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CHAPTER 8: Assets Accounting CHAPTER 8 Assets Accounting Main topics in Chapter 8: Historical cost valuation and some alternatives to it; How to determine the cost of an asset; Several specific topics, working down the asset side of the balance sheet: Cash and temporary investments;

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Chapter 8 l.jpg
CHAPTER 8:

Assets Accounting

© 2007 by Nelson, a division of Thomson Canada Limited.


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CHAPTER 8Assets Accounting

Main topics in Chapter 8:

  • Historical cost valuation and some alternatives to it;

  • How to determine the cost of an asset;

  • Several specific topics, working down the asset side of the balance sheet:

  • Cash and temporary investments;

  • Accounts receivable;

  • Inventories and cost of goods sold;

  • Capital assets, amortization, and gains/losses on disposal;

  • Other assets, intangibles, and capital leases.

© 2007 by Nelson, a division of Thomson Canada Limited.


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Balance Sheet Valuation: Why is it an issue?

Balance sheet numbers have to come from somewhere. Why not just from transactions (historical amounts)?

There is a lot of discussion and argument surrounding this issue, which is fundamental to the whole meaning of the balance sheet. It also affects the income statement because of the articulation between the two financial statements.

© 2007 by Nelson, a division of Thomson Canada Limited.


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The Asset Valuation Issue

So far in the course, asset values have been produced through accounting transactions, which probably has seemed natural. But there are questions about whether these assets values are appropriate, and much thought has been given to alternative ways of producing the asset numbers on the balance sheet (and the liability numbers, though the focus now is on assets).

The Problem:

  • History is just that, history! Who cares?

  • Balance sheet values should be useful in people’s decision making. Is historical value the most useful valuation method if we want to look into the future?

© 2007 by Nelson, a division of Thomson Canada Limited.


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7 Methods for Valuing Assets and Liabilities

  • Historical cost

  • Price-level Adjusted Historical Cost

  • Current or Market Value

  • Lower of Cost or Market

  • Fair Value

  • Value in Use

  • Liquidation Value

© 2007 by Nelson, a division of Thomson Canada Limited.


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1) Historical Cost (acquisition cost)

What is it?

  • Our traditional transaction-based valuation for assets at their original or acquisition cost.

  • Used since it is verifiable (purchase records) and the most conservative since a corporation would not pay more than the asset is worth

Problems

  • The longer a balance sheet item has existed, the more out of date its valuation

  • Amortization is used to match the expense of the asset with its revenue generating potential but does not create a meaningful net book value.

HC is the “default,” assumed unless there’s a problem


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2) Price-Level Adjusted Historical Cost

What is it?

Multiply HC valuation by some price index to adjust for inflation

Why use it?

It has had some theoretical support for 70 years and has been tried by some companies and countries

Why should we not use it?

The resulting numbers are hard to understand and do not really reflect company-specific current values

PLAHC has been tried in situations with high inflation


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3) Current or Market Value

  • Values assets at their true value (what they could be sold for today)

  • Recognizes losses or gains even if the asset is not being sold

  • Input Market Value – amount it would cost to replace the asset

  • Output Market Value – amount the asset could be sold for now (“net realizable value)

  • Examples: Financial Instruments


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4) Lower of Cost or Market

  • Values assets using historical cost unless the market price is deemed to be lower

  • Most conservative of the seven methods since the lowest value will always be used

5) Fair Value

  • Similar to market value but used in more ‘hypothetical’ agreements where estimates have to be made

  • Must be an accurate estimate of a viable transaction that would involve ‘arm’s-length’ participants

  • Used frequently now in valuing stock option compensation


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6) Value in Use

  • Values assets by taking the net present value (remember the present value analysis from Ch. 10) of the future cash flows generated by an asset

  • Used rarely except with capital leases

7) Liquidation Value

  • Occurs when the company is no longer a going concern

  • Assets are valued at the price they can be sold off for


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How to Implement a Balance Sheet Valuation Change from Historical Cost to Current Market Value?

Assumptions:

  • The current market value of a major asset such as land has been reliably estimated;

  • The company decides to revalue the asset to current market value (not appropriate under Canadian GAAP but OK in some countries).

  • There are no income tax consequences to revaluing the asset

© 2007 by Nelson, a division of Thomson Canada Limited.


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Five Possible Approaches to Implementing a Change in Asset Value from Historical Cost to Current Market Value

Possibilities:

  • Adjust land to market value and put the difference into income

  • Adjust land to market value and put the difference into retained earnings

  • Adjust land to market value and put the difference in a special equity account

  • Adjust land to market value only if market value is lower than cost

  • Don’t adjust the accounts; just disclose the information

© 2007 by Nelson, a division of Thomson Canada Limited.


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Have you ever wondered what “ Value from Historical Cost to Current Market ValueBuilding Cost $X” actually includes? What exactly is the cost of a noncurrent asset?

The cost of a noncurrent asset is anything that is needed to make the asset suitable for its intended use. This usually only includes the costs prior to putting the asset into service.


