Microsoft Word FA II Note edited by Nesredin Page 1 Chapter One Property, Plants and Equipment Classifications of long lived assets typically found on a balance sheet are Property, Plant, & Equipmen[.]
Chapter One Property, Plants and Equipment Classifications of long-lived assets typically found on a balance sheet are: Property, Plant, & Equipment Investments - Long terms assets acquired for resale in the normal course of business operation Intangibles- are used in the operation of the business, but have no physical substance eg Patent, Goodwill, Fixed (plant) Assets – are tangible long-lived resources that are used in the operation of the business & are not intended for sale to customers Property, plant, and equipment include land, building structures (offices, factories, warehouses), and equipment (machinery, furniture, tools) Unique features of fixed (plant) assets are: They are acquired for use in operations and not for resale They are long-term in nature and usually depreciated They possess physical substance: they can be seen & founded, they have physical existence Acquisition costs of plants, properties and equipment The cost of a plant asset is the amount of all expenditures incurred to acquire the asset and make it ready for use Cost of land The cost of land includes all expenditures incurred to acquire land and to make it ready for use including the following: (1) the purchase price; (2) closing costs, such as title to the land, attorney’s fees, and recording fees; (3) costs incurred in getting the land in condition for its intended use, such as grading, filling, draining, and clearing; (4) assumption of any liens, or encumbrances on the property; and (5) any additional land improvements that have an indefinite life Cost of land improvements The cost of land improvements includes all expenditures incurred to improve the land that are maintained and replaced by the owner These costs include costs of private driveways, sidewalks, fences, parking lots and lighting Note that the major reason to separate land and land improvements will be clear when we consider depreciation issues As you will soon see, land is considered to have an indefinite life and is not depreciated Alternatively, you know that parking lots, irrigation systems, fences and other land improvements wear and tear out, and, therefore these are subjected to depreciation Cost of buildings The costs of buildings include all expenditures incurred that are directly related to purchase or construction of buildings These costs include purchase price, professional fees that means, the costs architect fees to design the building, construction costs incurred from excavation to completion and costs of building permits Page Costs of machineries and equipment Costs of equipment and machineries include all expenditures incurred in acquiring the equipment and preparing it for use which includes purchase price, shipping costs like freight, handling charges and insurance on the equipment while in transit, installation costs like the cost of special foundation, assembly and installation and set up costs or costs of conducting trial runs Special Considerations A Cash Discounts When a plant asset is purchased subject to a cash discount, the discount (whether taken or not) is considered a reduction in the cost of the asset The ground reason is that the additional payment made due to the deferring of the payment is not the cost of the asset rather it is the penalty of late payment And the amount of discount lost will be treated as loss and not part of cost of the asset acquired Example: A corporation purchased equipment for Br 70,000 and arranged to pay a cash discount of 2% provided that payment was made within 10 days Suppose that cash payment was made within the discount period, the cost of the equipment is Br 68,600 [70,000 – (2% x 70,000)] Again consider company purchasing equipment for Br 50,000 with cash discount of 2% made available if payment was made within 10 days Suppose that payment is not made within the discount period, the cost of the equipment is Br 49,000 [50,000 – (2% x 50,000)] B Deferred Payments When a plant asset is acquired by issuing a long-term liability, the cost of the plant asset is equal to the present value of the future cash payments Example: Suppose that ABC Company purchased land by issuing a Br 500,000, 5-year noninterest bearing note on January of year when the market rate of interest was 10%; the note is to be repaid in equal instalments of Br 100,000 on December 31 of year 1, year 2, year 3, year and Year − (1.1) Cost of land = Br 100,000 0.1 Cost of land = Br 100,000X3.79079 = , C Issuance of securities When a plant asset is acquired by issuing securities, the cost of the plant asset is equal to either the fair market value of the securities issued or the fair market value of the plant assets themselves provided that the fair market value of the securities is not determinable Page Illustration: i Mega Corporation purchased machinery by issuing 2,000 shares of common stock with a par value of Br 40 and a fair market value of Br 75 Suppose that the fair market value of the machinery was Br 154,000, then, the cost of the machine acquired is Birr 150,000, computed as follows: (Birr 75 per share X 2,000 shares) = Br.150, 000 ii If the value of the common stocks of Mega Corporation is unknown, the value of the machine shall be equal to the fair market value of the machine which is equal to Birr 154,000 D Lump-sum purchase It is not unusual for a group of operational assets to be acquired for a single sum If these assets are indistinguishable, for example, identical delivery trucks purchased for a lump sum price of Br 200,000, valuation is obvious, each of the trucks would be valued at Br 40,000 ( Br 200,000 5) however, if the lump-sum purchase involves different assets, it is necessary to allocate the lump sum acquisition price among the separate items, usually in proportion to the individual assets’ relative fair market values Illustration: ABC Company purchased an existing factory for a single sum of Birr 2,100,000 This price includes the costs of title to the land, factory building and equipment An independent appraisal estimated the market values of the assets (if these would be purchased separately) at Birr 800,000 for the land, Birr 1,000,000 for the factory and Birr 700,000 for the building The lump sum purchase price of Birr 2,100,000 is allocated to the individual separate assets as follows: Step 1: Determine the percentage of the market value of each asset to the total sum Assets Land Factory Building Market value Br 800,000 1,000,000 700,000 2,500, 000 Percentage 32% 40% 28% 100% Step 2: Multiply the percentage of each asset’s market value (computed in step above) by the lump-sum price to get the cost of the assets and the following journal entry is recorded: Land (0.32 × Br 2,100,000) 672,000 Factory (0.40 × Br 2,100,000) 840,000 Building (0.28 × Br 2,100,000) .588,000 Cash .2,100,000 E Donated assets On occasion, companies acquire operational assets through donation Local government Chapter might provide land or pay all or some of the cost of new office building or manufacturing plant to entice a company to locate in its geographical boundaries; so that the factory brought jobs to the society and increase revenues to the city Assets donated by unrelated parties should be recorded at their fair value based on either an available market price or an appraisal value This is not a Page departure from historical cost valuation The treatment of the transaction is equivalent to the donor contributing cash to the company and the company using the cash to acquire the asset The contribution revenue should be recognized for the excess of the fair market value of the plant asset over any costs incurred to acquire the plant asset (legal fees, title costs, etc) Illustration: XYZ Manufacturing Company a corporation received land with a fair market value of Br 790,000 from a city with the stipulation that a factory be built on the land; the corporation incurred legal fees of Birr 20,000 to obtain title to the land Required: i Determine the cost of the land and contribution revenue ii Pass the journal entry on the book of the XYZ Company Solution i Cost of Land = Br 790,000 Contribution Revenue = Br 790,000 – Br 20,000 = Br 770,000 ii Journal entry: Land 790,000 Cash 20,000 Contribution Revenue 770,000 (To record the acquisition of land) F Self-constructed assets Occasionally, companies (particularly in the railroad and utility industries) construct their own assets Determining the cost of such fixed assets can be a problem Without a purchase price or contract price, the company must allocate costs and expenses in order to arrive at the cost of the self-constructed asset Materials and direct labour used in construction pose no problem; these costs can be traced directly to work and material orders related to the fixed assets constructed However, the assignment of indirect costs of manufacturing creates special problems These indirect costs, called overhead or burden, include power, heat, light, insurance, property taxes on factory buildings and equipment, factory supervisory labour, depreciation of fixed assets, and supplies These costs might be handled in one of two ways: i Assign no fixed overhead to the cost of the constructed asset or ii Assign a portion of all overhead to the construction process G Interest costs during construction The proper accounting for interest costs has been a long-standing controversy Three approaches have been suggested to account for the interest incurred in financing the construction or acquisition of property, plant, and equipment: Capitalize no interest charges during construction approach under this approach interest is considered a cost of financing and not a cost of construction Page Charge construction with all costs of funds employed, whether identifiable or not Under this method maintains that one part of the cost of construction is the cost of financing, whether by debt, cash, or stock financing and Capitalize only the actual interest costs incurred during construction This approach relies on the historical cost concept that only actual transactions are recorded Concept of Depreciation Depreciation- is the process of allocating the cost of a plant asset over its useful (service) life in a rational and systematic manner The basic purpose of depreciation is to provide the proper matching of expense with revenues in accordance with the matching principle Depreciation is a process of cost allocation, not a process of assets valuation Accountants make no attempt to measure the change in an assets mkt value during ownership, because plant assets are not held for resale Depreciation does not mean that the business sets aside or accumulates cash to replace assets as they become fully depreciated Establishing such a cash fund is decision entirely separate from depreciation Accumulate depreciation is that portion of the plant asset's cost that has already been recorded as expense Causes of Depreciation The two major causes of depreciation are physical deterioration & obsolescence a Physical Deterioration – occurs from wear & tear while in use as well as from the action of the weather (exposure to sun, wind, and other climatic factors) b Obsolescence (Function Depreciation) - is the process of becoming out of date before the assets physically wears out In today’s rapidly advance in technology, obsolescence is a more important consideration than physical deterioration E.g a personal computer made in the 1980's would not be able to provide an Internet connection Assets like computers, other electronic equipment & airplanes may become obsolete before they physically deteriorate An asset is obsolete when another asset can the job better or more efficiently Depreciation Methods There are several alternative methods of computing depreciation A business need not use the same method of depreciation for all its various assets Depreciation is computed using one of the following different methods: Straight line method Chapters of output method Declining balance method Sum-of-the-years’-digits method Interest method of computing depreciation Composite method of computing depreciation Page Like the inventory costing method, each method is acceptable under GAAP, thus it is up to the management of the business to select a method, which is believed to be appropriate in the circumstance Depreciation affects the Balance sheet reports through the account of accumulated depreciation, as well as the Income statement through the account of depreciation expense Thus, its proper accounting and record is imperative for financial reporting Three factors affect the computation of depreciation: a Cost - is the initial cost incurred in acquiring the asset Cost is measured in accordance with the cost principle of accounting b Useful Life - is an estimate of the expected productive life, also called service life, of the asset Useful life maybe expressed in term of time, Chapters of activity such as machine hours, or in Chapters of output c Salvage Value - also called scrap or residual value is an estimate of the asset's value at the end of its useful life o The full cost of a plant asset is depreciated if the asset is expected to have no residual value o The plant assets cost minus its estimated residual value is called the depreciable cost Straight - Line Method Under the Straight - Line Method, an equal portion of the cost of the asset is allocated to each period of use; consequently, this method is most appropriate when usage of an asset is fairly uniform from year to year It is the simplest & most widely used method of computing depreciation The Straight Line Method depreciation assumed that a business receives equal benefits from an asset each day of the asset's life Straight Line, then, allocates