acct 652 accounting - pepperdine...

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ACCT 652 Week 6ACCT652 Week 6 1

ACCT652 Week 6 11

ACCT 652 Accounting

Week 6–Receivables, notes, plant assets, natural resources and

intangible assets

Some slides © Times Mirror Higher Education Division, Inc. Used by permission© Michael D. Kinsman, Ph.D.

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Bad debts•  The best of all worlds is when you grant

your customers credit and all of them pay exactly as and when they are supposed to.

•  I can tell you from personal experience that doesn’t happen in the real world.

•  Trick question: What are the entries Kinsman & Kinsman makes on our books when a client doesn’t pay us?

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Answer to trick question•  None. We are a cash basis business, as we

discussed last time, and therefore nothing has been entered on our books for accounts receivable or sales from those receivables to start with. Therefore, we need make no entry.

•  We do whimper when this happens to us. If the amount is large enough, we cry.

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Bad Debts: Direct Write-Off Method

•  This method is only appropriate in a limited number of cases where the company experiences little or no bad debt losses.

•  No effort is made to estimate uncollectible accounts or bad debts expense.

•  No adjusting entry is made at year-end.•  Bad debts expense is recorded when specific

accounts are written off.

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Direct write-off–example

•  Your company has few bad debts, and finally you get a call that John Smith has died with no assets. He owed you $50.

GENERAL JOURNAL Page

D ate D escriptionP ost. R ef. D ebit C redit

M M DD Bad debts expense 50.00 Accounts receivable (Smith) 50.00

Write off bad debt of Smith

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Bad Debts•  The reporting of bad debts is normally

governed by the matching principle–bad debts expense should be recognized in the period in which the revenue was produced.

•  Managers realize that some portion of credit sales will eventually result in bad debts.

•  To match bad debts expense with revenue produced in an accounting period we use the allowance method

PAST DUE

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Allowance Method of Accounting for Bad Debts

•  At the end of the accounting period, we estimate total bad debts expected to be realized from sales in the current period.

•  Advantages of this method are:– Matches expenses with revenues– Reports accounts receivable at the estimated

cash to be collected.

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Estimating the Amount of Bad Debts Expense

•  There are two approaches to estimating the amount of bad debts expense . . .➊ Focus on the income statement relationship

between bad debts expense and sales.➋ Focus on the balance sheet relationship between

accounts receivable and the allowance for doubtful accounts.

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Income Statement Focus

•  This approach is based on the notion that a certain percentage of a company’s credit sales will become uncollectible.

•  We must determine the percentage relationship between credit sales and bad debts.

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Income Statement Focus•  Based on history, we determine the percentage

of credit sales that result in bad debts.

•  Bad debts expense is computed as follows: Current Year Credit Sales

x Bad Debt % Estimated Bad Debt Expense

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As of 12/31/X1 Melton, Inc. had total sales of $1,000,000 of which $250,000 were cash sales.

Historically, the bad debt percentage based on credit sales has been 0.5%.

Prepare the adjusting journal entry required for Melton, Inc. to record bad debts expense for 20X1.

Income Statement Focus Example

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Income Statement Approach

GENERAL JOURNAL Page 7

D ate D escrip tionPost. R ef. D eb it C red it

D ec . 31 Bad D eb ts Expense 3,75 0 A llowance fo r D oubtfu l A ccounts 3 ,75 0

S ales revenue 1,000,000$Cash sales (250,000) Credit sales 750,000 Historical bad debts percent 0.50%E stim ated bad debts expense 3,750$

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Balance Sheet Focus•  The assumption is that some portion of the

end-of-period accounts receivable will prove to be uncollectible.

•  The goal of the adjusting entry is to state the Allowance for Doubtful Accounts at the estimated uncollectible amount.

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Aging Accounts Receivable•  This balance sheet method produces a more

refined estimate of uncollectible amounts.•  It is useful after a company has considerable

experience estimating bad debts.•  The assumption we make is that the more past

due an account is, the less likely we are to collect the account.

