Instructor Notes to Accompany
Intermediate Financial Accounting
ACG 3101
Fall 1997
Marilyn T. Zarzeski, Ph.D., CPA
(Cocoa) Room 347 / 632-0098 x65578
(Orlando) BA 466 / 823-2150
zarzeski@pegasus.cc.ucf.edu
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1
Review of Accounting Basics (Chapters 3, 4, & 5)
USING THE VARIOUS TYPES OF ACCOUNTS
To Increase
Assets
Liabilities
Owners' Equity
,
,
,
DEBIT
CREDIT
CREDIT
Revenue/Income
Expenses
,
,
CREDIT
DEBIT
Income Statement Accounts
Dividends
,
DEBIT
Statement of Retained Earnings Account
Balance Sheet Accounts
To Decrease any of the above, do the opposite.
Try to become friends with ALICE; she will help you to recall the normal balance of the six
types of accounts. Question: What is the sixth type of account that is not shown below?
D
D
Assets
Liabilities
C
Income/Revenue
C
Capital/Stk. Equity
C
Expenses
To Do: Draw a large stomach on ALICE so that you now see a large “D” on the above diagram.
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2
HOW TO DO DEBITS AND CREDITS
Step 1:
Remember that there is only one meaning of a DEBIT and one meaning of a
CREDIT: (In accounting, that is!)
a)
b)
c)
Step 2:
DEBIT means LEFT SIDE
CREDIT means RIGHT SIDE
And.....DEBITS must equal CREDITS in an entry
Read the transaction given in words and numbers.
What accounts (Accts) are involved?
* Example:
Buy equipment for $10,000 and sign a promissory note for $7,000.
Accts:
EQUIPMENT, NOTE PAYABLE,
($10,000)
($7,000)
CASH
($3,000)
Step 3:
What TYPE of Account is each?
* EQUIP

Asset
NP

Liability
CASH

Asset
Step 4:
What is the NORMAL BALANCE of above account TYPES?
* EQUIP

Asset

DEBIT
Think of:
NP

Liability

CREDIT
CASH

Asset

DEBIT
Step 5:
Are we INCREASING or DECREASING each account?
* EQUIP
+
(increase)

DEBIT
NP
+
(increase)

CREDIT
CASH
(decrease) 
CREDIT
Step 6:
To INCREASE any account, do its NORMAL BALANCE
Equip 10,000
To DECREASE any account, do opposite of NORMAL BALANCE
NP
ZAR3101.doc
A
L
I
C
E
7,000
Cash 3,000
3
Understanding the Effect of Accounting Entries
When the accountant records payment of the telephone bill that just arrived today,
what effect is there on the following items? (Note: be sure that someone has not
already accrued the expense and liability.)
Your Thought Process
• Revenue or Gain
• Expense or Loss
• Dividend
1.
What is the entry?
Telephone Expense
Cash
2.
What kind of account is each
part of the entry?
Telephone Expense is an
EXPENSE
Cash is an ASSET  current
3.
Answer the above questions. Always start with NI first . . . since NI
affects Stk. Eqty.
• Asset
• Liability
• Stk. Eqty.
HINT:
Make up some numbers, if it helps you to understand the situation better.
a)
Net Income?
Decreases because expenses are higher 
NI is lower now.
b)
Assets?
Decreases because cash is being given away
c)
Liabilities?
No Effect (neither account is a Liability)
d)
Stockholders’ Equity?
Decreases because NI decreases
e)
Current Ratio?
( CA )
( CL )
ZAR3101.doc
CA
CL
=
Decr. =
Decrease
NE
 No Effect
4
ADJUSTING JOURNAL ENTRIES (AJE'S)
WHY?
a)
b)
Because GAAP requires ACCRUAL BASIS of accounting. In order to show
proper revenue earned during a period and proper expenses which helped
to earn the revenue.
Revenue Principle - Normally recognize revenue when the service is
rendered or when the title to the product is transferred from seller
to buyer.
Matching Principle - Within the same time period, recognize the expenses
that helped the company to earn the revenues.
WHAT?
AJE's are journal entries usually prepared at the end of the each month,
prior to preparation of the monthly financial statements. True AJE's contain
either an expense or a revenue. NOTE: In the text and on exams, annual
AJE's are often required, so read carefully.
TYPES?
I.
Accruals (Revenue has been earned or Benefit has been received BUT NO CASH
has yet been exchanged.)
Examples:
AJE's
A) Salary Expense
Salary Payable
B) Interest Receivable
Interest Revenue
Subsequent
entries
when CASH
is exchanged
A) Salary Payable
Cash
B) Cash
Interest Receivable
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5
II.
Deferrals (Cash has been exchanged prior to the AJE BUT the revenue or
expense has NOT been journalized until the AJE is written).
Examples:
Cash
exchanged
PRIOR to
getting use
or giving a service
A) Prepaid Insurance
Cash
B) Cash
Unearned Revenue
AJE's
A) Insurance Expense (Benefit)
Prepaid Insurance
B)Unearned Revenue
Revenue
(Service Rendered)
NOTE to Students: The accountant may not record the original entry into prepaid (asset)
or unearned (liab.). The accountant may just expense it all or
revenue it all at the receipt of CASH.
CASH
exchanged
PRIOR to
getting use or
giving a service
Y) Insurance Expense
Cash
Z) Cash
Revenue
AJE
Y) Prepaid Insurance (not used) Z) Revenue
Insurance Expense
Unearned Revenue
(service owed)
III.
Allocations of Cost (As a long-lived asset is used, some expense must be
recognized.)
Examples:
Purchase
of Asset
A) Equipment
Cash
AJE's
A) Depreciation Expense
B) Amortization Expense
Accumulated depreciation
Franchise
or
Accum.
(contra asset)
Amort.
ZAR3101.doc
B) Franchise
Note Payable
6
STEPS IN THE CLOSING PROCESS
WHAT?
A closing entry is an entry that makes an account balance ZERO.
1.
Close all revenue-type accounts into the income summary account.
2.
Close all expense-type accounts into the income summary account.
3.
Close the income summary account into the retained earnings account.
4.
Close dividends account into the retained earnings account.
WHY?
To start a new operating period with a clean slate, it is necessary to start
with zero balances in the revenue and expense and dividends accounts.
Note:
•
Closing entries are usually prepared annually.
•
Only the temporary (nominal) accounts are closed.
•
The post-closing trial balance should contain only assets, liabilities,
and equity accounts (the permanent accounts).

Note: Many companies do not use the Income Summary Account;
they merely close all temporary accounts directly to the Retained
Earnings account (if a Corporation) or the Capital account(s) (if a
Sole Proprietorship or Partnership).
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7
PROBLEM 3 - 7
Beg. = Unadjusted Balance
CASH
Beg. 15,000
Dues Receivable
Beg. 13,000
Rent Receivable
Unexpired Insurance
Beg. 9,000
Salaries Payable
_____Utilities Exp.___
Beg. 54,000
___Bad Debt Expenses
Unearned Rev.
Salaries Exp.
Beg. 80,000
Allowance for
Doubtful Accounts
1,100 Beg .
Land
Beg. 350,000
Buildings
Beg. 120,000
Accum. Depr.-Bldg
48,000 Beg.
Equipment
Beg. 150,000
ZAR3101.doc
Common Stock
400,000 Beg.
R.E.
Maintenance Exp.
Beg. 24,000
Depr. Exp. - Bldg.
72,400 Beg.
Revenues - Dues
200,000 Beg.
Revenues - Green Fees
8,100 Beg.
Accum. Depr.-Equip
70,000 Beg
Depr. Exp. - Equip
Insurance Exp.
Rental Revenue
15,400Beg
8
ERROR CORRECTIONS
Situation: We purchase machinery for $10,000 on March 1, 1995. We anticipate using the machinery for
three years and then hope to sell it for $1,000.
I.
If Error is discovered prior to closing the books:
(This is NOT a Prior-Period Adjustment.)
Error Done
3/17/95 Machinery Expense 10,000

Cash
10,000
Should Be
Ask yourself: "What is Wrong?"
Incorrect

OK
Ask yourself: "What should have

been the entry?"
Machinery 10,000
Cash 10,000
CORRECTION OF ERROR
Correct only the mistake
9/28/95 Machinery 10,000

Machinery expense 10,000
to debit correct account

to reverse error to zero
(Assumed that depreciation entry is done at year-end.)
II.
If Error is discovered after the 1995 books are closed: Two different situations may occur Situation A or B on next page.
Error Done
3/1
Machinery expense 10,000
Cash 10,000