an equal part of the total cost to each day of an asset's useful life To illustrate, assume a delivery truck has a cost of Br.17, 000 a residual value of Br 2,000 and an estimated useful life of five years The annual computation of depreciation exp will be as follows: Straight - Line depreciation per year = Cost - Residual value Useful life in years = Br 17,000.00 - Br 2,000.00 = Br 3,000.00 Depreciation Schedule – Straight-line method Depreciation Accumulated Depreciation Depreciation Book value Depreciable Rate x Cost Expense Year 1st 20% x Br 15,000 3rd 20% x nd 4th 5th 20% 20% 20% x x x 15,000 15,000 15,000 15,000 100% Br 3,000 3,000 3,000 3,000 3,000 Br 15,000 Br.3,000 Br 17,000 9,000 8,000 6,000 12,000 15,000 11,000 5,000 2,000 Page Depreciation rates for various types of assets can conveniently be stated as percentages In the illustration, it was assumed that the asset was acquired on Jan 1, the beginning of the accounting period If the asset had been acquired during the year, on October 1, it would have been in use for only months, or 3/12 of a year Then, the depreciation expense for the three months would be computed as follows: Depreciation on December 31 = Br 15,000.00 x 20% x 3/12 = 750 The straight-line method predominates in practice It is simple to apply, & it matches expenses with revenues appropriately when the use of the asset is reasonably uniform throughout the service life Chapter of Output Method This method is used for assets whose useful life is limited by physical wear- and -tear rather than obsolescence The asset life is expressed in expected Chapters of output, such as hours, miles, or number of Chapters This method is appropriate when the service of a fixed asset is related to use rather than time It is based on the assumption that an asset depreciates only as it is used Thus the asset life is expressed in expected Chapters of output such as miles, To illustrate, assume that the delivery truck in the previous example has an estimated useful life of 100,000 miles, and in the first year of its usage it is driven 15,000.00 miles The depreciation for the first year is then computed as follows: Depreciation Per Chapter of output = Cost - Residual Value Est Chapters of Output (Miles) = Br 17,000 - Br 2,000 100,000 Miles = Br 0.15 Dep per mile In the Chapters-of-output method, a fixed amount of depreciation is assigned to each Chapter of output produced or each Chapter of capacity used by the plant assets Year depreciation exp = Br 0.15 x 15,000miles = Br 2,250 So, when the amount if use of a fixed asset varies from year to year, the Chapters- of – output method is more appropriate than the straight –line method In such a case, the Chapters-of-output method better matches the expense with related revenue Declining Balance Method The basic idea behind the declining balance method is that more service benefits are received in the early years of an asset's life when it is new, & fewer benefits are received each year as the asset grows older So this method assigns more (greater) depreciation exp to the early years of the asset's life & less to later ones Page To illustrate, consider the previous e.g of the Br 17,000 delivery truck To depreciate the truck by the double declining balance method, we double the straight-line rate of 20% & apply the doubled rate of 40% to the book value at the beginning of each year Depreciation Schedule Declining Balance Method Year Computation Annual Dep exp Depreciation Book Value Rate Beg Of year - 4th 5th 3,672 2,203 1st 2nd 3rd Br 17,000 10,200 6,120 - 40% 40% 40% 40% 40% - Br 6,800 4,080 2,448 1,469 203 Accumulated Depreciation Book Value - Br 17,000 14,797 15,000 2,203 2,000 Br 6,800 10,880 13,328 10,200 6,120 3,672 The declining balance method produces a decreasing annual depreciation expense over the useful life of the asset The method is so named because computation of periodic depreciation is based on a declining book value (cost less accumulated depreciation) of the asset The depreciation rate remains constant from year to year, but the book value to which the rate is applied declines each year Unlike the other depreciation methods, salvage value is ignored in determining the amount to which the declining balance is applied Salvage value, however, does limit the total depreciation that can be taken Depreciation stops when the asset's B.V equals expected salvage value Because the declining balance method produces higher depreciation expense in the early years than in the later years, it is considered an accelerated depreciation method If the asset has been acquired on October 1, rather than on January 1, depreciation for only months would be computed as follows: 40% x Br 17,000.00 x 3/12 = Br 1,700 For the next year, the calculation would be, 40% x (17,000 -1,700) =Br 1,620 Sum of the years Digits method Like the declining balance method, the sum of the year's digit allocates a large portion of the asset cost to the early years of its use as accelerated depreciation method The depreciation rate to be used is a fraction, of which the numerator is the remaining years of useful life (as of the beginning of the year) & the denominator is the sum of the individual years that comprise total service life Page SYD is an appropriate method for assets that provide more service benefits in the early years of their lives & less in later years Many assets are efficient when first purchased but become less efficient as time passes This decrease in utility may be caused by technological obsolescence or by accumulated effects of physical wear and tear Copying machines & computer are examples of assets that are depreciated by an accelerated depreciation method Consider again the example of the delivery truck costing Br 17,000 having an estimated life of Five (5) years & an estimated residual value of Br 2,000 First the sum of the digits of the years of the asset’s useful life has to be determined through a short cut formula that yields the same results as the more tiresome addition process Sum of the digits = n (n+1), where n is number of years in the assets life 5- years sum of the digits = 5(5+1) = (3) = 15 Computation Annual Accumulated Year Dep exp Depreciation Depreciable Cost SYD Fraction 2nd 3rd 4th 5th st Br 15,000 15,000 15,000 15,000 15,000 5/15 4/15 3/15 2/15 1/15 Br 5,000 4,000 3,000 2,000 1,000 Br 5,000 9,000 12,000 14,000 15,000 Book Value Br 17,000.00 12,000.00 8,000.00 5,000.00 3,000.00 2,000.00 Br.15,000 If the truck was acquired on Oct 1, since the asset was in use for only months during the first accounting period, the depreciation to be recorded in the st period will be for only 3/12 of a full year i.e 3/12 x Br.5, 000 = Br.1, 250 For the second year, Br.15, 000 x 5/15 x 9/12 = Br 3,750 15,000 x 4/15 x 3/12 = Third year, Total Br.15, 000 x 4/15 x9/12 = 3,000 Br.15,000 x 3/15 x3/12 Total 1,000 4,750 750 Br = 3,500 Page Interest method of depreciation Under interest