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Arts and Business
Seth Brouwers

CHAPTER 1: REPORTING AND INTERPRETING THE FINANCIAL RESULTS OF BUSINESS ACTIVITIES BASIC BUSINESS ACTIVITIES • Three main business activities - Operating - Financing - Investing • Accounting: - Process of capturing and reporting the results of a business’s operating, financing and investing activities Operating Activities: • Day-to-day events that occur when running a business • Ex. - Mattel manufacturers and sells toys Financing Activities: • Exchange of money between a business and its lenders or owners • Ex. - Borrowing money from external lenders to help operate business Investing Activities: • Involves buying and selling long-lived assts • Ex. - Buying manufacturing equipment that will help the company earn future revenues Forms of Business Ownership: • Sole proprietorship - Business organizations owned by one person - Owner often is personally liable for business debts that cannot be paid • Partnership - Business organizations owed by two or more people - Each partner often is personally liable for partnership debts that cannot be paid • Corporations - Operate a business separate from their owners - Owners of corporations (shareholders) are nor personally responsible for debts of the corporations - Ex. Matel - PUBLIC COMPANIES: stocks are bought and sold on stock exchange - PRIVATE COMPANIES: stocks are bought and sold privately Reporting Financial Results: • Financial results of a companies business activities are presented in accounting reports called financial statements • Financial results are reported in the financial statements - Balance sheet - Income statement - State of retained earning - Statement of cash flows • Balance sheet: The Statement of Financial Positions • Income statement: The Statement of Income, The Statement of Operations, The Statement of Earnings, The Statement of Profit or Loss • Can be prepared for any time period but usually monthly, quarterly, and annually • Companies can choose any date to end their accounting year • All contain different content but: - All start with a heading that contains three parts: o Who: Name of Business o What: Title of Statement o When: Accounting period Balance Sheet: • Report at a specific point in time - Like a snapshot of the company at on a specific date • Communicates what a business owns, owes and what is left over for the shareholders • The basic accounting equation is reflected • Prepared “as at” a specific point in time • ASSETS = LIABILITIES + SHAREHOLDER’S EQUITY Components of a Balance Sheet: • Assets - Resources owned by a business - Cash, accounts receivable, inventories, property, plant and equipment, other assets (COMMON NAMES COMPANIES USE) - Listed in the order of how quickly they can be converted into cash • Liabilities - Amounts owned by the business - Accounts payable, notes payable (COMMON NAMES COMPANIES USE) • Shareholder’s equity - To amount invested in the business by its owners - Contributed capital, retained earnings (COMMON NAMES COMPANIES USE) Income Statement: • Reports if the business has made a profit from selling goods or services after subtracting the costs of doing business • Summarizes the entire year • Prepared for a period of time • REVENUES – EXPENSES = NET INCOME Components of an Income Statement: • Revenue - The price of goods sold or services rendered - Reported when the goods or services is delivered to the customer, regardless of when the payment occurs • Expenses - Costs of running the business - Reported in the same period they are used to help generate revenues, regardless of when payment occurs • When expenses = revenue company is said to “break even” The Statement of Retained Earnings: • Shows the amount of earnings that have been retained in the business and • Shows the amount of the company’s resources paid out to shareholders as dividends • Dividends is not an expense • Dividends is the distribution of profits to shareholders • Ending retained earnings balance is same as the amount on the Balance sheet under retained earnings • INCOME – DIVIDENDS = RETAINED EARNINGS Statement of Cash Flows: • Summarizes the business’s operating financing and investing activities that caused its cash balance to change over a particular period of time • End of year cash balance is equal to the amount reported as cash on the balance sheet • Two methods: - Direct - Indirect Relationship Amount Statements: • Income statement reports results of business operations for an accounting period • Net income from income statement flows to the statement of retained earnings • Ending retained earnings balance for the period is also on the balance sheet • If ending retained earnings isn’t on the balance sheet, it would not balance • Cash on the balance sheet and at