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Have you ever wondered what “ Value from Historical Cost to Current Market ValueInventory Cost $X” actually includes? What exactly is the cost of a current asset?

The cost of a current asset follows the same historical transaction “cost to make it suitable” idea for a noncurrent asset.

Historical cost is used only if it is lower than the market value and market value is used only if it is lower than the historical cost: “Lower or cost or market.”


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Asset Cost Value from Historical Cost to Current Market Value

Asset cost is the acquisition cost and preparation costs that are required to put the asset into service.

Asset Cost, Amortization, and Betterment

Dollars

Point asset is put into service

Time


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Asset Cost, Amortization, and Betterment Value from Historical Cost to Current Market Value

Net Book Value

Asset Cost

Dollars

Point asset is put into service

Time

After this point the asset is put into service. Its cost is amortized against the revenue it helps to earn. Any expenditures are included as maintenance expenses (except for “betterment” of the asset). The net book value goes down as the asset is amortized.


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Asset Cost, Amortization, and Betterment Value from Historical Cost to Current Market Value

Betterment

Dollars

Point asset is put into service

Time

If an expenditure on the asset is made and the asset undergoes an apparent improvement where its productivity or efficiency has increased or its useful life extended then there has been a betterment of the asset and the cost should be capitalized.


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Asset Cost, Amortization, and Betterment Value from Historical Cost to Current Market Value

Net Book Value

Betterment

Dollars

Point asset is put into service

Time

Betterments are recorded by adding the expenditure to the net book value of the asset.


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Summary of GAAP for Balance Sheet Valuation Value from Historical Cost to Current Market Value

  • At date of acquisition, it is assumed that HC=MV=Value in Use

  • Current assets are valued at lower of cost or market

  • Noncurrent assets are valued at historical cost (minus accumulated amortization representing economic value used), but if their value is impaired are written down to value in use or market value.

  • All liabilities are at historically determined amounts

© 2007 by Nelson, a division of Thomson Canada Limited.


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Let’s do an example: Value from Historical Cost to Current Market Value

“A Jolt of Java,” a well known café, is opening up a new location in a nearby city. In order to get the business started, several payments were made. Included in this long list is the cost of the building, the cost of the new coffee grinders and the cost of manufacturing special decorative bags filled with flavored coffee beans to be sold in the café. These bags are manufactured in a factory owned by “A Jolt of Java.” Given a list of potential costs for each category, the company decided whether each potential cost should be part of the asset cost, or should be included as an expense.


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Building Cost Value from Historical Cost to Current Market Value

Does the cost include:

Purchase price of the land?

No

Building materials costing $400,000 (included $5,000 in materials wasted due to workers inexperience)?

Yes. $395,000 worth

Machinery installation charges?

No

Grading and draining of site?

Yes

Parking lot grading and paving?

Maybe

Replacement of building windows shot out by vandals before production start-up?

No

Architect’s fees?

Yes


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Coffee Grinders Cost Value from Historical Cost to Current Market Value

(ordered specially from Italy)

Does the cost include:

The invoice price of the grinders?

Yes

Customs duties paid on machines?

Yes

The cost of the manager’s trip to the grinder manufacturing plant to choose the machine?

Maybe

The cost of painting “A Jolt of Java” on the machines?

Maybe

Estimated revenue lost because the machines were late arriving?

No

Interest on bank loan used to financing the machines?

No


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Decorative Bags Full of Coffee Beans Value from Historical Cost to Current Market Value

Does the cost include:

Cost of raw materials used to make the bags?

Yes

Cost of coffee beans?

Yes

Labour required to make the bags?

Yes

Supervision costs?

Maybe

Electric utilities at the factory?

Maybe

© 2007 by Nelson, a division of Thomson Canada Limited.


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Cash Value from Historical Cost to Current Market Value

What is included in cash?

Cash includes all varieties of unrestricted cash on hand and in banks.

  • Cash on hand, including petty cash

  • Cash in savings and chequing accounts

  • “Cash in transit” that is on its way from other banks or countries

© 2007 by Nelson, a division of Thomson Canada Limited.


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Cash Value from Historical Cost to Current Market Value

What is not included in cash?

Cash does not include any amounts not available for immediate use.

  • Bad cheques received from customers

  • Cash not available for immediate use, including term deposits and investments that can not be withdrawn

  • Cash subject to other countries’ exchange or currency controls that limits its availability for immediate use

© 2007 by Nelson, a division of Thomson Canada Limited.


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Cash Value from Historical Cost to Current Market Value

  • Cash on the balance sheet is different than the company’s actual bank balance

  • Cheques that have not cleared the bank or other adjustments may be taken into account

  • Underlines the importance of Bank Reconciliation

© 2007 by Nelson, a division of Thomson Canada Limited.


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Temporary Investments Value from Historical Cost to Current Market Value

What are they?

Temporary Investments are used to provide a better return on excess cash than bank deposits do. Examples are treasury bills, stocks, bonds, guaranteed investment certificates (GICs).

How are they valued?

Temporary Investments are valued on the balance sheet at the lower of cost or market.