method of depreciation, a plant asset is considered as a bundle of future service to be received periodically over the economic life of the asset The cost of such an asset is viewed as the present value of the equal periodic rents of services discounted at a rate of interest consistent with the risk factors identified with the investment in the plant asset There are two kinds of interest methods of depreciation Annuity Method: Annuity method of depreciation is appropriate when the periodic cost (depreciation) of using a long lived plant asset is considered to be equal to the total of the expired cost of the asset and the implicit interest on the unrecorded investment in the asset Depreciation expense is debited and accumulated depreciation and interest revenue are credited The following is the formula used to calculate depreciation under annuity method SV AC (1 i) n Deprciation (1 i) -n i Where: AC- Acquisition Cost SV- Salvage value i- Interest rate n- Useful life Example 5: Assume a machine with an economic life of five years and a net residual value of Br 67,388 is acquired by ABC Company for Br 800,000 If the fair rate of interest for this type of investment is 10% compounded annually, the yearly depreciation is computed as follows under annuity method Br 67 ,388 Br 800 ,000 (1 1) Deprciatio n Br 200 ,000 (1 1) Summary of the result of the annuity method of depreciation for the five years and the journal entries to record depreciation for the first three years are given below Year Depreciation Expense Br.200,000 200,000 200,000 200,000 200,000 Br.1,000,000 Implicit interest Credit to Balance of revenue accumulated accumulated Carrying (10% of carrying depreciation depreciation amount of the amount) ledger account ledger account plant asset Br.800,000 Br.80,000 Br.120,000 120,000 680,000 68,000 132,000 252,000 548,000 54,800 145,200 392,200 402,800 40,280 159,720 556,920 243,080 24,308 175,692 732,612 67,388 Br 267,388 Br 732,612 Page 10 For example, assume that Target merchandising Company decides to change its inventory valuation method in 2010 from the retail inventory method (FIFO) to the retail inventory (average cost) It provides comparative information for 2008 and 2009 based on the new method Target would adjust its assets, liabilities, and retained earnings for periods prior to 2008 and report these amounts in the 2008 financial statements, when it prepares comparative financial statements To illustrate the retrospective approach, assume that Lancer Company has accounted for its inventory using the LIFO method In 2010, the company changes to the FIFO method because management believes this approach provides a more appropriate measure of its inventory costs Additional information related to Lancer Company is provided hereunder Lancer Company started its operations on January 1, 2008 At that time stockholders invested Br 100,000 in the business in exchange for common stock All sales, purchases, and operating expenses for the period 2008–2010 are cash transactions Lancer’s cash flows over this period are as follows 2008 Sales……………………………… Br 300,000 Purchases…………………………… 90,000 Operating expenses………………… 100,000 Cash flow from operations………… Br 110,000 2009 Br 300,000 110,000 100,000 Br 90,000 2010 Br 300,000 125,000 100,000 Br 75,000 Lancer has used the LIFO method for financial reporting since its origin Inventory determined under LIFO and FIFO for the period 2008–2010 is as follows January 1, 2008…………………… December 31, 2008……………… December 31, 2009……………… December 31, 2010……………… LIFO Method Br 10,000 20,000 32,000 FIFO Method Br 12,000 25,000 39,000 Difference Br 2,000 5,000 7,000 Costs of goods sold under LIFO and FIFO for the period 2008–2010 are as follows Cost of Goods Sold LIFO 2008……………………… ……… Br 80,000 2009……………………………… 100,000 2010……………………………… 113,000 Cost of Goods Sold FIFO Difference Br 78,000 Br 2,000 97,000 3,000 111,000 2,000 Earnings per share information is not required on the income statement All tax effects for this illustration should be ignored Page 60 Given the information about Lancer Company, the following table shows its income statement, retained earnings statement, balance sheet, and statement of cash flows for 2008–2010 under LIFO Lancer Company Income Statement For the year ended December 31 Account 2008 2009 Sales………………………… Br 300,000 Br 300,000 Cost of goods sold (LIFO)………………… 80,000 100,000 Operating expenses………………………… 100,000 100,000 Net income………………………………… Br 120,000 Br 100,000 Lancer Company Retained Earnings Statement For the year ended December 31 Account 2008 2009 Retained earnings (beginning)……………… Br Br 120,000 Add: Net income…………………………… Br 120,000 Br 100,000 Retained earnings (ending)………………… Br 120,000 Br 220,000 Lancer Company Balance Sheet At December 31 Account 2008 2009 Cash…………………………………… Br 210,000 Br 300,000 Inventory (LIFO)…………………………… 10,000 20,000 Total assets………………………………… Br 220,000 Br 320,000 Common stock……………………………… Br 100,000 Br 100,000 Retained earnings…………………………… 120,000 220,000 Total liabilities and stockholders’ equity Br 220,000 Br 320,000 Lancer Company Statement Of Cash Flows For The Year Ended December 31 Account 2008 2009 Cash flows from operating activities Sales…………………………………… Br 300,000 Br 300,000 Purchases……………………………… 90,000 110,000 Operating expenses…………………… 100,000 100,000 Net cash provided by operating activities 110,000 90,000 Cash flows from financing activities -0issuance of common stock……………… 100,000 2010 Br 300,000 113,000 100,000 Br 87,000 2010 Br 220,000 Br 87,000 Br 307,000 2010 Br 375,000 32,000 Br 407,000 Br 100,000 307,000 Br 407,000 2010 Br 300,000 125,000 100,000 75,000 -0Page 61 Net increase in cash………………………… Cash at beginning of year………………… Cash at end of year………………………… 210,000 -0Br 210,000 90,000 210,000 Br 300,000 75,000 300,000 Br 375,000 As the above illustration indicates, under LIFO inventory costing method Lancer Company reports Br 120,000 net income in 2008, Br 100,000 net income in 2009, and Br 87,000 net income in 2010 The amount of inventory reported on Lancer’s balance sheet reflects LIFO costing The following table shows Lancer’s income statement, retained earnings statement, balance sheet, and statement of cash flows for 2008–2010 under FIFO You can see that the cash flow statement under FIFO is the same as under LIFO Although the net incomes are different in each period, there is no cash flow effect from these differences in net income (If we considered income taxes, a cash flow effect would result.) Lancer Company Income Statement For the year ended December 31 Account 2008 2009 2010 Sales………………………… Br 300,000 Br 300,000 Br 300,000 Cost of goods sold 78,000 97,000 111,000 (FIFO)………………… Operating 100,000 100,000 100,000 expenses………………………… Net Br 122,000 Br 103,000 Br 89,000 income………………………………… Lancer Company Retained Earnings Statement For the year ended December 31 Account 2008 2009 2010 Retained earnings Br Br 122,000 Br 225,000 (beginning)……………… Add: Net Br 122,000 Br 103,000 Br 89,000 income…………………………… Retained earnings Br 122,000 Br 225,000 Br 314,000 (ending)………………… Lancer Company Balance Sheet At December 31 Account 2008 2009 2010 Cash…………………………………… Br 210,000 Br 300,000 Br 375,000 Inventory (FIFO)…………………………… 12,000 25,000 39,000 Total Br 222,000 Br 325,000 Br 414,000 Page 62 assets………………………………… Common Br 100,000 Br 100,000 stock……………………………… Retained 122,000 225,000 earnings…………………………… Total liabilities and stockholders’ equity Br 222,000 Br 325,000 Lancer Company Statement Of Cash Flows For The Year Ended December 31 Account 2008 2009 Cash flows from operating activities Br 300,000 Br 300,000 Sales…………………………………… Purchases……………………………… 90,000 110,000 Operating expenses…………………… 100,000 100,000 Net cash provided by operating activities 110,000 90,000 Cash flows from financing activities -0issuance of common stock……………… 100,000 Net increase in 210,000 90,000 cash………………………… Cash at beginning of year………………… -0210,000 Cash at end of year………………………… Br 210,000 Br 300,000 Br 100,000 314,000 Br 414,000 2010 Br 300,000 125,000 100,000 75,000 75,000 -0- 300,000 Br 375,000 Dear Learners! Please try to compare the financial statements reported in the above two tables You can see that, under retrospective application, the change to FIFO inventory valuation affects reported inventories, cost of goods sold, net income, and retained earnings In the following sections we discuss the accounting and reporting of Lancer’s accounting change from LIFO to FIFO Accounting and reporting a change in principle Given the information provided in the above sections, we now are ready to account for and report on the accounting change Accounting for a change in principle: - Our first step is to adjust the financial records for the change from LIFO to FIFO To so, we perform the analysis as shown hereunder: Page 63 Year 2008………………………………… 2009………………………………… Total at the beginning of 2010…… Total in 2010……………………… Net Income LIFO FIFO Br 120,000 Br 122,000 100,000 103,000 Br 220,000 Br 225,000 Br 87,000 Br 89,000 Difference in Income Br 2,000 3,000 Br 5,000 Br 2,000 The entry to record the change to the FIFO method at the beginning of 2010 is as follows Inventory……………………………………….5, 000 Retained Earnings……………………………………………5,000 The change increases the inventory account by Br 5,000 This amount represents the difference between the ending inventory at December 31, 2009, under LIFO (Br 20,000) and the ending inventory under FIFO (Br 25,000) The credit to Retained Earnings indicates the amount needed to change prior-year’s income, assuming that Lancer had used FIFO in previous periods Reporting a change in principle: The disclosure of accounting changes is particularly important for users of the financial statements as far as they want consistent information from one period to the next Such consistency ensures the usefulness of financial statements The major disclosure requirements are as follows The nature of and reason for the change in accounting principle This must include an explanation of why the newly adopted accounting principle is preferable The method of applying the change, and: a A description of the prior-period information that has been retrospectively adjusted, if any b The effect of the change on income from continuing operations, net income (or other appropriate captions of changes in net assets or performance indicators), any other affected line item, and any affected per-share amounts for the current period and for any prior periods retrospectively adjusted c The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the earliest period presented Lancer Company will prepare comparative financial statements for 2009 and 2010 using FIFO (the new inventory method) The following table indicates how Lancer might present this information Lancer Company Page 64 Income Statement For The Year Ended December 31 2010 Sales……………………………………… Br 300,000 Cost of goods sold……………………… .111,000 Operating expenses……………………… .100,000 Net income……………………………… Br 89,000 2009 As adjusted (Note A) Br 300,000 97,000 100,000 Br 103,000 Note A Change in method of accounting for inventory valuation On January 1, 2010, Lancer Company elected to change its method of valuing its inventory to the FIFO method; in all prior years inventory was valued using the LIFO method The Company adopted the new method of accounting for inventory to better report cost of goods sold in the year incurred Comparative financial statements of prior years have been adjusted to apply the new method retrospectively The following financial statement line items for years 2010 and 2009 were affected by the change in accounting principle 2010 2009 Balance Sheet LIFO FIFO Difference LIFO FIFO Difference Inventory………………Br 32,000 Br 39,000 Br 7,000 Br 20,000 Br 25,000 Br 5,000 Retained earnings…… 307,000 314,000 7,000 220,000 225,000 5,000 Income Statement Cost of goods sold…….Br 113,000 Br 111,000 Br 2,000 Br 100,000 Br 97,000 Br 3,000 Net income…………… 87,000 89,000 2,000 100,000 103,000 3,000 Statement of Cash Flows (no effect) As a result of the accounting change, retained earnings as of January 1, 2009, increased from Br 120,000, as originally reported using the LIFO method, to Br 122,000 using the FIFO method As the above table shows, Lancer Company reports net income under the newly adopted FIFO method for both 2009 and 2010 The company retrospectively adjusted the 2009 income statement to report the information on a FIFO basis In addition, the note to the financial statements indicates the nature of the change, why the company made the change, and the years affected The note also provides data on important differences between the amounts reported under LIFO versus FIFO (When identifying the significant differences, some companies show the entire financial statements and line-by-line differences between LIFO and FIFO.) Page 65 Retained earnings adjustment As indicated earlier, one of the disclosure requirements is to show the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented; for Lancer Company, that date is January 1, 2009 Lancer disclosed that information by means of a narrative description (see Note A in the above table) Lancer also would disclose this information in its retained earnings statement The following section shows Lancer’s retained earnings statement under LIFO—that is, before giving effect to the change in accounting principle (This information comes from the earlier sections.) Retained Earnings Statements (LIFO) 2010 2009 2008 Retained earnings, January 1…………………Br 220,000 Br 120,000 Br Net income…………………………………… 87,000 100,000 120,000 Retained earnings, December 31…………… Br 307,000 Br 220,000 Br 120,000 If Lancer presents comparative statements for 2009 and 2010 under FIFO, then it must change the beginning balance of retained earnings at January 1, 2009 The difference between the retained earnings balances under LIFO and FIFO is computed