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Balance sheet method of Allowance for Doubtful Accounts

On December 31, 20X1, the balance in Allowance for Doubtful Accounts of Eastco is $500 (credit) before the adjustment to recognize bad debts expense. What is the company’s addition to Allowance for Doubtful Accounts?

First, we do an aged account receivables schedule for Eastco.

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Aging Accounts Receivable•  We classify each account receivable by how long it

has been outstanding.– We generally classify receivables as current, 1 to 30

days past due, 31 to 60 days past due, etc.•  We estimate an uncollectible amount for each class

of receivables.•  We add together the estimate for each class to

determine the balance in the allowance account.

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Aging Accounts ReceivableAt December 31,20X1 the receivables for EastCo, Inc. were categorized as follows:

$45,000 * .01 = $450

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Aging Accounts ReceivableAt December 31,20X1 the receivables for EastCo, Inc. were categorized as follows:

Desired balance in the Allowance for Doubtful Accounts

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Allowance for Doubtful Accounts–Balance Sheet method

•  What is the journal entry required to enter the bad debts expense and the allowance for doubtful accounts?

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Aging Accounts Receivable



D ec . 31 Bad D eb ts Expense 8 50 A llowance fo r D oubtfu l A ccounts 85 0

Desired allowance balance $1,350 Current account balance 500 Adjustment required $ 850

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Writing off an account using the allowance methods

•  Suppose you need to write off an account using the allowance methods. How do you do it?

•  For example, suppose John Smith (of our earlier example) died, owing us $50. What entries are required to write it off?

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Writing off bad debts using an allowance method

•  We don’t need to make any entry to Bad Debts Expense–that was done at the start of the period. Our entry is:


D ate D escriptionP ost. R ef. D ebit C redit

M M DD Allowance for doubtful accounts 50.00 Accounts receivable (Smith) 50.00

Write off bad debt of Smith

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What if a written off account is paid?

•  Simple. Just reverse the entry that was the write off.

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Property, plant and equipment

•  And now we’ll start an entirely new subject–long lived assets.

•  These are sometimes called property, plant and equipment.

•  They are on the assets side of the balance sheet, usually as the lowest thing on the assets side.

•  They have a contra account–accumulated depreciation

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Plant Assets Compared to Other Types of Assets

•  Plant assets are long-term, tangible assets used in the operation of the business.– Useful life is more than one accounting period.– They are used to produce revenue in the primary

business operations rather than being held for resale.

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Cost of a Plant Asset

•  Purchased plant assets are recorded at cost.•  Cost includes all normal and reasonable

expenditures necessary to get the asset in place and ready for its intended use.

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Cost of a Plant Asset

•  Suppose I were going to purchase a computer system. I will give you specifics as we go along. Please divide my specifics into four categories:– Basis of the asset– Expense item– Basis of something else– Something else–none of the above.

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Cost of a Plant Asset �Self-Constructed Assets

Cost includes all materials and labor cost directly traceable to the construction as well as a reasonable amount of indirect costs such as utilities and supervision.

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Cost of a Plant Asset �Land & Buildings

When land and building are purchased together, the land cost and the building cost are placed

in separate ledger accounts. ��

The total cost of the purchase is separated on the basis of relative market values.

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Nature of Depreciation•  The useful life of plant assets, other than land,

is limited, so the usefulness of the asset expires as it is used.

•  The expiration of usefulness of the asset is generally described as depreciation.

•  Depreciation is the process of allocating a plant asset’s cost to income statements for the years in which it is used.

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•  Depreciation results in matching the cost of acquiring plant assets with the revenues generated by their use.

•  Depreciation is recorded with the following adjusting entry:

Nature of Depreciation

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•  Depreciation results in matching the cost of acquiring plant assets with the revenues generated by their use.

•  Depreciation is recorded with the following adjusting entry:


Date DescriptionPost. Ref. Debit Credit

Depreciation Expense XXXXX

Accumulated Depreciation XXXXX


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•  Depreciation Expense–  Balance in Depreciation

Expense indicates how much depreciation has been recorded in the current year.