© 2007 by Nelson, a division of Thomson Canada Limited.


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Accounts Receivable Value from Historical Cost to Current Market Value

Trade accounts receivable - Recognized but uncollected revenue arising from the company’s day-to-day operations

Receivables are reduced by an allowance contra (allowance for doubtful accounts) if their collectible value has fallen

Other receivables - separated from trade receivables if important (e.g. notes receivable, loans to employees, tax refunds to be received)

© 2007 by Nelson, a division of Thomson Canada Limited.


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Allowance for Doubtful Accounts Value from Historical Cost to Current Market Value

How is the allowance determined?

2 Methods:

  • Percentage-of-Sales (Income Statement) Approach -

  • Matches costs with revenues because it relates the

  • charge to the period in which the sale is recorded.

  • Percentage-of-Receivables (Balance Sheet) Approach -

  • Using past experience, the company estimates the

  • percentage of its outstanding receivables that will

  • become uncollectible. An aging schedule is often set

  • up to view the age of all receivables.

© 2007 by Nelson, a division of Thomson Canada Limited.


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Inventory Valuation and Cost of Goods Sold Value from Historical Cost to Current Market Value

Why are we concerned with what the value of the Inventory account is?

Inventory is the lifeline of most companies, containing the goods whose sale will produce the revenue the business needs. Without inventory most establishments cannot survive.

How we value inventory will affect not only the balance sheet account, but also the income statement, via the cost of goods sold expense.

© 2007 by Nelson, a division of Thomson Canada Limited.


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Inventory Valuation and Cost of Goods Sold Value from Historical Cost to Current Market Value

Inventory valuation follows the GAAP rule for all current assets: lower of cost or market.

This means that all items in inventory are valued at either the cost they were purchased for or their current market value if it has fallen below cost.

So, what is the cost of inventory?

Total cost = quantity  unit cost

How do we get the quantity and unit cost?


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Inventory Valuation and Cost of Goods Sold Value from Historical Cost to Current Market Value

Total cost = quantity  unit cost

Getting Quantity:

  • Records

  • Counts

  • Estimates

Getting Unit Cost:

  • Purchase invoices

  • Manufacturing cost records

  • Estimates

In reality, tracking the cost for each item in inventory is difficult and costly, though less so as computer systems reduce information processing costs.


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Inventory Valuation and Cost of Goods Sold Value from Historical Cost to Current Market Value

The Problem:

How do we allocate the total cost of goods available between the Income Statement for the period (COGS expense) and the Balance Sheet at the end of the period (ending Inventory asset)?

The Solution:

We assume a flow of inventory items and their costs through the business. The different cost flow assumptions just allocate the available cost differently between the B/S valuation and the I/S expense.


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Gone: Value from Historical Cost to Current Market Value

Cost of

goods sold

Cost of

goods

purchased

Available

cost

+

=

OR

Still here:

Cost of

ending inv.

Inventory Valuation and Cost of Goods Sold

Derivation and Allocation of Available Cost

Cost of

beginning

inventory

There would be no problem if the costs of inventory were constant, but for most companies, they constantly change. Inventory costs could dramatically change between March 1, when an item was purchased, and March 31, the balance sheet date.


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Inventory Valuation and Cost of Goods Sold Value from Historical Cost to Current Market Value

Before we begin looking at the different types of cost calculation methods we must understand the following points:

  • Unsold or unused inventory is on the B/S

  • Used or sold inventory is in the COGS expense

  • Begin + Purchase – Used/Sold (COGS) = End

  • Begin + Purchase = Available, and

  • Available = Used/Sold (COGS) + End

  • Policy: allocation of available cost between COGS (expense) and End (B/S)

  • The more in COGS, the less on B/S, and vice versa


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Inventory Cost Policy Value from Historical Cost to Current Market Value

There are at least four possible policies. They are:

  • “Actual” cost

  • “First in, first out” assumption

  • “Average” assumption

  • “Last in, first out” assumption

© 2007 by Nelson, a division of Thomson Canada Limited.


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"Actual" Cost Value from Historical Cost to Current Market Value

  • Use it when the specific inventory items can be identified

  • Computer systems are making this method more practical

  • Successfully applied in situations where a relatively small number of costly, easily distinguishable items are handled

  • Serially numbered items like cars, jewellery, houses

© 2007 by Nelson, a division of Thomson Canada Limited.


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FIFO Assumption Value from Historical Cost to Current Market Value

  • The items on hand, in inventory, are the newest

  • Therefore, the ones sold were older

  • This is used (usually) for goods that are for sale

An advantage of the FIFO method is that the ending inventory amount is close to its current cost

© 2007 by Nelson, a division of Thomson Canada Limited.


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LIFO Assumption Value from Historical Cost to Current Market Value

  • The items just sold were the newest

  • Therefore, the items on hand are older

  • A little preposterous, but used in USA because it saves income tax there (not allowed for income tax purposes in Canada, so it is uncommon here)

The cost assigned to the inventory remaining in the LIFO method would come from the earliest acquisitions

© 2007 by Nelson, a division of Thomson Canada Limited.