the end of the year on the Statement of Cash flow are the same Assurance Statements: • Two statements generally appear before the other financial statements in an annual report - The Management’s Statement of Responsibility for Financial Reporting o Responsible for the integrity of the information in the statements - The Independent Auditor’s Report o States external accountants have examined the statements and that they follow the rules of accounting Notes to the Financial Statements: • Accounting policies - Describes the accounting decisions that were made when preparing financial statements • Contents included - Presents additional detail about what is included in certain financial statement account balances • Addition information - Provides additional financial disclosures about items not listed on the statements themselves • Without notes financial statements cannot be understood fully Account Rules: • Generally Accepted Accounting Principles (GAAP) - Underlying rules of financial reporting - In Canada, these rules are established by the Canadian Institute of Chartered Accountants (CICA) • Generally Accepted Auditing Standards (GAAS) - Rules used by auditors - Established whether a companies financial statements are prepared following GAAP • International Financial Reporting Standards (IFRS) - Standard moving forward Financial Statement Users: • People who base their decisions on information reported on a financial statement: - External Parties: o Creditors o Investors o Community groups o Canada Revenue Agency o Canadian Securities Administration o Board of Directors o External Auditors - Internal Parties: o Human Resources Managers o Credit managers o Purchasing managers o Employee Unions • People use the four basic financial statements to: - Understand the current state of business - Predict how the business will do in the future January 12, 2011 CHAPTER 2: REPORTING AND INTERRETING INVESTING AND FINANCING RESULTS ON THE BALANCE SHEET BASIC ACCOUNTING FORMULA: ASSETS=LIABILITIES+SHAREHOLDERS EQUITY ELEMENTS: • Assets - Resources controlled by an entity as a result of a past transaction - From which future economic benefits may be obtained • Liabilities - Obligations of an entity arising from past transactions - Settlement may result in the transfer or use of assets, provision of services - Or giving up of economic benefits in the future • Shareholders equity - Residual ownership interest in the assets after deducting liabilities Business Activities: • Study the business • Look into the projects and jobs and research it (FEASABILITY STUDY) BALANCE SHEET: 1. Standard elements are needed 2. This balance sheet classifies some assets and liabilities as “current”- what’s the criteria - Classified balance sheet is when you cut the assets and liabilities into current and long-term sections on the balance sheet 3. The line items are created by many of the activities/ transactions we identified Classified Balance Sheet • Classifies assets and liabilities into current • Current assets - Used up or converted into cash within the next 12 months • Long-term assets - Resources that will be used up or turned into cash more than 12 months after the balance sheet date • Current liabilities - Debts and obligations that will be paid or settled within the next 12 months • Long term liabilities - Debts are obligations that will be paid or settled more than 12 months from the balance sheet date • If your current liabilities is greater then current assets you have issues Transaction Analysis • Consists of two parts: - Analyzing business activities - Identifying transactions • A transaction: - Exchange or event that ha a direct economic impact on the assets, liabilities or shareholders equity of a business • Accounting Significance • Signing and agreement or a contract is not a transaction Ideas Behind Transaction Analysis 1) Duality of effects - Every transaction has at leas two effects on the a balance sheet 2) A = L + SE - Fundamental accounting equation must remain in balance after transactions - If one element is affected by transaction, there is an equal reaction that effects other elements DECIDE: A SYSTEMATIC APPROACH • Use these steps when analyzing transactions: 1) Does a transaction exist? 2) Examine it for the account effected. 