Incorrect
OK
Should Have Been
Machinery 10,000
Cash 10,000
Note:
The difference from above
Ask yourself: 1) "Have any adjusting entries been done?" 2) "Did the error affect the income
statement?"
For the above example:
1)
2)
No adjusting entries were done, but they would have been if MACHINERY had been debited.
Yes, there is too much money in the expenses; therefore, NI is understated until we correct the
error.
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9
II.
(continued)
3)
If done correctly, the following would have occurred:
3/1
Machinery 10,000
Cash 10,000
Assume: 3-yr. life
1,000 salvage
10,000
-1,000
9,000
9,000 x 1/3 = 3,000/yr.
1995
12/31 Dep. Exp. 2,500
Accum. Dep. 2,500
Error
Machinery Exp
10,000
3,000 x 10/12 = 2,500 (10 months' usage)
Cash
10,000 OK
SITUATION A:
Correcting Entries (after the 1995 closing process occurred, BUT before the financial statements are
released.) (This is NOT a prior-period adjustment.)
in
early
1996
Correcting (for 1995):
Machinery 10,000
Retained Earnings 10,000
Dep. Exp.
2,500
Accum. Dep.
Closing (for 1995):
RE
2,500
Dep. Exp.
2,500
These entries should be backdated to 12/31/95.
This situation is NOT a PriorPeriod Adjustment
_
2,500
SITUATION B:
Correcting entries (after the 1995 financial statements are released; in other words, during the next year).
THIS IS A PRIOR-PERIOD ADJUSTMENT (PPA) that is placed on the statement of Retained Earnings in
1996.
in
mid
1996
Machinery 10,000
Retained Earnings-PPA 10,000
Retained Earnings-PPA 2,500
Accum. Dep. (1995)
2,500
NOTE: Do not debit an expense this
(1996)year if
the dep. expense relates to last year!
Date the entries with July, 1996 date.
The NI was understated due to overstated
EXPENSES.
RE is understated because Mach. Exp.
was closed into RE.
1996
Dep. Exp.
1,500
(Assuming you discover the error at
the beginning of July 1996.)
Accum. Dep.
1,500
(First half year of usage)
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Chapter 3 -- Appendix
IA. To find ONLY cash revenue or ONLY cash expense
Accrual to Cash
Revenue
Expense
If A  , then -
If A  , then +
If A  , then +
If A  , then -
If L  , then +
If L  , then -
If L  , then -
If L  , then +
EXAMPLE:
Given: Accrual Revenue is $1,400,000 for 1996
Required: What is the Cash Revenue for 1996?
a)
What ASSET and/or LIABILITY accounts relate to revenue?
Accounts Receivable
b)
of
What is the NET change in the Accounts Receivable account--from the beginning
the year to the end of the year?
Accounts Receivable (AR)
Beg. 410,000
_______________
End. 520,000
The NET change is an increase of $110,000.
c)
Reasoning: Since AR is an asset and it increased, then subtract $110,000 from
the accrual revenue of $1,400,000. Therefore, the CASH revenue is $1,290,000.
BEWARE:
 Name of accounts can be misleading.
 Asset accounts:
 Liability accounts:
a) Receivables
a) Payables
b) Prepaids
b) Unearned Revenues
c) Deferred Expenses
c) Accrued Expenses
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IB. To find ONLY accrual revenue or ONLY accrual expense
Cash to Accrual
Revenue
Expense
If A  , then +
If A  , then -
If A  , then -
If A  , then +
If L  , then -
If L  , then +
If L  , then +
If L  , then -
EXAMPLE: (Ex 3-23 -- Cash expenses only)
Given: Cash expenses are $55,470 for 1995.
Required: What are the Accrual expenses for 1995?
a)
What ASSET and/or LIABILITY accounts relate to the expenses?
Accrued Expenses (miscellaneous payables)
Prepaid Expenses (miscellaneous assets that are paid in advance of usage)
b)
What is the NET change in each of the accounts?
Accrued Expenses DECREASED by $1,327 from beginning to end of year.
Prepaid Expenses DECREASED by $142 from beginning to end of year.
c)
Reasoning:
Since Accrued Expenses is a liability and it decreased, then subtract $1,327 from
Cash expenses.
Since Prepaid Expenses is an asset and it decreased, then add $142 to Cash
expenses.
Therefore, $55,470 (cash expenses)
- 1,327 (net change in Accrued Liabilities)
+ 142 (net change in Prepaid Expenses)
= $ 54,285 (EXPENSES based upon ACCRUAL ACCOUNTING
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12
IIA. To find cash NET INCOME
Accrual to Cash
Revenues and Expenses
If A  , then If A  , then +
If L  , then +
If L  , then EXAMPLE: Statement of Cash Flows (Indirect Method)
The CASH FLOWS FROM OPERATING ACTIVITIES must be prepared from the
Accrual Income Statement. In other words, the accountant converts the Accrual Net
Income to Cash Net Income (also known as Cash Flows from Operating Activities).
a) Start with Net Income per accrual accounting.
b) Determine whether related current assets and current liabilities have increased or
decreased from the beginning to the end of the year (accounting period). Calculate
the NET CHANGE for each related account.
c) Use chart above to determine whether to add or subtract the NET CHANGE to the
Net Income per accrual accounting.
d) The ACCRUAL Net Income plus or minus the NET CHANGES equals the CASH Net
Income (Cash flows from operating activities).
IIB. To find accrual NET INCOME
Do the opposite of IIA Chart.
Start with CASH Net Income and adjust to ACCRUAL Net Income.
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13
From CASH BASIS to ACCRUAL BASIS
Example:
(Cash to Accrual Basis) Joan E. Robinson, M.D., maintains the accounting records
of Robinson Clinic on a cash basis. During 1997, Dr. Robinson collected $142,600
from her patients and paid $55,470 in expenses. At January 1, 1997, and
December 31, 1997, she had fees receivable, unearned fees, accrued expenses,
and prepaid expenses as follows (all long-lived assets are rented):
January 1, 1997
Fees receivable
Unearned fees
Accrued expenses
Prepaid expenses
$9,250
2,840
3,435
2,000
December 31, 1997
$16,100
1,620
2,200
1,775
Instructions
Prepare a schedule that converts Dr. Robinson "excess of cash collected over cash
disbursed" for the year 1997 to net income on an accrual basis for the year 1997.
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Solution to Example:
Dr. Robinson does CASH Accounting
Cash Rev $142,600
Cash Exp
55,470
Cash NI
87,130
IF she did ACCRUAL BASIS, her GL Accounts would be as follows:
Cash Rev
1
Fees Rec.
142,600
B
9250
2
x
Unearned Fee Rev.
2840 B
142,6001
3
4
E
1620 E
16100
Rev.
149,450 2
9250 + X - 142,600
= 16,100
3
X = 16,100 + 142,600 - 9,520
X = 149,450
4
$150,670
Per Solutions Manual:
149,450 =
ZAR3101.doc
Cash Rev.
142,600
Add
16,100
2,840
Subtract
Accrual Rev.
9250
150,670
1620

the net change affects Revenue
in the Accrual-Basis
15
INCOME STATEMENT ITEMS
Exercise 4 - 13
Thought Process:
Income before tax  IBT
- Income Tax Expense  IBT x Tax Rate
= Net Income
 IBT x (1.00 - Tax Rate)
(3) 100% Inc. before tax
(2) 30% Inc. Tax Exp.
(1) 70% NI

START HERE
(4) IBT x 100% = 50 mil
IBT x 30% =_15 mil_
IBT x 70% = 35 mil
(5) IBT 50,000,000
Loss of 18,000,000
(before tax) is included in the IBT
(50 mil + 18 mil)
(6)  IBT before E/O Item = $68 mil.
Partial Income Statement
(7)
(8)
(9)
(10)
Inc. from cont. opns
$68,000,000
Inc. tax expense
20,400,000
(68 mil. x 30%)
Inc. before E/O Loss
47,600,000
E/O Loss
(net $5.4 mil. tax benefit)
12,600,000 (18 mil. x 30% = $5.4 mil.)
(11) NI
(12) Preferred Dividends:
$4,500,000 x 8%
= $360,000 div.
EPS = NI - Pref. Div =
# COMMON Shares
Outstanding
ZAR3101.doc
$35,000,000
Per Share Data:
$ 12,600,000
10,000,000 sh.
$35 mil. - $360,000
10 mil. sh.
(14)Inc.Bef. E/O $4.72
(13)E/O Loss
NI
= $3.46
(1.26)
$3.46
16
Company Name
Statement of Cash Flows
FYE 12/31/97
INDIRECT METHOD
Note:
Do Not use +'s and
-'s on the formal
statement.
Use parentheses for
CASH outflows.
Cash Flows from Operating Activities:
Net Income
± _'s in CA and CL, excluding S.T. Rec. and S.T. NP
+ Deprec. Exp., Amortiz. Exp., Depletion Exp.
+ Losses
- Gains
± Other non-cash flows related to operations
Net Cash Flows from Operating Activities
$
A
Cash Flows from Investing Activities:
± Property, Plant, and Equip.
± Other Operating Assets, e.g., Intangibles
Not the deprec exp.
± Investments in Stocks, Bonds, Mutual Funds, etc.
Short-term AND
Long-term
Not the int. income
and Not the dividend
income
± Notes Receivable, Loans Receivable, etc.
Net Cash Flows from Investing Activities
$
B
Cash Flows from Financing Activities:
± Common Stock, Preferred Stock
(including Paid in Capital Accts.)
± Treasury Stock
Short term
and
Long term
± Bonds Payable, Notes Payable
- Dividends, Drawings
Net Cash Flows from Financing Activities
Obtain from Balance Sheet
ZAR3101.doc
Net Increase (or Decrease) in Cash
$
Cash Balance, Jan. 1
$
Cash Balance, Dec. 31
$
$
C
(A+B+C)
Place this on
the Balance Sheet
17
Statement of Cash Flows
DIRECT METHOD
Problem 24-6
(Revenue)
Cash In
CA , CA , +
CL , +
CL , -
(Expense)
Cash Out
CA , +
CA , CL , CL , +
OPERATING ACTIVITIES:
ACCRUAL
CASH
Related
CA / CL
Inc. Stmt
Sales
1,007,500
CGS
AR
Inven 
403,000
AP
S & A Exp. 222,000
* L.T. Invest. Rev
115,000


Am't (000)
SCF
34  -34
973,500
60 +
 +35
25
438,000
Dep. Exp.
- 40-25
GW Exp.
-2
Prepaids
 6  -6
Supplies
 3  -3
Accrued Liab.  9.62 -9.62 136,380
(Not on exam)
See T-Account*
L.T. Invest 75 -75 40,000
55,000
S.T. Invest Rev. 15,000
Intrest Exp.
99,000
Inc. Tax Exp. 154,000
No Related Acct.
15,000

