MSE608C – Engineering and Financial
Cost Analysis
Refinements of Accounting
Transactions
Prepaids (also called Deferrals)
Cash flows occur BEFORE the revenue or
expense is recognized
Revenues
Down Payments
Unearned rent
Deposits
Expenses
Prepaid Insurance
Prepaid rent
Prepaid taxes
Accruals
Cash flows occur AFTER the revenue or
expense is recognized
Revenues
Sales
Notes receivable
Interest on loans
Expenses
Purchases on account
Accrued salaries
Warranty costs
Pensions and benefits
Depreciation of assets
• Warranty costs and Pensions are also know as Contingency
Obligations
Contra Accounts
• These are special accounts that are established to
decrease the balance in another account indirectly.
– They preserve the identity of the primary account.
– Provides an account to debit or credit when one does not exist.
• Examples:
Primary Account
Accounts Receivable
Fixed Assets
Intangible Assets
Sales Revenue
Loans Receivable
Contra Account
Allowance for Doubtful Accounts
Accumulated Depreciation
Accumulated Amortization
Sales Returns and Allowance
Sales Discounts
Allowance for Doubtful Loans
Accounting for Allowance Accounts
• Allowance accounts ensure the amount report in the
primary account is as accurate as possible.
• These require estimates
• Example: Allowance for Bad Debt
– This contra-account to Accounts Receivable acknowledges that, with
every credit sale, a portion will not be collected.
• With a credit sale of $1000 and an estimate of 6.5% bad debt and COGS =
$420 Accounts
Allowance for
Bad Debt
Sales Revenue
$1000
Receivable
$1000
Bad Debt
$65
Expense
$65
COGS
$420
Inventory
$420
• When it is clear that a customer will never pay $30 that is owed the Company
will record the following entries.
Allowance for
Bad Debt
$30
Accounts
Receivable
$30
• Now the Expense (Bad Debt) has offset the Sales Revenue in the same
period they were earned.
Prompt Payment Discounts
• It is common for a billing invoice to have
the follow type of verbiage added:
2 percent, 10 days/net, 30 days
– A 2 percent discount may be taken off the bill if
paid within 10 days
– The full amount is expected to be paid within
30 days.
– The 2 percent savings is forfeit if the bill is paid
after day 10.
Calculating the Interest
• Accounts Payable is considered non-interest borrowing but
in reality this is only true if the Prompt Payment Discount
is taken.
• By not paying within the first 10 days, the customer is
essentially borrowing money (the discounted amount) and
paying 2 percent interest.
• Calculating the Interest:
– The interest rate is based on 2 percent interest for 20 days of borrowing.
– There are 18 1/4 of these 20 day periods in a year (365/20 = 18 1/4).
– Therefore, the yearly Interest Rate is 36.5% (2% x 18 1/4).
• At this interest rate it would benefit of the company to use
the discount.
Accounting for Prompt Payment
Discounts
• There are two methods of accounting for
Prompt Payment Discounts:
– Net Method:
• Used when the Discount is attractive and most
customers are expected to take advantage.
– Gross Method
• Used when the Discount is not attractive or neutral
and most customers are not expected to take
advantage.
Net Method of Accounting for
Prompt Payment Discounts
It is expected that customers will take the discount!
• The sale is recorded at the discounted amount.
Sale = $1000 with terms of 2 percent, 10 days/net, 30 days.
Accounts
Receivable
Sales
$980
$980
• When the receipt of cash if the discount is taken.
Accounts
Receivable
$980
Cash
$980
• Recording the receipt of cash if the discount is not taken.
Accounts
Receivable
$980
Cash
$1000
Other Income
$20
Gross Method of Accounting for
Prompt Payment Discounts
It is expected that customers will not take
the discount!
• The sale is recorded at the full, billed amount.
Sale = $1000 with terms of 1/2 percent, 10 days/net, 30 days.
Accounts
Receivable
Sales
$1000
$1000
• Recording the receipt of cash if the discount is not taken.
Accounts
Receivable
$1000
Cash
$1000
• When the receipt of cash if the discount is taken.
Accounts
Receivable
$1000
Discounts
Allowed
Cash
$995
$5
Accounting for Inventory
• Inventory
– Purchased goods on hand to be sold.
• Two systems for valuing inventory that is sold
– Perpetual Inventory System
• Accounts for the cost of goods sold with each sale
• Most precise and highest investment
– Periodic Inventory System
• Tracks inventory purchase but not inventory sold
• Physical inventory count at end-of-period
• Can only estimates the Cost of Goods.
