1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Fixed Assets Chapter Five ©Black CPA Review www.BlackCPAreview.com Chapter 5 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Objectives: Objective 1: Know which costs associated with the purchase of fixed assets are capitalized Objective 2: Understand the capitalization of interest Objective 3: Understand nonmonetary exchanges Objective 4: Know the difference between capital expenditures and revenue expenditures and know how to account for expenses that occur after the acquisition of an asset Objective 5: Understand asset depreciation Objective 6: Understand the accounting for disposals and the impairment of an asset “held for use” Objective 7: Know how to calculate depletion of an asset Objective 8: Understand the accounting for goodwill and other intangible assets Objective 9: Know how to account for various costs Objective 10: Know IFRS for fixed assets ©Black CPA Review www.BlackCPAreview.com Chapter 5 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Objective 1: Know which costs associated with the purchase of fixed assets are capitalized A. Fixed assets are assets that are capitalized on the balance sheet and were acquired by the company for long-­‐
term use. a. The fixed asset account represents certain costs incurred when the asset was acquired. b. Capitalization – This refers to expenditures or costs being included in an asset account on the balance sheet. B. Acquisition costs a. The following acquisition costs should be capitalized for the purchase of equipment, land, and buildings. i. Equipment and Buildings 1. Purchase price + any additional liabilities assumed 2. Legal fees 3. Shipping 4. Taxes 5. Insurance 6. Testing of the equipment 7. Installation of the equipment 8. Any expenditures to get the building into “working condition” or ready to use. ii. Land 1. Purchase price 2. Survey costs 3. Any costs associated with the preparation of the land (clearing, grading, landscaping) 4. Costs of demolishing buildings or other permanent assets on the land a. Any proceeds received from the sale of scrap materials associated with the demolition should be subtracted from the cost i. Example: A piece of land with a building on it was acquired for $250,000, the cost of demolishing the old building was $35,000, and the sale of scrap from the building was $5,000. The total costs allocated to fixed assets for the land are $280,000 ($250,000 + $35,000 -­‐ $5,000). C. Relative Fair Value Method a. When land is purchased with a building for a lump sum it is necessary to allocate the costs between the two assets. i. Example: Marx Company acquires land and a building for a lump sum of $1,200,000. There is no information to determine the fair value of each asset except for the tax appraisal. The appraisal allocates $300,000 to the land and $600,000 to the building for a total tax value of $900,000. The relative fair value of each asset is calculated as follows: ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 1 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Land: Tax Fair Value: $300,000 ÷ $900,000 = Relative fair value: $1,200,000 x 33% = Building: Fair Value: Tax $600,000 ÷ $900,000 = Relative fair Value: $1,200,000 x 66% = Journal Entry: Land Building Cash 33% $396,000 66% $792,000 $396,000 $792,000 $1,200,000 b. If land is purchased for a lump sum with a depleting asset such as timber or oil, then the land is allocated the remaining value after the depleting asset is removed. For example, if the land and oil are purchased for $1,000,000 and the oil is worth $900,000, then the land is given a value of $100,000. The cost of preparing the land for oil drilling will also be allocated to the land. Objective 2: Understand the capitalization of interest A. Certain assets require the capitalization of interest. Fixed assets that require significant construction time or require a significant amount of time to be prepared for sale should have interest costs capitalized. a. The amount of interest that a company capitalizes is considered to be the avoidable interest. i. Avoidable interest is the interest that could have been avoided had the project not been undertaken. 1. Avoidable costs include: a. Interest incurred on construction loans b. Amortization of discounts, premiums or issue costs 2. The amount of avoidable costs to be capitalized cannot exceed the actual interest incurred during the period. ii. The avoidable cost/avoidable interest formula: Average accumulated expenditures during construction x Interest rate x Construction time = avoidable interest ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 2 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review b. Interest costs should be capitalized if: i. The asset was constructed for use by the company 1. It may either be constructed by the company or a third party ii. The assets being manufactured are for resale by special order. An example would be a company the builds yachts. They are not going to build a yacht unless contracted to do so. c. Interest costs should not be capitalized if: i. The costs are incurred after the construction or manufacturing process is complete ii. The interest costs are from inventory manufactured in the normal course of business d. The amount of interest to be capitalized is based on the following formula: Weighted average accumulated expenditures during the period x Interest rate = Amount capitalized B. Interest capitalization example: Marx Company is constructing a building for company use. They take out an 8% loan of $1,500,000 on 1/1/2012. The company begins construction immediately and spends $1,000,000 at an even pace throughout 2012. The remaining $500,000 is spent at an even pace throughout 2013 and construction is completed on 12/31/2013. Capitalized interest is computed as follows: Annual expenditures: Proration: Average current expenditures: Prior period spending: Average accumulated expenditure: Interest rate: Capitalized interest: 2012 $1,000,000 50% $500,000 0 $500,000 