Bond Discount  13.88  -13.88
"Contra-liability"
Tax Pay  11 -11
85,120
143,000
Note 1: Gain on Sale of Equipment is NOT a cash flow; therefore, ignore it in the DIRECT
METHOD.
Note 2: Dividends that our company gives are NOT an Operating activity.
Note 3: The "Cash IN" scheme is also used to prepare the Cash Flow from Operating
Activities for the INDIRECT METHOD.
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18
SCF - DIRECT METHOD
(PROBLEM 24-6)
INVESTING ACTIVITIES:
Land
Bldg
500,000
1,300,000
645,000
1,300,000
S.T. Investment
325,000
Equip
550,000
L.T. Investments *
700,000
50,000 115,000
40,000
cash div
500,000
Accum. Dep.-
775,000
Bldg
360,000
Accum. Dep.5,000
Equip
135,000
25,000
40,000
350,000
155,000
400,000
_____Goodwill______
65,000
_Dividends Payable__
80,000
63,000
_0_
FINANCING ACTIVITIES:
LTNP
50,000
BP
1,000,000
P. Stk
500,000
45,000
1,000,000
600,000
PIC - P. Stk
100,000
PIC- C Stk
550,000
115,000
550,000
Discount on BP
64,630
749,630
C Stk
T Stk ____
600,000 40,000
600,000
20,000
RE
150,000
50,750
ZAR3101.doc
874,130
19
Time Value of Money
Chapter 6
INTEREST is the time value of money.
In accounting records, we do NOT record the interest earned or owed UNTIL TIME
HAS PASSED from the time that we loaned the money or borrowed the money.
Examples:
a) Interest REVENUE cannot be recognized until the “lending service” that we have
provided has occurred over at least one month’s time. At the end of each month, we
can recognize some interest revenue.
b) Interest EXPENSE cannot be recognized until we receive some “benefit” from the
cash that we borrowed...over at least one month’s time. At the end of each month, we
can recognize some interest expense.
Interest CALCULATION:
Interest = Principal x Rate x Time
To use the PRESENT VALUE TABLES, you must know two items:
1) time period (n): the number of time periods that the interest compounds
(Beware: the n does not necessarily mean the number of years that the interest
compounds).
2) interest rate (i): the interest involved within each time period of compounding
======================================================
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20
There are three kinds of PRESENT VALUE situations.
1. PRESENT VALUE OF $1: This is used when you know the LUMP SUM future
amount and you are trying to determine the LUMP SUM present amount of money.
________________________
Present Value of
Future Value of
Lump Sum
Lump Sum
Formula:
PV$ = future value x table factor = fv x tf
To obtain table factor:
1) determine the number of time periods of compounding of the interest
2) determine the interest rate earned for each period of compounding
Example of PV$: You want to know how much money you have to deposit in your local
bank at the beginning of 1996 in order to have $10,000 in the account by the end of
1999. The bank gives 6% interest compounded annually.
Solution:
a)
Draw a time line of the situation:
____________________________________
???
$10,000
1/1/96
12/31/99
b) Decide whether it is a PV$ situation: Yes, it is. The lump sum that we are trying to
find
is at the beginning of the time period (in the present). Also, there is another lump
sum nvolved at the end of the time period.
c)
Determine n and i :
1) n = 4 because there are four years of compounding of annual interest
2) i = 6% because interest is compounded annually and 6% is the annual
interest.
d)
Find the table factor in the PV$ tables. Table 6-2 in the textbook.
e)
Use the PV$ formula and calculate the answer:
PV$ = $10,000 x .79209 = $7,920.90
ZAR3101.doc
tf = .79209
21
2.
PRESENT VALUE OF ORDINARY ANNUITY: This is used when you have
EQUAL
amounts of money involved, over EQUAL intervals of time AND the
amounts of money are
at the END of the period AND you want to find the present
value of those amounts.
_________________________________________________
Present Value
Am’t
Am’t
Am’t
Am’t
of the amounts
Formula: PVoa = Amount x table factor = A x tf
(Note that the Amount is the equal amount of money over equal intervals of
time).
To obtain table factor:
1) determine the number of time periods of compounding of the interest
2) determine the interest rate earned for each period of compounding
Example of PVoa: You want to know how much money you can pay today for new
machinery if you expect that the net cash inflows that the machinery manufacturer tells
you are $5,000 at the END of each year for the next four years. The interest rate that
your money can earn is 8%.
Solution:
a)
Draw a time line of the situation:
_________________________________________
?????
$5,000
$5,000
$5,000
$5,000
b)
Decide what kind of present value problem it is: PV of ordinary annuity. The
number we are trying to find is in the present AND there are equal amounts of money
over equal intervals of time in the future AND the amounts are at the END of the period.
c)
Determine n and i :
1) n = 4 because there are four amounts of money
2) i = 8% because interest is discounted backwards at an 8% rate.
d)
Find the table factor in the PVoa tables. Table 6-4 in the textbook. tf = 3.31213
e)
Use the PVoa formula and calculate the answer.
PVoa = $5,000 x 3.31213 = $16,561 (rounded to nearest dollar)
ZAR3101.doc
22
3. PRESENT VALUE OF ANNUITY DUE: This is used when you have EQUAL
amounts of money involved, over EQUAL intervals of time AND the amounts of
money are at the BEGINNING of the period AND you want to find the present value of
those amounts.
_____________________________________________
Am’t
Am’t
Am’t
Am’t
Present Value
of the Amounts
Formula: PVad = Amount x tfad
(Note that the Amount is the equal amount of money over equal intervals of
time).
For the exams, you will only be given the present value tables for PV $ and PVoa.
Therefore, you will need to convert the PVoa to PVad in order to work the annuity due
problems. To do the conversion, obtain the table factor for the present value of an
ordinary annuity, refer to #2 example above. Then multiply the tf oa x (1.00 + interest
rate in decimals) to obtain the tfad.
ZAR3101.doc
23
Example of PVad: You want to know how much money you must have saved in your
bank and investments when you retire in order to buy an annuity contract from your
insurance agent, such that you will receive $50,000 at the BEGINNING of each year of
your retirement and continuing for 20 years. The anticipated interest rate that the
insurance company thinks will be in effect when you retire is 6%. How much money
must you have at retirement?
Solution:
a) Draw a time line of the situation:
_________________________________________
$50,000 $50,000 $50,000 $50,000 .....$50,000
(twenty payments)
Retirement Savings?????
b) Decide what kind of present value problem it is: PV of annuity due. The number
we are trying to find is in the present AND there are equal amounts of money over
equal intervals of time in the future AND the amounts are the BEGINNING of the
period.
c)
Determine n and i :
1) n = 20 because there are twenty amounts of money
2) i = 6% because interest is expected to be earned on the funds at this rate
during your retirement years.
d) Find the table factor in the PVoa tables and multiply it by 1.06 (Table 6-4 in
textbook).
tfoa = 11.46992
Then, multiply 11.46992 x 1.06 to obtain the tf ad
tfad = 12.15812
(For your homework, you can check whether you have
calculated this table factor correctly. Look at Table 6-5
for n=20 and I=6% and you will find 12.15812!)
e)
Use the PVad formula and calculate the answer.
PVad = $50,000 x 12.15812 = $607,906 (rounded to nearest dollar)
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24
SHORT-TERM RECEIVABLES
A. Difference Between Accounts Receivable and Short-Term Receivables
•
AR = receivables which arise from selling goods and
services to customers because cash is owed;
normally collectible in 30 to 60 days, therefore no
interest is usually paid by customer. AR are called
open accounts.
Accrual Accounting
Sale of Service
Sale of Product
AR
AR
Service Rev.
Sales
Collection of AR
Cash
Caution: PV Concept not used on
AR
AR because time to collection is so short.
•
S.T. Note Receivable =
How notes
get on the STNR
books
Cash
receivables which involve promissory notes;
often easier to enforce than open accounts
(AR)


\
Principal
Interest
Maturity Date
STNR
STNR
Fee Revenue
Sales
STNR
AR
B. Cash Discounts = given to customer to encourage prompt payment of AR
Examples
2/10, n/30
 2% discount if paid within 10 days of invoice date, otherwise, pay
net (all the AR) within 30 days
(Note: n = gross amount)
n/10, EOM  net amount of sale is due no later than 10 days after the end of the
month
Quantity
Discounts
 a reduction in per unit prices if a large quantity is purchased;
quantity discounts are NOT reflected in accounting record.
Markdowns  reductions in sale prices normally due to decreased demand; e.g.,
retail stores' sales; markdowns are NOT reflected in the accounting
records
ZAR3101.doc
25
Accounting for Cash Discounts
$1,000
3/10, n/60
Entry at
Sales Date:
Gross Method
(1) More practical
Net Method
(1) Theoretically better
(2) Bkkping more tedious
(3) Better internal control,
especially for AP (buyer)
AR 1,000
Sales 1,000
AR
Sales
Case 1:
Cash
970
Payment Received
Cash Discount
30
within 30 days
AR
1,000
Cash
Case 2:
Payment received
after 10 days
but ‹ 60 days
Cash
Cash
AR
970
1,000
1,000
970
970
AR
970
1,000
AR
970
Cash
30
Discount not taken

Rev. acct. that
becomes part of
"Other Rev. & Exp."
Difference in Methods are usually immaterial, per auditors; therefore, use either method.
Sales
- Cash Discounts (Purchase Discounts)
= Net Sales
Note:
Economic value of transaction is $970 because
that would be the cash price.
$30 is a potential finance charge
(Expense) to customer fin. chg. revenue to the seller
NOTE: Missing cash discounts costs heavily to the buyer.
ZAR3101.doc
26
C.
Accounts Receivable
•
Two Possible ALLOWANCE METHODS:
(A) Percentage of Credit Sales (Adheres to Matching Principle  Income Statement)
(B) Percentage of Receivables (Adheres to Net Realizable Value  Balance Sheet)
(Aging Method)
•
Five Basic Entries:
(1) Sale on Credit

AR
Sales
AR
Collection (2)
(1) Sales
Sale
Sales (1)
W/O (3)
(2) Collection on AR  Cash
(4) Recovery
AR
(3) Write-off of an
account
Recovery (4)
 Allowance
AR
Allowance
(3) W/O
Recovery (4)
AJE (5)
 AR
Allowance
(4) Recovery of a
write-off

Cash
AR
Bad Debt. Exp.
(5) AJE
Cash
(2) Collect
(4) Recovery
(5) AJE (at end 
of period)
ZAR3101.doc
(Bad Debt Exp.)
Uncollectible Accts. Exp.
Allowance for Doubtful Accts.
27
Allowance Method for Receivables
Examples
Note:
Assume that the unadjusted Balance = $1,000 credit
(A) % of Sales
(B) % of Receivables

 

NET CREDIT SALES
END-OF-PERIOD
for the period
Balance in Accts. Rec.
2% x 300,000 = $6,000
10% x 40,000 = $4,000

AR

40,000
Allowance __
1,000
Unadjusted
4,000
Adjusted
The calculated am't
3,000 AJE
goes in the AJE.
Allowance
1,000 Beg.
Unadjusted
6,000 AJE
7,000 Adjusted
AJE for A:
Bad Debt Expense
Allowance
6,000
6,000
NOTE: The AJE is the calculated amount
in the % of Sales Method.
ZAR3101.doc
The calculated am't goes
in the End-of-Period
balance: the adjusted balance
AJE for B: (depends on unadjusted balance
of allowance account)
Bad Debt Exp.
3,000
Allowance
3,000
CAUTION: The AJE is NOT the
calculated amount in the % of Receivables
Method.
28
Theoretical View
1.
2.
(minus)

Net Realizable Value (NRV) = AR - Allowance for Doubtful Acc'ts (contra asset account)
The Allowance is the amount that is estimated to go "bad."
Recognizing Bad Debt Expense PRIOR to the actual write-off is consistent with the
MATCHING PRINCIPLE. Match this year's sales with the % of this year's sales that are
expected to be uncollectible in the future (Bad Debt Expense).
Over or underestimated Bad Debt Expense can eventually cause a significant debit or credit
accumulation in the Allowance account; in such cases, the company should change the
estimating formula and ajust the Allowance account to a reasonable value.
cause
Overestimates  credit balance in Allowance Account of bad debts
and vice versa
Aging Schedule Method  good management tool for the collection department; this method is
a more specific type of % of Receivables Method.
• DIRECT WRITE-OFF METHOD
GAAP says to use this in the following cases ONLY:
- unable to reasonably and objectively estimate bad debts
CASE 1:
CASE 2:
only a few high dollar accounts of receivables
all customers are companies, which usually pay their debts
Accounting for Direct Write-Off Method:
1) NO AJE is needed at end of accounting period
2) Only prepare entry when an account is written off
Bad Debt Expense
AR
Why not recommended:
1) No use of matching principle
2) AR may be overstated
Accounting for Sales Returns:
Returns result in:
1) removal of AR or
2) granting of future credit
1) Sales Returns
AR
ZAR3101.doc
2)
Sales Returns
AR or Allowance for Returns
29
D. NOTES RECEIVABLE (NR)
Two Methods for Accounting of NR:
1.
a) Record the principal into the NR account.
b) Accrue1 interest receivable and interest revenue as time passes.
2.
a) Record the principal and the interest into NR. Record interest in a
DISCOUNT ON NOTE RECEIVABLE account.
b) Recognize interest revenue as time passes, by amortizing the
DISCOUNT ON NOTE RECEIVABLE. (Amortizing means to
spread the Discount over the future time period.)
Journal entries vary BUT. . . . . . . . .
there is NO difference between the Balance Sheet and Income Statement Values.
1.
Note 1:
Note Rec. 10,000
2.
Note 2:
Note Rec.
Less Discount on NR
11,200
1,200
10,000
NOTE: INTEREST is the time value of money.
I = Principal x Rate x Time
* * * DO NOT recognize interest revenue or interest expense until TIME PASSES.
CASH Interest
= Principal x Stated Rate x Time
EFFECTIVE Interest
= Carrying Value2 x Effective Rate x Time
1
ACCRUE means to come into existence as a legally enforceable claim. (For example, a receivable or
a payable arises.)
2 Carrying Value = Note Receivable Minus Discount on Note Receivable.
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30
NOTES RECEIVABLE
Note 1:
Note 2:
Interest Bearing Note
Non-Interest-Bearing Note
Note A
Note B
12% Rate
for each note
$10,000
Due in one year
12%
$11,200
Due in one year

