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COMM 111
David Mc Conomy

Financial Accounting Final Exam Review Chapter 1 Accounting – the information system that measures business activities, processes data into reports, and communicates results to decision makers – the ‘language of business’ Who uses Accounting information? : investors and creditors, government and regulatory agencies, taxing authorities, individuals and not-for-profit organizations Financial accounting provides information for decision makers outside the organization, while management accounting generates inside information for the managers of the organization Forms of Proprietorship Partnership Corporation Business Organizations Owner(s) Proprietor – one Partners – two or Shareholders – owner more owners generally many owners Life of entity Limited by Limited by owner’s Indefinite owner’s choice or choice or death death Personal Liability Proprietor is Partners are Shareholders are of owner(s) for personally liable usually personally not personally business debts liable liable Accounting Status Accounting entity Accounting entity Accounting entity is separate from is separate from is separate from proprietor partners shareholders Board of directors – policy maker for the corporation and appoints officers The Accounting Equation Assets = Liabilities + Shareholder’s Equity Assets – economic resources of a business that are expected to produce a benefit in the future Liabilities – debts payable to outsiders, called creditors Owner’s Equity – represents the ‘insider claims’ of a business – the owner’s interest in the assets of a corporation. Can be divided into contributed capital and retained earnings Contributed Capital – the amount that shareholders have invested in the corporation Retained earnings – the amount earned by income-producing activities and kept for use in the business. Revenues, expenses and dividends affect retained earnings. Revenues – expenses = Net Income Beginning Balance of retained earnings +/- Net income/loss – Dividends = Ending Balance of retained earnings Income Statement (Statement of operations, statement of earnings) – reports the company’s revenues, expenses, and net income or loss for a period Statement of retained earnings – shows changes in retained earnings due to income/loss and dividends i.e. Huron Ltd. Statement of Retained Earnings For the year ended Dec 31, 2011 Beginning retained earnings…………………….$120 000 Net Income…………………………………………………30 000 Cash Dividends…………………………………………..(10 000) Ending retained earnings…………………………..$140 000 Balance sheet – (statement of financial position) reports assets, liabilities, and shareholder’s equity Current assets – include cash and cash equivalents, as well as assets the company expects to convert to cash, sell, or consume during the next year. i.e. Accounts receivable, inventory, prepaid expenses Current liabilities – debts payable within one year or current operating cycle if longer i.e. accrued liabilities, accounts payable, income taxes payable, current portion of long term debt Long term liabilities – those liabilities that are due beyond one year after the balance sheet date i.e. long term debt, future income taxes, non controlling interest in consolidated joint venture GAAP – generally accepted accounting principles; Canadian rules that govern how accountants measure, process, and communicate financial information IFRS – international financial reporting standards; international accounting standards Publicly Accountable Enterprises (PAEs) – corporations that have issued or plan to issue shares or debt in public markets, required to follow IFRS Private Enterprises (PEs) – required to follow accounting standards for private enterprises, but info not released to public Assumptions of Accounting  Entity assumption – all the assets and liabilities of an entity belong to the entity, and the owner may have personal assets and liabilities, however they are not added to those of the entity  Going concern assumption – assumes that the entity will remain in operation long enough to use existing assets for their intended purposes  Cost assumption – requires that assets and liabilities be measured at their cost when they are acquired or assumed  Stable monetary unit assumption – we ignore inflation and assume the dollar’s purchasing power is relatively stable Chapter 2 Transaction – any event that has a financial impact on a business and can be measured Accrued liability – a liability for an expense you have not yet paid like interest payable or salary parable Dividends – optional payments to shareholders, indicating a decrease in retained earnings (not an expense!) -each transaction affects at least two accounts in the double entry accounting system -the left side of a t-account is a debit, and the right side is a credit: each transaction involves both a debit and credit -DEBITS MUST EQUAL