The Perpetual Inventory System
• Accounts for each individual purchase or sale.
– More applicable to inventory that is high cost and low volume.
– Does not require end-of-period adjustments.
• Purchases of Inventory:
Inventory
Cash or Accounts Payable
Debit
$500
Credit
$500
• Sale of product (two entries):
Cash or Accounts Receivable
Sales Revenue
Cost-of-goods-sold
Inventory
Debit
$800
Debit
$500
Credit
$800
Credit
$500
The Periodic Inventory System
• Requires physical inventory counts.
• Best for low cost, high volume inventory.
• Purchases of inventory:
Purchases
Cash or Accounts Payable
Debit
$500
Credit
$500
• Sale of product (one entry):
Debit
Cash or Accounts Receivable $800
Sales Revenue
Credit
$800
The Periodic Inventory System
• Calculating Inventory consumed over the accounting period:
Beginning Inventory
+ Purchases
- Returns
= Inventory Available
Ending Inventory
= Inventory Sold (COGS)
$2500
$800
($250)
$3050
$1500
$1550
• End-of-period adjusting entries:
Inventory (ending amount)
Returns
Inventory (begin amt)
Purchases
Cost of Goods Sold
Debit
$1500
$250
Credit
$2500
$ 800
$1550
Inventory Accounting
• Issues in valuing Inventory and Cost-ofGoods-Sold:
– Different prices are paid for inventory
depending on when items were purchased.
– Price level changes due to Inflation and
Deflation.
– Currency fluctuations.
FIFO and LIFO
• The FIFO (First-in, First-out) convention:
– The value of the oldest inventory, the First-in, is the value of the
Cost-of-Goods-Sold for current sales, the First-out.
• The LIFO (Last-in, First-out) convention:
– The value of the newest inventory items, the Last-in, is used to
value Cost-of-Goods-Sold for current sales, the First-out.
• In periods of high Inflation:
– LIFO will have a higher COGS and better match Expenses to
Revenues;
– Profits are lower (more conservative);
– Better matches replacement costs of Inventory;
– Lower Income Taxes thus higher cash flows.
• GAAP allows FIFO or LIFO with restrictions (Riggs 147).
Price Level Changes
• Price level changes due to Inflation and Deflation
are a fact of life.
– Inflation:
a decrease in the purchasing power of currency; prices increase to compensate;
the value of inventory decreases.
– Deflation:
an increase in the purchasing power of currency; prices drop to compensate; the
value of inventory increases.
• Two approaches to price-level accounting:
– Specific-price adjustments (SPA)
– General-price-level adjustments (GPLA)
Specific-Price Adjustments (SPA)
Adjustments are made to specific goods and services;
typically inventory and fixed assets. This identifies that
only certain items may be affected by price changes.
• Several methods can be used to estimate the current value
of assets.
• Time-adjusted value:
Estimates the value of revenue streams over time. This method tends to be
inaccurate both in estimating the original value as well as the new value.
• Market value:
Determines the replacement value of assets and requires good secondary markets
to be efficient.
• Price indices:
Use of published indices for the asset being re-valued. Multiplying the current
value by the index number will establish the current value.
General-Price-Level Adjustments
(GPLA)
Recomputes the value of all assets and
liabilities on the financial statements. Also
called Constant-dollar Accounting.
• Uses General Price Indices
– Gross National Product (GNP)
– Consumer Price Index (CPI)
Currency Fluctuations
• Companies operating foreign subsidiaries must
account for gains or losses due to fluctuation in
currency exchange rates on their consolidated
financial statements.
• The value of assets and liabilities must be adjusted
to account for different rates of inflation between
the foreign and home currencies.
• The accountant must determine what exchange
rate to use and when should it be applied.
Fixed Asset Accounting
• Fixed Assets are Non-current Assets
• Revenue and Capital Expenditures
– Revenue expenditures are for Current Assets
– Capitalization expenditures are for Non-current Assets.
• Fixed Assets are also used to conduct an
organization’s business, rather than inventory for
resale.
– A truck is a fixed asset for a delivery service but an
inventory item for a car dealership.
Elements of Fixed Asset Accounting
1) Initial (capitalization) Cost
– Purchase price + freight + installation + major
overhauls
– Commonly called the “basis”
2) Useful life
–
–
–
–
Productive years for the present owner
Dictated by wear, obsolescence and new requirements.