3) Classify each account as asset, liability, or shareholders’ equity 4) Identify the direction and amount of the effects 5) Ensure the basic accounting equation still balances • Only go to step two, if the answer to step one is yes • Ex. You incorporate First Choice Haircutters on August 1. The company issues stock in exchange for $50,000, which is deposited in the company’s bank account. - Does a transaction exist? o Yes because cash is received and shares are issued - Examine it for the account effected. o Cash o Contributed capital - Classify each account as asset, liability, or shareholders’ equity o Cash is an asset and contributed capital is a shareholders equity account - Identify the direction and amount of the effects o Cash + 50,000, contributed capital + 50,000 - Ensure the basic accounting equation still balances o Yes, because assets + 50,000 and shareholders equity + 50,000 SYSTEM OF ACCOUNTING: • Used a combination of note-taking and summarizing • Analyzed transactions are entered in the journal • Journal entries are posted to summary sheets that show the effects of the month’s transactions • Summary sheets as a group are called ledger • Ledgers are the basis for preparing financial statements CONSERVATISM AND THE BALANCE SHEET: • Conservatism - Using the least optimistic measures when uncertainty exists about the value of assets and liabilities - Important implications for the balance sheet: o Affects what is and is not recorded, how transaction is recorded and the amounts assigned to recorded items • Cost principle - We ignore the idea that future increases value of idea, and initially record assets at their original cost January 17, 2011 CHAPTER 3: REPORTING AND INTERPRETING OPERATING RESULTS ON THE INCOME STATEMENT Expanding Accounting Equation: • Balance sheet: ASSETS = LIABILITIES + EQUITY • Income statement: REVENUE – EXPENSES = NET INCOME • A = L + C/S + R/E + bR – X) – D INCOME STATEMENT BASIC • Summary of revenue and expense transactions • NET INCOME= REVENUE – EXPENSE • Revenue > Expenses = Profit • Revenue < Expenses = Loss • Revenues recognized when earned - Three conditions for earned… • Expenses recognized when incurred - Regardless actual timing of payment Elements of Income Statement • Revenue: - Entire amount of income before any deductions are made - Normally arising from the sale of goods, the rendering of services or the use by others of entity resources yielding rent, interest, royalties or dividends • Expenses: - Decrease in economic resources - An outflow of money to another person or group to pay for an item or service • Gains: - Increasing equity/net assets from peripheral or incidental transactions and events affecting an entity - Ex. Excessive decline in value of equipment sold, write-down in carrying value of inventory to “market”, cost of asset destroyed by uninsured event, detriments of foreign currency fluctuations • Losses: - Decreases in equity/ net assets from peripheral or incidental transactions and events affecting an entity and from all other transactions - Ex. Increase in value of facilities, increase in value of investments of various types, benefits of foreign currency fluctuations Revenues and Expenses: • Revenue - Increase in company’s resources created by providing goods or services to customers during the accounting period - Reported on the top part of the income statement - Revenue for First choice would represent the amount charged to customers for hair cuts • Expenses: - Cost that results when a company gives up resources to generate revenue during the accounting period • Non Operating Revenue Expenses: - Businesses often have non-operating normal (but not central) transactions that result in revenues or expenses - Examples: o Interest revenue o Interest expense o Gain or loss from selling assets The Income Statement: No rule for listing operating expenses but grouping them improves usefulness OTHER ACCOUNTS • Income tax expense: - Calculated based on all the revenues and expenses of a company - Can be a complicated calculation - In AFM 102 taxes will be calculated as percentage of income before taxes Expenses versus Expenditures: • Terms used interchangeably in everyday life, but have different accounting meanings • EXPENDITURE: any outflows of cash for any purpose • EXPENSES: costs incurred to generate revenue, don’t always involve immediate outflow of cash Cash-Based Accounting: • Records revenues when cash is received and expenses when cash is paid • Does not measure financial performance very well when transactions are conducted on credit rather than with cash - Problem is the delay that exists Accrual Basis Accounting: • Records revenue when they are earned and expenses when they are incurred - Regardless of timing • Required under GAAP • Based on two important principles - Revenue recognition principle - Matching principle Accrual-Bases Measurement: • Revenues: - A company records revenues when it performs the acts promised to the customer o Cash can be received in the same period as the promised acts are performed, OR o Cash can be received in the period before the promised acts are performed, OR o Cash can be received in the period after the promised acts are performed - Cash is likely to be receive in the same period as the promised acts are performed • Unearned Revenue: - Liability account representing a company’s obligation to provide goods or services to a customer in the future (company has been paid in advance) - When the good or service is provided, revenue will be recognized and the liability account reduced • Prepaid Expenses: - An asst account representing a company’s prepaid costs expected to yield future benefit (company has paid for something in advance- capitalized cost) - When company uses asset, expense will be recognized in the income statement and the asset account will be reduced • Cost is said to be incurred when the company pays the cash or uses credit to obtain resources • Costs that do not benefit economic periods are immediately reported as expenses on income statement when they are incurred • Costs that have probably future economic benefit are capitalized initially as assets on balance sheet • CAPITALIZED COST: the cost that is reported as an asset on the balance sheet - Later costs are transferred from assets to expenses on income statement when assets future benefits are used up USERS RELY ON THE INCOME STATEMENT • Tells shareholders whether management has been able to make a profit for them • Managers may break down information into divisions or products - Used intentionally to help answer key questions o What product lines make the best contribution to profit? o What product lines are least profitable (should they be dropped)? o Are increases in our expenses over time proportionate to sales? o How does our ratio of various expenses--to sales compare to other members of our industry? • Other groups use the income statement: - Shareholders – Has Management done a good job? - Bankers – How risky is the company? - Employee Unions – Can the company afford to give employees a raise? - Canada Revenue Agency – Has the company paid all its income taxes? - Public Interest Groups – Is the company making a reasonable profit or is there a need for consumer price protection? NET INCOME ≠ CASH • Common mistake • Net income is NOT money that can be paid out to shareholders in cash • Revenues and expense are not recorded based on the timing of cash receipts and payments • Instead the income statement is based on two main accounting principles - Revenue principle - Matching principle January 19, 2011 CHAPTER 7: REPORTING AND INTERPRETING CURRENT ASSETS: RECEIVABLES Extending Credit to Customers: • Businesses extend credit to customers to stimulate sales. Credit sales are not without costs • Most obvious cost= customer does not pay when repeatedly billed (bad debt) • Incur costs when: - Keeping records of customer balances - Mailing statements - Processing cash receipts from customer billings - Delayed receipt of cash after sales (even if customers pay on time) Accounting info re: Credit Losses • There will be losses! - Accounts that don’t pay - Bad debts - Financial Reporting and Accounting Issues: o Profit determination: Matching bad debt expense with relates revenue o Asset valuation: Presenting A/R or B/s at the amount expected to be realized Allowance Method: • Bad Debts: - Credit customers who do not pay the business the amount they owe - Selling on credit creates a need to account for the bad debts - Companies need to consider the idea that not everyone will pay • Two key accounting principles come into play in accounting for receivables: - Conservatism principle o Accounts receivables are reported at the amount that is expected to be collected - Matching principle o All expenses (including bad debts) are recorded in the accounting period in which the related credit sales are made • Time will pass before the company can figure out what part of credit sales and customer balances aren’t going to be paid • What is the problem with following these principles? - Timing • Solution: - Estimate the amount of bad debts when the sale is recorded • Allowance Method Involves: 1. Recording an estimated bad debt expense in the period in which the sale took place 2. Removing (“Write off”) specific customer balances in the period in which they are determined to be uncollectible Recording Bad Debt Expense: • Estimate of this period’s credit sales that the company won’t collect from customers • Reduce Accounts Receivable by means of a contra-asset account (allowance for Doubtful Accounts) AND • Reduce net income with an expense account (Bad Debt Expense) • Credit in the journal entry cannot be recorded to Accounts Receivables • If a company were to remove the customer accounts believed to be uncollectible, it would lose track of which customer owed money and the opportunity to get the money back • Credit is made to the contra-account called Allowance for Doubtful Accounts Net Accounts Receivable: • Net Accounts Receivable is not a separate account - Line-item on the balance sheet that is computed by