CREDITS!!! -increases in assets are recorded on the left (debit) side of the account -decreases in assets are recorded on the right (credit) side of the account -increases in liabilities and shareholder’s equity re recorded by credits -decreases in liabilities and shareholder’s equity are recorded by debits Assets Liabilities or Equities Expenses Revenues -dividends and expenses accounts are exceptions to the rule – they are equity accounts that are increased by a debit. This is because they are contra equity accounts Journal – a chronological record of transactions Ledger – a grouping of all of the t-accounts with their balances Trial Balance – lists all accounts with their balances i.e. Tara Inc. Trial Balance April 30, 2011 Account Title Debit Credit Cash $33 300 Accounts Receivable 2000 Office Supplies 3700 Land 18000 Accounts Payable $1800 Common Shares 50 000 Dividends 2100 Service Revenue 10 000 Rent Expense 1100 Utilities Expense 400 Salary Expense 1200 Total $61 800 $61 800 Chapter 3 Accrual accounting – records the impact of a business transaction as it occurs. When the business performs a service, makes a sale, or incurs an expense, the accountant records the transaction even if it pays no cash Cash basis accounting – records only cash transactions – cash receipts and cash payments. Corporations use accrual accounting because cash basis accounting leaves defects on the income statement and the balance sheet. Revenue principle – governs when to record revenue and the amount of revenue to record – you record the cash value of the good or service that has been transferred to the customer once it has been earned (not just received) Deferral – an adjustment for which the business paid or received cash in advance i.e. prepaid expenses, unearned revenues, etc. i.e. Dr. Cash Cr. Unearned service revenue Then Dr. Unearned service revenue Cr. Service revenue Depreciation – the allocation of the cost of a capital asset to expense over the asset’s useful life Accumulate Depreciation – an account that shows the sum of all depreciation expense from the date of acquiring the asset. It is a contra asset account – an asset account with a normal credit balance Carrying amount – the net amount of a capital asset (cost minus accumulated depreciation), also known as book value Accrual – the opposite of a deferral, when revenue/expense is recorded before paying/collecting cash i.e. payables, receivables i.e. Dr. Salary Expense Cr. Salary Payable Then Dr. Salary Payable Cr. Cash Summary of Adjusting Type of Account Entries Prepaids: Cash First First Last Pay cash and record an asset: Record an expense and decrease Prepaid Expense Dr. Prepaid expense the asset: Cr. Cash Dr. Expense Cr. Prepaid Expense Receive cash and record unearnedRecord a revenue and decrease Unearned revenues revenue: unearned revenue: Dr. Cash Dr. Unearned revenue Cr. Unearned Revenue Cr. Revenue Accruals – the cash transaction occurs later Accrued expenses Accrue expense and a payable: Pay cash and decrease the Dr. Expense payable: Cr. Payable Dr. Payable Cr. Cash Accrued revenues Accrue revenue and a receivableReceive cash and decrease the Dr. Receivable receivable: Cr. Revenue Dr. Cash Cr. Receivable Closing the books – means preparing the accounts for the next period’s transactions. The closing entries set the balances of the revenue and expense accounts back to zero at the end of the period Temporary accounts – accounts that relate to a limited period, such as revenues, expenses, and dividends; accounts that are closed Permanent accounts – accounts that carry over to the next period and are not closed at the end of the period, such as assets, liabilities, and shareholder’s equity -To close the books, debit each revenue account for the amount of its credit balance and credit retained earnings for the sum of the revenues -Credit each expense account for the amount of its debit balance and debit retained earnings for the sum of the expenses -Then credit the dividends account for the amount of its debit balance, and debit retained earnings Liquidity – measures how quickly an item can be converted to cash Operating cycle – the time span during which cash is paid for goods and services, and these goods and services are sold to bring in cash a classified balance sheet separates current assets from long term assets and current liabilities from long term liabilities Current ratio = current assets Current liabilities -Measures the company’s ability to pay current liabilities with current assets Debt ratio = total liabilities Total assets -Indicates the proportion of a company’s assets that is financed with debt -Measures a business’ ability to pay both current and long term debt Single step income statement – lists all the revenues together under a heading, and all the expenses under another heading Multi step income statement – contains a number of subtotals to highlight important