8% $40,000 2013 $500,000 50% $250,000 $500,000 $750,000 8% $60,000 The amount of interest capitalized each year is only a portion of the total interest incurred during that period. For example, if the 8%, $1,500,000 loan required annual interest payments, then the journal entries would be as follows: 12/31/2012 Building WIP $40,000 (amount of capitalized interest) Interest expense $80,000 (remaining interest) Cash $120,000 (8% x $1,500,000) 12/31/2013 Building WIP $60,000 (amount of capitalized interest) Interest expense $60,000 (remaining interest) Cash $120,000 (8% x $1,500,000) Once the building is completed the WIP account is transferred to the building account as a fixed asset. Any interest incurred after the building is completed will be expensed in the period incurred and the interest incurred during construction will be depreciated along with the building. Because the expenditures occurred at ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 3 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review an even rate, the prorated amount was determined by taking the average of the beginning expenditure balance (o), adding it to the ending balance and then dividing by two. In other words, the yearly expenditures were multiplied by 50%. If the expenditures were not even, then a weighted average would be used. Objective 3: Understand nonmonetary exchanges A. A nonmonetary exchange involves a transfer of assets that is not a result of a monetary exchange. In other words, it is an exchange of assets that does not include a monetary asset. B. The most common way to account for a nonmonetary exchange is at the fair value of the asset given. a. Some difficulties may arise when determining fair value. i. If the company could have received cash instead of the nonmonetary asset, then the transaction is recorded for the amount of cash that could have been received. ii. If the fair value of the asset given cannot be determined, then the fair value of the asset received should be used to account for the transaction. b. There are two exceptions to using fair value to record the transaction. i. If the transaction lacks commercial substance 1. A transaction with commercial substance is one in which the cash flows of the company are changed as a result of the exchange. a. The cash flows are comprised of the following configuration: risk, timing and the amount of future cash flows. ii. If the fair value of the assets are not determinable C. Accounting for nonmonetary exchanges when the transaction has commercial substance a. There are three ways to account for a transaction that has commercial substance. i. First method: The asset received is recorded at the fair value, which is the fair value of the asset given, plus any cash paid, less any cash received. If the FMV of the asset given is not known, move to the second method. ii. Second method: The asset received is recorded at the fair value which is the FMV of the asset received. If the FMV for either asset is unknown, move to the third method. iii. Third method: The asset received is recorded at fair value which is the book value of the asset given, plus any cash paid, less any cash received. b. Besides the fair value of the asset being recognized, the company must also recognize any gains or losses. D. Accounting for nonmonetary exchanges when the transaction lacks commercial substance a. Most questions on the exam will be about a transaction with commercial substance. However, if one of the following conditions exists use the accounting process for transaction that lacks commercial substance. i. The fair value of either asset is unknown and cannot be determined with reasonable effort. ii. The exchange is done in order to facilitate a sale to a party that is not a party to the exchange. ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 4 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review 1. Example: If two parties enter into a contract so that one of the parties can receive goods that it will then sell to a third party, then the transaction lacks commercial substance. iii. A good indication that the question on the exam involves a transaction lacking commercial substance is that the question will state that the cash flows are expected to remain substantially unchanged as a result of the exchange. b. Gains are not recognized unless boot is received i. Boot is any property or cash given in a like-­‐kind exchange that is not of like-­‐kind. 1. Example: If Jeff gives his car plus $500 to Hank in exchange for Hank’s car, then the $500 is boot. If Jeff gives his car plus a computer for Hank’s car then the computer is boot. E. Summary of accounting for nonmonetary exchanges: a. Losses on the transaction are always recognized. b. Gains are recognized if the asset is recorded at fair value. c. If one of the two exceptions for recording an asset at fair value exists, then book value of the asset given is used to record the transaction. i. Dealing with boot for transactions not recorded at fair value: 1. If no boot is involved in the transaction, then there is no gain. 2. If boot is given, then recognize a gain. The new assets are recorded at the book value of the exchanged asset plus the value of the boot given. 