subtracting the contra- asset account (allowance for doubtful accounts from the asset account Gross Accounts and Notes Receivable) Percentage of Credit Sales Method: • Bases bad debt expense on the historical percentage of credit sales tat result in bad debts • Focus is on determining the amount to record on the income statement as Bad Debt Expense - Net Credit Sales x % estimated uncollectible= estimated expense • Amount of the current period’s Bad Debt expense is added to the “allowance” account (contra asset) on the balance statement Aging of Accounts Receivable Method: • Estimates uncollectible accounts based on the age of each accounts receivable • Focus is on determining the desired balance in the Allowance for Doubtful Accounts on the balance sheet - The amount of adjustment to the contra asset account to get it to this newly determined balance is the current period’s Bad Debt Expense ( I/S) • Relies on the fact that, as accounts receivable become older and more overdue, it is less likely that they will prove to be collectible Aging Schedule: • Customer accounts are separated into aging categories - Based on the number of days that have passed since uncollected amounts were first recorded in the account 1. Accounts receivable must be classified by age 2. For each age group we calculate a separate allowance amount 3. Add up all the allowance amounts and that gives us the desired balance in the allowance doubtful accounts Write Off Specific Customer Balances: • Write off when it becomes clear that a particular customer will not pay its balance - Reduce Allowance for Doubtful Accounts - The main purpose for writing off an uncollectible account is to clean up the accounting records • It is clear that a specific customer’s account receivable will be uncollectible, the amount should be removed from accounts receivable and charged to allowance for doubtful accounts Notes Receivable: • If a customer is having difficulty paying, its account receivable could be transferred to a note receivable • Formal contract stating: 1. Specified payments to be received at future dates 2. A specified rate of interest, which is charged on the outstanding balance • Each note typically outlines the: - Amount owed (principle) - Date by which it is to be repaid to the company (maturity date) - Interest rate charged while the note remains unpaid • Interest Formula: - Interest = Principle x Interest Rate x Time Notes Receivable Transactions • Establishing a note receivable • Recording interest earned • Recording interest received • Recording receipt of interest and principle at maturity • Establishing a note receivable - Debit Note Receivable, Credit Accounts Receivables, Credit Accounts Receivable - • Recording interest earned - Recorded when it is earned rather than when the interest payment is actually received in cash - Typically recorded at period end or when the note is due (whatever comes first) - Increase Interest Receivable, Increase interest Revenue • Recording Interest received - Increase Cash, Decrease Interest Receivable - May also need to credit an interest has been earned since the year end • Recording receipt of interest and principle at maturity - Increase Cash, decrease Note Receivable - May also need to credit interest collected depending on the timing Uncollectible and Defaulted Notes: • When the collectability of notes receivable is in doubt - Record an allowance for doubtful accounts against the notes receivable • If a company defaults on a note - Write off the note and any unpaid accrued interest, in the same way for accounts receivable Receivables Turnover Analysis: • Determine how many times, on average, the process of selling and collecting on account occurs during the period of average • Receivables Turnover Ratio= Net Credit Sales Revenue/ Average Net Trade Receivables • AVG NTR = (Beginning Receivables + Ending Receivables)/2 • The higher the ratio the faster the collection • Provides useful information for evaluating how efficient management has been in granting credit to produce revenue • Average net trade receivables is determined by adding together the Easier to think in terms of the amount of time (in days) it takes to collect an account receivable - Days to collect= 365/ receivable turnover ratio • Receivables turnover results can vary widely across industries Speeding up the Collection Process: • Offering customers a discount for early payment - Can be costly • Factoring - Sell outstanding accounts receivable to another company - Sell the receivable for cash less a factoring fee • Credit card sales - Company deposits credit card receipt directly into its bank account similar to receiving cash - Credit card companies charge a fee- credit card discount The Impact of Estimation • When evaluating a company’s results take