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Average Assumption Value from Historical Cost to Current Market Value

  • Those items on hand and sold were all taken from the same mixed-together group

  • This is used (usually) for raw materials, natural resources, non perishable items

The average cost method may be viewed as a compromise between the FIFO and LIFO methods

© 2007 by Nelson, a division of Thomson Canada Limited.


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Oryx Inc. sells a single product. During a recent period, the company’s records showed:

Units on hand, beginning of period 1,000 @ $10 cost

Units in Purchase A 2,000 @ $14 cost

Units sold in Sale 1 (1,500)

Units in Purchase B 3,000 @ $15 cost

Units sold in Sale 2 (2,800)

Units on hand, end of period 1,700

Let’s do an example:

ORYX INC.


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ORYX INC. the company’s records showed:

Calculate total “available cost” for the period and then allocate that cost between COGS expense and ending inventory asset by each of the indicated methods:

Available cost

=(1000  $10) + (2000  $14) + (3000  $15)

=$83,000

Now let’s sketch out the flow of sales and purchases to have a better idea of inventory movement.

© 2007 by Nelson, a division of Thomson Canada Limited.


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4500 on hand the company’s records showed:

3000 on hand

Sold 2800

Bought 3000 @ $15

Sold 1500

Bought 2000 @ $14

1700 on hand

1500 on hand

Time

Inventory Balance and Changes

1000 on hand


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a) the company’s records showed:Ending inventory cost

1700  $15 =

$25,500

b) COGS expense

Sale 1: (1000  $10) + (500  $14) = $17,000

Sale 2: (1500  $14) + (1300  $15) = $40,500

$57,500

ORYX INC.

FIFO (First In, First Out) :

Check: $25,500 + $57,500 = $83,000 = Total Available Cost

© 2007 by Nelson, a division of Thomson Canada Limited.


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Inventory Balance and Changes the company’s records showed:

3000 on hand

Sold 2800

Sold 1500

Bought 2000 @ $14

1700 left over in inventory; purchased for $15

1700 on hand

1500 on hand

Time

4500 on hand

Bought 3000 @ $15

1000 on hand


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a) the company’s records showed:Average cost = Total Available Cost/Total Units

$13.8333

83,000/6000 units =

b) Ending inventory cost

$23,517

1700  $13.8333 =

c) COGS expense

4300  $13,8333 =

$59,483

ORYX INC.

AVERAGE:

Annual Weighted:

Straight forward blended result of averaging all purchases and sales together.

© 2007 by Nelson, a division of Thomson Canada Limited.


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ORYX INC. the company’s records showed:

AVERAGE :

Moving Weighted:

Average cost of goods is recalculated after each purchase.

a) Weighted Average after first purchase

W1 = (1000  $10 + 2000  $14) (1000 + 2000)

= $12.6666

b) Weighted Average after second purchase

W2 = (1500  $12.6666 + 3000  $15) (1500 + 3000)

= $14.2222


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ORYX INC. the company’s records showed:

a) Ending inventory cost

We are ignorant of the ups and downs during the period. We started with 1000 and ended with 1700, so:

$19,800

(1000  $10) + (700  $14) =

b) COGS expense

(3000  $15) + (1300  $14) =

$63,200

LIFO (Last In, First Out):

Periodic:

Check: $19,800 + $63,200 = $83,000 = Total Available Cost


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Inventory Balance and the company’s records showed:Changes

1700 original items still in inventory

Sold 2800

Sold 1500

1700 on hand

1500 on hand

Last items purchased are first to be sold (1700 @ $14 and 3000 @ $15)

Time

4500 on hand

3000 on hand

Bought 3000 @ $15

Bought 2000 @ $14

1000 on hand


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LIFO (Last In, First Out): the company’s records showed:

Perpetual (keep track of inventory continuously:

a) Ending inventory cost

The lowest inventory point represents the goods that were never sold. The remainder come from purchases.

ORYX INC.

Using the graph, find the lowest point and analyze layers:

© 2007 by Nelson, a division of Thomson Canada Limited.


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Inventory Balance and Changes the company’s records showed:

3000 on hand

The remaining 200 come from the last purchase (200*$15)

Sold 1500

Bought 2000 @ $14

1500 on hand

Lowest inventory point = 1500 therefore those cost 1000 * $10 + 500 * $14.

Time

4500 on hand

Sold 2800

Bought 3000 @ $15

1700 on hand

1000 on hand

© 2007 by Nelson, a division of Thomson Canada Limited.


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ORYX INC. the company’s records showed:

a) Ending inventory cost

The lowest inventory point represents the goods that were never sold. The remainder come from purchases.

LIFO (Last In, First Out):

Perpetual:

Using the graph find, the lowest point and analyze layers:

(1000  $10) + (500  $14) + (200  $15) =

$20,000

b) COGS expense

(1500  $14) + (2800  $15) =

$63,000

Check: $20,000 + $63,000 = $83,000 = Total Available Cost


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Summary of the company’s records showed:ORYX INC.

© 2007 by Nelson, a division of Thomson Canada Limited.