–  Temporary account, reported on the income statement.

•  Accumulated Depreciation–  Permanent account, reported

on the balance sheet as a deduction from plant assets.

–  Balance in Accumulated Depreciation is a cumulative total of all depreciation recorded on an asset.


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Depreciation on the Balance SheetProperty, plant, and equipment: Land and buildings 150,000$ Machinery and equipment 200,000 Office furniture and equipment 175,000 Land improvements 50,000 Total 575,000$Less Accumulated depreciation (122,000) Net property, plant, and equipment 453,000$

Net property, plant, and equipment is the undepreciated cost of the plant assets. Book value is another term used for undepreciated cost.

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There are two kinds of depreciation. What are they?

•  Book Depreciation➊  Straight-line

➋  Units-of-production

➌  Declining-balance

•  Tax Depreciation➊  MACRS

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Book Depreciation�Straight-Line Method

Depreciation Expense per Year

Cost - Salvage Value Service Life in Years

=

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Straight-Line Method�Example

On January 1, equipment was purchased for $27,500 cash. The equipment has an

estimated useful life of 10 years and an estimated salvage value of $2,500.�

What is the annual straight-line depreciation expense?

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Straight-Line Method�Example


= $2,500


$27,500 - $2,500 10 years

=


Cost - Salvage Value Service Life in Years

=

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Book Depreciation�Units-of-Production Method

Depreciation Per Unit

= Cost - Salvage Value Predicted Units of Production

Step 1:

Step 2: Depreciation Per Period =

Depreciation Number of Per Unit Units Produced *

This is a straight line method with units instead of time as the denominator.

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Units-of-Production Method�Example

On January 1, equipment was purchased for $27,500 cash. The equipment is expected to produce 100,000

units during its useful life and has an estimated salvage value of $2,500.�

�If 12,000 units were produced this year, what�

is the amount of depreciation expense?

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Units-of-Production Method�Example

Depreciation Per Unit = $27,500 - $2,500

100,000 units

Step 1:

= $.25 per unit

Step 2:

Depreciation Per Period = $.25 per unit * 12,000 units = $3,000

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Accelerated Depreciation

More depreciation expense is taken in the early years of an asset’s life and less

depreciation expense is taken in the later years.

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Declining Balance methods

•  The final financial statement method of depreciation is declining balance. It is actually a family of methods, usually containing three members–125 percent, 150 percent, and 200 percent (also known as double)–declining balance depreciation.

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Declining-Balance Method

To calculate declining balance depreciation, you first have to calculate the straight line rate:

For example, an asset with a 10-year useful life would have a straight-line rate calculated as follows:

= Straight-Line Rate Useful Life in Years 100%

10 Years 100%

= 10%

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Declining balance depreciation

•  You then need to calculate the annual depreciation:

where X is the chosen rate: 200%, 150%, or 125%.

•  Setting up a table helps. One such is shown on the next slide.

Book Value * (X * Straight-Line Rate)

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Declining balance depreciation Remaining Depreciation Remaining

Year Basis Rate Expense Basis

1234567

In calculating declining balance depreciation, salvage value is ignored except that you don’t depreciate below it.

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Declining-Balance Method �Example

On January 1, 20x1, equipment was purchased for $27,500 cash. The equipment has a useful life of 5 years and an estimated salvage value of $2,500.��What is the amount of depreciation expense for each year of its useful life using the double-declining-balance method?

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Declining balance depreciation•  First, set up your table:

•  Now finish the problem.

[1] [2] [3] [4] [5] Remaining Depreciation Remaining

Year Basis Rate Expense BasisPrev [5] [2]*[3] [2]-[4]

1 0.42 0.43 0.44 0.45 0.4

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Declining balance depreciation•  The answer!

•  You didn’t go below salvage, did you?