as follows Retained earnings, January 1, 2009 (FIFO)…………………………………Br 122,000 Retained earnings, January 1, 2009 (LIFO)………………………………… 120,000 Cumulative effect difference……………………………………………… Br 2,000 The Br 2,000 difference is the cumulative effect The following table shows a comparative retained earnings statement for 2009 and 2010, giving effect to the change in accounting principle to FIFO Retained Earnings Statements after Retrospective Application 2010 2009 Retained earnings, January 1, as reported……………… Br 120,000 Add: Adjustment for the cumulative effect on prior years of applying retrospectively the new method of accounting for inventory……………… 2,000 Retained earnings, January 1, as adjusted……………… Br 225,000 122,000 Net income……………………………………………… 89,000 103,000 Retained earnings, December 31……………………… Br 314,000 Br 225,000 Lancer adjusted the beginning balance of retained earnings on January 1, 2009, for the excess of FIFO net income over LIFO net income in 2008 This comparative presentation indicates the type of adjustment that a company needs to make It follows that the amount of this adjustment would be much larger if a number of prior periods were involved Page 66 1.2.2 Changes in accounting estimates To prepare financial statements, companies must estimate the effects of future conditions and events For example, the following items require estimates Uncollectible receivables Inventory obsolescence Useful lives and salvage values of assets Periods benefited by deferred costs Liabilities for warranty costs and income taxes Recoverable mineral reserves Change in depreciation methods A company cannot perceive future conditions and events and their effects with certainty Therefore, estimating requires the exercise of judgment Accounting estimates will change as new events occur, as a company acquires more experience, or as it obtains additional information Companies report prospectively changes in accounting estimates That is, companies should not adjust previously reported results for changes in estimates Instead, they account for the effects of all changes in estimates in (1) the period of change if the change affects that period only, or (2) the period of change and future periods if the change affects both The FASB views changes in estimates as normal recurring corrections and adjustments, the natural result of the accounting process It prohibits retrospective treatment The circumstances related to a change in estimate differ from those for a change in accounting principle If companies reported changes in estimates retrospectively, continual adjustments of prior years’ income would occur It seems proper to accept the view that, because new conditions or circumstances exist, the revision fits the new situation (not the old one) Companies should therefore handle such a revision in the current and future periods To illustrate, Underwriters Labs Inc purchased for Br 300,000 a building that it originally estimated to have a useful life of 15 years and no salvage value It recorded depreciation for years on a straight-line basis On January 1, 2010, Underwriters Labs revises the estimate of the useful life It now considers the asset to have a total life of 25 years (Assume that the useful life for financial reporting and tax purposes and depreciation method are the same.) The following section shows the accounts at the beginning of the sixth year Building……………………………………………………………… Br 300,000 Less: Accumulated depreciation—building (5 x Br 20,000)………… 100,000 Book value of building…………………………………………………Br 200,000 Underwriters Labs records depreciation for the year 2010 as follows: Page 67 Depreciation Expense…………………10,000 Accumulated Depreciation—Building………………………10,000 The company computes the Br 10,000 depreciation charge as shown here under: Depreciation charge = Book value of asset = Br 200,000 = Br 10,000 Remaining service live 25-5 years Companies sometime find it difficult to differentiate between a change in estimate and a change in accounting principle Is it a change in principle or a change in estimate when a company changes from deferring and amortizing marketing costs to expensing them as incurred because future benefits of these costs have become doubtful? If it is impossible to determine whether a change in principle or a change in estimate has occurred, the rule is this: Consider the change as a change in estimate This is often referred to as a change in estimate effected by a change in accounting principle Another example of a change in estimate effected by a change in principle is a change in depreciation (as well as amortization or depletion) methods Because companies change depreciation methods based on changes in estimates about future benefits from long lived assets, it is not possible to separate the effect of the accounting principle change from that of the estimates As a result, companies account for a change in depreciation methods as a change in estimate effected by a change in accounting principle A similar problem occurs in differentiating between a change in estimate and a correction of an error, although here the answer is more clear-cut How does a company determine whether it overlooked the information in earlier periods (an error), or whether it obtained new information (a change in estimate)? Proper classification is important because the accounting treatment differs for corrections of errors versus changes in estimates The general rule is this: Companies should consider careful estimates that later prove to be incorrect as changes in estimate Only when a company obviously computed the estimate incorrectly because of lack of expertise or in bad faith should it consider the adjustment an error There is no clear demarcation line here Companies must use good judgment in light of all the circumstances Disclosures: - The following illustration shows disclosure of a change in estimated useful lives, which appeared in the annual report of Chiro Corporation Chiro Corporation Note 11: Change in Accounting Estimate The Corporation revised its estimate of the useful lives of certain machinery and equipment Previously, all machinery and equipment whether new when placed in use or not, were in one class and depreciated over 15 years The change principally applies to assets purchased new when placed in use Those lives are now extended to 20 years These changes were made to better reflect the estimated periods during which such Page 68 assets will remain in service The change had the effect of reducing depreciation expense and increasing net income by approximately Br 991,000 (Br 0.10 per share) For the most part, companies need not disclose changes in accounting estimate made as part of normal operations, such as bad debt allowances or inventory obsolescence, unless such changes are material However, for a change in estimate that affects several periods (such as a change in the service lives of depreciable assets), companies should