D104 - Intermediate Accounting II (Updated Version)

Depreciation Base

Original cost - Salvage value

Methods of Depreciation

• Activity method (units of use or production)

• Straight-line method

• Decreasing-charge methods (accelerated)

  • Sum-of-the-years’-digits

  • Declining-balance method

• Special depreciation method

  • Group & composite methods

  • Hybrid or combination methods

Activity Method

Depreciation Charge = [(Cost - Salvage Value)(Actual Activity)] / (Total Estimated Activity)

Straight-Line Method

Depreciation Charge = (Cost - Salvage Value) / (Estimated Service Life in Yrs)

Sum-of-the-Years’-Digits

Depreciation Charge = (Cost - Salvage)[(Remaining Useful Life) / (Sum-of-the-years’ digits]

Declining-Balance Method

• Does not deduct salvage value

• Step one: straight-line rate = 100% / (Useful Life)

• Step two: DDB Rate = (2)(straight-line rate)

• Step three: Depreciation expense = (DDB Rate)(Beginning period book value)

Composite Method

• Assets are dissimilar and have different lives

• Smallest depreciation in the first year of an asset’s life

• Straight-line method

Composite Depreciation Rate

(Depreciation per year for all assets - straight-line) / (Total cost of assets)

Composite Life

• Length of time it takes a company to depreciate its assets on a composite basis

• Composite Life = [(Total depreciation base of assets) / [(Total costs of assets)(Composite deprecation rate)]

Hybrid or Combination Method

• Assets are similar in nature and have approximately the same useful lives

• Production variable method: combination of straight-line and activity approach

Depreciation & Partial Periods

• Must determine depreciation expense for full year and then prorate depreciation expense between the two periods involved

• [(Actual months) / (12 months)] (Full year depreciation)

Fractional-Year

• Nearest fraction of a year: depreciate 8 2/3 months in the first year

• Nearest full month: most common. Depreciate for 9 months in the first year

• Half year in period of acquisition and disposal

• Full year in period of acquisition, none in period of disposal

• None in period of acquisition, full year in period of disposal

Changes in Depreciation in Subsequent Periods

Charges for depreciation in subsequent periods (assuming straight-line method) are determined by diving the remaining book value less salvage value by the remaining estimated life

Depreciation Entry

To determine impairments you use..

Recoverability test

Recoverability Test

• Sum of the expected future net cash flows (undiscounted) < carrying amount = impairment

• Sum of expected future net cash flows (undiscounted) >= carrying amount = no impairment

Impairment Loss

Amount by which the carrying amount of asset exceeds its fair value

Measuring Impairments

Fair value is measured based on market price if available. Otherwise, use present value of expected future net cash flows to determine fair value

Impairment Loss Entry

Restoration of Impairment Loss

• After recording impairment loss, the reduced carrying amount of an asset held for use becomes its new basis

• A company may NOT restore an impairment loss for an asset held for use

Impairment of Assets to be disposed of

• Assets held for disposal are like inventory; companies should report them at the lower-of-cost-or-net realizable value

• A company can write up or down an asset held for disposal in future periods, as long as the carrying value after the write-up never exceed the carrying amount of the asset before the impairment

Depletion Base

Sum of acquisition cost of the deposit, exploration costs, development costs, and restoration costs

Development Costs

• Tangible equipment costs: all transportation and other heavy equipment needed to extract the resource and get it ready for market

  • If equipment can be moved and used for other projects, do not include in depletion base

  • Some equipment cannot be moved (a drilling rig foundation) so they are included

• Intangible development costs: drilling costs, tunnels, saft & well. NOT considered part of depletion base

Depletion Cost per Unit

[(Total Depletion Base - Salvage Value)] / (Total estimated units available)

Depletion Charge

(Depletion cost per unit)(Number of units extracted)

Depletion Entry

Selling Inventory Entry

Asset Turnover

• How efficiently a company uses its assets to generate sales

• Asset Turnover Ratio = (Net Sales) / (Average Total Assets)

Profit on Margin Sales

• Analyzes return on sales of PPE

• Profit Margin on Sales = (Net Income) / (Net Sales)

Return on Assets

• Measures probability well since it combines the effects of profit margin and asset turnover