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What does the perpetual method do to average and LIFO? the company’s records showed:

The perpetual method keeps inventory up-to-date continuously, so more recent costs tend to be used in the balance sheet, tending to reduce the difference from FIFO.

© 2007 by Nelson, a division of Thomson Canada Limited.


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What are the effects of Accounting Cost Policies? the company’s records showed:

When purchase prices and quantities are rising (the usual case):

FIFO has the highest inventory asset, lowest COGS, and highest income

LIFOhas the lowest inventory asset, highest COGS, and lowest income (so it is popular in USA where it usually saves income tax)

Average is in between

© 2007 by Nelson, a division of Thomson Canada Limited.


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What are the effects of Accounting Cost Policies? the company’s records showed:

  • If prices and quantities fluctuate, the methods’ relative effects are hard to predict

  • If prices don’t change much, inventory policy doesn’t matter much

What is the connection, if any, between a company’s revenue recognition policy and its inventory cost determination policy?

The inventory cost policy affects COGS expense and so income measurement. The best way of determining COGS is probably LIFO! But, as long as inventory turns over rapidly, so price effects are not great, it doesn’t matter much.


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Lower of Cost or Market and other costing methods the company’s records showed:

Why is lower of cost or market used?

To follow the GAAP principle of conservatism.

Problem:

Should we value inventory at the lower of total cost, total market, or a combination of both?

Solution:

It depends. We have to use our judgment. Here’s an example.

© 2007 by Nelson, a division of Thomson Canada Limited.


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$643,290 the company’s records showed:

$858,400

$629,680

Lower of Cost or Market and other costing methods

$2,000

420

60,000

700

© 2007 by Nelson, a division of Thomson Canada Limited.


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Lower of Cost or Market and other costing methods the company’s records showed:

There are two versions of lower of cost or market:

1) Total cost $643,290 < total market $858,400

2) By individual comparisons, l. of c. or m. =$629,680

The individual comparisons result in a more conservative valuation, but the comparison of totals is more likely to be used if there is no evidence of a serious problem overall with the inventory.

© 2007 by Nelson, a division of Thomson Canada Limited.


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Lower of Cost or Market and other costing methods the company’s records showed:

Often the kind of inventory suggests both a cost flow assumption and a market value method:

Common accounting policy choice

Type of Inv.

For Cost

For Market

Replacement Cost

Raw materials

Average

Net realizable value

Finished goods

FIFO

© 2007 by Nelson, a division of Thomson Canada Limited.


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Other Inventory Methods the company’s records showed:

Retail inventory control method - uses selling prices instead of costs for control and estimates costs from retail prices minus markups (more common with smaller retail companies)

Standard costing method - uses estimated costs based on standard production costs and volumes (used for manufactured inventories)

© 2007 by Nelson, a division of Thomson Canada Limited.


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Amortization of Assets and Amortization Expense the company’s records showed:

What is amortization and amortization expense?

Amortization is a method of allocating asset cost to expense over time as the assets’ economic values are used up.

It is not a system to track value changes in the assets or to measure the current or market value of those assets in the balance sheet.

Amortization expense is the annual deduction from revenue.

© 2007 by Nelson, a division of Thomson Canada Limited.


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Amortization of Assets and Amortization Expense the company’s records showed:

Why have amortization?

To have a yearly amortization expense that matches the consumption of the asset year-by-year to the revenue the asset helps generate. Amortization expense is the annual deduction from revenue. (Matching)

© 2007 by Nelson, a division of Thomson Canada Limited.


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cost the company’s records showed:

Accumulation of cost

Book value

Dollars

Amortization of cost

Point asset is put into service

Asset’s service life

Time

Amortization of Assets and Amortization Expense

Problem:

When do we begin to amortize an asset?

Solution:

When it goes into service (begins to generate revenue).


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Amortization of Assets and Amortization Expense the company’s records showed:

Book value is the unexpired cost. It is the assumed future benefit. BV equals cost minus accumulated amortization.

cost

Accumulation of cost

Book value

Dollars

Amortization of cost

Point asset is put into service

Asset’s service life

Time


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Amortization of Assets and Amortization Expense the company’s records showed:

Some points about amortization:

  • Amortization has no cash effect

  • Amortization is never exact. It involves the prediction of economic use and useful life. It does not estimate current value.

  • In Canada, amortization calculated in the accounts is irrelevant for income tax purposes (tax “capital cost allowance” is used instead)

  • Land is never amortized

© 2007 by Nelson, a division of Thomson Canada Limited.


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Gains and Losses on Non-current the company’s records showed:

Asset Disposals and Write-offs

Problem:

When noncurrent assets are sold the proceeds can be handled as ordinary revenues. However, this would mix day-to-day revenues with non ordinary events. What should we do instead?

Solution:

We keep the event separate using this journal entry:

DR Cash or nontrade receivables (proceeds) X

CR Cost of the noncurrent asset X

DR Accum. amort. to date on that asset X

DR Loss or CR Gain on sale X or X

© 2007 by Nelson, a division of Thomson Canada Limited.