relationships among revenues and expenses Return on sales ratio – determines how much of the company’s sales revenue ends up as net income Return on sales = net income Sales revenue Chapter 4 – Internal Control and Cash Fraud – an intentional misrepresentation of facts, made for the purpose of persuading another party to act in a way that causes injury or damage to that party Misappropriation of assets – when employees of an entity steal money from the company and cover it up through erroneous entries in the books Fraudulent financial reporting – when company managers make false and misleading entries in the books, making financial results of the company appear to be better than they actually are Fraud triangle – composed of motive, opportunity, and rationalization Internal control – a plan of organization and system of procedures designed, implemented, and maintained by company management and the board of directors to deal with risks to the business that have been identified and relate to:  The reliability of the company’s financial records and financial reporting  The company’s ability to operate effectively and efficiently  The company’s compliance with legal requirements Components of internal control: Control environment – corporate code of conduct etc Risk assessment – company must be able to identify risks and establish procedures to deal with the risks Information systems – mgmt of a business needs accurate info to keep track of assets and measure profits and losses Control procedures – means by which companies gain access to the fice objectives of internal controls Monitoring of controls – no one person or group can process a transaction completely without being seen and checked by another person or group i.e. auditors -in processing transactions, smart management separates three key duties: asset handling, record keeping, and transaction approval Budget – quantitative financial plan that helps control day to day managemnt activities Audit – an examination of the company’s financial statements and its accounting system, including its controls. Internal auditors are employees of the business, external auditors are completely independent of the business -records must be adequate -company policy should limit access to assets only to those persons or departments that have custodial responsibilities -no transaction should be processed without managements specific or genera approval -mandatory vacations and job rotation improve internal control -pitfalls of ecommerce include stolen credit card numbers, computer viruses and Trojan horses, and phishing expeditions -the bank account can be used as a control device, it helps control cash because there is a signature card, bank statement, deposit slips,etc. -a cash budget helps a company or an individual manage cash by planning receipts and payments during a future period. The company must determine how much cash it will need and then decide whether or not its operations will bring in the needed cash 1. Start with the entity’s cash balance at the beginning of the period (the amount left over from the preceding period) 2. Add the budgeted cash receipts and subtract the budgeted cash payments 3. The beginning balance plus receipts minus payments equals the expected cash balance at the end of the period 4. Company the ending cash balance to the budgeted cash balance at the end of the period. If the budget shows excess cash, it can be invested. If the expected cash balance falls below the budgeted balance, the company will need additional financing Chapter 5 – short term investments and receivables Short term investments (marketable securities) – investments that a company plans to hold for one year or less. They allow the company to invest excess cash for a short period of time and earn a return until the cash is needed -short term investments are the next most liquid asset after cash, and so we report them immediately after cash and before receivables on the balance sheet Fair value – the amount the owner can receive when selling the investment. A gain occurs when the fair value is greater than the investment cost, and its an unrealized gain if the company has not yet sold the investment. Trading investments are reported on the balance sheet at their fair value because that is the amount the investor can receive by selling the investment i.e. Loblaw buys TransCanada shares paying $100 000 cash Short term investment 100 000 Cash 100 000 Loblaw receives a cash dividend of $800 Cash 800 Dividend Revenue 800 TransCanada’s shares have risen in value, and now the investment has a fair value of $102 000 Short Term Investment 2000 Unrealized gain on investments 2000 -a gain has the same effect on owner’s equity as a revenue -a loss has the same effect on owner’s equity as an expense -the gains and losses appear on the income statement under ‘Other revenue, gains and losses’ Realized gain/loss – occurs only when the investor sells an investment. A realized gain is when the sale price is greater than the investment carrying amount, and a realized loss occurs when the sale price is less than the investment carrying amount i.e. Suppose Loblaw sells its TransCanada shares for a sale price of $98 000 Cash 98 000 Loss on sale of investments 4000 Short Term investments 102 000 -notice that you record the loss from the last updated short term investment amount (in this case 102 000) and not from the purchase price (100 000) Receivables – monetary claims against others. They are acquired mainly by selling goods and services (accounts receivable) and by lending money (notes receivable). They are the third most liquid asset – after cash and short term investments. -selling on credit creates both a benefit and a cost: -benefit: customers who cannot pay cash immediately can buy on credit, so company profits rise as sales increase -cost: the company will be unable to collect from some credit customers Uncollectible account expense/doubtful account expense/bad-debt expense – the amount of accounts receivable that is uncollectible -accounts receivable are reported in the financial statements at cost minus an appropriate allowance for uncollectible accounts (so net realizable value) Allowance method - a way to measure bad debts by recording collection losses on the basis of estimates. Managers estimate bad-debt expense on the basis of past experience. The business records the estimated amount as uncollectible account expense and sets up an allowance for uncollectible accounts. This is a contra account to accounts receivable. The allowance shows the amount of the receivables that the business expects not to collect There are two ways to estimate uncollectibles: Percentage of sales method – computes uncollectible account expense as a percentage of revenue. Is an income statement approach because it focuses on the amount of expense to be reported on the income ststament i.e. Customers owe Blacks corporation $138 370 and the allowance account amount is currently $346. The economy slows down, and Black’s top managers estimate that uncollectible account expense is ½ of 1% of total revenues, which were $725 532 for 2010. The entry to record bad debt expense for the year is as follows: Uncollectible account expense ($725532 x .005)3628 Allowance for uncollectible accounts 3628 Now Black’s balance sheet will report accounts receivable at their net realizable value: Accounts receivable, net of allowance for uncollectible accounts of $3974 $134 396 (the amount 134 496 is 138 370 – 3974 (which is 346 + 3628)) Aging of accounts receivable – individual receivables from specific customers are analyzed based on how long they have been outstanding. Is a balance sheet approach because it focuses on accounts receivable. Number of Days past due Customer Total 1-30 31-60 61-90 Over 90 City of Regina $500 500 IBM Canada 1000 1000 Keady Pipe Corp. 2100 1000 1100 TorBar Inc. 200 200 Others 134 570 66070 57000 9000 2500 Total 138 370 67570 58000 10300 2500 Estimated % Uncollectible 2% 5% 10% 35% Total Estimated Uncollectible $6156 1351 2900 1030 875 Accounts -the aging method will bring the balance of the allowance account ($346) to the needed amount ($6156) as determined by the aging schedule Black’s would make this entry: Uncollectible account expense ($6156 – 346) 5810 Allowance for uncollectible accounts 5810 Suppose that the credit department determines that Black’s cannot collect from customers Keady Pipe and TorBar Inc. : Allowance for uncollectible accounts 2300 Accounts Receivable – Keady Pipe 2100 Accounts Receivable – TorBar Inc. 200 -the write off of uncollectibles has no affect on total assets or on net income Percentage of sales Aging of accounts receivable Adjusts allowance for Adjusts allowance for uncollectible accounts uncollectible accounts BY BY The amount of The amount of UNCOLLECTIBLE ACCOUNT EXPENSE UNCOLLECTIBLE ACCOUNTS RECEIVABLE -if an account is written off and then the company unexpectedly receives the money, the company will make two entries: one to reverse the earlier write off and a second to record the cash collection i.e. Accounts Receivable – TorBar 200 Allowance for Uncollectible Accounts 200 Cash 200 Accounts Receivable 200 Direct write off method – the company waits until it decides that a specific customer’s receivable is uncollectible. Then the accountant records uncollectible account expense and writes off the customer’s account receivable i.e. Uncollectible Account Expense 2000 Accounts Receivable 2000 -the direct write off method is acceptable only when the uncollectibles are so low that there is no significant difference between uncollectible account expense b the allowance method and the direct write off method Creditor – the party to whom the money is owed with a note receivable, the lender Debtor – the party that