3. If boot is received, then a portion of the boot is recognized as a gain. F. Examples: Fair value of the assets cannot be determined: A company enters into a contract to exchange a piece of equipment for a parcel of land. The equipment has a cost of $25,000 and accumulated depreciation of $10,000. The fair value of either asset cannot be determined. The book value for the asset given up will be used to account for the new asset. Land Accumulated depreciation Equipment $15,000 $10,000 $25,000 Book value is the cost of the asset less any deprecation. Losses on nonmonetary exchanges occur when the fair value of the asset is less than the book value. The loss is recognized immediately in the period incurred. There are three different situations where a loss can occur: Loss with no boot, Loss with boot given and Loss with boot received. Remember that a loss on a transaction that lacks commercial substance is accounted for in the same way as a loss on a transaction that has commercial substance. Example of a loss when no boot is involved: ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 5 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review A company enters into a contract to exchange equipment with a fair value of $10,000, cost of $20,000 and accumulated depreciation of $6,000 for a parcel of land. Loss calculation: Fair value – book value (cost – accum. depr.) = loss $10,000 -­‐ $14,000 = ($4,000) Transaction journal entry: Land Accumulated Depreciation Loss Equipment $10,000 $6,000 $4,000 $20,000 Examples of loss when boot is given: Fair value of asset given is known: A company enters into a contract to exchange $1,000 cash and equipment with a fair value of $10,000, cost of $20,000, and accumulated depreciation of $6,000, for a parcel of land. Loss calculation: Fair value of asset given – book value of asset given = loss $10,000 -­‐ $14,000 = ($4,000) The boot received is allocated to the value of the asset given Transaction journal entry: Land Accumulated Depreciation Loss Equipment Cash $11,000 $6,000 $4,000 $20,000 $1,000 Fair value of asset given is unknown: If the fair value of the asset was not known and the fair value of the land was $10,000, then the calculation would be as follows: Loss calculation: (Fair value of asset received – boot given) – book value of asset given = loss Transaction journal entry ($10,000 -­‐ $1,000) -­‐ $14,000 = ($5,000) Land Accumulated Depreciation Loss Equipment Cash $10,000 $6,000 $5,000 $20,000 $1,000 ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 6 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Examples of loss when boot is received: Fair value of asset given is known: A company enters into a contract to exchange equipment with a fair value of $10,000, cost of $20,000, and accumulated depreciation of $6,000, for a parcel of land and $1,000. Loss calculation: Fair value of asset given – book value of asset given = loss $10,000 -­‐ $14,000 = ($4,000) Transaction journal entry (the value of the boot is deducted from the value of the asset given) Land Accumulated Depreciation Loss Cash Equipment $9,000 $6,000 $4,000 $1,000 $20,000 Fair value of asset given is unknown: If the fair value of the machine was not known and the fair value of the land was $10,000, then the calculation would be as follows: Loss calculation: (Fair value of asset received + boot received) – book value of asset given = loss Transaction journal entry ($10,000 + $1,000) -­‐ $14,000 = ($3,000) Land $10,000 Accumulated Depreciation $6,000 Loss $3,000 Cash $1,000 Equipment $20,000 G. The following examples will show the accounting procedures for gains on nonmonetary transactions Example of gain that has commercial substance A company enters into a contract to exchange equipment with a fair value of $30,000, cost of $20,000, and accumulated depreciation of $6,000, for a parcel of land. Note that this action has commercial substance and does not qualify for any exceptions. Gain Calculation: Fair value of asset given – book value of asset given = gain Transaction journal entry $30,000 -­‐ $14,000 = $16,000 ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 7 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Land $30,000 Accumulated Depreciation $6,000 Equipment $20,000 Gain $16,000 *note that if boot had been either given or received, the accounting would be the same as the loss example except using a gain instead of a loss. Example of a gain that lacks commercial substance and no boot is given A company enters into a contract to exchange equipment with a fair value of $30,000, cost of $20,000 and accumulated depreciation of $6,000, for a parcel of land. This exchange does not significantly affect the cash flows of the new asset. Gain calculation: Fair value of asset given – book value of asset given = gain $30,000 -­‐ $14,000 = $16,000 Transaction journal entry: Land Accumulated Depreciation Equipment $14,000 $6,000 $20,000 Notice that the journal transaction for this example differs from the last example. This is because the exchange lacks commercial substance and no boot is received. This means that the $16,000 gain is deferred and will be recognized over the life of the asset. If the asset is sold before the basis is completely depreciated, then the gain is recognized at the sale. Example of a gain that lacks commercial substance and boot is given A company enters into a contract to exchange $5,000 plus equipment with cost of $20,000 and accumulated depreciation of $6,000, for a parcel of land worth $30,000. This exchange does not significantly affect the cash flows of the new asset Gain calculation: (Fair value of asset received – boot given) -­‐ book value of asset given = gain ($30,000 -­‐ $5,000) -­‐$14,000 = $11,000 Transaction journal entry: Land Accumulated Depreciation Equipment Cash $19,000 $6,000 $20,000 $5,000 ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 8 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review There are a few ways to calculate the value of the new asset. The first is done by adding the boot given to the book value of the asset given. The second is to take the fair value of the asset received and subtract the gain deferred. Also, recognize that again the gain is deferred. Example of a gain that lacks commercial substance and boot is received A company enters into a contract to exchange equipment with a fair value of $30,000, cost of $20,000 and accumulated depreciation of $6,000, for a parcel of land and $5,000. This exchange does not significantly affect the cash flows of the new asset. First, it is important to recognize that in a transaction that lacks commercial substance but boot is received the gain must be recognized for the portion of the boot received. The amount of gain to be recognized is based on the following formula: !
