ACCT 5120 EXAM 1

Capitalization

record cost of acquisition as an asset and allocate to expense over its useful life

Why would you capitalize rather than expense?

you believe the product will benefit you over multiple periods; future economic benefits (matching principle)

If capitalizing a product is not meaningful & significant to a company...

expense

WorldCom

capitalizing line maintenance costs that should've been repair expenses; inflated their net income for a few years; company went under because they couldn't pay the depreciation

How to capitalize (journal entry)

Dr. Asset account

Cr. Cash, other assets, Liabilities or equity

How to capitalize: relevance vs representational faithfulness

Historical cost: strong on both the day of the purchase but becomes less relevant over time as prices change

Market value: hard to get a representationally faithful number without an expensive appraisal; stock prices can be found easily

Replacement cost: how much for this asset in this condition today; not always representationally faithful b/c people list items for prices other than retail

Effects of capitalization vs expense

Balance Sheet: Assets and equity are higher early on; lower debt rations with more assets

Income Statement: Expenses are lower early on and higher later; approx. same total either way but different timing

Statement of Cash Flows: Operating vs Investing activity

Property Plant and Equipment

tangible, non-current assets, company uses in normal operations

Characteristics of PP&E

Assets must be:

- held for use, not investment

- have expected life of 1 year or 1 operating cycle, whichever is longer

- tangible in nature

Additional considerations: materiality

Which should be capitalized and included in PP&E?

- Trash cans

- University cars/trucks

- Land

- Buildings

- Electrical wiring

- Machinery

- Furniture

- Aircraft

No, Yes, Capitalize land and depends on its use for PP&E, Same for buildings, Depends on costs associated with wiring, Yes, Can use group accounting to increase materiality of furniture, Yes: Engine asset, airframe asset, and interior furniture asset

What amount should be capitalized?

costs necessary to obtain benefits derived from assets ("get it ready to go"); contract price less discounts, freight, assembly, installation, testing costs, asset retirement obligations (ex. nuclear power plant disposes of waste, etc.)

How do we capitalize expenditures?

- Capitalize if they are expected to increase the future economic benefits of the asset above what was originally expected

- Expense if it is something that you KNEW you would have to do (ex. oil change)

Economic benefits can be increased by:

extending the life of the asset, improving the productivity of the asset by enabling it to produce more goods at the same or lower cost, increasing the quality of the product

How do we capitalize expenditures subsequent to acquisition?

Additions: capitalized

Improvements and replacements: Capitalized (substitution, reduction of accumulated depreciation, capitalization as a new asset)

Rearrangement and moving: Capitalized OR expensed depending on circumstance

Repairs and maintenance: Expensed

Disposal of PP&E

record depreciation through the date of disposal, compare book value to the proceeds received from disposal

proceeds>book value= GAIN

proceeds

______ writes up values while ______ does not.

IFRS; GAAP

If an asset was written up to fair value under IFRS, what journal entry must be made?

Dr. Reevaluation Surplus xxx

Cr. Retained Earnings xxx

Whenever events/changes in circumstances indicate that the BV of a property may not be recoverable:

you must evaluate whether an impairment has occurred

Testing of impairment held for USE

2 step approach

2 Step Impairment testing

1. Do total undercounted net cash flows expected to result from the use and disposal of an asset exceed its book value? If so, NO journal entry is necessary

2. If the NCF are less than the BV, an impairment has occurred

Impairment=

Book value - fair value

Fair value can be calculated by...

discounting net cash flows and using discount rate equal to the rate of return that the company would require for a similar investment with similar risks

How to record an impairment loss:

Dr. Impairment loss

Cr. Asset OR Accumulated Depreciation

Impairment of PP&E held for SALE

Reported at lower of book value or NRV

impairment loss= book value - NRV

Net realizable value=

sales proceeds - selling costs

better reflection of what we expect to receive when we sell

What must a company disclose when an impairment occurs?

description of the impaired asset and why it is impaired, amount of the loss and how the assets fair value was determined, income statement caption where the loss was included, operating segment affected

How does impairment affect the financial statements?

reduces assets, equity, and net income which rolls into retained earnings

What is the "big bath" ?

taking a lot of extra loss in a period to make a bad year worse

Why might companies take the "big bath" ?

less depreciation in the future= higher net income

If taking an impairment is conservative, why might the SEC be concerned?

they expect accuracy and have to make sure that companies do not over impair to improve their future net income

Depletion deals with

natural resources

Steps to determine depletion

1. determine the cost to acquire the natural resource and put it into service (ie. acquisition, exploration, development, and restoration or reclamation costs; are there retirement costs?)

2. Determine the Unit depletion rate

3. Determine current year depletion

Unit depletion rate=

(Cost-residual value) / units

Current year depletion=

unit depletion rate * units recovered

When do you capitalize interest?

when the asset was constructed for your own use or as discrete projects for sale or lease to others

Amount of interest to capitalize

Interest rate x weighted average accumulated expenditures