borrowed and owes money on the note Interest – the cost of borrowing money, stated in an annual percentage rate Maturity date – the date on which the debtor must pay the note Maturity value – the sum of principal and interest on the note Principal – the amount of money borrowed by the debtor Term – the length of time from when the note was signed by the debtor to when th debtor must pay the note i.e. A woman signs a note receivable and is give $1000 cash on July 1 2010 with a year end of Oct 31 2010. The annual interest rate is 9%. The bnks entries are as follows: Jul 1 Note Receivable 1000 Cash 1000 At Oct 31, the bank accrues interest revenue for four months: Oct 31 Interest Receivable (1000 x .09 x 4/12) 30 Interest Revenue 30 The bank collects the note on Dec 31, 2010 Dec 31 Cash 1045 Note Receivable 1000 Interest Receivable 30 Interest Revenue (1000 x .09 x 2/12) 15 -interest rates are always for an annual period unless stated otherwise Principal x interest rate x time = amount of interest i.e. $1000 x .09 x 4/12 = $30 -the time element (4/12) is the fraction of the year that the note has been in force during the year -you can do a note receivable for days of the year, also (like 90/365) -you can sell your accounts receivable at a discounted price to speed up cash flow i.e. Blacks sells $100 000 of accounts receivable, receiving cash of $95 000 Cash 95 000 Financing Expense 5000 Accounts Receivable 100 000 Acid test (quick) ratio – a more stringent measure of the company’s ability to pay current liabilities. Is similar to the current ratio but it excludes inventory and prepaid expenses Acid Test Ratio = Cash + short term investments + net current receivables Total current liabilities -the higher the acid test ratio, the easier it is to pay current liabilities day’s sales in receivables – or collection period, tells how long it takes to collect the average level of receivables. Shorter is better because cash is coming in quickly. The longer the collection period, the less cash is available to pay bills and expand. First compute day’s sales, and then divide one day’s sales into average receivables for the period Day’s sales = net sales 365 Day’s sales in average accounts receivable = average net accounts receivables one day’s sales Chapter 6 – Inventory and Cost of Goods Sold Cost of goods sold – the cost of inventory that Leon’s buys and then sells (at a higher price presumably) -Cost of inventory on hand is an asset on the balance sheet, while cost of inventory sold is an expense on the income statement -Merchandisers have two accounts that service entities don’t need: inventory on the balance sheet and cost of goods sold on the income statement -Sale revenue is based on the sale price of the inventory sold (i.e. $500 per chair) while cost of goods sold is based on the cost of the inventory sold (i.e. $300 per chair) -Inventory on the balance sheet is based on the cost of the inventory still on hand Gross profit (gross margin) – the excess of sales revenue over cost of goods sold. It is gross profit because operating expenses have not yet been subtracted Periodic inventory system – a store counts its inventory periodically – at least once a year – to determine the quantities on hand. Mainly used by businesses that sell inexpensive goods Perpetual inventory system – uses computer software to keep a running record of inventory on hand -when a company makes a sale, two entries are needed in the perpetual system: -the company records the sale: debits cash or accounts receivable and credits sales revenue for the sale prices of the goods -the company also debits cost of goods sold and credits inventory for the cost of the inventory sold Freight in – the transportation cost paid by the buyer to move goods from the sller to the buyer Purchase returns – a decrease in the cost of inventory because the buyer returned the goods to the seller Purchase allowance – a decrease in the cost of inventory because the buyer got a discount (often from merchandise defect) Purchase discount – a decrease in the cost of inventory that is earned by paying quickly NET PURCHASES = PURCHASES - PURCHASE RETURNS AND ALLOWANCES - PURCHASE DISCOUNTS + FREIGHT IN NET SALES = SALES REVENUE - SALES RETURNS AND ALLOWANCES - SALES DISCOUNTS -Freight out paid by the seller is not a part of the cost of inventory, instead it is a delivery expense; the seller’s expense of delivering merchandise to customers There are three generally accepted inventory-costing methods: 1. Specific unit cost 2. Weighted-average cost 3. First-in, first-out (FIFO) cost Specific unit cost method – when businesses cost their inventories at the specific cost of the particular unit. This method is too expensive to use for inventory items that have common characteristics (like lumber, litres of paint) but often used for unique inventory items, like antique furniture, jewels, and real estate