these steps: - Assess the consistency of estimates - Don’t rely on just one number - Understand how management develops estimates - “Income smoothing”- Manipulating net income • Both methods involve estimates (percentage of credit sales method, and the aging of accounts receivable method) • If we underestimate bad debt expense, we overstate net income and net receivables. • If we overestimate bad debt expense, we understate net income and net receivables • While most estimations are based on good faith judgments, it is possible to manipulate net income, in a practice called income smoothing, by overestimating bad debt expense in periods of strong sales and strong gross margins, and then underestimating bad debt expense in periods of weak sales and weak gross margins. January 24, 2011 CHAPTER 8: REPORTING AND INTERPRETING CURRENT ASSETS: INVENTORIES The Business of Inventory Management • Primary goals of inventory managers: 1) To ensure sufficient quantities of inventory are available to meet customers needs 2) To ensure inventory quality meets customers expectations and company standards 3) To minimize the costs of acquiring and carrying inventory • Product innovation drives a managers inventory decision Types of Inventory • Includes goods that are: - Held for sale in the normal course of business (finished goods) - Used to produce goods for sale • Reported on the balance sheet asset - Manufacturer also holds goods in the normal course of business and has items used to produce a product for sale • Merchandiser - INVENTORY: acquired in a finished condition and is ready for sale without further processing • Manufacturer - RAW MATERIAL INVENTORY: materials that are processed further into finished goods - WORK IN PROCESS INVENTORY: goods that are in the process of being manufactured - FINISHED GOODS INVENTORY: includes goods that are complete and ready to sell • Consignment inventory - Goods a company is holding on behalf of the goods owner - Willing to sell the goods on behalf of the owner for a fee • Goods in transit - Goods being transported - Need to know FOB term to determine who has ownership of the goods FOB Terms • Determining factor: who is subject to the benefits and risks of owning the goods? • If a sale is made FOB destination: the goods belong to the seller until they are delivered to the customer • If the sale is made FOB shipping point: inventory belong to the customer the moment it leaves the sellers premises Computing Cost of Goods Sold • Company start with its beginning inventory and purchases additional inventory during the period • Goods available for sale= beginning inventory + purchases (represents all inventory that we could possibly sell during the period) • If all goods are not sold, that are placed in the unsold inventory in the ending inventory • Ending inventory represents the inventory that is still available • COGS= BEGINNING INVENTORY + PURCHASES- ENDING INVENTORY Inventory Costing Methods • We must decide how we will associate cost with the item sold • Different inventory costing methods are alternative ways to split the total dollar amount of goods available for sale between ending inventory and cost of goods sold • Four inventory costing methods: - Specific identification o Identifies the cost of the specific item that was sold o Requires keeping track of the purchase cost of each item • Coding the purchase cost on each unit before placing it in stock • Keeping a separate record of the unit and identifying it with a serial number o Impractical when large quantities of similar items are stocked o Appropriate method when dealing with expensive and unique items o Allow for the unethical manipulation of financial results when the units are identical - First-in, first-out (FIFO) o Oldest costs cost of goods sold o Recent costsending inventory o We assume that the first goods in our inventory are the first goods sold out of that inventory o Sell first goods placed in our inventory first o Most recent costs stay in ending inventory - Last-in, first-out (LIFO) o Recent costscost of goods sold o Oldest costsending inventory o Last goods in our inventory are the first goods sold from the inventory o Most recent costs are assigned to cost of goods sold and the oldest costs are assigned to ending inventory o Least commonly used in Canada o CICA removed it as an acceptable costing method in 008 o Remains a popular method in the united states - Weighted average cost o Requires calculating the weighted average unit cost of goods available for sale o Cost of goods available for sale/ units on hand on the date of sale o Weighted average unit cost is then used to assign a dollar amount to cost of goods sold and to ending inventory o After each purchase we calculate a new weighted average unit cost o Failing to weigh the costs