disclose the effect on income from continuing operations and related per-share amounts of the current period When a company has a change in estimate effected by a change in accounting principle, it must indicate why the new method is preferable In addition, companies are subject to all other disclosure guidelines established for changes in accounting principle 1.2.3 Change in reporting entity Occasionally companies make changes that result in different reporting entities In such cases, companies report the change by changing the financial statements of all prior periods presented The revised statements show the financial information for the new reporting entity for all periods Examples of a change in reporting entity are: Presenting consolidated statements in place of statements of individual companies Changing specific subsidiaries that constitute the group of companies for which the entity presents consolidated financial statements Changing the companies included in combined financial statements Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments In this case, a change in the reporting entity does not result from creation, cessation, purchase, or disposition of a subsidiary or other business Chapter In the year in which a company changes a reporting entity, it should disclose in the financial statements the nature of the change and the reason for it It also should report, for all periods presented, the effect of the change on income before extraordinary items, net income, and earnings per share These disclosures need not be repeated in subsequent periods’ financial statements Illustration below shows a note disclosing a change in reporting entity, from the annual report of Awash Company Page 69 Awash Company Note: Accounting and Reporting Changes (In Part) Consolidation of Awash Finance Company The company implemented a new accounting pronouncement on consolidations With the adoption of this new pronouncement, the company consolidated the accounts of Awash Finance Company (AFC), a wholly owned subsidiary previously accounted for under the equity method, with those of the company The change resulted in an increase in consolidated assets and liabilities but did not have a material effect on the company’s financial position Since AFC was previously accounted for under the equity method, the change did not affect net earnings Prior years’ consolidated financial information has been restated to reflect this change for comparative purposes 1.3 Correction of errors No business, large or small, is immune from errors As the opening story discussed, the number of accounting errors that lead to restatement are beginning to decline However, without accounting and disclosure guidelines for the reporting of errors, investors can be left in the dark about the effects of errors Certain errors, such as misclassifications of balances within a financial statement, are not as significant to investors as other errors Significant errors would be those resulting in overstating assets or income, for example However, investors should know the potential impact of all errors Even “harmless” misclassifications can affect important ratios Also, some errors could signal important weaknesses in internal controls that could lead to more significant errors In general, accounting errors include the following types: A change from an accounting principle that is not generally accepted to an accounting principle that is acceptable The rationale is that the company incorrectly presented prior periods because of the application of an improper accounting principle For example, a company may change from the cash (income tax) basis of accounting to the accrual basis Mathematical mistakes, such as incorrectly totaling the inventory count sheets when computing the inventory value Changes in estimates that occur because a company did not prepare the estimates in good faith For example, a company may have adopted a clearly unrealistic depreciation rate An oversight, such as the failure to accrue or defer certain expenses and revenues at the end of the period A misuse of facts, such as the failure to use salvage value in computing the depreciation base for the straight-line approach The incorrect classification of a cost as an expense instead of an asset, and vice versa Accounting errors occur for a variety of reasons Table below indicates 11 major categories of accounting errors that drive restatements Page 70 Accounting Category Expense recognition Revenue recognition Type of Restatement Recording expenses in the incorrect period or for an incorrect amount Improper revenue accounting This category includes instances in which revenue was improperly recognized, questionable revenues were recognized, or any other number of related errors that led to misreported revenue Misclassification Misclassifying significant accounting items on the balance sheet, income statement, or statement of cash flows These include restatements due to misclassification of short- or long-term accounts or those that impact cash flows from operations Equity—other Improper accounting for EPS, restricted stock, warrants, and other equity instruments Reserves/Contingencies Errors involving accounts receivables bad debts, inventory reserves, income tax allowances, and loss contingencies Long-lived assets Asset impairments of property, plant, and equipment, goodwill, or other related items Taxes Errors involving correction of tax provision, improper treatment of tax liabilities, and other tax-related items Equity—other Improper accounting for comprehensive income equity transactions comprehensive income including foreign currency items, minimum pension liability adjustments, unrealized gains and losses on certain investments in debt, equity securities, and derivatives Inventory Inventory costing valuations, quantity issues, and cost of sales adjustments Equity—stock options Improper accounting for employee stock options Other Any restatement not covered by the listed categories including those related to improper accounting for acquisitions or mergers As soon as a company discovers an error, it must correct the error Companies record corrections of errors from prior periods as an adjustment to the beginning balance of retained earnings in the current period Such corrections are called prior period adjustments If it presents comparative statements, a company should restate the prior statements affected, to correct for the error The company need not repeat the disclosures in the financial statements of subsequent periods To illustrate, in 2011 the bookkeeper for Selectro Company discovered an error: In 2010 the company failed to record Br 20,000 of depreciation expense on a newly constructed building This building is the only depreciable asset Selectro owns The company correctly included the depreciation expense in its tax return and correctly reported its income taxes payable Table below presents Selectro’s