[1] [2] [3] [4] [5] Remaining Depreciation Remaining

Year Basis Rate Expense BasisPrev [5] [2]*[3] [2]-[4]

1 27,500 0.4 11,000 16,5002 16,500 0.4 6,600 9,9003 9,900 0.4 3,960 5,9404 5,940 0.4 2,376 3,5645 3,564 0.4 1,064 2,500

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Depreciation for Partial YearsSo far we have assumed that the plant asset was

purchased at the beginning of the year.�

When a plant asset is acquired during the year, depreciation is calculated for the fraction of the

year the asset is owned.

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On June 30, 20x1 equipment was purchased for $75,000 cash. The equipment has a useful life of 10 years and estimated salvage value of $5,000.�

Calculate the straight-line depreciation for the year ended December 31, 20x1.

Depreciation for Partial Years �Example

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Depreciation = ($75,000 - $5,000) ÷ 10= $7,000 per year normal depreciation

Depreciation = $7,000 * 6/12 = $3,500 half year depreciation.

June 30

Depreciation for Partial Years �Example

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Revising Depreciation Rates

•  Because depreciation is based on the estimated useful life and the estimated salvage value of an asset, depreciation expense is an estimate.

•  Over the life of an asset, new information may come to light that indicates the original estimated useful life or estimated salvage value was inaccurate.

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•  If the estimate of the useful life or the salvage value of an asset changes, the depreciation rate must be revised.

•  For these changes in accounting estimates, the remaining book value of the asset is depreciated over the remaining useful life.

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•  The easiest way to think about the problem of revising depreciation method, life, or salvage value is to think of “selling” the asset to yourself. You then depreciate the “newly bought” asset over its remaining life with its remaining basis under the appropriate method.

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Revising Depreciation Rates Example

On January 1, 20x1, equipment was purchased that cost $30,000, has a useful life of 10 years and no salvage value. During 20x4, the useful life was revised to 8 years total (5 years remaining), and a $1,000 salvage value.

�Calculate depreciation expense for the year ended December 31, 20x4 using the straight-line method.

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Revising Depreciation Rates Example

Asset cost 30,000$ Accumu lated depreciation , 12/31/X3 ($3,000 per year * 3 years) (9,000) New salvage value (1,000)

Remain ing depreciable value 20,000 Divide by remaining life ÷ 5Revised annual depreciation 4,000$

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Tax Depreciation�(MACRS)

•  The asset is placed into one of several different asset classes.

•  Classes include 3, 5, 7, 10, 15, 20, 27.5 and 39 year lives.

•  Salvage value is ignored.•  Published depreciation rates are based upon

accelerated depreciation using the half-year convention.

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•  The common asset classes (the ones you will be concerned with 99 percent of the time) for non-real estate assets are:–  3 year property: R&D equipment and certain

animals.–  5 year property: Wheeled vehicles and most

electronic equipment.–  7 year property: Office furniture and things not

otherwise listed.

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Tax depreciation table �(non-real estate)

Year 3 year 5 year 7 year

1 33.33 20.00 14.29 2 44.45 32.00 24.49 3 14.81 19.20 17.49 4 7.41 11.52 12.49 5 11.52 8.93 6 5.76 8.92 7 8.93 8 4.46

Total 100.00 100.00 100.00

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•  The common asset classes (the ones you will be concerned with 99 percent of the time) for real estate assets are:–  27.5 year property: Residential real estate.

This is straight line monthly depreciation.–  39 year property: Non-residential real estate.

Again, this is straight line monthly depreciation.

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Tax depreciation table� (real estate)

•  Residential real estate is 27.5 year (330 month) depreciation, figured on a monthly basis. Each month of ownership gets 1/330 of the total allowed depreciation.

•  Non-residential real estate is 39 year (468 month) depreciation, figured on a monthly basis. Each month of ownership gets 1/468 of the total allowed depreciation.

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Tax Depreciation�Example

On January 1, a computer is purchased for $27,500 cash. For financial statement purposes, the equipment is being depreciated over seven years with an estimated salvage value of $2,500.��Calculate MACRS depreciation for each year of the asset’s life.

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Tax Depreciation�Example answer

MACRSYear Basis rate Deprec.