No interest typed on
the note, but interest
is implied in the deal.
• Issue Date
1/2/91
Note Rec. 10,000
Cash
10,000
• • 12 Monthly AJEs
Note Rec. 11,200
Cash
"Interest"Disc. on NR
Interest Rec. 100
Interest Rev. 100
• • • Maturity Date
12/31/91
Cash
11,200
Note Rec. 10,000
Interest Rec. 1,200
10,000
1,200
Disc. on NR 100
Interest Rev. 100
Cash
11,200
Note Rec. 11,200
Notes Payable would have mirror-image entries:
• Cash
N Pay
• • Int. Exp.
Int. Pay
• • • N Pay
Int. Pay
Cash
ZAR3101.doc
• Cash
Disc. on NP
NP
• • Int. Exp.
Disc. on NP
• • •N Pay
Cash
31
Interest Bearing Note
Chapter 7
Page 335, Textbook
1/1/95
12/31/95
12/31/96
12/31/97
N. Rec
Disc. on NR
Cash
10,000
Cash
Disc. on NR
Int. Rev
1,000
142
Cash
Disc. on NR
Int. Rev.
1,000
159
Cash
Disc. on NR
Int. Rev.
1,000
179
Cash
10,000
N. Rec.
ZAR3101.doc
Supporting Calculations
480
9,520
CV x ER = Int. Rev.
9,520 x 12% = 1,142
+ 142
1,142
9,662 x 12% = 1,159
+ 159
1,159
9,821 x 12% = 1,179
+ 179
1,179
C.V. = 10,000=Note Rec. - Disc.
10,000
32
UNDERSTANDING THE EFFECT OF ACCOUNTING ENTRIES
If accountant forgets to amortize the DISCOUNT ON NOTES RECEIVABLE, what
effect is there on the following items: assets, liabilities, stockholders’ equity, and
profit margin.
Thought Process
1.
What is the entry?
Disc. on NR
Int. Rev
2.
What kind of account is each part of the entry?
3.
Answer the above questions.
Disc. on NR is a Contra-asset
Interest Rev. is a Revenue
Hint: Make up some numbers for the entry, if it
helps you to understand the situation
better.
a)
Profit Margin?
Understated because NI is understated but sales is correct
b)
Total Assets?
Understated because too much DISC. On REC. 
NOTES REC. will be understated
c)
T. Liabilities?
No effect because no liability account is involved
d)
Stockholders’ Equity?
Understated because not enough rev and NI went into
Retained Earning
ZAR3101.doc
33
Non-Interest Bearing Note
Chapter 7
Page 337, Textbook
Present Value
20,000

Future Value
35,247
“IF” sold for cash, entry is:

Cash 20,000
Land 14,000 (orig. cost)
“Interest”
Gain
6,000
= 15,247  place it into Disc. on NR
PV$1
20,000
.5674
= FV x Table Factor (tf)
= 35,247 x tf
= tf
n=5
i =?
Go into PV$1 table to find the interest rate. (12% is the implied rate)
1/1/95
Note Rec.
35,247
Disc. on NR
Land
Gain
Supporting Calculations
15,247
14,000
6,000
CV
12/31/95
12/31/96
12/31/97
12/31/98
12/31/99
Disc. on NR 2,400
Int. Revenue
20,000 x 12% = 2,400
+2,400
Disc. on NR 2,688
Int. Revenue
2,688
22,400 x 12% = 2,688
+ 2,688
Disc. on NR 3,011
Int. Revenue
3,011
25,088 x 12% = 3,011
+3,011
Disc. on NR 3,372
Int. Revenue
3,372
28,099 x 12% = 3,372
+3,372
3,776
31,471 x 12% = 3,776
+3,776
35,247
C.V. = 35,247
Disc. on NR 3,776
Int. Revenue
Cash
ZAR3101.doc
2,400
x ER = Int. Rev.
35,247
Note Rec.
34
Notes Receivable
Implied Interest Rate versus Incremental Interest Rate
Situation: On January 2, 1995, our company receives a non-interest-bearing note for
$20,000 to be paid to us at the end of 1999. In exchange, our company gives a onemonth-old truck with book value of 15,000. As the accountant, you are to prepare the
journal entries for January 2, 1995, and every fiscal year-end until the note matures.
The fiscal year is the calendar year. (Assume that you only depreciate assets that you
have had for at least six months).
Question: At what value do we record the Note?
Answer: a) If we know the fair market value of the truck ($15,670), use that
value. In this case, we compute the IMPLIED interest rate that is evident in the
situation. See the timeline below.
1/2/95
12/31/99
___________________________________________
$15,670
$20,000
Fair Value of Truck
Maturity Value of Note
(This includes principal & interest)
Because there are TWO lump sums on the timeline, this is a present value of a dollar
problem.
n= 5
and
Present value of $1 formula:
i = ? You must compute the implied rate.
PV = FV x table factor (tf)
$15,670 = $20,000 x tf
$15,670/$20,000 = .7835 = tf
Go the present value of $1 tables at n=5 and go ACROSS the line until you find a table
factor that is close to .7835; then go UP from .7835 until you find the interest rate of
5%. That is the IMPLIED INTEREST RATE, implied by the facts of this transaction.
ZAR3101.doc
35
Journal Entries:
1/2/95
Note Receivable
Discount on NR
Truck
Gain on Sale
20,000
4,330
15,000
670
The present value (carrying value) of the note is 20,000-4,330=15,670.
12/31/95
Discount on NR
784
Interest Revenue
784
(Effective interest=Carrying Value x effective rate (implied rate)
(784 = 15,670 x 5%)
The new carrying value is 15,670 + 784 = 16,454.
12/31/96
Discount on NR
Interest Revenue
(823 = 16,454 x 5%)
823
823
YOU, the accountant, complete the remaining items:
The new carrying value of the note is _____________________________.
Entry for 12/31/97:
Calculation of interest revenue 12/31/97:
The new carrying value of the note is____________________________.
Entry for 12/31/98:
Calculation of interest revenue 12/31/98:
The new carrying value of the note is_____________________________.
ZAR3101.doc
36
Entry for 12/31/99: (Hint: It may help to prepare two different entries. On entry
will recognize the interest accumulated since last year-end. The other entry will
recognize the maturity of the note.)
Calculation of interest revenue 12/31/99:
Note Receivable Discount on N.R.
1/2/95
12/31/95
12/31/96
12/31/97
12/31/98
12/31/99
20,000
C.V.
4330
15670
3546
16464
2723
17277
1859
18141
952
19048
784
823
864
907
952
0
20000
==============================================================
C.V. = carrying value = net of the two accounts
ZAR3101.doc
37
“Imputed” Interest
Answer: b) If we do NOT know the fair market value of the truck, then we must use the
borrrower’s INCREMENTAL BORROWING rate. That is the rate at which that company
could obtain a bank loan of approximately $20,000 for five years. How do you find this
out? Ask the local bank loan officer. Every company should always have at least two
banking relationships in town.
Solution for the journal entries to the problem are similar to the above situation, if
we assume that the INCREMENTAL BORROWING RATE is 5%. The THOUGHT
PROCESS, though, is different when you are trying to determine the present value of
the note receivable.
Show your thought processes here: (Hint: Say what you KNOW in this situation and
show how to obtain the unknown present value).
?
present value
of $1
20,000
n=5
I = 5% (imputed rate)
ZAR3101.doc
38
Exercise 7-20
Situation 1: Entries for 12/31 continued through maturity of note.
12/31/96
Discount on NR
42,000
700,000 x 12% x ½ = 42,000
Interest Revenue
42,000
(one-half year)
……………………………………………………………………………………………..
6/30/97
Same accounts
700,000 x 12% x ½ = 42,000
12/31/97
784,000 x 12% x ½ = 47,040
……………………………………………………………………………………………..
6/30/98
784,000 x 12% x ½ = 47,040
12/31/98
878,080 x 12% x ½ = 52,685
……………………………………………………………………………………………..
6/30/99
878,080 x 12% x ½ = 52,685
12/31/99
983,450 x 12% x ½ = 59,005 (rounded $2 off)
……………………………………………………………………………………………..
983,450 x 12% x ½ = 59,005 (rounded $2 off)
6/30/00
Discount on NR 59,005
Interest Revenue
59,005
Cash
1,101,460
Note Receivable
1,101,460
+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
Exercise 7-20
Situation 2: Entries for 12/31 for first two years, assuming that the
note was signed on 1/1/96.
12/31/96
Cash
9,000
Interest Rev. 19,905
Disc. on NR 10,905 *
12/31/97
Cash
9,000
Interest Rev. 21,213
Disc. on NR 12,213
Supporting Calculations
300,000 x 3% = 9,000
165,873 x 12% = 19,905
300,000 x 3% = 9,000
176,778 x 12% = 21,213
etc.
ZAR3101.doc
39
Impairment of Loan

Creditor still hopes for payment, but thinks it is probable that some of the
PRINCIPAL (or interest) will not be paid. Therefore, the Creditor sets up an
allowance account. The debtor does not do an impairment entry!
Bad Debt Exp.
Allowance for Bad Debt
12/31/97
310,460
500,000

Step 1:


Principal
12/31/95
1
2
3
4
Total
5

Impairment Date CV
375,657
225,3 96
300,000
  Expected

Step 2:
Principal
12/31/97
Payment
CV
=PV
Step 3:
n=3
i= 10%
Find the difference (Step 1 - Step 2)  Loss due to impairment
$150,261
Restructuring of Loan

Reduce Principal owed

Reduce Interest owed

Increase Time to maturity
 Entries sometimes are needed
at restructure date
That is, the debtor gets a “good deal.”
ZAR3101.doc
40
Chapters 8 & 9
MERCHANDISE INVENTORY
A. DEF'N OF INVENTORY: items held for sale in the ordinary course of business (going
concern).
Company wants to ensure a demand for its inventory; should carry enough inventory to
satisfy demands, but should not overstock because it is costly.
Why accounting methods for inventory are important:
1)
2)
Large dollar amounts are usually involved