by the number of units at each cost (COMMON MISTAKE)  People use simple average unit cost instead, which averages only the units purchased at each cost o Cost of goods available for sale/ units on hand on the date of sale Financial Statement Effects • Inventory methods nearly always assign different cost amounts because prices change • Companies use weighted average cost because it tends to smooth out changes in price paid for inventory items • If a company uses first-in, first out, we can say that inventory on the balance sheet is stated at an amount very close to its replacement cost • Last-in, first out does a good job of matching current costs with current revenue, and may tend to give an income amount that reflects current costs and selling prices • Advantages of methods: - Weighted average o Smoothes out price changes - First-in, first- out o Ending inventory approximates current replacement cost - Last-in, First-out o Better matches current costs in cost of goods sold with revenues Inventory Turnover Ratio • Inventory turnover ratio= cost of goods sold/ average inventory • Both measured in terms of selling prices • Average inventory=(beginning inventory + ending inventory)/2 • Process of buying and selling is called inventory turnover • Higher ration means that inventory moves more quickly from purchase (or production) to the customer, reducing storage and obsolescence costs • Think in terms of the amount of time it takes to sell inventory, rather than the number of times inventory is turned over during a particular year • Days to sell= 365/inventory turnover ratio • The faster the turnover, the less likely we are to have out of date items in inventory Lower of Cost of Market (LCM) • Variation rule that requires the inventory account to be reduced when the value of the inventory falls to an amount less than it cost • Conservatism drives this principle • Reasons the value of inventory can fall below cost: - Easily replaced by identical goods at a lower cost - Become outdated or damaged • Loss in inventory value is typically combined with selling expenses or COGS for purposes of external reporting Perpetual and Periodic Systems • Perpetual system will calculate its cost of goods sold perpetually (perhaps daily) • Period system will calculate cost of goods sold periodically (once a year) Effect of Errors • Type of errors: - Failure to value inventory properly - Inappropriate quantities or unit costs are used in calculating inventory costs • Results: - Significantly affect both the balance sheet and the income statement - Effects are felt in more than one year because the ending inventory for one year becomes the beginning inventory for the next year January 26, 2011 CHAPTER 9: REPORTING AND INTERPRETING LONG-LIVED TANGIBLE AND INTANGIBLE ASSETS Long-Lived Assets: • Actively used in operations • Will not be used up within the next year • Two types of long lived assets: - Tangible: physical substance (sometimes called fixed assets, because they are fixed in places) - Intangible: no physical substance (can be combined under the heading capital assets) Acquisition of Tangible Assets: • All reasonable and necessary costs of acquiring and preparing an asset for use should be recorded as a cost of the asset • Recording costs as part of the asset is called capitalizing • Financing charges not included in the cost of an asset, interest charged on it is an expense Acquisition Costs: • Cost should include the purchase price plus legal fees, appraisal fees and architectural fees • Equipment is recorded as its purchase price, includes sale taxes, delivery charges and installation costs • Purchasing land cost includes purchase price, legal fees, surveying fees, brokers commissions, and other costs generally incurred in connection with the purchases such as taxes and recording fees • Land is not a depreciable asset Basket Purchase and Acquisition Cost: • The total cost of a combined purchase of land and building is allocated in proportion to their relative market values • Not uncommon to have a basket purchase of assets, usually occurs when you purchase building and land • Land is not depreciable but the building is • Accountants normally divide the cost between the assets on the basis of relative fair market values Self-Constructed Tangible Assets: • Asset cost includes: - All materials and labour traceable to construction - Capitalized interest on debt incurred during the construction Tangible Assets Maintenance Costs: • If it is in need of repair or maintenance it is an expense • If it is to extend the life of the asset is capitalize Amortization (also know as Depreciation): • The cost of a long-lived tangible asset over their productive lives using a systematic and rational method (not valuation) • F/S impact: - Increase “amortization