1 27,500 20.00 5,500 2 27,500 32.00 8,800 3 27,500 19.20 5,280 4 27,500 11.52 3,168 5 27,500 11.52 3,168 6 27,500 5.76 1,584

Check: 100.00 27,500

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Capital and Revenue Expenditures � Ordinary Repairs

•  Keep an asset in normal, good operating condition.

•  Do not increase the productivity of the asset.•  Do not extend the useful life of the asset beyond

the original estimate.•  Are revenue expenditures.

– Debit an expense account for the expenditure.

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•  Extend the asset’s service life beyond the original estimate.

•  Are typically major overhauls or partial replacements.

•  Are capital expenditures.– Debit accumulated depreciation to increase

book value and therefore increase depreciation in future years benefited by the expenditure.

Capital and Revenue Expenditures � Extraordinary Repairs

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•  Modify a plant asset to make it more efficient or increase its quality of service.

•  May not extend the useful life of the asset.•  Are typically additions or improvements.•  Are capital expenditures.

– Debit the asset account and depreciate over future periods benefited by the expenditure.

Capital and Revenue Expenditures � Betterments

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Plant Asset Disposals •  Getting rid of plant assets is straight forward. You

need to remove all aspects of the asset from your books. This usually involves the following type of journal entry:



M M DD Cash 500.00Accumulated depreciation 300.00Loss on disposition Gain on disposition Asset 1,000.00

Record disposition of asset

Note that only one of the red entriesis made. Enter everything else firstand see which you need.

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Plant Asset Disposals �Example

On September 30, 20x6, Evans Company sold a machine that originally cost $100,000 for $60,000 cash. The machine was placed in service on January 1, 20x1. It was depreciated using the straight-line method with an estimated salvage value of $20,000 and a useful life of 10 years.

Prepare the entry to dispose of it.

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Sale of Plant Assets Example answer



Sept. 30 Cash 60,000.00

Accumulated Dep reciation 46,000.00

Gain on Sale 6,000.00

M ach ine 100,000.00

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•  Accounting depends on whether assets are similar or dissimilar.– Dissimilar - building for a equipment

– Similar – truck for a truck

Exchanging Plant Assets, AKA “trades” or exchanges

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Exchanges of Dissimilar Assets

Gains and losses are always recognized when the exchange

involves dissimilar assets.

DISSIMILAR

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Exchanges of dissimilar assets

•  You treat the exchange as two different transactions:– The sale of the old asset for its fair market

value, recognizing gain or loss, just as we did with a normal disposition.

– The purchase of the new asset for the fair market value of the old asset plus the cash given.

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Are you doing taxes, or financial statements?

Don’t recognize means that the gain or loss becomes part of the basis of the new asset.

SIMILAR

Exchanges of Similar Assets

Tax Financial statement

G ain Don't recognize Don’t recognizeLoss Don't recognize Recognize

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On May 30, 20x6, Essex Company exchanged a used airplane and $35,000 cash for a new airplane. The old airplane originally cost $40,000, had up-to-date accumulated depreciation of $30,000, and a fair value of $4,000. Prepare the entry.

SIMILAR

Exchanges of Similar Assets Example

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Exchanges: Kinsman’s law

Put in what you know first!

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Exchanges of Similar Assets What you know goes in first!



May 30 New Airplane (cash plu s FM V of old plane) 39,000

Accu mulated Dep reciation 30,000

Old Airplane 40,000

Cash 35,000

Red entry is tentative.

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Exchanges of Similar Assets Financial statements–loss recognized!



May 30 New Airplane 39,000

Accumulated Depreciation 30,000

Loss on Exchang e 6,000

Old Airplane 40,000

Cash 35,000

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Exchanges of Similar Assets Taxes–loss not recognized!



May 30 New Airplane 45,000.00

Accu mulated Dep reciation 30,000.00

Old Airplane 40,000.00

Cash 35,000.00

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Let’s change the example so that a gain results by increasing the fair value of the old airplane to $18,000 from $4,000 in the previous example. The assets are still similar.

