Chapter 5
Special Topics in Accounting
Changes in the Equity Account
• Two most common changes in equity account are
the result of:
1. Owners’ contributions of additional equity capital
2. Owners’ capital withdrawals or profit distributions
• Recall other changes in equity account that are the
result of:
– Earning Revenue
– Incurring expenses
Changes in the Equity Account
• For sole proprietorships, partnerships, or LLCs,
contributions of additional equity capital
normally take the form of direct cash
contributions.
• For corporations, contributions of additional
equity capital take the form of stock sales, and
the associated cash inflow is treated in a
comparable manner.
Changes in the Equity Account
• Sole proprietorships, partnerships, and some
LLCs maintain drawing accounts to account for
owners’ withdrawals of equity capital from
the business.
– Drawing account: accounting mechanism through
which owner withdraws his/her share of
company’s profits
– At end of year, drawing account is closed to capital
account. Total drawings are deducted from capital.
Changes in the Equity Account
• Corporations distribute profits as dividends to
stockholders so withdrawals of equity capital
take the form of:
• Dividend payment
• Stock splits
• Stock dividends
Depreciation Accounting
• Contra account: entitled “accumulated
depreciation” and maintained to offset its
associated asset account
• Capital asset: asset with expected useful life
of more than one year
• Depreciation accounting: technique used to
allocate cost of capital asset over its expected
useful life
Depreciation Accounting
• 4-Step Process
1. Determine value of asset
•
“Delivered and installed” price: cost of acquiring asset
and preparing it for use
2. Estimate expected useful life of asset
3. Estimate asset’s salvage value
•
Salvage value: asset’s estimated value at end of its
expected useful life
4. Select a method to allocate dollar value of asset
expected to be used up (depreciable balance = cost –
salvage value) to its expected useful life
Depreciation Accounting
• Most common methods:
1.
2.
3.
4.
Straight line
Units of production
Sum of years’ digits
Double declining balance
Depreciation Accounting
1. Straight line depreciation
– Write off depreciation expense at an even rate
(“straight line”)
2. Units-of-production depreciation
– Allocate depreciable balance according to
number of units the capital asset is expected to
produce
Depreciation Accounting
3. Sum-of-years’-digit (SYD) depreciation
– Sum the digits of number of years over which
asset is to be depreciated
– Establish series of depreciation fractions that
have the sum of years’ digits as their
denominator
– Each year’s depreciation expense is determined
by multiplying appropriate depreciation fraction
times depreciable balance
– (Type of accelerated method)
Depreciation Accounting
4. Double-declining-balance (DDB)
– Firm may write off up to double the straight-line
depreciation rate
– Apply DDB depreciation rate to declining balance
of cost of asset, rather than to depreciable
balance
– Firm may not write off more total depreciation
than amount of depreciable balance
– (Type of accelerated method)
Choice of Depreciation Method
• How do you select the appropriate
depreciation method?
– Use the depreciation method that most closely
matches rate at which asset actually depreciates!
Depreciation for Tax Purposes
• Tax Reform Act of 1986 (TRA 86)
– MACRS depreciation: number of years over which
asset is depreciated is not tied to expected life of
asset, and salvage value of asset is disregarded
• Entire cost of asset is depreciated over its
MACRS life
• Modified accelerated cost recovery system
• Most asset categories must be depreciated under
MACRS
• Allows up to $250,000 of cost of asset to be expensed
in year of acquisition
Depreciation for Tax Purposes
• MACRS cannot be used for financial
accounting purposes since this it is not an
acceptable depreciation method under GAAP.
• Companies use a depreciation method for
financial accounting purposes different from
the one they use for tax purposes.
Depreciation for Tax Purposes
• Many firms use straight-line depreciation for
financial accounting purposes
– Recognizes general erosion in value of asset that is
expected to be used over its entire useful life
– Minimizes impact of depreciation on firm’s
reported earnings per share (see next slide)
Depreciation for Tax Purposes
• Tax timing difference: results in creation of
liability account entitled “deferred income
taxes”
– If firm uses straight-line depreciation for financial
accounting purposes and MACRS depreciation for
tax purposes, the later will exceed the former
– Taxable earnings will be less than earnings
reported on firm’s financial statements
Inventory Accounting
• Most common methods:
1.
2.
3.
4.