income statement for 2010 (starting with income before depreciation expense) with and without the error Page 71 Selectro Company Income Statement For The Year Ended, December 31, 2010 Without Error Income before depreciation expense…………………Br 100,000 Depreciation expense………………………………… 20,000 Income before income tax…………………………… 80,000 Current…………………………… Br 32,000 Br 32,000 Deferred…………………………… –0– 32,000 8,000 Net income………………………… Br 48,000 With Error Br 100,000 100,000 40,000 Br 60,000 The entries that Selectro should have made and did make for recording depreciation expense and income taxes are shown hereunder as follows: Entries Company Should Have Made Entries Company Did Make (Without Error) (With Error) Depreciation Expense……….20,000 No entry made for depreciation Accumulated Depreciation Buildings………………………………20,000 Income Tax Expense………32,000 Income Tax Expense………40,000 Income Tax Payable……………………….32,000 Deferred Tax Liability……………8,000 Income Tax Payable…………….32,000 As the earlier illustration indicates the Br 20,000 omission error in 2010 results in the following effects: Income Statement Effects Depreciation expense (2010) is understated Br 20,000 Income tax expense (2010) is overstated Br 8,000 (Br 20,000 x 40%) Net income (2010) is overstated Br 12,000 (Br 20,000 - Br 8,000) Balance Sheet Effects Accumulated depreciation—buildings is understated Br 20,000 Deferred tax liability is overstated Br 8,000 (Br 20,000 x 40%) To make the proper correcting entry in 2011, Selectro should recognize that net income in 2010 is overstated by Br 12,000, the Deferred Tax Liability is overstated by Br 8,000, and Accumulated Depreciation—Buildings is understated by Br 20,000 The entry to correct this error in 2011 is as follows: Retained Earnings……………………… 12,000 Deferred Tax Liability…………………… 8,000 Page 72 Accumulated Depreciation—Buildings………………20,000 The debit to Retained Earnings results because net income for 2010 is overstated The debit to the Deferred Tax Liability is made to remove this account, which was caused by the error The credit to Accumulated Depreciation—Buildings reduces the book value of the building to its proper amount Selectro will make the same journal entry to record the correction of the error in 2011 whether it prepares single-period (non-comparative) or comparative financial statements Single-period Statements To demonstrate how to show this information in a single-period statement, assume that Selectro Company has a beginning retained earnings balance at January 1, 2011, of Br 350,000 The company reports net income of Br 400,000 in 2011 Selectro’s retained earnings statement for 2011 is shown hereunder as: Selectro Company Retained Earnings Statement For The Year Ended December 31, 2011 Retained earnings, January 1, as reported…………………………………………… Br 350,000 Correction of an error (depreciation)……………………………Br 20,000 Less: Applicable income tax reduction………………………… 8,000 (12,000) Retained earnings, January 1, as adjusted………………………… 338,000 Add: Net income………………………………………………… 400,000 Retained earnings, December 31…………………………………… Br 738,000 The balance sheet in 2011 would not have any deferred tax liability related to the building, and Accumulated Depreciation—Buildings is now restated at a higher amount The income statement would not be affected Comparative Statements If preparing comparative financial statements, a company should make adjustments to correct the amounts for all affected accounts reported in the statements for all periods reported The company should restate the data to the correct basis for each year presented It should show any catch-up adjustment as a prior period adjustment to retained earnings for the earliest period it reported These requirements are essentially the same as those for reporting a change in accounting principle For example, in the case of Selectro, the error of omitting the depreciation of Br 20,000 in 2010, discovered in 2011, results in the restatement of the 2010 financial statements Table below shows the accounts that Selectro restates in the 2010 financial statements Page 73 In the balance sheet: Accumulated depreciation—buildings……………………………… Br 20,000 increase Deferred tax liability…………………………………………… ……Br 8,000 decrease Retained earnings, ending balance…………………………………………Br 12,000 decrease In the income statement: Depreciation expense—buildings………………………………………… Br 20,000 increase Income tax expense………………………………………………………….Br 8,000 decrease Net income………………………………………………………………….Br 12,000 decrease In the retained earnings statement: Retained earnings, ending balance (due to lower net income for the period)……………………………………… Br 12,000 decrease Selectro prepares the 2011 financial statements in comparative form with those of 2010 as if the error had not occurred In addition, Selectro must disclose that it has restated its previously issued financial statements, and it describes the nature of the error Selectro also must disclose the following: The effect of the correction on each financial statement line item and any per-share amounts affected for each prior period presented The cumulative effect of the change on retained earnings or other appropriate components of equity or net assets in the statement of financial position, as of the beginning of the earliest period presented 1.4 Financial statements from incomplete records The heart of the double-entry accounting system is the analysis of the effect of each business transaction or event on the accounting equation: Assets = Liabilities + Owner’s Equity Many small business enterprises operate with varying degrees of success with only minimal accounting records and without the benefit of a complete accounting system A system (or lack of system) in which transactions are not analyzed and recorded in the double-entry framework sometimes is called a single-entry accounting system The accounting records of social clubs, civic organizations, and small business enterprises often are maintained on a single-entry basis At some time after the data have been well mixed-up, an accountant is likely to be called on to sift through the accounting records and gather enough information to complete an income tax return and to prepare financial statements Thus, the process of recasting single-entry accounting information into the double-entry framework is a practical exercise Page 74 ... Discount on Notes Payable 2,000 Notes Payable 102,000 (To record issuance of 4-month, zero-interest-bearing note to Dashen Bank) Discount on Notes Payable is a contra account to Notes Payable,... the present value of the note The present value equals the face value of the not eat maturity minus the interest or discount charged by the lender for the term of the note In essence, the bank... interest at maturity) Page Zero-Interest-Bearing Note Issued A zero-interest-bearing note does not explicitly state an interest rate on the face of the note Interest is still charged, however At maturity