SIMILAR

Exchanges of Similar Assets Example

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Exchanges of Similar Assets The gain is not recognized for either tax or financial statement purposes. The extra basis goes to the new plane.



May 30 Airplane (new) 45,000.00

Accumulated Depreciation 30,000.00

Airplane (old ) 40,000.00

Cash 35,000.00

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Natural Resources•  Supplied by nature and extracted from

natural environment.– Examples include standing timber, mineral

deposits and oil reserves.•  Because the asset is physically consumed,

they are often called wasting assets.•  Presented on balance sheet as non-current

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Natural Resources•  Total cost of asset is cost of acquisition,

exploration and development.

•  Total cost created by consuming the usefulness of the resource is called depletion.

•  Depletion expense is calculated on the units-of-production basis.The image

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Intangible Assets•  Noncurrent assets without physical existence.

•  Often provide exclusive rights or privileges to the owner of the asset.

•  Examples: patents, copyrights, leaseholds, leasehold improvements, goodwill, and trademarks.

•  When an intangible asset is purchased it is recorded at cost.

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Intangible Assets

•  The recorded cost of an intangible asset is amortized over the shorter of economic or legal life.

•  The straight-line method is used to amortize recorded cost.

•  If the cost is immaterial, it may be expensed.

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Patents•  Exclusive right granted by federal

government to sell or manufacture an invention.

•  The recorded cost includes the purchase price plus any legal cost incurred to defend the patent.

•  Amortized over shorter of useful life or 20-year legal life.

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Patent ExampleOn January 1, 20X1, Jar, Inc. purchased a

patent for $12,000 cash. While the patent has a legal life of 20 years, Jar determines that it will have a useful life to the company of only 8 years.�

Prepare the adjusting entry to record amortization of the patent on December 31, 20X1

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Patent Example GENERAL JOURNAL Page 18


D ec . 31 Am ortization Expense, Patent 1,50 0 Paten ts 1 ,50 0

Cost of patent $12,000 Useful life in years ÷ 8 Annual amortization $ 1,500

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Copyrights•  The federal government grants an exclusive

right to protect artistic or intellectual properties.

•  The legal life is the life of creator plus 70 years.

•  The actual amortization is over the useful life of the asset.

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Leaseholds•  A lease is a contract to rent property

granted �by lessor to lessee.

•  The rights granted by lessor under the lease are calleda leasehold.

•  A leasehold is recorded only if an advance payment is involved. Otherwise the periodic payments are recorded as rent expense.

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Leasehold Improvements•  Leasehold improvement are long-lived

improvements made to leased property by the lessee.

•  Capitalize the costs incurred with a debit to Leasehold Improvements.

•  Amortize the improvements over the shorter of useful life of the asset or the life of the lease.


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Goodwill

•  Occurs when one company buys another company.

•  Goodwill is the amount by which purchase price exceeds the fair market value of net assets acquired.

•  Only purchased goodwill is recorded as an intangible asset.

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Goodwill•  Each year, the value of the goodwill

recorded on the balance sheet is analyzed.

•  If the value has gone down (this is called “goodwill impairment”), the decrease is recorded as an expense and the value of the goodwill on the balance sheet is reduced.


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Goodwill•  In order to determine the decrease in

value, we must analyze the fair market value of the goodwill. Essentially, we do an appraisal of it annually.

•  You will talk more in finance about how to do that appraisal–it is essentially the present value of the increased after tax cash flows the purchase brings the firm.


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Goodwill•  For taxes, we amortize goodwill over a

straight line amortization period of 15 years. The image cannot be

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Trademarks and Trade Names•  A symbol, design, or logo associated with a

business.

•  Purchased trademarks are recorded at cost and amortized over shorter of legal life or economic life. If the use of the trademark will not expire, it is not amortized.

•  Amounts spent to maintain or enhance the value of a trademark or trade name are charged to expense.

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ACCT652 Week 6 9797ACCT 652 Week 6 97

Thank you for a good night

•  Remember that appeals on your exams, if any, are due back by next week before the start of class.

acct 652 accounting - pepperdine...

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