$
Boot Re cieved
#
& x!Total gain=Gain torecognize " Boot Re ceived + FV of Asset Re ceived %
Secondly, it is important to note that the FV of the asset received may not always be given. If it is not given, the FV can be calculated by subtracting the boot received from the FV of the asset given. Gain calculation: Fair value of asset given -­‐ book value of asset given = gain $30,000 -­‐ $14,000 = $16,000 Amount of gain recognized: $5,000
+ $16,000 = $2,667 $5,000 + $25,000
*The FV of the asset received was calculated by taking the $40,000 FV of the asset given and subtracting the boot received of $5,000. Transaction journal entry: Land Accumulated Depreciation Cash Equipment Gain $11,667 $6,000 $5,000 $20,000 $2,667 Objective 4: Know the difference between capital expenditures and revenue expenditures, and know how to account for expenses that occur after the acquisition of an asset. A. Capital and revenue expenditures both occur after the fixed asset has been acquired and put into operation. ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 9 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review a. Capital expenditures are expenditures that are not considered to be normal or reoccurring. These expenses typically affect the company for more than one period and are accounted for by capitalizing the costs as part of the value of the asset. An example would be overhauling a piece of equipment to extend its useful life. b. Revenue expenditures are expenditures that are frequent and considered normal costs. These are expensed in the year incurred. Some capital expenditures that are considered immaterial are expensed in the year incurred rather than capitalized. Examples of revenue expenditures would be normal repairs and maintenance expenses. c. The following expenses should be capitalized: i. Additions (new part of a factory) ii. Additional capacity iii. Expenditures to improve the efficiency of the asset iv. Expenditures to increase the useful life of an asset (overhauls) 1. These costs are generally subtracted from the accumulated depreciation account v. Refurbishment (replacing old components with new ones but keeping the basic shell of the asset) 1. If the book value of the old component can be identified, then account for the transaction as if the asset had been sold and then replaced by a new asset. This would involve removing the accumulated depreciation account and the corresponding asset from the balance sheet and adding the new asset. 2. If the component is not identifiable, then account for it as a normal capital expenditure. Objective 5: Understand asset depreciation A. A company depreciates certain assets over time in order to comply with the matching principle. Depreciation is a way to systematically and rationally allocate the costs of the asset over the life of the asset. B. There are several methods used to calculate depreciation. a. Straight-­‐line method i. Used primarily when an asset provides an equal benefit to the company throughout the assets’ useful life. ii. With straight-­‐line depreciation, the amount of depreciation taken is the same each year. iii. Salvage value is factored into straight-­‐line depreciation. 1. Salvage value is the residual value left in the asset after it has been depreciated. It is the amount the company could sell the asset for after the useful life has been exhausted. iv. Straight-­‐line formula: ( Asset cost ! Salvage value) = Depreciation Expense Useful Life
b. Double Declining Balance method (DDB) i. This is an accelerated depreciation method in which twice the straight-­‐line rate is used. ii. Salvage value is not factored into the DDB method. ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 10 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review iii. When using the DDB method the balance never reaches zero. Once the asset is depreciated to its salvage value, the company must switch depreciation methods and use either straight-­‐line or sum of the years’ digits iv. DDB formula: Depreciation Rate: !
$
1
& x 2= Depreciation Rate " # of years of useful life %
#
Year 1 depreciation: Cost of asset x depreciation rate= first year depreciation Depreciation for year 2 and beyond: (Cost ! accumulated depreciation) x depreciation rate=current year depreciation c. Sum of the Years’ Digits (SYD) i. Considered an accelerated depreciation method. ii. Calculating SYD requires two steps. 1. Step one: Determine the denominator for the SYD equation N(N+1) ÷ 2 = Sum of the years in the asset’s life N = number of years in the asset’s useful life 2. Step two: Calculate depreciation " # of yearsleft in asset 's useful life %
' = Depreciation Expense # Sum of the yearsin asset 'slife &
(Cost ! Salvage value) x $
d. Examples: The following example will show the difference between straight-­‐line, DDB and SYD An asset worth $24,000 with a useful life of 4 years and a salvage value of $4,000 Straight-­‐line: Depreciation expense: ($24,000 -­‐ $4,000) ÷ 4 = $5,000 per year DDB: Depreciation rate: (1 ÷ 4) x 2 = 50% ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 11 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Year 1: $24,000 x 50% = $12,000 deprecation Year 2: ($24,000 -­‐ $12,000) x 50% = $6,000 depreciation Year 3: ($24,000 -­‐ $18,000) x 50% = $3,000 however only $2,000 can be taken as the salvage value has been reached. Year 4: None, the DDB cannot depreciate an asset past salvage value SYD: Sum of the years’ digits calculation: 4(4+1) ÷ 2 = 10 Depreciation: Year 1: ($24,000 -­‐ $4,000) x (4/10) = $8,000 depreciation Year 2: ($24,000 -­‐ $4,000) x (3/10) = $6,000 depreciation Year 3: ($24,000 -­‐ $4,000) x (2/10) = $4,000 depreciation Year 4: ($24,000 -­‐ $4,000) x (1/10) = $2,000 depreciation Summary: Year 1 2 3 4 Straight-­‐line $5,000 $5,000 $5,000 $5,000 DDB $12,000 $6,000 $2,000 $0 SYD $8,000 $6,000 $4,000 $2,000 C. Along with the traditional deprecation methods, there are a few methods that apply to special situations a. Physical usage depreciation: i. This type of depreciation is based on the amount of usage of the asset rather than an expected useful life. ii. Formula: ! Current activity or output
$
Annual Depreciation= #
& x Depreciation Base " Total exp ected activity or output %
iii. Example A piece of equipment has a cost of $100,000. The equipment’s total expected output is 1,000,000 units. If during the first year 180,000 units were produced, the depreciation would be $18,000 as calculated below: ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 12 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review ! 180, 000Units $
