income from continuing operations. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 15 Section 2: Reporting Irregular Items A. Six types of irregular items: B. Presentation of items after income from continuing operations. a. b. C. (1) “D”—Discontinued Operations. (2) “E”—Extraordinary Items. GAAP requires presentation of these items net of tax. Discontinued Operations—results from disposal of a segment of the business. Disposals of segments are reported net of tax in the income statement immediately below income from continuing operations. Results of the disposal are reported in two components. a. b. Income or loss from operation of the discontinued segment up to the measurement date, net of tax. Gain or loss from disposal of the discontinued segment, net of tax. e.g. KC Corporation had after tax income from continuing operations of $55,000,000 in 2008. During 2008, it disposed of its restaurant division at a pretax loss of $270,000. Prior to disposal, the division operated at a pretax loss of $450,000 in 2008. Assume a tax rate of 30%. Prepare a partial income statement for KC. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 16 D. Extraordinary Items—unusual in nature and infrequent in occurrence, considering the environment in which the entity operates. a. If an item is not unusual and infrequent and material, it is disclosed in some section of the income statement other than the extraordinary item section. b. Some items are given extraordinary item treatment by pronouncement, and not necessarily because they are unusual or infrequent. c. Extraordinary items are presented net of tax in the income statement, below discontinued operations and above changes in accounting principle. e.g., KC Corporation had after tax income from continuing operations of $55,000,000 in 2007. In addition, it suffered an unusual and infrequent pretax loss of $770,000 from a volcano eruption. The corporation’s tax rate is 30%. Prepare a partial income statement for KC Corporation beginning with income from continuing operations. E. Unusual Gains and Losses—items that are unusual or infrequent but not both. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 17 F. Changes in Accounting Principle e.g., Gaubert Inc. decided in March 2010 to change from FIFO to weighted-average inventory pricing. Gaubert’s income before taxes, using the new weighted-average method in 2010, is $30,000. G. Changes in Estimates. e.g., Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2010 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 18 H. Correction of errors. e.g., in 2011, Hillsboro Co. determined that it incorrectly overstated its accounts receivable and sales revenue by $100,000 in 2010. In 2011, Hillboro makes the following entry to correct for this error (ignore income taxes). I. a. Earnings Per Share—a widely used measure of business performance. EPS is equal to Net Income – Preferred Dividends Weighted Average Common Shares Outstanding e.g., In 2010, Hollis Corporation reported net income of $1,000,000. It declared and paid preferred stock dividends of $250,000. During 2010, Hollis had a weighted average of 190,000 common shares outstanding. Compute Hollis’s 2010 earnings per share. b. Per share figures must be disclosed in the income statement for the following amounts: 1. 2. 3. 4. 5. Income from continuing operations. Discontinued operations. Income before extraordinary items. Extraordinary items. Net income. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 19 Section 3: Statement of Retained Earnings and Comprehensive Income A. Statement of Retained Earnings. The following items are disclosed in the retained earnings statement: a. Prior period adjustments. b. Dividends and net income. c. Restrictions of retained earnings. e.g. Before issuing the report for the year ended December 31, 2011, you discover a $50,000 error (net of tax) that caused 2010 inventory to be overstated (overstated inventory caused COGS to be lower and thus net income to be higher in 2010). Would this discovery have any impact on the reporting of the Statement of Retained Earnings for 2011? Woods, Inc. Statement of Retained Earnings For the Year Ended December 31, 2011 Balance, January 1 Net income Dividends Balance, December 31 $ $ 1,050,000 360,000 (300,000) 1,110,000 Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 20 B. Comprehensive Income—includes all changes in equity during a period except those resulting from investments by owners and distributors to owners. a. Other comprehensive income—includes those gains and losses that bypass net income but affect stockholders’ equity. b. FASB requires that the components of other comprehensive income be reported in one of three ways. V. Gill Inc. Combined Statement of Comprehensive Income For the Year Ended December 31, 2010 Sales revenue $ 800,000 Cost of goods sold 600,000 Gross profit 200,000 Operating expenses 90,000 Net income 110,000 Unrealized holding gain, net of tax 30,000 Comprehensive income Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale $ 140,000 Page 21 CHAPTER 5 Balance Sheet and Statement of Cash Flows Section 1: Balance Sheet A. Usefulness and Purpose of the Balance Sheet. 1. 2. 3. Provides information about entity’s assets, liabilities, and equity. Evaluation of liquidity, solvency, and financial flexibility. Aids in assessing risk and predicting future cash flows. B. Limitations of the Balance Sheet. 1. 2. 3. Current value is not reflected. Estimates and judgments must be utilized: Omits many items that are of financial value to the business. C. Classifications in the Balance Sheet. Review definitions on text page 180. 1. Assets. 2. Liabilities. 3. Equity. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 22 D. Major Sub-classifications in the Balance Sheet. a. Current assets: Resources which are expected to be turned into cash, sold, or consumed within a year or the operating cycle, whichever is longer. (Point out the distinction between the operating cycle and the accounting cycle.Items included in the current asset section are presented in order of liquidity. a) Cash b) Short-term investments c) Receivables d) Inventories e) Prepaid expenses b. Long-term investments—management intent is to hold these investments for an extended period of time. a) Investments in securities: b) Investments in tangible fixed assets not currently used in operations: c) Investments set aside in special funds: d) Investments in nonconsolidated subsidiaries or affiliated companies. c. Property, plant, and equipment—durable physical property such as land, buildings, machinery, furniture, and “wasting resources” (timberland, minerals) used in operations. d. Intangible assets—resources that lack physical substance but provide economic rights and advantages. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 23 e. Other assets—a special classification for unusual items that cannot be included in one of the other asset categories. f. The classification of assets depends on both the nature of the item and the use to which it is put. For example: o Land used as factory site—classify as ___________________ o Land owned by a realty company and held for sale—classify as ____________ o Land held for speculation—classify as _________________ o Idle land and facilities that have been withdrawn from production—classify as ________ g. Current liabilities. a) Definition: Obligations that are reasonably expected to be liquidated through the use of current assets or the creation of other current liabilities within one year or operating cycle, whichever is longer. b) Current liabilities are frequently reported on the balance sheet in the order they will be paid. c) Some liabilities that will be paid within a year are reported as long-term liabilities. d) Working capital is a measure of a firm’s ability to meet its currently maturing obligations: Current assets - current liabilities h. Long-term liabilities. Definition: Obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. e.g., BE5-9: Included in Adams Company’s December 31, 2010, trial balance are the following accounts: Accounts Payable $220,000; Pension Liability $375,000; Discount on Bonds Payable $29,000; Advances from Customers $41,000; Bonds Payable $400,000; Wages Payable $27,000; Interest Payable $12,000; Income Taxes Payable $29,000. Prepare the long-term liabilities section of the balance sheet. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 24 i. Owners’ equity. Stockholders’ equity of corporations. j. Other Issues. a) b) k. Balance sheet format. Additional Information reported. Techniques of Disclosure. a) b) c) d) Parenthetical explanations Notes Cross-reference and contra items Supporting schedules Section 2: Statement of Cash Flow A. Purposes of the statement. a. To provide information about the cash receipts and cash payments of an entity during a period. b. To summarize the operating, investing, and financing activities of the business. B. Classification of cash flows. a. Operating activities. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 25 b. Investing activities. c. Financing activities. C. Significant noncash transactions. All significant financing and investing activities must be disclosed in the statement or notes, even though cash is not affected. D. Investing activities and financing activities. Investing Activities Financing Activities E. Preparation of the statement of cash flows in detail. (More in Chapter 23) e.g., Determine: 1. Cash provided by (or used in) operating activities. 2. Cash provided by or used in investing and financing activities. 3. Determine the change (increase or decrease) in cash during the period. Reconcile the change in cash with the beginning and the ending cash balances. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 26 e.g., BE5-12. Keyser Beverage Company reported the following items in the most recent year. Net income Dividends paid Increase in accounts receivable $40,000 5,000 10,000 Increase in accounts payable 7,000 Purchase of equipment (capital expenditure) 8,000 Depreciation expense 4,000 Issue of notes payable 20,000 Compute net cash provided by operating activities, the net change in cash during the year, and free cash flow. F. Usefulness of the statement of cash flows: 1). Information on the statement is used to evaluate liquidity, solvency, and financial flexibility. 2). Analysis of net cash provided by operating activities includes: Textbook Pg204-205 a. Current cash debt coverage: used to determine if a company can pay off its current liabilities from its operating activities. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 27 b. Cash debt coverage: used to determine if a company can repay all of its liabilities from its operating activities. c. Free cash flow: used to determine the discretionary cash flow a company has for additional investments, debt retirement, treasury stock, or adding to its liquidity. 3). Management uses data contained on the statement to prepare cash forecasts. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 28 CHAPTER 6 Accounting and the Time Value of Money Section 1: Basic Time Value Concepts A. Introduction. 1. The time value of money. 2. Accounting applications of time value concepts: 3. Personal applications of time value concepts: B. Nature of Interest. 1. Interest is payment for the use of money. It is the excess cash received or repaid over and above the principal (amount lent or borrowed). 2. Interest rates are stated on an annual basis unless indicated otherwise. C. Simple Interest. 1. Simple interest is computed on the amount of the principal only. 2. Simple interest = p X i X n where p = principal. i = rate of interest for a single period. n = number of periods. e.g., KC borrows $20,000 for 3 years at a rate of 7% per year. Compute the total interest to be paid for the 3 years. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 29 e.g., KC borrows $20,000 for 3 years at a rate of 7% per year. Compute the total interest to be paid for the 1 year. e.g., On March 31, 2011, KC borrows $20,000 for 3 years at a rate of 7% per year. Compute the total interest to be paid for the year ended Dec. 31, 2011. D. Compound Interest. 1. Compound interest is computed on the principal and on any interest earned that has not been paid or withdrawn. 2. The term period should be used instead of years. a. Interest may be compounded more than once a year: If interest is compounded Number of compounding periods per year Annually 1 Semiannually 2 Quarterly 4 Monthly 12 b. Adjustment when interest is compounded more than once a year. (1) Compute the compounding period interest rate: (2) Compute the total number of compounding periods: e.g., Tomalczyk Company deposits $10,000 in the Last National Bank, where it will earn simple interest of 9% per year. It deposits another $10,000 in the First State Bank, where it will earn compound interest of 9% per year compounded annually. In both cases, Vasquez will not withdraw any interest until 3 years from the date of deposit. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 30 E. The five interest tables provided in the text: a. Table 6-1: Future Value of 1. b. Table 6-2: Present Value of 1. c. Table 6-3: Future Value of an Ordinary Annuity of 1. d. Table 6-4: Present Value of an Ordinary Annuity of 1. e. Table 6-5: Present Value of an Annuity Due of 1. F. Terminology Used in Compound Interest Problems. 1. The four fundamental variables in compound interest problems: a. Rate of interest. b. Number of time periods. c. Future value. d. Present value. 2. The difference between single sum and annuity problems. a. Single sum problems involve a single amount of money that either exists now or will in the future. b. Annuity problems involve a series of equal periodic payments or receipts called rents. (1) In an ordinary annuity the rents occur at the end of each period. The first rent will occur one period from now. (2) In an annuity due the rents occur at the beginning of each period. The first rent will occur now. G. Steps in Solving Compound Interest Problems. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 31 Section 2: Specific Problems A. Specific Problems—Single Sum Problems. 1. Formula for future value: Future value = present value x future value factor for n periods at i % FV = PV(FVFn, i) 2. Formula for present value: Present value = future value x present value factor for n periods at i % PV = FV(PVFn, i) 3. The present value is always a smaller quantity than the future value. 4. The process of finding the future value is called accumulation. The process of finding the present value is called discounting. e.g., Bruegger Co. wants to determine the future value of $50,000 invested for 5 years compounded annually at an interest rate of 11%. e.g., Chris Spear invested $15,000 today in a fund that earns 8% compounded annually. To what amount will the investment grow in 3 years? e.g., Chris Spear invested $15,000 today in a fund that earns 8% compounded semi-annually. To what amount will the investment grow in 3 years? e.g., What is the present value of $84,253 to be received or paid in 5 years discounted at 11% compounded annually? e.g., Tony Bautista needs $25,000 in 4 years. What amount must he invest today if his investment earns 12% compounded annually? Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 32 e.g., Tony Bautista needs $25,000 in 4 years. What amount must he invest today if his investment earns 12% compounded quarterly? e.g., The Village of Somonauk wants to accumulate $70,000 for the construction of a veterans monument in the town square. At the beginning of the current year, the Village deposited $47,811 in a memorial fund that earns 10% interest compounded annually. How many years will it take to accumulate $70,000 in the memorial fund? e.g., The Village of Somonauk wants to accumulate $1,409,870 for the construction of a veterans monument in the town square in 5 years. At the beginning of the current year, the Village deposited $800,000 in a memorial fund. What is the required return rate if compounded annually? B. Specific Problems—Ordinary Annuities. 1. Formula for future value of an ordinary annuity: Future value of ordinary annuity = periodic rent X future value of ordinary annuity factor for n periods at i % FVOA = R(FVF – OAn, i) 2. Formula for present value of an ordinary annuity: Present value of ordinary annuity = periodic rent X present value of ordinary annuity factor for n periods at i % PVOA = R(PVF – OAn, i) 3. The present value of an ordinary annuity is always smaller than the future value of a similar annuity. 4. Some confusion may arise in annuity problems because of two different meanings of the word “period.” a. For the purpose of looking up interest factors, n equals the number of “periods” and is always equal to the number of rents. b. In the phrase “when computing the future value of an ordinary annuity the number of compounding periods is one less than the number of rents,” the term “periods” refers to “compounding periods” or “interest-bearing periods.” This refers to the number of times interest is earned on the principal and any accumulated interest. This usage of the term “period” is useful for distinguishing between ordinary annuities and annuities due. e.g., Assume that $1 is deposited at the end of each of 5 years (an ordinary annuity) and earns 12% interest compounded annually. What is the future value? Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 33 e.g., What is the future value of five $5,000 deposits made at the end of each of the next 5 years, earning interest of 12%? e.g., Bayou Inc. will deposit $30,000 in a 12% fund at the end of each year for 8 years beginning December 31, 2010. What amount will be in the fund immediately after the last deposit? e.g., What is the present value of rental receipts of $6,000 each, to be received at the end of each of the next 5 years when discounted at 12%? e.g., Assume that you plan to accumulate $14,000 for a down payment on a condominium apartment 5 years from now. For the next 5 years, you earn an annual return of 8% compounded semiannually. How much should you deposit at the end of each 6-month period? e.g., Suppose that a company’s goal is to accumulate $117,332 by making periodic deposits of $20,000 at the end of each year, which will earn 8% compounded annually while accumulating. How many deposits must it make? e.g., Jaime Yuen wins $2,000,000 in the state lottery. She will be paid $100,000 at the end of each year for the next 20 years. How much has she actually won? Assume an appropriate interest rate of 8%. e.g., Assume you receive a statement from MasterCard with a balance due of $528.77. You may pay it off in 12 equal monthly payments of $50 each, with the first payment due one month from now. What rate of interest would you be paying? Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 34 C. Specific Problems—Annuities Due. 1. Formula for future value of annuity due: Future value of annuity due = periodic rent x future value of ordinary annuity factor for n periods at i % X (1 + i) FVAD = R X (FVF – OAn, i ) X (1 + i) * An interest table is not provided for the future value of an annuity due. 2. Formula for present value of annuity due: Present value of annuity due = periodic rent x present value of annuity due factor for n periods at i % PVAD = R(PVF – ADn, i ) e.g., Mr. Goodwrench deposits $2,500 today in a savings account that earns 9% interest. He plans to deposit $2,500 every year for a total of 30 years. How much cash will Mr. Goodwrench accumulate in his retirement savings account, when he retires in 30 years? e.g., Bayou Inc. will deposit $20,000 in a 12% fund at the beginning of each year for 8 years beginning January 1, Year 1. What amount will be in the fund at the end of Year 8? e.g., Space Odyssey, Inc., rents a communications satellite for 4 years with annual rental payments of $4.8 million to be made at the beginning of each year. If the relevant annual interest rate is 11%, what is the present value of the rental obligations? e.g., Jaime Yuen wins $2,000,000 in the state lottery. She will be paid $100,000 at the beginning of each year for the next 20 years. How much has she actually won? Assume an appropriate interest rate of 8%. D. Specific Problems—Deferred Annuities. 