Weighted average cost method – based on the average cost of inventory for the period Weighted average cost per unit = cost of goods available Number of units available Goods available is beginning inventory + purchases Cost of goods sold = number of units sold x weighted average cost per unit Ending inventor = number of units on hand x weighted average cost per unit -a new average cost is computed each time a new purchase I made i.e. Leon’s began the period with 10 lamps that cost $10 each. During the period, they bought 50 more lamps (25 at $14 and 25 at $18), sold 40 lamps, and ended the period with 20 lamps. Weighted average cost per unit = $900 (10 x $10 + 25 x $14 + 25 x $18) 60 (10 + 25 + 25) Cost of goods sold = 40 units sold x $15 = $600 Ending inventory = 20 units left x $15 = $300 Assume that after the sale, the company bought 10 more units at a cost of $20. A new average cost would be computed as follows: Balance 20 units @ $15 per unit = $300 Purchase 10 units @ $20 per unit = $200 Total cost $500 divided by 30 units = $16.67 per unit First-in, First-out Cost Method (FIFO) – the first costs into inventory are the first costs assigned to cost of goods sold i.e. (using purchases from last example with Leon’s): Cost of goods sold (40 units) 10 units @ $10 =$100 25 units @ $14 =$350 5 units @ $18 =$90 $540 -in a period of rising prices, FIFO will generally lead to higher profits and higher taxes than weighted average while the opposite is true is a period of falling prices -Weighted average results in the most realistic net income figure -FIFO reports the most current inventory cost -IFRS requires that a change in accounting method be disclosed, and should be applied retrospectively Disclosure principle – a company’s financial statements should report enough information for outsiders to make informed decisions about the company Lower of cost and net realizable value rule (LCNRV) – based on the premise that inventory can become obsolete or damaged or its selling price can decline. Inventory must be reported on the financial statements at whichever is lower – the inventory’s cost or its net realizable value (the amount the business could get if it sold the inventory less the costs of selling it) Gross profit percentage – markup stated as a percentage of sales. Measures what percentage of gross profit is generated by sales. Gross profit = sales – COGS Gross profit percentage = Gross profit Net sales revenue Inventory turnover – the ratio of cost of goods sold to average inventory, indicates how rapidly inventory is sold. Shows how many times a company sold its average inventory level during the year. Inventory turnover = cost of goods sold Average inventory Cost of goods sold model: Beginning inventory +Purchases = goods available for sale -ending inventory =cost of goods sold -to figure out how much inventory a company should buy: Cost of goods sold + ending inventory =goods available for sale -beginning inventory =purchases (how much inventory the manager needs to buy) -beginning inventory and ending inventory have opposite effects on cost of goods sold (beginning inventory is added while ending inventory is subtracted) therefore, after two periods, an inventory accounting error ‘washes out’ or counterbalances -an understatement of beginning inventory results in an overstatement f gross profit and an understatement of ending inventory results in an understatement of gross profit -this is because an understatement of ending inventory makes cost of goods sold higher and so gross profit lower; an understatement of beginning inventory means COGS is lower and so gross profit is higher Chapter 7 – Property, Plant, and Equipment, and Intangible Assets Intangible assets – assets that are useful because of the special rights they carry, that have no physical form. i.e. patents, copyrights, trademarks etc. -the cost of any asset is the sum of all the costs incurred to bring the asset to its location and intended use -the cost of land includes its purchase price, real estate commission, survey fees, etc. It does not include the cost of fencing, paving, sprinkler systems, etc. – these are recorded in a separate account, land improvements that is subject to depreciation -with buildings, once the asset is up and running, insurance, taxes, and maintenance costs are recorded as expenses, not part of the asset’s cost -when a company purchases several assets as a group for a lump sum amount, the total cost is divided among the assets according to their relative fair values i.e. Suppose a company purchases land and a building for $2 800 000. An appraisal indicates that the land’s fair value is $300 000 and that the buildings market value is $2 700 000. Therefore total appraised value is $300 000 + $2 700 000 = $3 000 000. The land is $300 000/$3 000 000 = %10 of total appraised value, and the building is 90% of total appraised value. Multiply .10 