#
& x $100, 000=$18, 000 " 1, 000, 000Units %
b. Inventory depreciation i. This method of depreciation is not used very often because it does not match cost to benefits. ii. It is often used when there are a lot of homogenous, low-­‐cost items in inventory. iii. Formula: Depreciation = Beginning inventory + cost of acquisitions during period – ending inventory c. Group and Composite depreciation i. This method is used to depreciate a group of assets. ii. A group refers to a set of assets that are similar in nature with similar useful lives. iii. A Composite refers to a set of assets that are different in nature and have different useful lives. iv. Depreciation rate formula: Sum of annual straight-­‐line depreciation of individual assets ÷ total asset costs = depreciation v. Example: Asset A B C D total Salvage Value $2,500 $5,000 $30,000 $15,000 $52,500 Cost $15,000 $80,000 $120,000 $75,000 $290,000 Depreciation base $12,500 $75,000 $90,000 $60,000 $237,500 Life 4 5 8 10 Depreciation rate = $35,375 $290,000 = 12% Composite life = $237,500 $35,375 = 6.7 years Straight-­‐
line Depre. $3,125 $15,000 $11,250 $6,000 $35,375 Objective 6: Understand the accounting for disposals and the impairment of an asset “held for use” A. Disposal of an asset a. When a company disposes of an asset the company must remove the initial cost of the asset as well as the accumulated depreciation from the balance sheet. The company may also recognize any cash ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 13 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review received on the disposal of the asset along with any gain or loss. The gain or loss is recognized in continuing operations as other income or loss. b. Example: A company sells a piece of equipment with a cost of $25,000 and a carrying amount of $5,000. They receive $10,000 for the asset. Cash $10,000 Accum. Depre. $20,000 Equipment $25,000 Gain $5,000 B. Impairment a. Assets that are held for use must be tested periodically for impairments i. Impairment occurs when the carrying value of the asset is greater than the market or fair value. ii. An entity may recognize a loss if the value of the asset cannot be recovered. 1. If the sum of the undiscounted cash flows is less than the carrying value of the asset, then the value cannot be recovered. iii. The amount of loss to be recognized is the fair value less carrying value. 1. The fair value is determined by using the most advantageous market. iv. Example: An asset has carrying value of $1,000 and expected undiscounted cash flows of $850. Since the $850 is less than the $1,000, the asset is impaired and must be adjusted for the impairment. The fair value of the asset is determined to be $750. The amount of the loss is $1,000 -­‐ $750 = $250. The asset will now be written down to $750. Any depreciation taken in the future will be taken from the new amount of $750. Journal entry to record impairment: Loss on impairment $250 Accumulated Depreciation $250 The value of the asset cannot be recovered in future periods. Objective 7: Know how to calculate depletion of an asset A. Depletion is used to account for the use of natural resources owned by a company. Depletion is essentially depreciation for natural resources. B. The rate of depletion is determined by dividing the amount of units of natural resources used in a period by the total amount available. This rate is then used to deplete the development costs which include exploring, drilling, excavating and other costs to prepare the resource for extraction. C. Formula: Units extracted during period
x Costs Total exp ected units to berecov ered
©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 14 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Objective 8: Understand the accounting for goodwill and other intangible assets A. Intangible assets are assets that have no physical presence. a. Examples include: i. Copyrights ii. Patents iii. Goodwill iv. Trademarks v. Franchise Agreements B. Accounting for the acquisition of intangibles a. If the asset is purchased, then it should be recorded at cost. The cost also is considered to be the fair value of the intangible b. Any intangible assets that are developed within the company rather than purchased should be expensed as research and development costs. The only exception is any costs to register a patent. These should be recorded at cost. C. Acquisition of goodwill a. Goodwill is primarily tested in BEC. However, there are a few concepts that you need to know for this exam. b. Goodwill is only recognized when one company purchases another company in its entirety. A purchase of a portion of a company does not produce goodwill. c. The amount of goodwill recognized is the difference between the fair value of the company (or individual reporting units within the company) and the value of all the assets and liabilities of that company (or reporting unit). i. Example of allocation of goodwill to a reporting unit: ABC Company acquired all of the assets of XYZ Company for $1,000,000. The assets relate to three separate operating units of XYZ; X, Y and Z. The fair value of segment X at the time of acquisition was $400,000 and the total value of the assets and liabilities were only $350,000. The amount of goodwill assigned to the operating unit X would be $50,000 ($400,000 -­‐ $350,000). D. Amortization of intangible assets a. If the intangible asset does not have an infinite life or the option to extend the life, then the asset should be amortized using the useful life of the asset. i. Example: ABC Company owns an intangible asset with a useful life of 10 years and a recorded book value of $100,000. Each year (for ten years) the asset should be amortized using the following journal entry: Amortization expense $10,000 Intangible asset $10,000 E. Accounting for the impairment of intangible assets (not including goodwill) a. The impairment on intangible assets is accounted for in the same way as for tangible assets. b. If the intangible asset has an indefinite life, then no amortization should be taken. It should be evaluated each year to determine if the life is still indefinite. ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 15 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review F. Accounting for the impairment of goodwill a. Goodwill should be reviewed annually to determine if it is impaired. i. Impairment of goodwill should be examined at the operating segment level or one level below b. If the fair value of the reporting unit is not less than the carrying cost of the goodwill then goodwill is not impaired and the goodwill tests are not necessary. If, however, it is determined that it is likely that the fair value is less than the carrying cost, then goodwill tests must be performed. i. The impairment test requires two steps: 1. Step one: the fair value of the reporting unit is compared to the carrying value a. If the carrying value exceeds the fair value and zero, then the second step is performed. b. If the carrying amount is less than zero or zero, then step two should also be performed. 2. Step two: The implied fair value of the reporting unit’s goodwill is compared to the carrying amount of the goodwill a. Implied goodwill is determined by comparing the total value of the reporting unit’s assets and liabilities to the carrying value assigned to them. This is the same process as when goodwill was first valued. b. If the implied value is greater than the carrying value of goodwill, then goodwill should be written down to match. Example: ABC Company is performing the test of impairment of the reporting unit A. The first test of goodwill has been performed and the company has moved on to step two. The reporting unit has been valued at $1,500,000 but has a carrying amount of $1,750,000. The goodwill was reported at $200,000 when the segment was purchased. The fair value of the assets and liabilities is $1,400,000. The implied goodwill is $100,000 ($1,500,000 -­‐ $1,400,000). Because the implied goodwill of $100,000 is less than the recorded goodwill of $200,000, the goodwill is impaired and must be written down with the following journal entry. Impairment loss $100,000 Goodwill – Unit A $100,000 Objective 9: Know how to account for various costs A. Reporting for start-­‐up costs a. Start-­‐up costs should be expensed as incurred. i. The following are considered start-­‐up costs: 1. One-­‐time activities related to the start of a new company 2. The opening of a new facility 3. Costs to start a new process within an existing facility 4. Costs to engage a new class of customer ii. The following are not considered start-­‐up costs. 1. Any ongoing efforts to improve existing ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 16 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review a. Products b. Services c. Facilities B. Computer software costs a. There are three different categories of software costs to account for. i. Costs incurred pre-­‐technological feasibility 1. These costs are expensed in the year incurred as research and development ii. Costs incurred post-­‐technological feasibility but pre-­‐market feasibility 1. These costs are amortized after the software has reached market feasibility. 2. The amount amortized is the greater of: Straight-­‐line amortization Or (Current revenue ÷ Expected revenue) x Cost iii. Costs incurred post-­‐market feasibility 1. These are the costs of duplicating the software and packaging the product for sale. 2. They are expensed to COGS as the product is sold. C. Research and development costs a. R&D costs should be expensed when incurred. i. The following are exceptions to the expense rule: 1. If the intangible or fixed assets were purchased from another company with alternative future uses (meaning the asset won’t always be used for its current purpose), then it should be capitalized and amortized over the useful life. 2. Patents and equipment purchased from other parties should be capitalized and amortized. 3. R&D expenses incurred on behalf of another company are not required to be expensed. The costs should be deferred and matched to revenues received for doing work for another company. Objective 10: Know IFRS for fixed assets A. One of the areas that IFRS differs significantly from GAAP is in the area of fixed assets. There are assets classified as noncurrent under GAAP which are categorized as something else under IFRS. IFRS requires specific categories for noncurrent assets such as plant, property and equipment, investment property, intangible assets and biological assets. B. Plant, Property and Equipment a. When any PP&E is acquired it is recorded at the purchase cost plus any costs incurred to get it ready for use. b. The PP&E account is broken down into categories (e.g. cars, buildings, equipment, office furniture, etc.) i. Each category is then valued yearly using either the cost model or the revaluation model. c. The following depreciation methods are allowed by IFRS: ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 17 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review i. Straight-­‐line ii. Sum of the years’ digits iii. Units of production iv. Declining balance d. Companies must depreciate each component of an asset individually. e. If using the cost model, the asset is measured at the cost less any accumulated depreciation and less any accumulated impairment costs. f. If using the revaluation model, then the asset is carried on the books at the fair value at the date of revaluation less any accumulated depreciation and less any accumulated impairment loss. i. Used when an asset’s fair value can be easily measured. ii. Revaluation is not necessary every year, but when it is done it must be done for the entire class of assets. C. Investment property a. Investment property is property that is held for renting, appreciation, or both. i. The property cannot be used for any normal business activities such as being used to add production, used to render services, or for administrative purposes. ii. The property may also not be held for sale in the ordinary course of business. iii. Investment property is initially recognized at cost. Then the company may use either the cost model or the fair value method moving forward. 