Useful life generally shorter than the asset’s total life.
Income tax laws establish guidelines
3) Salvage Value
– Estimated sale value of the asset at the end of it’s
useful life, usually $0.
Elements of Fixed Asset Accounting
4) Depreciation
– The rational, equitable, and systematic allocation of
the difference between an asset’s initial cost and it’s
estimated salvage value over the useful life.
– It allows an organization to deduct, or expense, the
incremental consumption of a fixed asset to the
periods that benefit from it’s use.
– It is a non-cash transaction.
– It reduces taxable income.
– Journal entries at the end of each accounting period
and no source documents (an Internal accounting
event).
Methods for Depreciation
• Computation uses formulas or tables
• Many accepted methods for depreciation
including:
–
–
–
–
–
Straight line;
Sum-of-the-years-digits;
Units of production;
Declining balance;
Modified accelerated cost recovery system (MACRS)
• One method is allowed for financial statements
and a different method may be used, for the same
fixed asset, for income tax accounting purposes.
Disposition of a Fixed Asset
• Calculating Net Gain or Loss on Sale/Salvage
Book Value = Capitalization Cost – Accumulated Depreciation
Net Gain (Loss) = Sales/Salvage Proceeds – Book Value
• If proceeds are greater than the Book Value = Gain
• If proceeds are less than the Book Value = Loss
Disposition of a Fixed Asset
Consider: BV = $26,000 - $14,400 = $11,600
Sold for $12,000 (a Gain):
Debit
Accumulated Depreciation, Equipment ($14,400 remaining)
Fixed Asset, Equipment (Capital Cost = $26,000)
Cash
Gain on Disposition of Fixed Asset
Credit
$14,400
$26,000
$12,000
_______
$400
$26,400
$26,400
Debit
Credit
Sold for $8,000 (a Loss):
Accumulated Depreciation, Equipment ($14,400 remaining)
Fixed Asset, Equipment (Capital Cost = $26,000)
Cash
Loss on Disposition of Fixed Asset
$14,400
$26,000
$8,000
$3,600
________
$26,000
$26,000
Disposition of a Fixed Asset
Making a Deal (Riggs pg 172)
Consider: BV = $13,000 - $8,000 = $5,000
Purchasing equipment for $21,000
Trade-in equipment, paid $14,000 cash:
Debit
Accumulated Depreciation, Equipment ($7,000 remaining)
Fixed Asset, Equipment (Capital Cost = $13,000)
Fixed Asset, Equipment (new Purchase of $21,000)
Cash
Gain on Disposition of Fixed Asset
Credit
$8,000
$13,000
$21,000
_______
$14,000
$2,000
$29,000
$29,000
Would have accepted $19,500 if no trade-in:
Debit
Accumulated Depreciation, Equipment ($14,400 remaining)
Fixed Asset, Equipment (Capital Cost = $26,000)
Fixed Asset, Equipment (new Purchase of $19.500)
Cash
Loss on Disposition of Fixed Asset
Credit
$7,000
$13,000
$19,500
$500
$27,000
$14,000
________
$27,000
Depreciation and Income Taxes
• A company is obligated to minimize the amount of income
tax it must pay.
• They are allowed to keep two sets of “books”; one for
preparing financial statements and one for reporting
taxable income.
– For financial reporting a less aggressive method will increase a fixed
asset’s net book value.
– For tax reporting a more aggressive method will increase depreciation
expense; decrease taxable income and decrease income taxes.
• The lower income taxes are reported on the Income Statement and
this improves Net Income.
• Deferred Income Taxes is the difference between the two
depreciation methods.
Accounting for Deferred Taxes
For Financial Reports
(actual amount of taxes owed)
Alternate Allowed to Reduce Paid Tax
Operating Profit
less: Depreciation
Taxable Income
Income Taxes (@40%)
Operating Profit
less: Depreciation
Taxable Income
Income Taxes (@40%)
Income Tax Payable
168,000
$780,000
250,000
530,000
212,000
Deferred Income Taxes
44,000
$780,000
360,000
420,000
168,000
Income Tax Expense
212,000
Assessment
• For Prepaids, cash flow occur when?
• What is the purpose of a Contra account?
• What are the two methods for Prompt Payment
Discounts?
• What are the two methods for valuing Inventory?
• What is the impact of Inflation using FIFO?
• A Gain on the sale of a fixed asset results in a
Credit or Debit entry?
• Where do Deferred Income Taxes come from?