1. A deferred annuity does not begin to produce rents until two or more periods have expired. 2. A deferred annuity problem can occur in either an ordinary annuity situation or an annuity due situation. Future Value - Calculation same as the future value of an annuity not deferred. Present Value - Must recognize the interest that accrues during the deferral period. 3. The following formula is required for deferred annuity due. FVAD – d = R X (FVF – OAn, i ) X (1 + i) where FVAD – d = future value of an annuity due of n rents deferred for y periods Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 35 R = periodic rents (FVF – OAn, i ) = factor from Table 6-3 for n periods at i % (1 + i ) = 1 +the interest rate e.g., As of the beginning of his first year in college, a student plans to deposit $1,000 in an 8% account at the end of his third, fourth, and fifth years in school. What will be the balance in the account one year after the last deposit? E. Specific Problems—Bond Valuation Problems. 1. The distinction between the stated rate of interest and the market or effective yield rate of interest: a. The stated interest rate is used to determine the periodic amount of cash interest paid. b. The market or effective interest rate is used to value the bonds. This is the rate which is looked up in the present value tables. 2. Two Cash flows: e.g., Clancey Inc. issues $2,000,000 of 7% bonds due in 10 years with interest payable at year-end. The current market rate of interest for bonds of similar risk is 8%. What amount will Clancey receive when it issues the bonds? Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 36 CHAPTER 7 Cash and Receivables LECTURE OUTLINE Chapter 7, the first of six asset chapters, covers cash, accounts receivable, and notes receivable. Session 1: Cash A. What is cash? Cash and receivables represent two of the most liquid of assets. Liquidity is an indication of an enterprise’s ability to meet its obligations as they come due. Cash includes coin, currency, bank deposits including checking and savings accounts, and negotiable instruments such as money orders, cashiers’ checks, personal checks, and bank drafts. Exceptions: 1. Postdated checks and I.O.U.s should be reported as 2. Travel advances to employees should be reported as 3. Postage stamps on hand should be reported as 4. Petty cash funds and change funds should be included in B. Reporting cash and related items. 1. Cash equivalents. a. This category includes items that are both (1) readily convertible to known amounts of cash, and (2) so near their maturity that they present insignificant risk of changes in interest rates (generally 3 months or less). 2. Restricted cash. 3. Bank overdrafts. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 37 Session 2: Receivables A. Receivables: Claims held against customers and others for money, goods, or services. 1. 2. 3. Accounts receivable are oral promises of the purchaser to pay for goods and services sold. Notes receivable are written promises to pay a certain sum of money on a specified future date. Nontrade receivables B. Accounts Receivable—Recognition Issues. These involve the concepts of timing and measurement. Measurement is complicated by: 1. 2. Trade Discounts. Cash Discounts. a. Gross Method (more practical than the net method). Sales and receivables are recorded at the gross amount. b. Net Method. Sales and receivables are recorded at the net amount. On June 3, Bolton Company sold to Arquette Company merchandise having a sale price of $2,000 with terms of 2/10, n/60, f.o.b. shipping point. On June 12, the company received a check for the balance due from Arquette Company. Prepare the journal entries on Bolton Company books to record the sale assuming Bolton records sales using the gross method. Prepare the journal entries on Bolton Company books to record the sale assuming Bolton records sales using the net method. Prepare the journal entries on Bolton Company books to record the sale assuming Bolton records sales using the net method, and Arquette did not remit payment until July 29. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 38 C. Accounts Receivable—Valuation Issues. 1. Accounting for Accounts Receivables: 1) Journal entry for credit sale of $100? 2) Collected of $333 on account? 3) Adjustment of $15 for estimated Bad-Debts? 4) Write-off of uncollectible accounts for $10? 2. Methods of accounting for uncollectible accounts: a. Direct write-off method—When a specific account is determined to be uncollectible (which may not occur in the period of sale), Bad Debt Expense is debited and Accounts Receivable is credited. This method is theoretically undesirable. b. Allowance method—At the end of each accounting period an estimate is made of expected losses from uncollectible accounts. This estimate is debited to Bad Debt Expense and credited to the Allowance for Doubtful Accounts. Methods of estimating bad debt expense under the allowance method. (a) Percentage-of-Sales (Income Statement Approach). (b) Percentage-of-Receivables (Balance Sheet Approach). . Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 39 E7-7 (Recording Bad Debts) Sandel Company reports the following financial information before adjustments. Dr. Accounts Receivable Cr. $160,000 Allowance for Doubtful Accounts $ 2,000 Sales (all on credit) 800,000 Sales Returns and Allowances 50,000 Instructions Prepare the journal entry to record bad debt expense assuming Sandel Company estimates bad debts at (a) 1% of net sales and (b) 5% of accounts receivable. D. Notes Receivable—Recognition Issues. The present value of the future cash flows is the proper amount to record for notes. 1. Review the terminology in accounting for notes: a. b. c. d. e. f. g. h. i. Face value Stated interest rate Effective (market) rate of interest Present value Discount on notes receivable Premium on notes receivable Net carrying amount of the note Amortization Effective-interest method 2. Notes Bearing Interest Equal to the Effective Rate—The interest element is ignored for short-term notes and therefore they are carried at face value. However, long-term notes are recorded at the present value of the cash expected to be collected. 3. Zero Interest or Unreasonable Interest-Bearing Notes—An appropriate rate of interest must be determined in order to compute the present value of the note. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 40 e.g., Bigelow Corp. lends Scandinavian Imports $10,000 in exchange for a $10,000, three-year note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is also 10 percent. How does Bigelow record the receipt of the note? e.g., Jeremiah Company receives a three-year, $10,000 zero-interest-bearing note. The market rate of interest for a note of similar risk is 9 percent. How does Jeremiah record the receipt of the note? e.g., Morgan Corp. makes a loan to Marie Co. and receives in exchange a three-year, $10,000 note bearing interest at 10 percent annually. The market rate of interest for a note of similar risk is 12 percent. How does Morgan record the receipt of the note? G. Notes Receivable—Valuation Issues. 1. Notes should be reported at net realizable value although allowance for doubtful accounts can be difficult to estimate for long-term notes. 2. Companies must disclose the fair value of notes receivables in the notes to the financial statement. 3. Companies have the option of using fair value as the basis of measurement in the financial statements. a. If companies choose the fair value option, receivables are recorded at fair value and unrealized holding gains or losses are reported as part of net income. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 41 b. Unrealized holding gains or losses are the net change in the fair value of receivables from one period to another, excluding recognized but unrecorded interest revenue. I. Presentation and analysis of receivables. 1. General classification rules: a. b. c. d. e. f. 2. Segregate the different types of receivables, if material. Offset appropriate valuation accounts against the proper receivable accounts. Determine that receivables classified as current assets will be converted into cash within the year or the operating cycle, whichever is longer. Disclose any loss contingencies that exist on the receivables. Disclose any receivables designated or pledged as collateral. Disclose all significant concentrations of credit risk arising from receivables. Accounts receivable turnover ratio: measures the number of times, on average, receivables are collected during the period. a. A/R Turnover = Net Sales Average Trade Receivables (net) Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 42 CHAPTER 8 Valuation of Inventories: A Cost-Basis Approach LECTURE OUTLINE Chapter 8, the second of six asset chapters, covers inventory. Section 1: Inventories valuations A. What are inventories? Among the most significant assets of many enterprises, inventories are asset items held for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold. B. Inventory Record Systems. 1. Perpetual inventory system—The costs of purchases and sales are recorded directly in the Inventory account 2. Periodic inventory system—The cost of purchases is recorded in a Purchases (nominal or temporary) account. e.g., Fesmire Company had the following transactions during the current year. Record these transactions using the Perpetual and Periodic systems. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 43 C. Basic Issues in Inventory Valuation. These include the determination of the (1) goods to be included in inventory, (2) the costs to be included in inventory, and (3) the cost flow assumption to be adopted. D. Goods to be Included in Inventory. Technically, purchases should be recorded when legal title passes to the buyer. The following items require careful judgment: 1) Goods in Transit. 2) Consigned Goods. 3) Sales with buyback agreement: 4) Sales with high rates of return. 5) Installment sales In your audit of Garza Company, you find that a physical inventory on December 31, 2010, showed merchandise with a cost of $441,000 was on hand at that date. You also discover the following items were all excluded from the $441,000. 1. Merchandise of $61,000 which is held by Garza on consignment. The consignor is the Bontemps Company. 2. Merchandise costing $33,000 which was shipped by Garza f.o.b. destination to a customer on December 31, 2010. The customer was expected to receive the merchandise on January 6, 2011. 3. Merchandise costing $46,000 which was shipped by Garza f.o.b. shipping point to a customer on December 29, 2010. The customer was scheduled to receive the merchandise on January 2, 2011. 4. Merchandise costing $73,000 shipped by a vendor f.o.b. destination on December 30, 2010, and received by Garza on January 4, 2011. 5. Merchandise costing $51,000 shipped by a vendor f.o.b. shipping point on December 31, 2010, and received by Garza on January 5, 2011. Instructions Based on the above information, calculate the amount that should appear on Garza's balance sheet at December 31, 2010, for inventory. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 44 E. Effect of inventory Errors. a. The most common types of inventory errors: b. Corrections of inventory errors may involve two procedures: (1) Preparation of correcting journal entries (2) Computation of the correct amounts of inventory and related items including purchases, cost of goods sold, net income, retained earnings, accounts payable, working capital, and the current ratio. c. The impact of inventory errors on the affected accounts. e.g. Bienvenu Enterprises reported cost of goods sold for 2010 of $1,400,000 and retained earnings of $5,200,000 at December 31, 2010. Bienvenu later discovered that its ending inventories at December 31, 2009 and 2010, were overstated by $110,000 and $35,000, respectively. Determine the corrected amounts for 2010 cost of goods sold and December 31, 2010, retained earnings. E. Costs Included in Inventory. 1. Distinguish between product costs and period costs. 2. Interest costs 3. Manufacturing Costs. 4. Purchase Discounts. Discuss the gross and net methods. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 45 a. Gross method. b. Net method Section 2: Flow Assumption A. Choice of a Flow Assumption. This problem arises when numerous purchases have been made at different prices and it is necessary to identify which goods remain on hand and which have been sold. e.g., Young & Crazy Company makes the following purchases: 1. One item on 2/2/11 for $10 2. One item on 2/15/11 for $15 3. One item on 2/25/11 for $20 Young & Crazy Company sells one item on 2/28/11 for $90. What would be the balance of ending inventory and cost of goods sold for the month ended Feb. 2011, assuming the company used the FIFO, LIFO, Average Cost, and Specific Identification cost flow assumptions? Assume a tax rate of 30%. 1. Specific Identification: 2. Average Cost: 3. First-In, First-Out: Assumes goods are used in the order purchased. 4. Last-In, First-Out: Assumes that the last goods purchased are used first. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 46 1. Assuming the Perpetual Inventory Method, compute the Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. 2. Assuming the Periodic Inventory Method, compute the Cost of Goods Sold and Ending Inventory under FIFO, LIFO, and Average cost. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 47 G. LIFO Reserve is the difference between the inventory method used for internal reporting purposes and LIFO. H. Dollar-value LIFO. (Dollar-Value LIFO) Presented below is information related to Martin Company. Date Ending Inventory (End-of-Year Prices) Price Index December 31, 2007 $ 80,000 100 December 31, 2008 111,300 105 December 31, 2009 108,000 120 December 31, 2010 122,200 130 December 31, 2011 147,000 140 December 31, 2012 176,900 145 Instructions Compute the ending inventory for Martin Company for 2007 through 2012 using the dollar-value LIFO method. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 48 CHAPTER 9 Inventories: Additional Valuation Issues LECTURE OUTLINE This chapter describes inventory valuation problems and estimation techniques. A. Lower-of-Cost-or-Market (LCM). 1. The general rule is that the historical cost principle is abandoned when the future utility of the asset is no longer as great as its original cost. 2. The term “market” in the LCM rule means the cost to replace the item by purchase or reproduction. This is a measurement of entry value. a. The market amount is limited by ceiling and floor restrictions that are based on measurements of exit value. (1) The ceiling is equal to net realizable value: (2) The floor is equal to: 3. The two-step computational approach to LCM valuation: a. b. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 49 4. The LCM rule may be applied either (a) directly to each item or (b) to the total of the inventory or (c) in some cases, to the total of the components of each major category. 5. Recording market declines in inventory. Two possibilities: a. Direct method b. Indirect or Allowance method KC Company manufactures desks. The company attempts to obtain a 20% gross margin on selling price. At December 31, 2010, the following finished desks appear in the companys inventory. Instructions: At what amount should the desks appear in the company’s December 31, 2010, inventory, assuming that the company has adopted a lower-of-FIFO-cost-or-market approach for valuation of inventories on an individual-item basis? Finished Desks Inventory cost Est. cost to manufacture Commissions and disposal costs Catalog selling price A $ 470 460 50 500 B $ 450 430 60 540 C $ 830 610 80 900 D $ 960 1,000 130 1,200 Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 50 B. The relative sales value method 1. The relative sales value method—When several different assets are acquired in a lump-sum purchase the joint cost can be allocated on the basis of relative sales value. E9-7: Larsen Realty Corporation purchased a tract of unimproved land for $55,000. This land was improved and subdivided into building lots at an additional cost of $30,000. These building lots were all of the same size but owing to differences in location were offered for sale at different prices as follows. Operating expenses allocated to this project total $18,200. Instructions: Calculate the net income realized on this operation to date. Group No. of Lots 1 9 2 3 Price per Lot $ Lots Unsold at Year-End 3,000 5 15 4,000 7 19 2,000 2 C. The Gross Profit Method. 1. 2. This method is used when an estimate of a firm’s inventory is required. The resulting estimate is acceptable for interim reporting purposes but not generally for annual reporting. Four items of information are sufficient to estimate the cost of ending inventory: e.g., Cetus Corp. has a beginning inventory of $60,000 and purchases of $200,000, both at cost. Sales at selling price amount to $280,000. The gross profit on selling price is 30 percent. Cetus applies the gross margin method as follows. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 51 3. The distinction between markup expressed as a percentage of cost and markup expressed as a percentage of sales. 4. How to convert a markup on cost to a markup on sales. 5. Appraisal of the gross profit method. a. b. It provides an estimate based on past percentages. Use of a blanket gross profit rate is not appropriate when a company handles different lines of merchandise with widely varying rates of gross profit. e.g., Astaire Company uses the gross profit method to estimate inventory for monthly reporting purposes. Presented below is information for the month of May. (a) Compute the estimated inventory assuming gross profit is 25% of sales. (b) Compute the estimated inventory assuming gross profit is 25% of cost. Inventory, May 1 Purchases (gross) Freight-in Sales Sales returns Purchase discounts $ 160,000 640,000 30,000 1,000,000 70,000 12,000 Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 52 D. The Retail Inventory Method. 1. Like the gross profit method, the retail inventory method provides an estimate of ending inventory. Unlike the gross profit method, the retail inventory method produces estimates that may be acceptable for financial statement purposes. 2. More detailed records are required for the retail inventory method than for the gross profit method. Under the retail inventory method, records must be kept of the following. 3. Variations of the retail inventory method: a. b. 4. The retail inventory method can be adapted for use with: (1) any of the major inventory cost flow assumptions: FIFO, LIFO, or Average. (2) either of the inventory valuation methods: cost or LCM. The textbook illustrates two of the possible variations: (1) Cost (2) Average at LCM (conventional retail). (3) LIFO at cost with stable prices (LIFO retail). Three basic steps in computing all retail inventory problems: a. Compute ending inventory at retail. This step is the same regardless of which variation (LIFO cost or average LCM) is used. Special items: b. Compute the cost-to-retail ratio. This step will vary depending on which variation of the retail method is used. The following formulas may be used: (1) Conventional retail (average LCM) ratio = (2) LIFO retail (stable or fluctuating prices) ratio = c. Apply the cost-to-retail ratio to the ending inventory at retail to obtain the ending inventory. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 53 Fuque Inc. uses the retail inventory method to estimate ending inventory for its monthly financial statements. The following data pertain to a single department for the month of October 2011. Instructions: Prepare a schedule computing estimate retail inventory using the following methods: (1) Cost COST RETAIL (2) LCM Beg. inventory, Oct. 1 $ 52,000 $ 78,000 (3) LIFO at cost Purchases 272,000 423,000 Freight in Purchase returns Additional markups Markup cancellations Markdowns (net) Normal spoilage Sales 16,600 5,600 8,000 9,000 2,000 3,600 10,000 390,000 Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 54 E. Presentation of Inventories. 1. The following items must be disclosed: a. The composition of manufactured inventory (raw materials, work in process, and finished goods). b. Significant or unusual financing arrangements including related party transactions, firm purchase commitments, involuntary LIFO liquidation, etc. c. The inventory costing methods used. d. The consistency of costing methods from one period to another. G. Inventory Turnover Ratio Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 55 CHAPTER 10 Acquisition and Disposition of Property, Plant, and Equipment LECTURE OUTLINE Chapter 10, the fourth of six asset chapters, covers PP&E. A. Characteristics of Property, Plant, and Equipment. 1. Acquired for use and not resale. 2. Long-term in nature and subject to depreciation, except for land. 3. Possess physical substance. B. Acquisition and Valuation of Property, Plant, and Equipment. 1. Historical cost is the usual basis for valuation. This is the cash or cash equivalent price of obtaining the asset and getting it ready for its intended use. 2. Components of cost. a. Cost of Land:All expenditures made to acquire the land and prepare it for use are included in the cost of the land. b. Cost of Buildings: All expenditures related directly to acquisition or construction are capitalized. c. Cost of Equipment: All expenditures incurred in acquiring the equipment and preparing it for use are included. d. Self-Constructed Assets: Such assets may cause valuation problems because of the assignment of overhead. The options are to assign a portion of all overhead, or assign no fixed overhead. The first option is preferred. E10-1 (variation): The following expenditures and receipts are related to land, land improvements, and buildings acquired for use in a business enterprise. Determine how the following should be classified: Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 56 C. Interest Costs during Construction. 1. Basic principle: Interest cost incurred during construction of plant assets is part of the cost of acquiring the assets and preparing them for their intended use. Like other acquisition costs, interest cost should be capitalized and depreciated over the expected useful life of the assets involved. 2. Describe the computational steps involved in determining the amount of interest to be capitalized. a. Determine which assets qualify for capitalization of interest. b. Determine the capitalization period. c. Compute the expenditures made during the capitalization period. d. Compute the weighted-average accumulated expenditures. e. Compute avoidable interest. f. Compute the actual interest cost incurred. g. Determine the interest cost to be capitalized. e.g., KC Corporation borrowed $200,000 at 12% interest from State Bank on Jan. 1, 2011, for specific purposes of constructing special-purpose equipment to be used in its operations. Construction on the equipment began on Jan. 1, 2011, and the following expenditures were made prior to the project’s completion on Dec. 31, 2011: Actual Expenditures: January 1, 2011 April 30, 2011 November 1, 2011 December 31, 2011 Total expenditures $100,000 150,000 300,000 100,000 $650,000 Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 57 On November 1, 2009, Shalla Company contracted Pfeifer Construction Co. to construct a building for $1,400,000 on land costing $100,000 (purchased from the contractor and included in the first payment). Shalla made the following payments to the construction company during 2010. Pfeifer Construction completed the building, ready for occupancy, on December 31, 2010. Shalla had the following debt outstanding at December 31, 2010. Compute the weighted-average accumulated expenditures during 2010. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 58 D. Means of Acquisition and Valuation. 1. Cash Discounts: The asset should be recorded at the current cash equivalent price at the date of acquisition. 2. Deferred-Payment Contracts: Assets purchased on long-term credit contracts should be accounted for at the present value of the consideration exchanged. 3. Lump Sum Purchases: Total cost should be allocated on the basis of relative fair values. Insurance appraisals, property tax assessments, or independent appraisals may be used as indicators of relative fair values. 4. Issuance of Stock: Market value of stock issued is used as an indication of the cost of the property acquired. 5. Exchanges of property, plant, and equipment (nonmonetary assets). a. Basic accounting procedures. (1) (2) (3) (4) Compute the net book value of the old asset. Compute the realized gain or loss. Determine the amount of gain or loss to be recognized. Prepare the journal entry to record the exchange. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 59 e.g., Information Processing, Inc. trades its used machine for a new model at Jerrod Business Solutions Inc. The exchange has commercial substance. The used machine has a book value of $8,000 (original cost $12,000 less $4,000 accumulated depreciation) and a fair value of $6,000. The new model lists for $16,000. Jerrod gives Information Processing a trade-in allowance of $9,000 for the used machine. e.g, Interstate Transportation Company exchanged a number of used trucks plus cash for a semi-truck. The used trucks have a combined book value of $42,000 (cost $64,000 less $22,000 accumulated depreciation). Interstate’s purchasing agent, experienced in the second-hand market, indicates that the used trucks have a fair market value of $49,000. In addition to the trucks, Interstate must pay $11,000 cash for the semi-truck. e.g., Now assume that Interstate Transportation Company exchange lacks commercial substance. That is, the economic position of Interstate did not change significantly as a result of this exchange. In this case, Interstate defers the gain of $7,000 and reduces the basis of the semi-truck. e.g., Queenan Corporation traded in used machinery with a book value of $60,000 (cost $110,000 less accumulated depreciation $50,000) and a fair value of $100,000. It receives in exchange a machine with a fair value of $90,000 plus cash of $10,000. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 60 e.g., E10-19 variation: Carlos Arruza Company exchanged equipment used in its manufacturing operations plus $3,000 in cash for similar equipment used in the operations of Tony LoBianco Company. The following information pertains to the exchange. Prepare the journal entries to record the exchange on the books of both companies. Equipment (cost) Accumulated Depreciation Fair value of equipment Cash given up Arruza $28,000 19,000 15,500 LoBianco $28,000 10,000 12,500 3,000 Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 61 E. Dispositions of Plant Assets. Depreciation up to the date of disposition must be recorded. The cost and accumulated depreciation of the asset must be removed from the books, any cash received must be recorded, and a gain or loss is recognized. 1. Sale of Plant Assets. 2. Involuntary Conversion. Ottawa Corporation owns machinery that cost $20,000 when purchased on July 1, 2007. Depreciation has been recorded at a rate of $2,400 per year, resulting in a balance in accumulated depreciation of $8,400 at December 31, 2010. The machinery is sold on September 1, 2011, for $10,500. Prepare journal entries to a) update depreciation for 2011 and b) record the sale. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 62 CHAPTER 11 Depreciation, Impairments, and Depletion LECTURE OUTLINE Chapter 11, the fifth of six asset chapters, covers depreciation, impairment and depletion related to long term assets. Section 1: A. Depreciation, Depletion, and Amortization: Procedures to indicate that the service potential of an asset has declined. 1. Depreciation is not a matter of valuation, but a means of cost allocation. 2. Depreciation is the accounting process of allocating the cost of tangible assets to expense in a rational and systematic manner over the periods of use. B. Factors involved in the depreciation process: 1. Depreciation base. 2. Estimated service life. a. An asset’s physical life is limited by physical factors such as wear and tear. These factors set the outside limit for an asset’s useful life. b. An asset’s service life is limited by economic factors such as inadequacy, supersession, and obsolescence. C. Methods of Depreciation. Describe the characteristics of these methods and the factors that influence the choice of method, as described below. 1. Activity Methods: Assumes that depreciation is a function of use. This method is not appropriate in situations where depreciation is a function of time instead of activity. e.g., If Stanley uses the crane for 4,000 hours the first year, the depreciation charge is: 2. Straight-line Method: This method is widely used because of its simplicity in charging a constant amount each period. This method assumes that the asset’s economic usefulness is the same each year and that repair and maintenance expenses are essentially the same each year. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 63 3. Decreasing-Charge (Accelerated Depreciation) Methods: Justified on the grounds that since the asset is more efficient in the earlier years more depreciation should be charged in those years. a. Sum-of-the-Years’-Digits Method. b. Declining-Balance Methods. E11-5 (Depreciation Computations—Four Methods): KC Corporation purchased a new machine for its assembly process on August 1, 2010. The cost of this machine was $150,000. The company estimated that the machine would have a salvage value of $24,000 at the end of its service life. Its life is estimated at 5 years and its working hours are estimated at 21,000 hours. Year-end is December 31. Instructions: Compute the depreciation expense under the following methods. (a) Straight-line depreciation. (c) Sum-of-the-years’-digits. (b) Activity method (d) Double-declining balance. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 64 D. Special Depreciation Issues. 1. Depreciation for partial periods. Many methods are applied and are acceptable as long as they are used consistently. 2. Depreciation as a source of asset replacement funds 3. Revision of estimates. Changes in estimates of salvage value or service life are shown in current and prospective (future) periods as required by GAAP. a. In a change of accounting estimate, no retroactive adjustment of opening balances is made and no journal entry is required. e.g., Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2010 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Instruction: 1. What is the journal entry to correct the prior years’ depreciation? 2. Calculate the depreciation expense for 2010. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 65 E. Impairment in Value. 1. An impairment occurs when the expected future net cash flows (undiscounted) of an asset is less than the asset’s carrying value. a. b. 2. Review events for possible impairment. Apply recoverability test to determine if impairment has occurred. If impairment has occurred, recognize impairment loss for the amount by which the carrying value of the asset exceeds the fair value of the asset. a. b. 3. Fair value is market value if an active market exists for the asset. If no active market exists, use present value of expected future net cash flows. If the impaired asset is held for use, the new cost basis of the asset is the reduced carrying amount. The cost basis is not written up, even if the fair value of the asset increases in future years. Depreciation is taken on the new cost basis over the asset’s remaining useful life. 4. If the impaired asset is intended to be disposed of, it is reported at the lower of cost or fair value less cost to sell (net realizable value). There is no depreciation expense for the impaired assets being held for disposal because their costs will be recovered during the sale. Restoration of the impairment loss is possible, as long as the write-up does not exceed the carrying amount of the asset before impairment. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 66 E11-16 (Impairment): Presented below is information related to equipment owned by Pujols Company at December 31, 2010. Assume that Pujols will continue to use this asset in the future. As of December 31, 2010, the equipment has a remaining useful life of 4 years. Cost Accumulated depreciation to date Expected future net cash flows Fair value $ 9,000,000 1,000,000 7,000,000 4,400,000 Instructions: (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010. (b) Prepare the journal entry to record depreciation expense for 2011. (c) The fair value of the equipment at December 31, 2011, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value. Section 2: A. Depletion: Used to account for natural resources which are physically consumed over the period of use, such as petroleum, minerals, and timber. 1. Establishment of depletion base. The costs of natural resources may be classified as either: a. Acquisition cost b. Exploration costs c. Development costs d. Restoration costs 2. Write-off of resource cost: Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 67 E11-19 (Depletion Computations—Timber): Hernandez Timber Company owns 9,000 acres of timberland purchased in 1999 at a cost of $1,400 per acre. At the time of purchase the land without the timber was valued at $400 per acre. In 2000, Hernandez built fire lanes and roads, with a life of 30 years, at a cost of $87,000. Every year Hernandez sprays to prevent disease at a cost of $3,000 per year and spends $7,000 to maintain the fire lanes and roads. During 2001, Hernandez selectively logged and sold 700,000 board feet of timber, of the estimated 3,000,000 board feet. In 2002, Hernandez planted new seedlings to replace the trees cut at a cost of $100,000. Instructions: Determine the depreciation expense and the cost of timber sold related to depletion for 2001. 3. Special problems in depletion accounting. a. Difficulty of estimating recoverable reserves. Estimates of natural resource reserves are in large measure merely “knowledgeable guessess”. b. Liquidating dividends. The major accounting problem is to distinguish between those dividends that are a return of capital and those that are not. e.g., Callahan Mining had a retained earnings balance of $1,650,000 and paid-in capital in excess of par of $5,435,493. Callahan’s board declared a dividend of $3 a share on the 1,000,000 shares outstanding. It records the $3,000,000 cash dividend as follows. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 68 G. Presentation and Analysis of Property, Plant, Equipment, and Natural Resources. 1. Disclosures for Property, Plant, and Equipment: a. b. c. d. e. f. 2. Disclosures for Natural Resources: a. b. c. d. e. 3. The basis of valuation (usually historical cost). Pledges, liens, and other commitments or liabilities related to the property. Depreciation expense for the period. The balances of major classes of depreciable assets. Accumulated depreciation, either by major classes of depreciable assets, or in total. A general description of the depreciation methods used. The basis of valuation (usually historical costs). Pledges, liens, and other commitments or liabilities related to the property. The accounting method used—full-cost or successful-efforts. The manner of disposing of costs relating to oil and gas producing activities. Public companies must also supply supplemental information regarding reserve quantities, capitalized costs, acquisition, exploration and development activities, and measures of discounted net cash flows related to proved oil and gas reserve quantities. Analysis ratios: a. Asset turnover = (1) Indicates how efficiently a company uses its assets to generate sales. b. Rate of return on assets = (1) Measures how profitably assets were used during a period. (2) May also be calculated as: e.g., Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 69 CHAPTER 12 Intangible Assets LECTURE OUTLINE The last of six asset chapters, covers intangibles. A. Intangible Asset Issues. 1. Characteristics. a. They lack physical existence. b. They are not financial instruments. 2. Valuation. a. Purchased intangibles are recorded at cost. (1) Includes purchase price, legal fees, and other incidental expenses. (2) If acquired for stock or other assets, cost is the fair value of the consideration given or the fair value of the intangible received, whichever is more clearly evident. b. Internally-created intangibles. (1) Only direct costs incurred in obtaining the intangible are capitalized, 3. Amortization of Intangibles. a. Limited-life intangibles are amortized over their useful lives. Factors affecting useful life are: (1) Expected use of the asset. (2) Expected useful life of a related asset. (3) Any legal, regulatory, or contractual provisions that may limit the useful life. (4) Provisions that enable renewal of extension of the asset’s legal or contractual life without substantial cost. (5) The effects of obsolescence, demand, competition, and other economic factors. (6) The level of maintenance expenditure required to obtain the expected future cash flows from the asset. b. Amortizable base is equal to cost less residual value. (1) Residual value is assumed to be zero, unless (2) The intangible has value to another company at the end of its useful life. c. Indefinite-life intangibles are not amortized. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 70 B. Types of Intangible Assets. 1. Marketing-related intangible assets—primarily used in the marketing or promotion of products or services. a. Trademarks and trade names. (1) Considered indefinite-life intangibles, therefore, not amortized. (2) If insignificant cost, it is usually expensed. b. Company names. 2. Customer-related intangible assets—result from interactions with outside parties. a. Customer lists, order or production backlogs, and contractual or noncontractual customer relationships. b. Amortized over the asset’s useful life. c. Residual value is assumed to be zero, unless the useful life is less than the economic life and reliable evidence exists about the residual value. e.g., Assume that Green Market Inc. acquires the customer list of a large newspaper for $6,000,000 on January 1, 2010. Green Market expects to benefit from the information evenly over a three-year period. Record the purchase of the customer list and the amortization of the customer list at the end of each year. 3. Artistic-related intangible assets—ownership rights to plays, literary works, music, pictures, photos, and video and audiovisual material. a. Copyrights are granted for the life of the creator plus 70 years. b. Useful life is usually less than legal life. 4. Contract-related intangible assets—rights that arise from contractual arrangements. a. Franchise—contractual arrangement under which the franchisor grants the franchisee certain rights. (1) Corporate. (2) Governmental—Licenses or permits. (3) Limited-life franchises should be amortized over the term of the contract. (4) Indefinite-life franchises should be carried at cost and not amortized. 