expense”, reducing net income for the period - Increase “accumulated amortization”, a contra asset account reducing total assets • Carrying value (CV) of an asset: - Acquisition cost- accumulated amortization • Involves allocating the cost of tangible assets, rather than determining their current values, the amounts reported on a balance sheet for long-lived tangible assets are likely to differ from their current market values Alternative Amortization Methods: • STRAIGHT-LINE METHOD: pattern of cost utilization or generation of benefits, judged to be consistent over time - Easiest to use, most commonly used - FORMULA: AMORTIZATION EXPENSE PER YEAR= COST- RESIDUAL VALUE/ LIFE IN YEARS - Amortization expense is constant amount each year - Accumulated amortization increases by an equal amount each year - Book value decrease by the same equal amount each year • UNITS OF ACTIVITY METHOD: asset’s service capacity consumed with units produced - Used in special circumstances - Used if the method of life of the asset is generally measured in terms of units of production - Unit of production may be (operating hours, EX. Airplanes—hours of travel) - Step one: amortization rate= cost-residual value/ life in units of activity - Step two: amortization expense= amortization rate x numbers of units produced for the year • DECLINING BALANCE METHOD: accelerated—greater benefit generation or higher proportion of cost utilization earlier in life - Take more amortization expense in the early years of the assets life and lower amounts of amortization in later years - Income tax amortization calculations are based on the declining balance method - FORMULA: ANNUAL AMORTIZATION EXPENSE = NET BOOK VALUE X (2/ USEFUL LIFE IN YEARS) - NBV= COST- ACCUMULATES AMORTIZATION - Amortization expense amounts are higher in the early years of an assets life and lower in the later years - Sometimes called and accelerated amortization method - Sometimes called an accelerated amortization method - Uses the rate of 2 time the straight line rate Amortization Calculations: • Require 3 factors: 1) C = asset acquisition cost 2) EUL= estimated useful life 3) RV= estimated residual value • Depreciable cost= C- RV • Land is the only tangible asset that is assumed to have an unlimited (indefinite) useful life - Land is not amortize Other Amortization Issues: • Amortization and income tax - Most public companies use one method of amortization for reporting to shareholders and a different method for determining income taxes - This is because the objectives of GAAP and those of the Canada Revenue Agency (CRA) differ o CRA has its own way of recording amortization called capital cost allowance Asset Impairment Losses: • Impairment exists when the carrying amount of a long-lived asset exceeds its fair value • Calculation: - Loss= Book value- Fair value • Loss is typically included with other expenses reported below “operating income” Disposable of Tangible Assets: • Update amortization • Record the disposable by: - Recording cash received or paid o Writing off accumulated amortization - Recording a gain or loss o Writing off the asset cost • Complete the entry by removing the assets cost from out books with a decrease and remove the related accumulated amortization with a decrease • A gain or loss? - If cash > CV, record a gain - If cash< CV, record a loss - If cash = CV, no gain or loss • Gains on disposal work the same as revenue but are not recorded with sales revenues because they arise from non- operating activities rather than reported below operating income in the bottom half of the income statement Intangible Assets: • Rights and things you can’t scratch/sniff • Acquisition: - Almost all intangible assets are recorded as assets only if they have been purchased - The costs of almost all self-constructed or self-developed intangibles are reported as expenses often as research and development costs • Companies only record the cost of goodwill, software, trademarks, franchise rights and other intangibles if they purchase those assets from outside • Internally developed intangible assets are almost always expensed • Self developed intangibles are easy to say they are developed Goodwill: • Occurs when one company buys another company • Only purchased goodwill is an intangible asset • The amount by which the purchase price exceeds the fair market value of net assets acquired Intangible Assets Amortization: • If a limited life: - Straight-line basis over its useful life • If an unlimited life: - Not amortized, but are subject to impairment tests - Ex. goodwill • Same mechanics as for Amortization of Tangible Assets (usually straight line) • Most companies do not estimate a residual value for their intangible assets because, unlike tangi
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