Methods affect  CGS = > NI

and Ending Inventory 

CA
ROI
EPS
Bal. Sheet


WC
CR

etc.
• Purchase inventory on account (never pay CASH until due)
Inventory
AP
• Sale of inventory
Two entries
if perpetual
inventory
10,000
10,000
(½ of above sold at 60% markup)
5,000 x 160% = $8000 sales price
CGS
5000
Inventory 5000
AR/Cash 8000
Sales 8000
(only this entry, if periodic)
Sales
$8000
-CGS
5000
Gross Profit/Gross Margin 3000  Mark-up on Cost
B. FOUR MAIN ISSUES in Accounting for Inventories:
1. Acquiring Inven.  What costs are capitalized?
units?
costs?
2. Carrying Inven.  Which timing method to use?
perpetual
periodic
3. Selling Inven.  What Cost Flow assumption?
FIFO
Wt. Av.
LIFO
4. Ending Inven.  Applying LCM Rule
units
categories
totals
ZAR3101.doc
41
asset
expense


C. ACQUIRING INVENTORY (PFEB) 
Sold Inventory CGS (B = Benefit)
Note: PFEB = probable future economic benefit
CGS = cost of goods sold
General Rule:
Include costs if inventory is held for resale and ownership is
unrestricted  co. bears complete loss if items are lost, (unless
there is insurance coverage) etc. and co. owns all rights to the
benefits
Variations in the Real World:
• consignments  inventory items held by an entity which does not hold legal title
to the goods (consignor is the owner). The entity holding the inventory is the
consignee.
NOTE: the inventory belongs on the owner's Balance Sheet
• goods in transit  at end of accounting period, these items belong to the legal
owner, per shipping terms:
FOB Shipping Point  title passes to buyer at the shipping point
FOB Destination  title passes to buyer at the destination
NOTE: Auditors do special audit procedures to ensure Sales and Purchases
of Inventory are recorded in the proper accounting period!
Costs to be Capitalized:
· manufacturing costs
· acquisition costs
· storage
· preparation for sale
· packaging
· transportation IN costs
(Note: Trans. OUT is a selling expense)
ZAR3101.doc
42
Accounting for CASH Discounts (similar to the AR discounts)
1/10, n/30 Perpetual Method
Gross Method
(economically more accurate)
Purchase
Inven
10,000
AP
10,000
Net Method
(better internal control)
Case 1
Pay within
10 days
AP
AP
Case 2
Paid after
10 days
AP
10,000
Cash
9900
Inven.
100
10,000
Cash
10,000
Freight Costs In:
Inven
200
Cash
Inven. 9900
AP
9900
Cash
9900
9900
Purch. Dis. Lost* 100
AP
9,900
Cash
10,000
(*similar to "Interest Expense")
200
Mfg. Cos. have several inventory accounts that hold all necessary costs incurred
to get the product ready for sale:
· materials
· labor
· overhead (misc. costs)
D.
CARRYING INVENTORY (2 timing methods possible  periodic and perpetual))
Ask: Should we credit inventory as we sell it daily, or should we do an AJE at
end of accounting period?
Closing Entries:
ZAR3101.doc
• Periodic
CGS
Inventory (end)
Purchases
Inventory (beg.)
• Perpetual
(None required because Inventory is debited as we buy it and
credited as we sell it.)
43
COST OF GOODS SOLD
Be
Particularly
Careful of the GASoline
Empty
Cars Go Slow
Beginning Inventory
Purchases
+
Purchase
Purchase Returns and Allowances
Purchase Discounts
Freight IN
+
+
Cost of Goods Available for Sale
=
Ending Inventory
-
Cost of Goods Sold
=
Example of Gross Margin Method
(How to find the cost of the goods lost or stolen)
Income Statement
Net
Purchases
Beg. Inven
$120
Purchases 200
P.R.&A
(10)
P. Disc
(20)
Freight IN
30 200
CGAS
320
Sales
CGS
Operating Exp.
40 Freight OUT goes
End. Inven
(100)
CGS
*220
Net Income
70
Gross Profit
$330
220*
110 (Mark-up on Cost)
here
Note:
Purchase Discounts Lost
goes in "other rev. and expenses"
(50% Mark-up on COST = 220 x (50% = $110)
(Cost of $220 + Mark-up of $110 = Selling price of $330)
ZAR3101.doc
44
INVENTORY
E.
TIMING METHODS - how often entries are made to the Inventory Account
a)
b)
Inventory account is not touched until end of period  use
PURCHASES account
Perpetual- should equal inventory on hand at all times (except for damages and
theft)
Periodic-
F. COSTING METHODS - how the dollar values flow through the general ledger
accounts
a) First In First Out
b) Weighted Average
c) Last In First Out
d) Specific Identification
G.
END-OF-MONTH METHOD - how much value should go on Balance Sheet
LOWER OF COST OR MARKET



RC
NRV
NRV -normal profit
Purpose is to value the Ending Inventory conservatively by valuing one of the following:
a) Individual Items
b) Class of Items
c) Total Inventory
H.
ESTIMATION OF INVENTORY
a) Gross Margin Method
b) Retail Inventory Method
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45
E.
TIMING METHODS
Purchase
Sales
Closing
Inventory
Shortage
Perpetual*
Inventory
AP
Periodic
Purchases
AP
CGS
Inventory
Cash/AR
Sales
Cash/AR
Sales
None
CGS (plug figure)
Inven. (Ending)
Purchases
Inven. (Beg.)
NOTE: Inventory Losses get buried
in the CGS account
Inventory Shortage (a separate expense on I/S)
Inventory
CGS = BI + Purchases - EI
OR Use T-Account:
Inventory
BI
Purchases
CGS
CGS
CGS
EI
NOTE:
A physical count must be taken once a year per SEC, no matter which
method the co. uses.
* Use if computer system is available with details daily.
** For accounting purposes, a physical count must be taken to determine this entry.
ZAR3101.doc
46
F.
INVENTORY COSTING METHODS
1)
2)
3)
4)
FIFO
(perpetual is same as periodic)
Wt. Av. (perpetual and periodic differ )
LIFO(perpetual and periodic differ)
Specific Identification (Physical Flow always matches Cost Flow)
Information Given:
Wt. Av.
LIFO
B
C
FIFO
A
Specific Oranges Sold Day
example)
4
Mon.
4
Tues.
5
Thurs.
4
Fri.
17
Wt. Av. Cost =
Purchases
PERIODIC (this
5 Oranges @ $1 ea. = 5
4 Oranges @ $2 ea. = 8
Weekly Sales
6 Oranges @ $4 ea. = 24
17 oranges
5 Oranges @ $7 ea. = 35
Sale Price = $10 ea.
20 Oranges
$72 CGAS
$
units
=
Inc. Stmts
Sales
CGS
GP
Bal. Sheets
M. Inven.
$72 = $3.60/orange
20 oranges
Sold
ZAR3101.doc
Spec. Iden.
D
A
$170
51
$119
B
$170.00
61.20
$108.80
C
$170
69
$101
D
$170
60
$110
$21
3 x $7
$10.80
3x$3.60
$3
3x$1
$12
(FIFO)
CGS:
5 x $1= 5
4 x 2= 8
6 x 4=24
2 x 7=14
17
$51
(Wt. Av.)
CGS:
17 x $3.60
= $61.20
CGS
(LIFO)
CGS:
5 x 7=35
6 x 4=24
4 x 2= 8
2 x 1= 2
17
$69
(Spec. Inden.)
CGS:
4 x 1=4
4 x 2 =8
5 x 4=20
4 x 7=28
17
$60
47
EFFECTS OF INVENTORY COST FLOW ASSUMPTIONS (CFA'S)
1. All 3 CFAs allocate entire capitalized inventory cost* to either
CGS or EI
2. Rising per unit prices affect the CGS and EI differently than if inventory prices varied
or were falling
Assume INFLATION (rising prices):
· FIFO
largest balance sheet inventory
smallest CGS  highest NI
· Wt. Av.
medium value - EI
medium value - CGS
· LIFO
smallest balance sheet inventory
largest CGS  lowest NI
vice versa for DEFLATION (re: LIFO and FIFO)
Income Taxes
LIFO Conformity Rule: If a company uses LIFO for its tax return, it must also use
LIFO to prepare its financial statements.
(LIFO achieves lowest NI during INFLATION)
Beware: The COST FLOW of the goods used does not necessarily coincide with the
PHYSICAL FLOW of the goods!
* Also called  cost of goods available for sale
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48
Tradeoffs due to Cost Flow Assumptions:
1.
Income and Asset Measurement
LIFO -- better for matching principle
FIFO -- better for Balance Sheet valuation of Inventory
2.
Economic Consequences
a) Income taxes and liquidity (cash position) --LIFO reduces cash sent to IRS if
possible, but it reduces NI on financial statements. However it improves
LIQUIDITY of the company..
Note: FIFO gives paper profits.
b)
Bookkeeping Costs
LIFO more costly
c)
LIFO Liquidation
If inventory levels are grossly cut back, the old, old inventory costs might
end up in CGS  low CGS high NI
(Care should be taken with inventory purchases)
d)
Debt and Compensation Contracts
FIFO  higher NI  good for bonus plans
LIFO  lower EI  debt covenants usually are less severe for FIFO cos.
e)
G.
Capital Markets
The Stock Market is not dumb: analysts understand the different effects
of accounting method options.
Since LIFO company saves taxes, it should be valued more highly.
END-OF-MONTH VALUATION METHOD:
Apply the Lower-of-Cost-or-Market Rule (LCM)
At end of accounting period, after the timing method and cost flow method have been
applied, the accountant has to ask one more question:
Is the ENDING BALANCE of inventory overvalued with respect to its current
REPLACEMENT COST?
·Replacement Cost
·NRV
·NRV - minus profit 3 potential market values
If so, an AJE is needed to write down the inventory:
LOSS on Inventory
Inventory
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49
INVENTORY ERRORS
(A)
CGAS
EI
A purchase of inventory NOT recorded AND NOT counted in ending inventory:
_________Inventory_________
NI:
NE*
Ok

U
CGS
_________________________
U
TA:
TL:
SE:
U
U
NE
Current Ratio = _CA_ = _U_*
CL
U *
________ AP___________
U
____________________
U Ending
* understated by equal am’ts BUT cannot
determine the overall effect
S/B Done
BI
5
5
Purch _U_ 13
12
CGAS
18
17
EI
( U ) (4) (3)
CGS
14 *14
(B)
A purchase of inventory NOT recorded AND ending inventory is properly stated:
_______Inventory_________
CGS
CGS
NI:
O
TA:
NE
TL:
U
SE:
O