• Return on assets = (Net Income) / (Average Total Assets) = (Profit Margin on Sales)(Asset Turnover)

Typical Current Liabilities

• Accounts Payable

• Notes Payable

• Dividends Payable

• Customer advances and deposits

• Unearned revenues

• Sales taxes payable

• Current maturities of long-term debt

Interest-Bearing Note - Issuance Entry

Interest-Bearing Note - Adjusting Entry to Recognize Interest

Interest to be Recognized

(Amount received)(Interest percentage)(# of months / 12 months)

Interest-Bearing Note - Payment Entry

Zero-Interest-Bearing Note Issued - Issuance Entry

Unearned Revenues - Sale Entry

Unearned Revenues - Redeemed Entry

Sales Taxes Payable - Segregated Entry

Sales Taxes Payable - Non-Segregated Entry

Sales Taxes Payable - Non-Segregated Formulas to Separate Accounts

• The amount recorded in the Sales Revenue is compromised of the sales amount plus the tax percentage of the sales amount

• Sales Revenue (with Sales Tax) = (Sales Revenue Balance) / [(1 + Percentage Interest)]

  • Sales Tax Collected = Sales Revenue - [Sales Revenue (with Sales Tax)]

• Sales Tax Payable = (Sales Tax Collected)(1 - Percentage Interest)

Gain Contingencies

• Do NOT record gain contingencies, onl dislcose in notes when a high probability exists for realizing them

Loss Contingencies

• Accrue an estimated loss by a charge to expense and a liability recorded only if BOTH conditions are met:

  • Probable a liability has been incurred at the date of the financial statements prior to their issuance

  • The amount of the loss can be reasonably estimated

Reporting a Loss Contingency

To report a loss and a liability in the financial statements, the cause for litigation must have occurred on or before the date of the financial statements

Common Loss Contingencies

• Litigation, claims and assessments

• Guarantee and warranty costs

• Consideration payable (premiums & coupons)

• Environmental liabilities

Warranty

• Product guarantee. Promise made by a seller to a buyer to make good on a deficiency of quantity, quality or performance in a product

• Two types:

  • Assurance-type

  • Service-type

Assurance-Type Warranty

• Included in sales price

• Warranty that product meets agreed-upon specifications

• Record a warranty libaility

• Expensed in the period the goods are provided or services performed

Service-Type Warranty

• Not included in sales price

• Warranty that provides an additional service beyond the assurance-type warranty

• Usually recorded in "Unearned Warranty Revenue” and recognize revenue on a straight-line basis

Assurance-Type Warranty - Sales Entry for Year 1

(# of units sold)(Total cash acquired) for Year 1

Assurance-Type Warranty - Payment for Warranty Costs Entry Year 1

$ in warranty costs incurred for Year 1

Assurance-Type Warranty - Adjusting Entry for Estimated Warranty Expense/Liability Year 2

(Total expected warranty expense) - (Warranty Expense Year 1)

Assurance-Type Warranty - Payment Entry for Warrant Costs in Year 2

(Total expected warranty expense) - (Warranty Expense Year 1)

Service-Type Warranty - Recognize Revenue Entry

(Total cost of warranty) / (Years it lasts)

Cash Rebate

Buyer can obtain by returning the store receipt, a rebate coupon, and universal product code (UPC label) or “bar code” to the manufacturer

Consideration Payable - Purchase Entry

(# items purchased)(Cost per item purchased)

Consideration Payable - Sale Entry

(# of items sold)(Cost per item sold)

Consideration Payable - Actual Redemption Entry

• Cash = [(# of items redeemed) / (# of items needed to redeemed)] ($ amount needed to redeem)

• Premium Expense = [(# of items redeemed) / (# of items needed to redeemed)] (Cost per item purchased)

Consideration Payable - Adjusting Entry for Additional Premium Expense and Estimated Premium Liability

• Total estimated redemptions = (Total items sold)(Percentage of estimated redemptions)

• Cost of estimated redemptions = [(Total estimated redemptions) / (# of items needed to redeem)](Cost of item purchased - $ amount to redeem)

• Redemptions to date = Estimated redemptions - actual redemptions

Loss contingency that only meets one condition

• If the loss is either probable or estimable, but not both, and if there is at least a reasonable possibility that a company may have incurred a liability, it must disclose the following:

  • Nature of contingency

  • Estimate of the possible loss or range of loss or a statement that an estimate cannot be made
    
    

Current Ratio

Current Ratio = (Current Assets) / (Current Liabilities)

Acid-Test Ratio

Acid-Test Ratio = (Cash + Short-term investments + Net accounts receivable) / (Current liabilities)

What is a bond valued at?