1. With the fair value method, no depreciation is recognized and any change in fair value of the asset is recorded as profit or loss each year. 2. The cost model for investment property is the same as for PP&E. iv. If the investment property is leased under an operating lease, then the entity can record the lease as an asset if the fair value is easily measured. Once this option is chosen for one property it must be used by all other leased property. D. Intangible assets a. Intangible assets are categorized as either identifiable or unidentifiable. b. If the asset is acquired, then it is recorded at cost. i. If it is acquired through the purchase of a business or in a business combination, then the asset is recorded at fair value. c. Internally generated intangible assets are not recognized as assets. d. Research costs are expensed in the period incurred e. Development costs are recognized as intangible assets if the following conditions exist: i. The technological feasibility of completing the asset has been reached ii. The asset can be sold or used iii. The company intends to sell or use the asset iv. The company can determine how the asset will effect or generate future economic benefits v. The resources necessary to complete the asset are available vi. The entity can measure the expenditures that correspond with the asset f. If the previous conditions are not met, then development costs are expensed in the period incurred ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 18 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review g. Intangible assets may have indefinite lives or finite lives. If the lives are finite, then the asset is amortized based on the useful life of the asset. If the asset has an indefinite life, then it is tested for impairment each year but not amortized. h. Intangible assets are valued either using the cost method or the revaluation method. i. The assets can only be valued using the revaluation method if there is an active market for the item. ii. Any changes using the revaluation method are recoded in other comprehensive income. E. Impairment of assets a. Assets are evaluated each year for impairment. b. If the carrying value of the asset is greater than its recoverable amount, then the asset is impaired. i. The recoverable amount is the greater of the net selling price or its value in use. c. If the asset is valued at historical cost, then the impairment is expensed in the period incurred. d. If the asset is valued using the revaluation method, then the following apply: i. If the asset had been written-­‐up, that amount may be reduced back to cost and any remaining impairment is expensed. ii. If there were no write-­‐ups to the asset, then the entire amount is expensed. e. The major difference between GAAP and IFRS is that IFRS allows for impairments to be reversed. F. Biological assets a. IFRS uses this category to represent any living animals or plants owned by the company. It is a separate category listed on the balance sheet. b. These assets are recognized when: i. The future economic benefits are probable ii. The entity controls the asset based on past events iii. The cost can be fairly and accurately measured c. Agricultural assets are measured at fair value less any costs to harvest the assets. ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 19 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Questions Objective 1: Question 1: Lox Company acquires land and a building for a lump sum of $1,600,000. There is no information to determine the fair value of each asset except for the tax appraisal. The appraisal allocates $500,000 to the land and $750,000 to the building. What is the relative fair value of the land? A. $960,000 B. $640,000 C. $500,000 D. $850,000 Objective 2: Question 2: What is the avoidable interest formula? A. Average accumulated expenditures during construction x Interest rate x Construction time = avoidable interest B. Total accumulated expenditures during construction x Interest rate x Construction time = avoidable interest C. (Average accumulated expenditures during construction x Interest rate) ÷ Construction time = avoidable interest D. (Average accumulated expenditures during construction x Construction time) ÷ Interest rate = avoidable interest Objective 3: Question 3: There are three ways to account for a nonmonetary exchange that has commercial substance. Which of the following is not one of the ways to account for a nonmonetary transaction that has commercial substance? A. The asset received is recorded at the fair value of the asset given plus any cash paid, less any cash received B. The asset received is recorded at the fair value of the asset received C. The asset received is recorded at the book value of the asset given plus any cash paid, less any cash received D. The asset received is recorded at the book value of the asset received plus any cash paid, less any cash received Question 4: A nonmonetary exchange is recognized at fair value of the assets exchanged unless A. Exchange has commercial substance B. Fair value is not determinable C. The assets are similar in nature D. The assets are dissimilar Question 5: Amble, Inc. exchanged a truck with a carrying amount of $12,000 and a fair value of $20,000 for a truck and $2,500 cash. The cash flows from the truck are not expected to be significantly different from the cash flows of the old truck. The fair value of the truck received was $17,500. At what amount should Amble record the truck received in the exchange A. $7,000 ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 20 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review B. $9,500 C. $10,500 D. $17,500 Objective 4: Question 6: Which of the following expenses should not be capitalized? A. Expenditures to improve the efficiency of an asset B. Expenditures to increase the useful life of an asset C. Costs of normal repairs of an asset D. Costs to increase the capacity of an asset Objective 5: Question 7: ABC Company has an asset worth $40,000 with a useful life of 5 years and a salvage value of $5,000. Using the sum of the year’s digits method what is the amount of depreciation ABC Company will take in year 3? A. $8,000 B. $7,000 C. $28,000 D. $0 Question 8: ABC Company has an asset worth $40,000 with a useful life of 5 years and a salvage value of $5,000. Using the straight-­‐line method what is the amount of depreciation ABC Company will take in year 3? A. $8,000 B. $7,000 C. $5,000 D. $0 Question 9: Which of the following uses the straight-­‐line depreciation method? Group Depreciation Composite Depreciation A. No No B. Yes No C. Yes Yes D. No No Objective 6: Question 10: During 2010, the management o the West Inc. decided to dispose of some of its older equipment and machinery. By year-­‐end, December 31, 2010, these assets had not been sold, although the company was negotiating their sale to another company. On the December 31, 2010 balance sheet of West Inc., this equipment and machinery should be reported at A. Fair Value B. Carry amount C. The lower of carrying amount or fair value D. The lower of carrying amount or fair value less cost to sell ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 21 