U
U
_______________________
EI
Ok
_________AP__________
U
______________________
Current Ratio =
_CA_ =_NE_ = O
CL
U
Profit Margin =_NI_ =
Sales
_O_ = O
NE
U Ending
ZAR3101.doc
50
ERRORS IN THE INVENTORY COUNT:
(a)
If EI is overstated, CGS is understated
 NI is overstated
1991
RE is overstated
(b)
If EI is understated, CGS is overstated
 NI is understated
 RE is understated
THEN. . . . . . . .
the EI becomes the BI for the next year (1992).
(a)
If BI is overstated, CGS is overstated
 NI is understated
 RE is understated
1992
(b)
If BI is understated, CGS is understate
 NI is overstated
 RE is overstated
NOTE: If correct physical count is taken in second year (1992), then the
error self-corrects itself. The ending RE is finally ok.
EI = Ending Inventory
BI = Beginning Inventory
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51
DOLLAR-VALUE LIFO
Textbook, page 394
Path: From Total Current $
To Total Base $
To Layers of Base $
To Layers of Current $
Step 1
From Total Current $
To Total Base $
Step 2
To Layers of Base $
To Layers of Current $
1993
____
Inventory__________________
1993*
T. Current Index
Total Base
200,000  100 = 200,000
*Base Year when we
first adopted Dollar Value
LIFO
______________Inventory________________
1993 cont’d
Current
Base
200,000
200,000
--------------------------------------Base
Current
Layers
Layers
‘93 200,000 x 1 200,000
EI at Current $
Total Layers
(Dollar Value LIFO)
___________Inventory____________________
_________
1994
T. Current
T. Base
299,000  115
260,000
--------------------------------------------Base
Current
Layers
Layers
‘93 200,000 x 100
200,000
‘94 60,000 x 115
69,000
269,000
1995
T. Current
T. Base
300,000  120,000
250,000
--------------------------------------------Base
Current
Layers
Layers
‘93 200,000 x 100
200,000
‘94 50,000 x 115
57,500
257,000
EI at Current $ (Dollar Value LIFO)
ZAR3101.doc
Inventory__________________
EI at Current $ (Dollar Value LIFO)
52
Determining Market Value for Lower-of-Cost-or-Market Rule:
Cost
Designated Market
Historical Cost (HC)
"Ceiling"
RC
"Floor"
NRV
NRV-normal profit
Step 1 (SHORT-CUT)
From the three values on the right-hand side of the DOUBLE DOTTED LINE, select the
middle value for DESIGNATED MARKET VALUE ("MV").
Step 2 Compare HC to "MV" selected in Step 1.
Step 3 (a)
(b)
Typical AJE:
ZAR3101.doc
If "MV" is lower than historical cost (HC), then prepare an AJE.
If "MV" is higher than HC, you MIGHT need an AJE, if there is
a balance in the Allowance Account.
Unrealized LOSS due to LCM (Inc. Stmt account)
Allowance for LCM Inventory (Balance Sheet account)
53
Chapters 10, 11, & 12
Overview of LONG-LIVED ASSETS
Method of Expensing

DEPRECIATE
A. Property, Plant, and Equipment
B. Natural Resources (mineral deposits)

DEPLETE
C. Intangible Assets
· patent
· copyright
· franchise
· trademark

AMORTIZE
·
·
·
•
lease
leasehold improvements
goodwill  know the entry
NOT research & development
D. Things to know about above assets
1. Acquisition—Use Fair Value
· single asset
· basket purchase
Why
How
· making the asset
· replacing a part
*
2.
Usage
· 4 Depreciation Methods
· 1 Depletion Method (units of production)
· 1 Amortization Method (usually straight-line)
3.
Disposal *
· scrap (no cash received)
· sale
· exchange
Always remember to update the depreciation expense for usage up to the date of disposal
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54
Long-Lived Assets (LLA)
A. Definition of LLA:
assets that are used in the operations of the business and that
provide benefits beyond the current operating period.
No Depreciation • Land
(Depreciate)
• Fixed Assets - Bldg, Machinery, Autos, etc.
(Deplete)
• Natural Resources - oil wells, coal mines, etc.
(Amortize)
• Intangible Assets - patents, goodwill, trademarks, etc.
(Amortize)
• Deferred Costs - L.T. prepaids, organizational costs
Matching Principle:
expenses should be matched against revenues in the period
when the revenues are recognized; i.e., when the expenses
give benefit to the company.
B. Three Major Questions
1. What $ amount should be capitalized?
2. Over what time period should this cost be expensed?
3. At what rate should this cost be expensed?
Very
Important Note 
ZAR3101.doc
LLA are large dollar values; therefore, the
income statement and balance sheet can be
greatly affected by the way the company
answers the above 3 questions.
55
C. Costs to be capitalized:
•
debit the asset for all necessary costs required to get the
LLA into serviceable condition and location.
Acquisition of Land
- debit the LAND account for:
·purchase price
·closing costs
·razing old bldgs, grading, clearing, etc.
·assumptions of back taxes, liens, mortgages
·permanent land improvements  landscaping
 street lights
 sewers
 drainage systems
LAND has an indefinite life: DO NOT depreciate it.
Notes:
•
Land improvements with limited lives are debited to a separate account and
amortized.
e.g. driveways, fences, parking lots
•
Lump-Sum Purchases
-if two or more LLA are purchased for one lump sum, use the RELATIVE FMV (fair
market value) to allocate the cost to the separate asset accounts.
"Why do we need to use separate asset accounts?"
(Because land is not depreciated and because the various depreciable assets may
have different economic lives.)
•
Construction of Long-lived Assets
-include materials, labor, and overhead and interest expense on borrowed funds in
the LLA account. Depreciation (expensing) occurs when the asset starts to be
used.
ZAR3101.doc
56
Exercise 10 - 15
Notes Payable with Principal Installments
(textbook)
15,000
15,000
15,000
15,000
15,000
15,000
Down
______________________________________________________
PVOA
n=5
I = 10%
90,000
-15,000
75,000  5 = 15,000
cash installment per yearend
PVOA = A x tf
= 15,000 x 3.79079
= 56,862
56,862
+15,000
$71,862
(a)
(b)
Carrying Value
Down Payment
Total Present Value of Computer
Dec. 31, 1994
Computer
Disc. on NP
NP
Cash
71,862
18,138
75,000
15,000
12/31/94
CV = NP - Disc. on NP = 56,862
56,862 x 10% x 1
CV x ER x T

Dec. 31, 1995
Int. Exp.
5,686
+ 5,686
Discount on NP
5,686
NP
15,000
Cash
15,000
- 15,000
12/31/95
(c)
Dec. 31, 1996
47,548 x 10% x 1

Int. Exp.
Disc. on NP
NP
Cash
4,755
4,755
+ 4,755
15,000
15,000
12/31/96
ZAR3101.doc
47 ,548
- 15,000
37,303
57
D. Post-acquisition expenditures:
(A) Betterments

improves the quality or quantity of benefits \f1
CAPITALIZE (make it an asset)

What is a Betterment?
Expense?
1) Increase of useful life
2) Quality Improvements
3) Increase of Quantity
4) Reduction of operating costs
(B) Maintenance

simply maintains the asset in
working condition
EXPENSE AT ONCE (maintenance
expense)

What is a Maintenance
1) Tune-up and service
2) Muffler replacement
3) Paint Job
E. Cost Allocation: Expensing Capitalized Costs
NOTE: There are no set guidelines in accounting standards/rules.
3 Steps:
1)
Estimate the USEFUL LIFE
2)
Estimate the SALVAGE VALUE (amount that is expected to be obtained after
our company has used the asset, i.e., the cash we estimate that we'll collect
when we sell the LLA)
3)
Choose an ALLOCATION METHOD
IMPORTANT: Financial statement effect of the above choices can be significant.
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58
Revision of Useful-Life Estimate
• if a company changes its estimate of life, do the following:
1) Determine the Accum. Dep. up to the date of change of estimate (therefore, you
may need to record depreciation expense first).
2) Calculate the Book Value (Orig. cost minus Accum. Dep.)
3) Book value at date of change
- Salvage value still anticipated
= Depreciable Amount (to be depreciated over the est. REMAINING years of life)
F. Miscellaneous Issues
1) How Management chooses an Acceptable Depreciation Method
•
•
desired effect on important financial ratios
desired effect on NI


bonus plans debt covenants (agreements)
2) Depreciation Methods for INCOME TAX purposes
income tax.)
(Note: Corporations pay
• Company may use different depreciation for financial accounting versus tax
accounting
• For IRS, use MACRS (modified accelerated cost-recovery system) -- very specific
guidelines for dep. tax deduction calculation.
ASSET DEPRECIATION RANGE specifies allowable dep'n method for specific lives
of assets
To reduce taxes, use accelerated methods and shorter estimated lives minimize the
present value of tax payments
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59
3) DEPLETION of natural resources (use the units-of-production method). Following are
typical entries.
Purchase an oil well:
Oil Reserves $10 mil.
Cash 10 mil.
Extract Oil:
Depletion Exp. $2 mil.
Accum. Depletion $2 mil.
Sale of one fourth of oil:
(with 200% mark-up on cost)
AR
$1.5 mil.
Sales $1.5 mil.
CGS $ .5 mil.
Depl. Exp. $ .5 mil.
Sold
Mineral Inventory $1.5 mil.
Depl. Exp
$1.5 mil. Unsold
Note: Depletion Expense itself does NOT appear on the financial statements.
Depletion Expense becomes cost of goods sold if the minerals are sold.
Depletion Expense becomes inventory if the minerals are NOT sold.
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60
G. Disposal of LLA:
(1) Retirement -- discontinue use of the asset
(2) Sale - exchange LLA asset for cash or a receivable
(3) Trade-ins -- exchange LLA or LLA and cash for other LLA or LLA and cash
Note: For each of the three disposal examples, always remember to update the
depreciation expense to the date of disposal.
(1) Retirement — company no longer can use the asset and no cash is received (no sale
is made)
• remove asset’s original cost and its accumulated depreciation;
therefore, will result in either
No salvage
value
no gain or loss