5. Technology-related intangible assets—relate to innovations or technological advances. a. Patents—exclusive right to use, manufacture, and sell a product or process 20 years. b. Amortized over the useful life or legal life, whichever is shorter. c. Legal fees and other costs incurred in successfully defending a patent suit are capitalizable. for Harcott Co. incurs $180,000 in legal costs on January 1, 2010, to successfully defend a patent. The patent’s useful life is 20 years, amortized on a straight-line basis. Harcott records the legal fees and the amortization at the end of 2010 as follows. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 71 6. Goodwill—is only recorded when an entire business is purchased because goodwill is a “going concern” valuation and cannot be separated from the business as a whole. a. Internally generated goodwill is not recorded. b. Purchased goodwill is recorded as the excess of the purchase price of an acquired business over the fair value of the identifiable net assets acquired. c. Goodwill is the residual amount—the excess of cost over the fair value of identifiable net assets acquired. e.g., Multi-Diversified, Inc. decides that it needs a parts division to supplement its existing tractor distributorship. The president of Multi-Diversified is interested in buying Tractorling Company, a small concern in Chicago. Illustration 12-3 presents the balance sheet of Tractorling Company. Multi-Diversified investigates Tractorling’s underlying assets to determine their fair values. Tractorling Company decides to accept Multi-Diversified’s offer of $400,000. What is the value of the goodwill, if any? Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 72 Example: Global Corporation purchased the net assets of Local Company for $300,000 on December 31, 2010. The balance sheet of Local Company just prior to acquisition is: Assets Cash Cost $ 15,000 FMV $ 15,000 Receivables 10,000 10,000 Inventories 50,000 70,000 Equipment 80,000 130,000 $ 155,000 $ 225,000 $ $ 25,000 $ 25,000 Total Liabilities and Equities Accounts payable Common stock Retained earnings Total 25,000 100,000 30,000 $ 155,000 d. Goodwill write-off. (1) Goodwill is considered an indefinite-life intangible, therefore is not subject to amortization. (2) Goodwill is only charged if it has been impaired. e. A bargain purchase—occurs when fair value of net assets acquired is greater than the purchase price. (1) FASB requires that the excess be recognized as a gain by the purchaser. (2) FASB also requires companies to disclose the nature of the gain. C. Impairment of Limited-Life Intangibles. Same as impairment for long-lived assets in Chapter 11. 1. If the sum of the expected future net cash flows is less than the carrying amount of the asset, an impairment has occurred (recoverability test). 2. The impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset (fair value test). 3. If the impaired asset is held for use, the new cost basis of the asset is the reduced carrying amount. The cost basis is not written up, even if the fair value of the asset increases in future years. Amortization is taken on the new cost basis over the asset’s remaining useful life, or legal life, whichever is shorter. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 73 4. If the impaired asset is intended to be disposed of, it is reported at the lower of cost or fair value less cost to sell (net realizable value). There is no amortization expense for the impaired assets being held for disposal because their costs will be recovered during the sale. 5. Impairment losses and restoration of losses are recognized in the other gains and losses section of the income statement. e.g., E12-14: (Copyright Impairment) Presented below is information related to copyrights owned by Botticelli Company at December 31, 2010. Cost $ 8,600,000 Carrying amount 4,300,000 Expected future net cash flows 4,000,000 Fair value 3,200,000 The copyright has a remaining useful life of 10 years. (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010. (b) Prepare the journal entry to record amortization expense for 2011 related to the copyrights. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 74 D. Impairment of Indefinite-Life Intangibles. 1. Intangibles other than Goodwill. a. Should be tested for impairment at least annually. b. A one-step test (fair value test). If the fair value of the intangible is less than its carrying amount, an impairment has occurred and must be recognized. Recoverability test is not used. e.g., Arcon Radio purchased a broadcast license for $2,000,000. Arcon Radio has renewed the license with the FCC twice, at a minimal cost. Because it expects cash flows to last indefinitely, Arcon reports the license as an indefinite-life intangible asset. Recently the FCC decided to auction these licenses to the highest bidder instead of renewing them. Arcon Radio expects cash flows for the remaining two years of its existing license. It performs an impairment test and determines that the fair value of the intangible asset is $1,500,000. 2. Goodwill. a. Involves a two-step process. (1) If the fair value of the reporting unit is less than its carrying amount including goodwill, then the second step is performed. (2) In the second step, the fair value (implied value) of the goodwill must be determined and compared to its carrying amount. (i) Implied value of goodwill = Fair value of reporting unit – carrying value of net assets (excluding goodwill). (ii) If implied goodwill is less than the carrying amount of goodwill an impairment loss has occurred and must be recognized. Presented below is net asset information related to the Mischa Division of Santana, Inc. as of December 31, 2010 (in millions): Cash $ Receivables Property, plant, and equipment, net 2,600 Goodwill 200 Less: Notes payable Net assets 60 200 (2,700) $ 360 Management estimated its future net cash flows from the division to be $400 million. Management has also received an offer to purchase the division for $335 million. All identifiable assets’ and liabilities’ book and fair value amounts are the same. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 75 (a) Prepare the journal entry (if any) to record the impairment at December 31, 2010. (b) At December 31, 2011, it is estimated that the division’s fair value increased to $345 million. Prepare the journal entry (if any) to record this increase in fair value. E. Research and Development Costs. 1. Definitions of research and development. 2. Accounting for research and development costs. a. Materials, equipment, and facilities. b. Personnel costs. c. Purchased intangibles. d. Contract service costs. e. Indirect costs. 3. All R&D costs 4. Research performed under contract by the reporting company for others is accounted for differently. 5. Other costs similar to R&D costs. a. Start-up costs. b. Initial operating losses. c. Advertising costs. d. Computer software costs. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 76 F. Presentation of Intangibles and Related Items. 1. Intangibles: are usually reported at their unamortized cost. a. All intangibles other than goodwill should be reported as a separate item. b. If goodwill is present, it should be reported as a separate item. c. The income statement should reflect: (1) (2) Amortization expense and impairment losses for all intangibles other than goodwill. Goodwill impairment losses should be shown as a separate item in continuing operations. d. The notes to the financial statements should include: (1) (2) 2. Aggregate amortization expense for each of next 5 years. Changes in the carrying amount of goodwill for the period. R&D costs: the footnotes should disclose the total R&D costs charged to expense in each period for which an income statement is presented. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 77 CHAPTER 13 Current Liabilities and Contingencies LECTURE OUTLINE The first of liabilities chapters. Section 1—Current Liabilities A. The Concept of Liabilities. 1. In SFAC No. 6, the FASB defined liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” B. Current Liabilities. 1. 2. Nature of current liabilities: Obligations whose liquidation is reasonably expected to require use of existing resources classified as current assets, or the creation of other current liabilities. Current liabilities are recorded and reported at their full maturity value. C. Types of Current Liabilities. 1. Accounts Payable. 2. Notes Payable. a. b. Trade notes. Short-term notes (1) Interest-bearing notes. (2) Zero-interest-bearing notes. c. Current maturities of long-term debt: That portion of long-term debt that matures within the next fiscal year is reported as a current liability, unless it is to be refinanced by a new debt issue or by conversion into stock. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 78 e.g., E13-2: (Accounts and Notes Payable) The following are selected 2010 transactions of KC Corporation. Sept. 1 - Purchased inventory from Orion Company on account for $50,000. KC records purchases gross and uses a periodic inventory system. Oct. 1 - Issued a $50,000, 12-month, 8% note to Orion in payment of account. Oct. 1 - Borrowed $75,000 from the Shore Bank by signing a 12-month, zero-interest-bearing $81,000 note. 3. Short-term obligations expected to be refinanced. a. Must be excluded from current liabilities only if the firm: (1) Intends to refinance, and (2) Demonstrates an ability to refinance. b. Ability can be evidenced by: (1) Actual refinancing, or (2) Signing a refinancing agreement that clearly permits refinancing of the debt on a longterm basis with readily determinable terms. c. Amount excluded cannot exceed the amount available under the agreement. d. Refinancing must occur before the current debt is due e.g., E13-3 (Refinancing of Short-Term Debt): On December 31, 2010, Alexander Company had $1,200,000 of short-term debt in the form of notes payable due February 2, 2011. On January 21, 2011, the company issued 25,000 shares of its common stock for $36 per share, receiving $900,000 proceeds after brokerage fees and other costs of issuance. On February 2, 2011, the proceeds from the stock sale, supplemented by an additional $300,000 cash, are used to liquidate the $1,200,000 debt. The December 31, 2010, balance sheet is issued on February 23, 2011. Show how the $1,200,000 of short-term debt should be presented on the December 31, 2010, balance sheet, including note disclosure Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 79 4. Dividends Payable: At the date of declaration of a cash dividend, the corporation assumes a liability. 5. Customer advances and deposits. 6. Unearned revenues. 7. Sales taxes payable. BE13-6: Dillons Corporation made credit sales of $30,000 which are subject to 6% sales tax. The corporation also made cash sales which totaled $20,670 including the 6% sales tax. (a) prepare the entry to record Dillons’ credit sales. (b) Prepare the entry to record Dillons’ cash sales. 8. Employee-related liabilities. a. Payroll deductions. (1) Social security taxes (F.I.C.A.): A combination of the O.A.S.D.I. and Hospital Insurance taxes. (a) Paid by both the employee and employer. (b) 7.65% on wages up to $102,000 and 1.45% on wages in excess of this amount. (2) Unemployment taxes: paid by the employer. (a) F.U.T. A. is 0.8% on the first $7,000 of compensation paid to each employee. (b) S.U.T. A. is 5.4% of the same amount. (3) Income tax withholding: federal and state income taxes on employee earnings. e.g., Assume a weekly payroll of $10,000 entirely subject to F.I.C.A. and Medicare (7.65%), federal (0.8%) and state (4%) unemployment taxes, with income tax withholding of $1,320 and union dues of $88 deducted. The company records the salaries and wages paid and the employee payroll deductions as follows: a) Journal entry to record salaries and wages paid: Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 80 b) Journal entry to record employer payroll taxes: Section 2—Contingencies A. Contingencies: an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. 1. Gain contingencies: are not recorded and are only disclosed when the probability is high that it will become a reality. 2. Loss contingencies: result in recognition of a contingent liability. B. Contingent Liabilities: Liabilities which are dependent upon the occurrence of one or more future events to confirm either the amount payable, the payee, the date payable, or its existence. The condition had to exist at the balance sheet date. Information has to be available prior to issuing financial statements. 1. The likelihood that the future event or events will confirm the incurrence of a liability can be classified as: a. Probable. The future event or events are likely to occur. A liability is recorded if the information indicates that it is probable that a liability had been incurred at the balance sheet date and the amount of the loss can be reasonably estimated. b. Reasonably possible. The chance of the future event or events occurring is more than remote but less than likely. c. Remote. The chance of the future event or events occurring is slight. 2. Accrual of a loss contingency should be made if both of the following conditions are met: a. b. 3. It is probable that a liability has been incurred at the date of the financial statements. The amount of the loss can be reasonably estimated. Common loss contingencies. a. Litigation, claims, and assessments. The following factors should be considered. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 81 (1) The time period in which the underlying cause of action occurred. (2) The probability of an unfavorable outcome. (3) The ability to make a reasonable estimate of the amount of loss. e.g., BE13-10: Scorcese Inc. is involved in a lawsuit at December 31, 2010. (a) Prepare the December 31 entry assuming it is probable that Scorcese will be liable for $900,000 as a result of this suit. (b) Prepare the December 31 entry, if any, assuming it is not probable that Scorcese will be liable for any payment as a result of this suit. b. Guarantee and warranty costs: The amount of the liability is an estimate of all the costs that will be incurred after sale and delivery. (1) Cash-basis method. (2) Accrual methods. (i) Expense warranty approach. This method should be used whenever the warranty is an integral and inseparable part of the sale and requires warranty costs to be charged to operating expense in the year of sale. (ii) Sales-warranty approach. This method is used when the warranty is sold separately from the product and requires that revenues from the sale of the warranty be deferred and subsequently recognized as income over the life of the warranty contract. e.g., BE13-13: Streep Factory provides a 2-year warranty with one of its products which was first sold in 2010. In that year, Streep spent $70,000 servicing warranty claims. At year-end, Streep estimates that an additional $400,000 will be spent in the future to service warranty claims related to 2010 sales. Prepare Streep’s journal entry to record the $70,000 expenditure, and the December 31 adjusting entry. c. Premiums and coupons offered to customers: Result in the probable existence of a liability at the date of the financial statement. e.g., Fluffy Cakemix Company offered its customers a large nonbreakable mixing bowl in exchange for 25 cents and 10 boxtops. The mixing bowl costs Fluffy Cakemix Company 75 cents, and the company estimates that customers will redeem 60 percent of the boxtops. The premium offer began in June 2010 and resulted in the transactions journalized below. Fluffy Cakemix Company records purchase of 20,000 mixing bowls as follows. The entry to record sales of 300,000 boxes of cake mix would be: Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 82 Fluffy records the actual redemption of 60,000 boxtops, the receipt of 25 cents per 10 boxtops, and the delivery of the mixing bowls as follows. Finally, Fluffy makes an end-of-period adjusting entry for estimated liability for outstanding premium offers (boxtops) as follows. d. Environmental liabilities. (1) Asset retirement obligation (ARO). (2) An ARO should be measured at fair value. (3) The cost of the ARO is included in the cost of the related long-lived asset. (i) A liability is recorded for the same amount. (ii) The cost is expensed through the depreciation expense recognized on the related long-lived asset. e.g., On January 1, 2010, Wildcat Oil Company erected an oil platform in the Gulf of Mexico. Wildcat is legally required to dismantle and remove the platform at the end of its useful life, estimated to be five years. Wildcat estimates that dismantling and removal will cost $1,000,000. Based on a 10 percent discount rate, the fair value of the asset retirement obligation is estimated to be $620,920 ($1,000,000 x .62092). Wildcat records this ARO as follows. During the life of the asset, Wildcat allocates the asset retirement cost to expense. Using the straight-line method, Wildcat makes the following entries to record this expense. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 83 In addition, Wildcat must accrue interest expense each period. Wildcat records interest expense and the related increase in the asset retirement obligation on December 31, 2010, as follows. On January 10, 2015, Wildcat contracts with Rig Reclaimers, Inc. to dismantle the platform at a contract price of $995,000. Wildcat makes the following journal entry to record settlement of the ARO. Section 3—Presentation and Analysis A. Presentation of current liabilities. 1. 2. 3. 4. 5. Because of their short-term nature, current liabilities are reported at their full maturity value, not their present value. The current liabilities accounts are generally the first classification in the liabilities section of the balance sheet. Current liabilities are frequently listed in order of maturity, in descending order of amount, or in order of liquidation preference. Secured liabilities should be identified and the related assets clearly indicated. Currently maturing debt to be paid with noncurrent assets should be classified as long-term liabilities. B. Presentation of Contingencies. 1. If a loss contingency is either probable or estimable but not both, and if there is at least a reasonable possibility that a liability may have been incurred, the following disclosure is required: a. b. 2. The nature of the contingency. An estimate of the possible loss or range of loss or a statement that an estimate cannot be made. Other contingent liabilities that should be disclosed even if the possibility of a loss is remote are: a. b. c. Guarantees of indebtedness to others. Obligations of commercial banks under “stand-by letters of credit.” Guarantees to repurchase receivables (or any related property) that have been sold or assigned. Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 84 3. Disclosure should include the nature and amount of the guarantee and, if estimable, the amount to be recovered from outside parties. C. Analysis of current liabilities. Current assets Current liabilities 1. Current ratio = 2. Acid-test ratio = Cash + Short-terminvestments + Net receivables Current liabilities Intermediate Accounting 1, ACCT321 Southern Illinois University at Carbondale Page 85 ...
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This note was uploaded on 09/23/2010 for the course ACCOUNTING 321 taught by Professor And during the Spring '10 term at Southern Illinois University Edwardsville.

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