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Objective 7: Question 11: What is the formula used to calculate depletion of an asset? A. (Units extracted during the period ÷ total expected units to be recovered) x costs B. (Units extracted during the period ÷ costs) x total expected units to be recovered C. (Units extracted during the period ÷ total units already recovered) x costs D. (Total units extracted ÷Units extracted during the period) x costs Objective 8: Question 12: Which of the following is an intangible asset? A. Copyrights B. Trademarks C. Goodwill D. All of the above Objective 9: Question 13: All of the following are included in start-­‐up costs except A. The opening of a new facility B. One-­‐time activities related to the start of a new company C. Any ongoing efforts to improve existing facilities D. Costs to engage a new class of customer Objective 10: Question 14: IFRS uses this category to represent any living animals or plants owned by the company? A. Biological assets B. Living assets C. Organic assets D. Natural assets Question 15: Which of the following depreciation methods are allowed by IFRS? A. Straight-­‐line B. Units of production C. Sum of the years’ digits D. All of the above ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 22 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Answers Objective 1: 500 Question 1: B Relative Fair Value Method – When land is purchased with a building for a lump sum it is necessary to allocate the costs between the two assets. Land: Tax Fair Value: $500,000 ÷ $1,250,000 = Relative fair value: $1,600,000 x 40% = Building: Fair Value: Tax $750,000 ÷ $1,250,000 = Relative fair Value: $1,600000 x 60% = Journal Entry: Land Building Cash 40% $640,000 60% $960,000 $640,000 $960,000 $1,600,000 Objective 2: Question 2: A The avoidable cost/avoidable interest formula: Average accumulated expenditures during construction x Interest rate x Construction time = avoidable interest Objective 3: Question 3: D There are three ways to account for a transaction that has commercial substance. i. First method: The asset received is recorded at the fair value, which is the fair value of the asset given, plus any cash paid, less any cash received. If the FMV of the asset given is not known, move to the second method. ii. Second method: The asset received is recorded at the fair value which is the FMV of the asset received. If the FMV for either asset is unknown, move to the third method. iii. Third method: The asset received is recorded at fair value which is the book value of the asset given, plus any cash paid, less any cash received. ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 23 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Question 4: B There are two exceptions to using fair value to record the transaction. -­‐
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If the transaction lacks commercial substance If the fair value of the assets are not determinable Question 5: C First, it is important to recognize that in a transaction that lacks commercial substance but boot is received the gain must be recognized for the portion of the boot received. The amount of gain to be recognized is based on the following formula: !
$
Boot Re cieved
#
& x!Total gain=Gain torecognize " Boot Re ceived + FV of Asset Re ceived %
$2,500 ÷ ($17,500 + $2,500) x $8,000 = $1,000 Transaction journal entry: New Truck Cash Old Truck Gain Objective 4: Question 6: C The following expenses should be capitalized: -­‐
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$10,500 $2,500 $12,000 $1,000 Additions (new part of a factory) Additional capacity Expenditures to improve the efficiency of the asset Expenditures to increase the useful life of an asset (overhauls) Refurbishment (replacing old components with new ones but keeping the basic shell of the asset) Objective 5: Question 7: B Sum of the Years’ Digits (SYD) -­‐
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Considered an accelerated depreciation method. Calculating SYD requires two steps. 1. Step one: Determine the denominator for the SYD equation N(N+1) ÷ 2 = Sum of the years in the asset’s life N = number of years in the asset’s useful life ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 24 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review 2. Step two: Calculate depreciation " #of yearsleftinasset'susefullife %
Cost!Salvagevalue
x
' =DepreciationExpense (
)$
# Sumof the yearsinasset'slife &
Sum of the years’ digits calculation: 5(5+1) ÷ 2 = 15 Depreciation: Year 1: ($40,000 -­‐ $5,000) x (5/15) = $11,667 depreciation Year 2: ($40,000 -­‐ $5,000) x (4/15) = $9,333 depreciation Year 3: ($40,000 -­‐ $5,000) x (3/15) = $7,000 depreciation Question 8: B Straight-­‐line method Straight-­‐line formula: ( Asset cost ! Salvage value) = Depreciation Expense
Useful Life
($40,000 – $5,000) ÷ 5 = $7,000 Question 9: C Both group and composite depreciation averages the useful life of multiple assets and depreciates them as if one asset using the average useful life. Both methods use the straight-­‐line depreciation method. Objective 6: Question 10: D These assets would be reported at the lower of carrying value or fair value less the cost to sell. Objective 7: Question 11: A Formula to calculate depletion: Units extracted during period
x Costs Total exp ected units to berecov ered
©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 25 1-­‐855-­‐75-­‐BLACK Financial Accounting and Reporting Exam Review Objective 8: Question 12: D Intangible assets are assets that have no physical presence. Examples include: i.
ii.
iii.
iv.
v.
Copyrights Patents Goodwill Trademarks Franchise Agreements Objective 9: Question 13: C The following are considered start-­‐up costs: -­‐
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-­‐
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One-­‐time activities related to the start of a new company The opening of a new facility Costs to start a new process within an existing facility Costs to engage a new class of customer The following are not considered start-­‐up costs. -­‐
Any ongoing efforts to improve existing a. Products b. Services c. Facilities Objective 10: Question 14: A Biological assets – IFRS uses this category to represent any living animals or plants owned by the company. Question 15: D The following depreciation methods are allowed by IFRS: i.
ii.
iii.
iv.
Straight-­‐line Sum of the years’ digits Units of production Declining balance ©Black CPA Review www.BlackCPAreview.com Page 5 -­‐ 26