if asset has been
fully depreciated
a loss

if asset has NOT been
fully depreciated
(2) Sale — cash is received when we sell the asset
• Remove the asset orig. cost and the accum. depn. and debit the cash. The
"PLUG FIGURE" to balance the entry will be a gain or loss.
(3) Trade-ins -- two or more assets are exchanged; they can be SIMILAR assets
(NO GAIN recognized) whereby the earnings process is NOT yet complete,
OR DISSIMILAR assets (treated like an actual sale). The GAIN or LOSS
recognized
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61
COST ALLOCATION METHODS FOR LONG-LIVED ASSETS
(Depreciation Methods for Partial Year )
Situation:
Straight
Sum of
Double
Purchase
Line
Years’
Declining
Equipment
(SLD)
Digits (SYD)
Balance(DDB)
Orig.Cost=
O.C. 10,000
O.C. 10,000
O.C. 10,000
$10,000
-R.V. 1,000
-R.V. 1,000
and Deprec.
=Depreciable
=Depreciable
Am’tm=$9,000
Purchase
DDB rate=
Am’t of 9,000
Am’t of 9,000
Date: 9/1/90
2 x SLD rate
SLD rate = 1/life
Sum the years:
Entry
1+2+3=6
Dep.Expense =
Equip.10,000
Step 1: O.C.
Dep.Expense =
Cash 10,000
Year 1 is largest
balance x DDB
Deprec.Am’t x
fraction =>3/6
rate x time
SLD rate x time
Estimates
Year 2 =>2/6
Life = 3 years
Year 3 =>1/6
Step 2: Decline
9,000 x 1/3 x 4/12
Residual
(Note: Year 1
the O.C. balance
= 1,000 for 1990
Value=$1,000
means the first
before
Total Products
12 months, Year
calculating next
9,000 x 1/3 x 12/12
= 90,000
2 means the next year’s dep.exp.
= 3,000 for a year
12,etc.)
Step 3: Never
depreciate the
Dep. Expense =
residual==>so
Deprec.Am’t x
Entries
beware of
fraction x time
O.C.balance
12/31/90
12/31/90
12/31/90
Dep.Exp. 1,000
10,000 x 2/3 x
9,000x3/6x 4/12
Acc.Dep. 1,000
4/12 = 2,200
= 1,500
(10,000-2,200
12/31/91
=OC bal 7,800)
Dep. Exp. 3,000
12/31/91
12/31/91
Acc.Dep. 3,000
9000x3/6 x 8/12
plus 9000 x 2/6 x 7,800 x 2/3 x 1
= 5,200
12/31/92
4/12 =4,000
(7,800-5,200
Dep. Exp. 3,000
=OC bal 2,600)
Acc.Dep. 3,000
12/31/92
12/31/92
9,000x2/6x 8/12
2,600 x 2/3 x 1
8/31/93
plus 9000 x 1/6
=1,733 BUT the
Dep. Exp. 2,000
x4/12 = 2,500
RV must be
Acc.Dep. 2,000
1,000 \f1 only
8/31/93
depreciate 1,600
9,000x1/6x8/12
= 1,000
Units
of
Production
O.C. 10,000
-R.V. 1,000
= Depreciable
Am’t of 9,000
$/unit =
Deprec.Am’t /
Total Units
Estimated
$9,000 / 90,000
units =
$ .10/unit
Dep.Expense =
Units produced x
$/unit
12/31/90
11,000 units x $
.10/u
= $1,100
12/31/91
32,000 units x $
.10/u
= $3,200
12/31/92
30,500 units x $
.10/u = $3,050
etc.
Beware: Do not
depreciate beyond
the
depreciable
amount of
$9,000
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62
ZAR3101.doc
63
Similar and Dissimilar Exchanges of Nonmonetary Assets
Information:
OUR company owns a used truck:
Original cost is $30,000
Accum. dep. is 20,000
Book value is 10,000 Fair value is $11,000
The new truck has Fair value of $15,000
Rule to remember: When trying to determine the dollar value to debit to the asset received,
following sequence of thinking should occur.
First, compare FAIR VALUE GIVEN to BOOK VALUE to determine gain or loss.
If FV GIVEN is not known, then second, compare FAIR VALUE RECEIVED to BOOK
VALUE to determine gain or loss.
If neither FV is known, then third, compare BOOK VALUE to BOOK VALUE  which results
in no gain or loss recorded.
<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>
The following examples show SIMILAR EXCHANGES because these are the situations for
which the accountant must determine whether any of the determined “gain” is recorded in the
Theoretically, in an exchange of similar assets, the
earnings process of the old asset (given) is not complete; therefore, if
a gain arises, the company must defer recognition of it until the new
asset (received) is sold at some future time.
accounting records.
A. Situations with NO CASH or OTHER MONETARY ASSET
1) OUR company knows the fair value given
Worksheet
FV given
BV given
GAIN
11,000
10,000
1,000
Entry
Accum. Dep. 20,000
Truck
30,000
Truck (new) 10,000
2) OUR company knows the fair value received
Worksheet
FV rec’d
BV given
GAIN
15,000
10,000
5,000
Entry
Accum. Dep. 20,000
Truck
30,000
Truck (new) 10,000
3) OUR company knows neither fair value
NO gain or loss;
The old BV becomes
the new BV.
ZAR3101.doc
Accum. Dep. 20,000
Truck
30,000
Truck (new) 10,000
64
B. Situations with CASH RECEIVED (Our company receives $1,000)
1) OUR company knows the fair value given1
Worksheet
FV given
11,000
BV given
10,000
PossibleGain 1,000
Entry
Accum. Dep. 20,000
Truck
30,000
Cash
1,000
Gain
83 *
Truck (new)
9,083
Calculate the portion of the “Possible Gain”
That will be recorded, because this exchange has a “partial sale” (the cash portion).
* ____1,000___
1
(portion of “Possible Gain” to be recognized
1,000 + 11,000 12
= Cash/Cash+FV of Exchange)
1/12 x $1,000 = $83 (Gain to be recorded = above fraction x “Possible Gain”)
2) OUR company knows the fair value received
Worksheet
FV rec’d
16,000
BV given
10,000
Possible Gain 6,000

Entry
Accum. Dep. 20,000
Truck
30,000
Cash
1,000
Gain
375 *
Truck (new)
9,375
= Similar to prior example
(1,000/1,000 +16,000) x $6,000 = 375
3) OUR company knows neither fair value
NO gain or loss;
The old BV becomes
The new BV.
Accum. Dep. 20,000
Truck
30,000
Cash
1,000
Truck (new) 9,000
On your worksheet, be sure to consider the CASH in the fair
value or book value, as appropriate.
1
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65
C. Situations with CASH GIVEN (Our company gives $3,000)
1) OUR company knows the fair value given
Worksheet
FV given
14,000
BV given
10,000
Possible Gain 4,000
Entry
Accum. Dep. 20,000
Truck
30,000
Cash
3,000
Truck
13,000
Determine whether ALL or NONE of the Possible Gain will be recorded;
use the 25% Rule of the Emerging Issues Task Force (EITF).
25% Rule: If Cash is greater than or equal to 25% of the fair value of the exchange (refer to your
worksheet), then the transaction is considered by GAAP to be an outright purchase of the asset
received and an outright sale of the asset given. Therefore, ALL of the GAIN is recorded, as it
would be with an outright sale.
25% Rule applied: Is 3,000  25% x 14,000? NO; therefore, no gain is recorded.
2) OUR company knows the fair value received
Worksheet
FV received 15,000
BV given
13,000
Possible Gain 2,000
Entry
Accum. Dep. 20,000
Truck
30,000
Cash
3,000
Truck (new) 13,000
Similar to prior example
Is 3,000  25% x 15,000? NO, therefore, no gain is recorded.
3) OUR company knows neither fair value
NO gain or loss;
The old BV becomes
The new BV.
Accum. Dep. 20,000
Truck
30,000
Cash
3,000
Truck (new) 13,000
----------------------------------------------------------------------------------------------------------NOTE: For all of the exchange transactions, do one final check:
Be sure that the value recorded in the Asset RECEIVED is not greater than its fair market value
on the date of the exchange.
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SALES AND EXCHANGES OF LONG-LIVED ASSETS
MAJOR QUESTION: How do we value the asset RECEIVED?
Equipment
9/1/90 10,000
A.
SALE on 12/31/92 for:
Situation a: $4,200 cash received
Cash
4,200
Acc. Dep. 7,000
Equip.
10,000
Gain
1,200
B.
Acc. Dep.
1000 12/31/90
3yr. Life
3000 AJE
$1,000 Salvage
4000 12/31/91
3000 AJE
7000 12/31/92
Situation b: $2,300 cash received
Cash
2,300
Acc. Dep.
7,000
Loss
700
Equip. 10,000
EXCHANGES on 12/31/92
1. Dissimilar: For a Truck
Situation a: FMV of Truck = $4,200
(received)
Truck
4,200
Acc. Dep. 7,000
Equip.
10,000
Gain
1,200
2. Similar: For another machine
Equip. or Machinery 3000*
Acc. Dep
7000
Equip
10,000
Two Acceptable Methods for New Asset:
FMV of Asset Given Or
FMV of Asset Received
Situation b: FMV of Truck= $2,300
(received)
Truck
2,300
Acc. Dep.
7,000
Loss
700
Equip
10,000
(NO GAINS recognized)
Machinery 2,300
Acc. Dep
7,000
Loss
700
Equip
10,000
DISSIMILAR ASSETS ONLY: Value the asset received with the following order of
preferences: (1) market value of asset given or (2) market value of asset received or (3) if
neither is known, use the book value of asset given. We always know book value!
SIMILAR ASSETS ONLY:
* The highest value debited for what we receive is the B.V. given or F.V. received,
whichever is LOWER.
EXCHANGES OF LONG-LIVED ASSETS (continued)
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67
C.
EXCHANGES WITH BOOT on 12/31/92
In general, to determine the value of the asset we receive:
1) Use FMV of assets given;
2) If 1 is not known, then use FMV of assets received;
3) If 1 & 2 are not known, then use the BV of assets given.
1. Situation c: FMV of truck=$4,200
Situation d: FMV of truck=$2,300
Dissimilar: Receive a truck and $500 cash (boot)
Entry: Cash
500
Truck
4200
Acc.Dep.
7000
Equip.
10000
Gain
1700
Cash
500
Truck
2300
Acc.Dep.
7000
Equip.
10000
Loss
200
2. Situation c: FMV of new equip.=$4200
Situation d:FMV of new eq.=$2300
Similar: Receive new equipment and $500 cash (boot)
(FMV total of $4700)
PARTIAL GAIN will be recognized.
(FMV total of $2800)
TOTAL LOSS will be recognized.
FMV received
BV given
Total Gain
FMV received
BV given
Total Loss
4700
3000
1700
2800
3000
200
Partial Gain = (500/4700) x 1700 =
10.6% x 1700 = $180
Recognize total loss of $200
Entry: Cash
500
Acc.Dep.
7000
Equip.
10000
Gain
180
Machinery 2680
Cash
500
Acc.Dep.
7000
Equip.
10000
Loss
200
Machinery 2300
(Do the above entry in the order of
accounts given. The balancing
figure should be the ASSET
RECEIVED.)
(Do NOT have to do the entry in
the above order.)
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68
D.
CORRESPONDING ENTRIES ON OTHER COMPANY’S BOOKS (for the
“gain” situations only): The capital letters below refer to the first company’s entries
on the prior two pages.
A. Sale on 12/31/92 is a PURCHASE for Other Co.
Entry: Equip.
4200
Cash
4200
________________________________________________________________
For the remaining situations, use the following data:
Other Co. receives equipment and gives a truck with original cost of $20,000 and acc.
dep. of $16,000.
The FMV of the truck ($4,200) is known by both companies.
B. 1. Dissimilar EXCHANGE without boot:
Worksheet
BV given
4000
FMV given
4200
GAIN
200
And, these are dissimilar; therefore,
recognize total gain.
Entry: Acc. Dep.
16000
Truck
20000
Gain
200
Equipment
4200
2. Similar EXCHANGE without boot:
Worksheet
Same as prior, but now the assets are
similar; therefore, NO gain is recorded.
Entry: Acc. Dep.
16000
Truck
20000
Equipment
4000
Note: The old book value becomes the new book value. And, the gain is deferred until
Other Co. sells the equipment at some future date.
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69
C. 1. Dissimilar EXCHANGE WITH BOOT:
Worksheet
BV given (truck + cash)
4500
FMV given (truck + cash) 4700
GAIN
200
Entry: Acc. Dep.
16000
Truck
20000
Cash
500
Gain
200
Equip.
4700
2. Similar EXCHANGE WITH BOOT:
Worksheet
Same as prior, but now the assets are
similar. The CASH is GIVEN, therefore,
use the 25% rule to determine whether
to treat this as DISSIMILAR.
If BOOT GIVEN  25% of FMV of the exchange, then treat as DISSIMILAR and
recognize the gain. Otherwise, treat as SIMILAR do not recognize any of the gain.
If $500  25% x $4700
If $500  $1175....BUT it is NOT, therefore, treat as SIMILAR,
with no gain involved.
Entry: Acc. Dep.
16000
Truck
20000
Cash
500
Equip.
4500
==================================================
Reminders:
1. Each company’s “old” asset being exchanged has a different book value, most
likely.
2. Always remember to compare the book value (BV) of what the company is
exchanging (giving) with one of the following values (in this order):
a) FMV of asset GIVEN, but not always known.
b) If a is not known, then use FMV of asset RECEIVED.
c) if a and b are not known, then use the BV of asset given. (We always
know this because we are the accountants of the company!)
3. The amount of cash involved is at book value and at fair market value.
4. If there is a loss, ALWAYS record the entire loss. This is done because of
conservatism.
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70
Similar and Dissimilar Exchanges of Nonmonetary Assets
Additional Example
Information:
OUR company owns a used truck:
Original cost is $30,000
Accum. dep. is 20,000
Book value is 10,000
Fair value is $11,000
The new truck has Fair value of $15,000
Rule to remember: When trying to determine the dollar value to debit to the asset received,
following sequence of thinking should occur.
First, compare FAIR VALUE GIVEN to BOOK VALUE to determine gain or loss.
If FV GIVEN is not known, then second, compare FAIR VALUE RECEIVED to BOOK
VALUE to determine gain or loss.
If neither FV is known, then third, compare BOOK VALUE to BOOK VALUE  which results
in no gain or loss recorded.
<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>
The following examples show SIMILAR EXCHANGES because these are the situations for
which the accountant must determine whether any of the determined “gain” is recorded in the
accounting records.
D. Situations with NO CASH or OTHER MONETARY ASSET
1) OUR company knows the fair value given
Worksheet
FV given
BV given
GAIN
11,000
10,000
1,000
Entry
Accum. Dep. 20,000
Truck
30,000
Gain
1,000
Truck (new) 11,000
2) OUR company knows the fair value received
Worksheet
FV rec’d
BV given
GAIN
15,000
10,000
5,000
Entry
Accum. Dep. 20,000
Truck
30,000
Gain
5,000
Truck (new) 15,000
3) OUR company knows neither fair value
NO gain or loss;
The old BV becomes
the new BV.
ZAR3101.doc
Accum. Dep. 20,000
Truck
30,000
Truck (new) 10,000
71
E. Situations with CASH RECEIVED (Our company receives $1,000)
4) OUR company knows the fair value given2
Worksheet
FV given
11,000
BV given
10,000
PossibleGain 1,000
Entry
Accum. Dep. 20,000
Truck
30,000
Cash
1,000
Gain
83 *
Truck (new)
9,083
Calculate the portion of the “Possible Gain”
That will be recorded, because this exchange has a “partial sale” (the cash portion).
* ____1,000___
1
(portion of “Possible Gain” to be recognized
1,000 + 11,000 12
= Cash/Cash+FV of Exchange)
1/12 x $1,000 = $83 (Gain to be recorded = above fraction x “Possible Gain”)
5) OUR company knows the fair value received
Worksheet
FV rec’d
16,000
BV given
10,000
Possible Gain 6,000