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Proceeds>BV the company’s records showed:

GAIN on sale

Book Value

Proceeds

Proceeds<BV

LOSS on sale

Gains and Losses on Non-current

Asset Disposals and Write-offs

Gains and Losses on Sale of Assets

Time


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Gains and Losses on Non-current the company’s records showed:

Asset Disposals and Write-offs

Gains and Losses on Sale of Assets:

A Quick Summary

Proceeds = BV  No gain or loss

Proceeds > BV  Gain

Proceeds < BV  Loss

If proceeds = 0, then BV is just written off

© 2007 by Nelson, a division of Thomson Canada Limited.


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Gains and Losses on Non-current the company’s records showed:

Asset Disposals and Write-offs

Let’s do a quick example:

Gain or Loss

Cost

Acc. Amt.

Proceeds

1

$8,000

$6,000

$2,000

zero

2

10,000

8,000

3,000

1,000 gain

3

12,000

11,000

0

1,000 loss

4

18,000

6,000

4,000

8,000 loss

5

20,000

5,000

28,000

13,000 gain

zero

6

8,000

8,000

0

© 2007 by Nelson, a division of Thomson Canada Limited.


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Policy Choices the company’s records showed:

  • Various companies have different assets and revenues, so amortization policy should vary to achieve proper revenue matching

  • Try to match amortization expense to the economic use of the asset

  • Follow the usual GAAP criteria: fairness, consistency, industry practice (comparability), conservatism (risk of obsolescence)

  • Keep it simple and easy to calculate (since amortization has no cash or income tax effect)

© 2007 by Nelson, a division of Thomson Canada Limited.


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Amortization, Income and Tax the company’s records showed:

  • Amortization expense has no effect on income tax as previously mentioned

  • CCRA uses its own formula for calculating “Capital Cost Allowance”

  • Nevertheless, amortization expense does affect accrual income

  • The higher the expense, the lower the income and vice versa

© 2007 by Nelson, a division of Thomson Canada Limited.


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How do you make the amortization policy choice? the company’s records showed:

  • Try to match amortization expense to the economic use of the asset

  • Follow the usual GAAP criteria: fairness, consistency, industry practice (comparability), conservatism (risk of obsolescence)

  • But also why not keep it simple and easy to calculate (since amortization has no cash or income tax effect)

© 2007 by Nelson, a division of Thomson Canada Limited.


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Amortization Methods the company’s records showed:

There are 4 kinds of amortization methods. They are based on different believed economic use patterns over the asset’s life. Theses methods are:

  • Straight-line Amortization

  • Accelerated Amortization

  • Decelerated Amortization

  • Units-of-Production Amortization and Depletion

Let’s look at each method more carefully….

© 2007 by Nelson, a division of Thomson Canada Limited.


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STRAIGHT-LINE AMORTIZATION the company’s records showed:

What is it?

We expense the same amount each year of the asset’s useful life.

Why use it?

The asset’s economic value is consumed evenly over its life since it is equally valuable in earning income in each year. This is also a simple and easily understandable method.

© 2007 by Nelson, a division of Thomson Canada Limited.


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STRAIGHT-LINE AMORTIZATION the company’s records showed:

Per-period value of the asset in generating revenue

Resulting book value of the asset

$

$

periods

periods


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Cost minus estimated salvage value the company’s records showed:

Amortization for one period

=

Estimated useful life (no. of periods)

STRAIGHT-LINE AMORTIZATION

How is it done?

We need to know three things before we can use this method. They are:

  • The cost of the asset

  • The estimated useful life of the asset

  • The estimated “salvage value”

The formula:

© 2007 by Nelson, a division of Thomson Canada Limited.


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ACCELERATED AMORTIZATION the company’s records showed:

What is it?

We expense larger amounts in earlier years than in later years.

Why use it?

The asset’s economic value is consumed mostly early in its life. This is also a conservative method (e.g. obsolescence risk).

© 2007 by Nelson, a division of Thomson Canada Limited.


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ACCELERATED AMORTIZATION the company’s records showed:

Per-period value of the asset in generating revenue

Resulting book value of the asset

$

$

periods

periods


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ACCELERATED AMORTIZATION the company’s records showed:

How is it done?

The most common method of accelerated amortization is the declining balance. We need to know three things before we can use this method. They are:

  • The cost of the asset

  • The total amortization recorded since the acquisition of the asset

  • The amortization rate – the percentage of the book value of the asset that is to be amortized in the period


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Amortization for one period the company’s records showed:

=

(Cost – Accumulated Amortization) * Rate

=

Amortization expense

ACCELERATED AMORTIZATION

The formula for DDB accelerated:

The amortization expense continually gets smaller so most of the expense is allocated to the first few periods.

© 2007 by Nelson, a division of Thomson Canada Limited.


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DECELERATED AMORTIZATION the company’s records showed:

What is it?

We expense larger amounts in later years than in earlier years.

Why use it?

The asset’s economic value is consumed mostly later in its life. This method is not viewed as meeting GAAP’s fairness and conservatism requirements because it is hard to justify that such assets exist.