A bond is valued at the present value of its expected future cash flows, which consists of: interest and principal

Stated, coupon, or nominal rate

• Interest rate written in the terms of the bond indenture

• The issuer of the bonds sets this rate

Face value

Par value, principal amount, or maturity value

Effective Yield or Market Rate

Rate of interest actually earned by bondholders

Discount or Premium Bonds

• The difference between the face value and the present value of the bonds determined the actual price buyers pay for the bonds

  • Discount: bonds sell for less than face value

  • Premium: bonds sell for more than face value

Inverse relationship between the market interest rate and the price of bonds

• If bonds sell at a discount, effective yield > stated rate

• If bonds sell at a premium, effective yield < stated rate

Bonds Issued at Par on Interest Date

• When a company issues bonds on an interest payment date at par (face value), it accrues no interest

• No premium or discount exists

Bonds Issued at Par on Interest Date - Entries

Bonds Issued at Discount on Interest Date - Entries

Bonds Issued at Premium on Interest Date - Entries

Bonds Issued Between Interest Dates

• Buyers of the bonds will pay the seller the interest accrued from the last interest payment date to the date of issue

• Ex.: If a bond is issued on March 1 and it is payable semiannually on Jan 1 and July 1, you will pay for interest accrued on Jan-Feb on March 1

Effective-Interest Method

• Used for amortization of a discount or premium

• AKA Present value amortization

• Steps:

  • Compute bond interest expense first by multiplying the carrying value (book value) of the bonds at the beginning of the period by the effective-interest rate

  • Determine the bond discount or premium amortization next by comparing the bond interest expense with the interest (cash) to be paid

Effective-Interest Method - Amortization Amount

Effective-Interest Method - Discount Bonds

Effective-Interest Method - Premium Bonds

Ending Warranty Liability

Beginning liability + Warranty expense - Claims paid

Warranty Expense

(Units sold)(Estimated cost per unit)

Effective-Interest Method - Discount vs Premium

• Discount bond

  • Interest expense > Cash interest

  • Credit Discount on Bonds Payable

  • Carrying value increases over time

• Premium bond

  • Interest expense < Cash interest

  • Debit Premium on Bonds Payable

  • Carrying value decreases over time

Reacquisition Price

• Amount paid on extinguishment or redemption before maturity, including any call premiums and expense of reacquisition

• Reacquisitions price < Net carrying amount = Gain from extinguishment

• Reacquisition price > Net carrying amount = Loss from extinguishment

Reacquisition - Calculating Loss on Redemption

• Reacquisition price = (Par value of bond)(Percentage)

• Unamortized discount = [(Reacquisition price - face value - unamortized discount balance)] x (# of years left / total # of years)

Refunding

The replacement of an existing issuance with a new one

Reacquisition - Loss Entry

Book Value of Bonds

Face Value - Unamortized Discount

Notes Issued at Face Value

Zero-Interest-Bearing Notes

• AKA Non-Interest Bearing

• Measures the note’s present value by the cash received

• Interest is implied

Implicit Interest Rate

Rate that equates the cash received with the amounts to be paid in the future

Zero-Interest-Bearing Notes - Entries

Interest-Bearing Notes - Entries

Special Notes Payable

If there is no stated rate of interest, the amount of interest is the difference between the face amount of the note and the fair value of the property

Two ratios that provide info about debt-paying ability and long-run solvency:

• Debt to Assets

• Times Interest Earned

Debt to Assets Ratio

• Measure percentage of total assets provided by creditors

• Debt to Assets Ratio = (Total Liabilities) / (Total Assets)

  • Includes current and long-term liabilities

• The higher the percentage, the greater the risk the company may be unable to meet its maturing obligations

Times Interest Earned

• Indicates company’s ability to meet interest payments as they come due

• Times Interest Earned = (Net Income + Interest Expense + Income Tax Expense) / (Interest Expense)