Entry
Accum. Dep. 20,000
Truck
30,000
Cash
1,000
Gain
375 *
Truck (new)
9,375
= Similar to prior example
(1,000/1,000 +16,000) x $6,000 = 375
6) OUR company knows neither fair value
NO gain or loss;
The old BV becomes
The new BV.
Accum. Dep. 20,000
Truck
30,000
Cash
1,000
Truck (new) 9,000
On your worksheet, be sure to consider the CASH in the fair
value or book value, as appropriate.
2
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F. Situations with CASH GIVEN (Our company gives $5,000; the fair value of the asset
received is now $20,000.
4) OUR company knows the fair value given
Worksheet
FV given
14,000
BV given
10,000
Possible Gain 4,000
Entry
Accum. Dep. 20,000
Truck
30,000
Cash
5,000
Gain
4,000
Truck (rec’d) 19,000
Determine whether ALL or NONE of the Possible Gain will be recorded;
use the 25% Rule of the Emerging Issues Task Force (EITF).
25% Rule: If Cash is greater than or equal to 25% of the fair value of the exchange (refer to your
worksheet), then the transaction is considered by GAAP to be an outright purchase of the asset
received and an outright sale of the asset given. Therefore, ALL of the GAIN is recorded, as it
would be with an outright sale.
25% Rule applied: Is 5,000  25% x 14,000? YES; therefore, record the entire gain.
5) OUR company knows only the fair value received
Worksheet
FV received 20,000
BV given
15,000
Possible Gain 5,000
Entry
Accum. Dep. 20,000
Truck
30,000
Cash
5,000
Gain
5,000
Truck (rec’d)
20,000
Similar to prior example
Is 5,000  25% x 20,000? YES; therefore, record the entire gain.
6) OUR company knows neither fair value
NO gain or loss;
The old BV becomes
The new BV.
Accum. Dep. 20,000
Truck
30,000
Cash
5,000
Truck (new) 15,000
NOTE: For all of the above transactions, do one final check:
Be sure that the value recorded in the Asset RECEIVED is not greater than its fair market value
on the date of the exchange.
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H. ECONOMIC CONSEQUENCES related to Accounting for Long-Lived Assets
•
Problems with Historical Cost (HC)
1) Fin. Stmt users may find that HC of a LLA is not relevant for decision-making.
They might rather have:
a) present value (PV)
b) fair market value (PMV) or
c) replacement cost (RC)
2) Although HC is more objective than other valuation bases, it still is subjective
due to the estimates and choices involved in the accounting process.
•
Problems with Cost Allocation
1) Difficult to match depreciation of the asset directly with the generation of
revenues because of all the estimates.
2) Depending on the choices made by management, financial statement
numbers can vary significantly.
•
Clearing up Misconceptions about Cost Allocation
1) Book Value is not FMV or PV or RC.
2) Depreciation entry does not set cash aside for future replacement of old LLA.
(However, depr. exp. lowers RE (retained earnings) change and could
lower dividends, thereby preserving more cash in company.)
I.
and DEFERRED COSTS

L.T. Prepaids
OR Start-up Costs
INTANGIBLE ASSETS

Characterized by rights,
privileges, and benefits
RATHER THAN
by physical substance
RULES FOR AMORTIZATION:
(Use Economic Life or Legal Life, whichever is shorter),
but not more than 40 years.
Special Rule for companies that develop COMPUTER SOFTWARE:
development and production costs can be capitalized and later amortized
deferment of expenses higher NI
• Goodwill — only arises when one company purchases another company and pays more than the
FMV of the net assets (TA-TL = Net Assets = Stockholders' Equity)
• Organization Costs — expenses incurred prior to the start up of the company may be capitalized and
amortized over the future years.
For tax purposes, use 5 years of life IRS allows high deductions
For financial accounting purposes, use more years because company wants lower expenses
on income statement.
• R & D — expensed immediately, even though inconsistent with MATCHING PRINCIPLE.
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CAPITALIZATION OF INTEREST Worksheet
1)
Find the Weighted Average Accumulated Expenditures
2)
Specific Rate is given
$
Weighted Average Rate must be calculated, but only use the NON-construction debt
Debt A: Principal x SR x T =
Interest
Debt B: Principal x SR x T =
Interest
Total Principal
Total Interest
Total Interest  Total Principal = Wt. Avg. Rate (Weighted Average Rate
Ca
3)
Basic Idea: Avoidable Interest = Wt. Avg. Accum. Expend x Interest Rate
Total Wt. Avg. Accum. Expend (Step 1)
- Principal of the Construction Debt x Spec. Rate
- Remainder of Accum. Expend. x Wt. Avg. Rate
= AVOIDABLE INTEREST
$
$
3)
4) Calculate Total “Interest Expense” for the year1:
Principal1 x Rate1 x Time1 =
Principal2 x Rate2 x Time2 =
etc.
TOTAL INTEREST EXPENSE
Interest
Interest
__etc.
4)
5) Compare 3 and 4, and capitalize the LESSER of the two. All remaining interest must
be expensed immediately. CAUTION: Be careful about the credit(s) in the entry; at
year-end there may be CASH and/or INTEREST PAYABLE credits.
NEXT PERIOD
1. Wt. Avg. Accum. Expend = TOTAL EXPEND. FROM ALL PRIOR PERIODS and add CAPITALIZED
INTEREST and add WT. AVG. EXPEND. OF THIS PERIOD
1 A year is usually the time frame for the problems
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Impairment of Long-Lived Assets
Statement of Financial Accounting Standards (SFAS) No. 121
Purpose:
Provides a systematic procedure for management writedown of long-lived
assets. Therefore, it prevents the “big bath” that is often taken when new management
arrives at a company.
Application: This standard relates to the loss of value of long-lived assets used and
long-lived assets to be disposed.3
a. Both tangible and identifiable intangible long-lived assets are included.
Goodwill related to the long-lived assets are included.
b. Which assets apply? Those that have independent identifiable cash flows.
Therefore, accounting for impairment is performed only on large
segments or divisions of the company.
Calculation:
Step 1: Compare undiscounted FUTURE CASH FLOWS (FCF) related to
the assets to the assets’ CV (carrying value on the books) to
determine whether to write the assets down.
Step 2: Write the assets down a) to FAIR VALUE (MARKET VALUE), if
known, or otherwise b) to PRESENT VALUE (PV) of future cash
flows expected from the assets impaired.
3
Note that SFAS #121 excludes disposal of a segment of a business.
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Accountant’s Routine Procedure:
a. Periodically, review events and circumstances for possible asset impairment.
b. If Carrying Value (CV)4 of any long-lived assets may not be
recoverable, then apply the Recoverability Test presented below:
1. Estimate the net future cash flows (cash in minus cash out)
expected from the use of the asset and its eventual disposition.
2. If the FCF < CV of the asset, then the asset is impaired. And vice versa.
3. If impairment occurred, then compute the loss, per next step (#4).
4. Impairment Loss = CV of asset - FMV of asset
or
Impairment Loss = CV of asset - PV of FCF5
Procedure of Write Down:
Step 1: Reduce goodwill first.
Step 2: Then prorate the remaining impaired value over the tangible assets.
ENTRY:
Loss on Impairment
Accumulated Depreciation
Goodwill
Note: Typically, the reduced CV of asset becomes its new cost basis:
therefore, you usually do not write up the value, even if FMV
increases later.
However, if the asset is held for disposal, its value can be written
up to the CV that it was before the impairment.
4
Carrying value is also book value (BV).
To calculate the present value of the future cash flows, use the company’s market
interest rate.
5
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