However, some real estate companies do utilize this method because its amortization expense (low at beginning, higher later) combined with interest expense for financing the property (higher at beginning, lower later) produces a roughly even total expense over the life of the property.


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DECELERATED AMORTIZATION the company’s records showed:

Per-period value of the asset in generating revenue

Resulting book value of the asset

$

$

periods

periods

© 2007 by Nelson, a division of Thomson Canada Limited.


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DECELERATED AMORTIZATION the company’s records showed:

How is it done?

Because it is complex and not very common we will not demonstrate this method.

© 2007 by Nelson, a division of Thomson Canada Limited.


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UNITS-OF-PRODUCTION AMORTIZATION AND DEPLETION the company’s records showed:

What is it?

We expense amounts based on the use or consumption of the asset not as a function of time.

Why use it?

The asset’s economic value is consumed in variable amounts over its life (e.g. according to production volume). We use this method especially for “wasting assets” like ore bodies, timber, oil.

© 2007 by Nelson, a division of Thomson Canada Limited.


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UNITS-OF-PRODUCTION AMORTIZATION AND DEPLETION the company’s records showed:

Per-period value of the asset in generating revenue

Resulting book value of the asset

$

$

periods

periods

© 2007 by Nelson, a division of Thomson Canada Limited.


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UNITS-OF-PRODUCTION AMORTIZATION AND DEPLETION the company’s records showed:

How is it done?

We need to know the following before we can use this method. They are:

  • The cost of the asset

  • Estimated salvage value

  • Estimated number of units to be produced during the life of the asset

  • The number of units produced in the year for which the amortization is to be calculated

© 2007 by Nelson, a division of Thomson Canada Limited.


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Cost – Estimated salvage value the company’s records showed:

Estimated no. of units of use or production during life

=

=

amortization or depletion  no. of units for one unit

UNITS-OF-PRODUCTION AMORTIZATION AND DEPLETION

The formula:

Amortization or depletion for one unit or measure of use (for example, a km)

Then, total amortization for the period

© 2007 by Nelson, a division of Thomson Canada Limited.


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Two Additional Policy Choices the company’s records showed:

(1) Amortization for partial years

  • You can calculate amortization to the day if you wish

  • Usually try to do partial amortization in the year the asset is purchased and/or sold

  • This is a policy choice too: for example, you might choose to amortize half the usual amount in the year the asset is purchased and the year it is sold, without worrying about specific dates

© 2007 by Nelson, a division of Thomson Canada Limited.


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Two Additional Policy Choices the company’s records showed:

(2) Groups versus individual amortization

  • Most assets are amortized in groups (easier than calculating amortization for each individual asset)

  • Usually no gain or loss on sale of individual assets

  • Usually only very large or unique assets are done separately

  • This is a policy choice too

Let’s do an example of amortization using the different methods…


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1) the company’s records showed:Straight-line

Cost $60,000

Estimated Useful Life 10 years

Estimated Salvage Value $4,000

Amortization:

First year:

(60,000 – 4,000) / 10 = $5,600

Second year:

same

Third year:

same

Strength or Weakness of Method:

Produces a stable, understandable amortization. It can be expressed as a rate (e.g. 10% above), but may be too simple if your assets aren't used so evenly.


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2) the company’s records showed:Accelerated Amortization (double declining balance)

Cost $60,000

Estimated Useful Life 10 years

Estimated Salvage Value Ignored

Amortization:

First year:

60,000  2/10 = $12,000

Second year:

(60,000 – 12,000)  2/10 = $9,600

Third year:

(60,000 – 12,000 – 9,600)  (2/10) = $7,680


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2) the company’s records showed:Accelerated Amortization (double declining balance)

Strength or Weakness of Method:

  • Fairly simple

  • Approximates the capital cost allowance method used for income tax purposes (which is generally based on the DDB method)

  • Conservative

  • BV never actually gets to zero and equals salvage value at date of disposal only by accident


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3) the company’s records showed:Accelerated Amortization (sum of years’ digits)

Used mainly in the USA. We will not illustrate it.

4) Decelerated Amortization

Used only by a few real estate companies. Not GAAP for most companies. We will not illustrate it.


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5) the company’s records showed:Units of Production

Cost $60,000

Estimated Useful Life 100,000 units

Estimated Salvage Value $4,000

Amortization:

(60,000 – 4,000) / 100,000 units = $0.56 per unit

First year (5,000 units produced):

Amort. = 5,000  $0.56 = $2,800

Second year (10,000 units produced):

10,000  $0.56 = $5,600


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5) the company’s records showed:Units of Production

Strength or Weakness of Method:

  • Easy to understand

  • Probably the best match to revenue, but it requires an accurate estimate of total lifetime volume. Therefore, it is seldom accurate.