Specific identification
Weighted average
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Inventory Accounting
• Perpetual inventory: inventory records are
updated whenever new items are received
and old items are used up or sold
– Specific identification
Inventory Accounting
• Periodic inventory: inventory is counted
periodically (i.e. monthly, quarterly) and
quantity used up or sold is determined by
subtracting current quantity on hand from
prior inventory on hand plus purchases since
then
– Weighted average, FIFO, LIFO
– Practical for large quantities of inventory, high
inventory turnover, or large numbers of very
similar items in inventory
Inventory Accounting
1. Specific identification
– Commonly used for “big ticket” items (i.e.
automobiles, jewelry, heavy equipment)
– Each item is specifically identified by serial
number and carried in inventory at its actual cost
Inventory Accounting
2. Weighted average
– Commonly used for fungible goods (i.e. wheat,
physically indistinguishable products)
– Each unit is priced as a weighted average of cost
prices of items at time of purchase
Inventory Accounting
3. FIFO
– Corresponds closely to actual physical flows of
inventory
– Assume that oldest inventory is used up first, so
that ending inventory is priced at newest (and
higher) prices
– Ending inventory is valued on balance sheet at
prices that are closest to current prices, but
inventory that is used in production is charged
against income at older (and lower) prices that
are less than replacement costs
Inventory Accounting
4. LIFO
– Assume that newest (and higher-priced) items
are used first and that oldest (and lower-priced)
items remain in inventory
– Realistic method of measuring cost flows on
income statement
Inventory Accounting
• FIFO vs. LIFO
– FIFO: balance sheet is “accurate” (inventory is
priced closest to replacement value), but income
statement is “distorted” (“phantom profits” occur)
– LIFO: balance sheet is “distorted,” but income
statement is “more accurate”
• LIFO more closely matched current costs with current
revenues than does FIFO
* LIFO results in lower reported earnings after tax
than FIFO but a higher cash flow due to lower tax
burden
Accounting for Leases
• Operating lease: any lease agreement that does
not meet criteria for a capital lease
• Capital lease: lease that can be capitalized and
recorded as asset with associated liability
1. Title is transferred to lesseeat end of lease term.
2. Lease contains bargain purchase option.
3. Term of lease is greater than or equal to 75% of
estimated economic life of asset
4. Present value of minimum lease payments is greater
than or equal to 90% of fair value of leased property
Accounting for Leases
• Capital lease is recorded on lessee firm’s balance sheet as an
asset entitled “capital-lease asset” and an associated liability
entitled “obligation under capital lease”
• Amount of asset and liability entitled “obligation under capital
lease” is equal to present value of minimum lease payments
• Asset is accounted for like any other asset that is amortized
• Liability is accounted for like interest-bearing debt that is
reduced over its term
• Lease payments are treated partially as interest expense and
partially as amortization of capital-lease liability
Intercorporate Investments
• Accounting methods to account for ownership
of voting stock in another corporation:
1. Consolidated financial statements
2. Equity method
3. Cost method
• Choice of method is function of voting control
exercised by parent corporation over
subsidiary
Intercorporate Investments
1. Consolidated financial statements
– Use when one corporation (parent) owns 50% or
more of voting stock of another corporation
(subsidiary) or, pursuant to FIN 46 has controlling
financial interest other than equity or voting
rights
•
Wholly owned subsidiary: parent owns 100% of
voting stock of subsidiary
Intercorporate Investment
1. Consolidated financial statements
(continued)
– Present operations of parent and subsidiary as
one consolidated entity
•
Combine accounts of subsidiary with accounts of
parents and eliminate intercompany accounts
– Show minority interest if subsidiary is not wholly
owned
•
Minority interest: subsidiary ownership held by
stockholders other than parent
Intercorporate Investment
2. Equity method (One-line consolidation)
– Used when from 20-50% of subsidiary is owned
by parent, and when parent owns more than
50% of subsidiary but consolidation would be
considered inappropriate
– Takes parent’s share of subsidiary’s earnings as
single line item on parent’s income statement
– Shows investment in common stock of subsidiary
as single asset item on parent’s balance sheet
Intercorporate Investment
3. Cost method
– Use when corporation owns less than 20% of
voting stock of another corporation and when it
is unlikely that equity of subsidiary is effectively
accruing to benefit of parent
– Records investment in subsidiary at cost on
parent’s balance sheet
– Records income on parent’s income statement
only when received in form of dividends