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6) the company’s records showed:Depletion

Cost $10,000,000

Estimated Useful Life 1,000,000 tonnes

Estimated Salvage Value $900,000

Amortization:

=(10,000,000 – 900,000) / 1,000,000 tonnes =$9.10 per tonne

First year (75,000 tonnes consumed):

Depletion. = 75,000  $9.10 = $682,500

Second year (90,000 tonnes consumed):

Depletion. = 90,000  $9.10 = $819,000


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6) the company’s records showed:Depletion

Strength or Weakness of Method:

  • Similar to those of units of production method

  • But reasonably accurate for well-measured wasting assets like oil wells


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Intangibles the company’s records showed:

What’s the issue?

Should we have balance sheet assets for non-physical things such as patents, happy employees, goodwill, the next cure for cancer, etc?

Problem:

Under double entry, if we put a cost on the balance sheet, then it cannot be an expense. So a doubtfully valid asset would also create a doubtfully higher income by removing some expense.

© 2007 by Nelson, a division of Thomson Canada Limited.


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Accounting for Intangibles the company’s records showed:

  • Accounting for intangibles is a challenge for GAAP

  • With new emphasis on science and technology (internet and biotech companies), there has been a push to capitalize R&D instead of expensing it

  • In the late 90’s, as the stock market soared, there was an active lobby of many companies to capitalize many more intangible assets

    • At its height of the 1990s stock market boom, Yahoo, Amazon.com, and other internet companies dwarfed companies such as IBM in market capitalization.

  • Since the stock market has fallen and with accounting scandals, more emphasis has been placed on the historical system of valuing real assets.


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Intangibles the company’s records showed:

Specific questions to address?

  • What is an “intangible asset”?

  • Purchased from outside:

    • Identifiable (patents etc.)

    • Unidentifiable (goodwill)

  • Internally generated:

    • Development projects (may be okay)

    • Research and Development (no)

    • Goodwill (no)

© 2007 by Nelson, a division of Thomson Canada Limited.


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Intangibles the company’s records showed:

(2) What is the cost of an intangible asset?

  • For external costs, same as any asset

  • Goodwill is just the difference between the total cost and the sum of the values of the other (mostly tangible) assets acquired

  • For internally generated intangible assets the problem is that expenses have to be capitalized, helping current income, so we’re leery of this

© 2007 by Nelson, a division of Thomson Canada Limited.


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Here’s an example on how to calculate goodwill: the company’s records showed:

Say you paid $1,000,000 cash for a company’s business assets. The fair market values of the assets are as follows:

Accounts receivable $55,000

Inventories $175,000

Land $200,000

Building $320,000

Equipment $190,000

Total $940,000

Assume no liabilities exist for this company


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As we said before, goodwill is calculated as the difference between the total cost and the sum of the other assets acquired.

DR Accounts receivable 55,000

DR Inventories 175,000

DR Land 200,000

DR Building 320,000

DR Equipment 190,000

DR Goodwill 60,000

CR Cash 1,000,000

$1,000,000 – 940,000 = $60,000

$60,000 is the goodwill. We debit this amount to get the following:


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whole = sum of parts + goodwill between the total cost and the sum of the other assets acquired.

Brief comments about goodwill:

  • Negative goodwill, “badwill”, is never recorded. If the whole is less than the sum of the parts, the individual asset (minus liabilities) values are reduced until the whole equals the sum of the parts

© 2007 by Nelson, a division of Thomson Canada Limited.


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Intangibles between the total cost and the sum of the other assets acquired.

(3) Valuation of Intangibles

  • Amortize each over the asset’s useful life (usually straight-line)

  • We have difficulty with the useful life for several intangibles (e.g., incorporation costs, goodwill)

  • Usually we just show net unamoritzed amounts on the balance sheet (no contra accounts disclosed)

© 2007 by Nelson, a division of Thomson Canada Limited.


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Capital Leases between the total cost and the sum of the other assets acquired.

What are they?

They represent leased assets that are so important to the company, they are like owned assets.

Problem:

What if an asset, through leased, is really used as if it were owned?

Accrued accounting always tries to get at real economic and business issues, so why not overlook the legal nicety that we don’t own it?

© 2007 by Nelson, a division of Thomson Canada Limited.


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Capital Leases between the total cost and the sum of the other assets acquired.

Types of Leases

Capital Lease:

  • Treat it as if it is owned

  • Account for it just like any fixed asset

Operating Lease:

  • Just expense the rent payments

  • Maybe footnote disclosure

Capital leases are on the balance sheet, operating leases are not.

© 2007 by Nelson, a division of Thomson Canada Limited.


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At present value of future lease payments between the total cost and the sum of the other assets acquired.

Capital Leases

Journal Entries

Acquisition:

DR Leased asset

CR Lease liability

Leased assets are non-current assets that are usually included with property and plant.

Lease liabilities are non-current liabilities that are usually included with debt.

© 2007 by Nelson, a division of Thomson Canada Limited.


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Total payment between the total cost and the sum of the other assets acquired.

Remove part of PV

Rest of payment

Capital Leases

Journal Entries

Acquisition:

At present value of future lease payments

DR Leased asset

CR Lease liability

Lease Payment:

CR Cash

DR Lease liability

DR Interest expense

Amortization:

DR Amortization Expense

CR Accumulated Amortization


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