by the purchase price, $2 800 000 = $280 000 and .9 by $2 800 000 = $2 520 000, so the entry to record the purchases is: Land $280 000 Building $2 520 000 Cash $2 800 000 Capital expenditures – expenditures that increase the asset’s productivity or extend its useful life i.e. cost of a major overhaul that extends the useful life of a Canadian tire truck. These costs can be capitalized and added to an asset account rather than be expensed immediately -Costs that do not extend the asset’s productivity or its useful life, but merely maintain the asset or restore it to working order, are considered repairs and are recorded as expenses i.e. oil change in a truck Depreciation – allocating an asset’s cost to expense over its life Estimated useful life – the length of service expected from using the asset Estimated residual value – the expected cash value of an asset at the end of its useful life Depreciable cost – the amount of the asset that will be depreciated: Depreciable cost = asset’s cost – estimated residual value There are three main depreciation methods: Straight line method – an equal amount of depreciation is assigned to each year (or period) of asset use. Depreciable cost is divided by useful life in years to determine the annual depreciation expense Straight line depreciation/year = cost – residual value Useful life, in years i.e. if there’s a van owned that a company paid $41 000 for and has an estimated residual value of $1000, and an estimated useful life of 5 years: depreciation per year = 41 000 – 1000 = $8000 5 Depreciation expense $8000 Accumulated Depreciation $8000 -the straight line depreciation rate is 1/number of years of estimated useful life, in this case is 1/5 = .20 Units of Production Method – a fixed amount of depreciation is assigned to each unit of output, or service, provided by the asset. Depreciable cost is divided by useful life – in unit of production – to determine this amount. This per unit depreciation expense is then multiplied by the number of units produced each period to compute deprecation. Units of production depreciation = cost – residual value per unit of output useful life, in units of production i.e. assume that the van in the previous example has an estimated useful life of 100 000 units (kilometers). Assume that the van is expected to be driven 20 000 km during the first year, 30 000 during the second year, 25 000 during the third, 15 000 during the fourth, and 10 000 during the fifth UOP depreciation per unit of output = 41000 – 1000 = $.40/km 100 000 So First year 20 000 x .4 = $8000 Second year 30 000 x .4 = $12 000 Third year 25 000 x .4 = $10 000 Fourth year 15 000 x .4 = $6000 Fifth year 10 000 x .4 = $4000 Double Diminishing balance method – is an accelerated depreciation method where a larger amount of the asset is written off near the start of its useful life than the straight line method. It computes annual depreciation by multiplying the asset’s declining carrying amount by a constant percentage, which is two times the straight line depreciation rate. First, compute the straight line depreciation rate per year. Is 1 divided by the number of useful years the asset is expected to have Second multiply the straight line rate by two to compute the double diminishing balance rate Third, multiply the double diminishing balance rate by the period’s beginning asset carrying amount (cost less accumulated depreciation) DDB depreciation rate per year = 1 x 2 Useful life, in years Fourth, determine the final year’s depreciation amount – the amount needed to reduce the asset carrying amount to its residual value. Residual value is ignored initially, and depreciation expense in the final year is the amount needed to reduce the asset’s carrying amount to its residual value i.e. example with the $41000 car. The DDB rate is (1/5) x 2 = .40, or 40%. DDB Rate Asset Carrying Depreciation Accumulated Asset Carrying Amount Expense Depreciation Amount .40 x $41 000 = $16400 $16 400 $24 600 .40 x $24 600 = $9840 $26 240 $14 760 .40 x $14 760 = $5904 $32 144 $8856 .40 x $8856 = $3542 $35 686 $5314 (5324 - $1000)= $4314 $40 000 $1000 -For an asset that generates revenue evenly over time, the straight-line method best meets this criterion -The units of production method best fits those assets that wear out because of physical use rather than obsolescence -The double diminishing balance method applies best to assets that generate greater amounts of revenue earlier in their useful lives and less in later years -if a company buys an asset halfway through a year or month, compute the depreciation for a full year first and then multiply the full year’s depreciation by the fraction of the year that you held the asset -if a company decides that the useful life remaining is different from the original estimated useful life, take the asset’s remaining depreciable carrying amount and divide by the new estimated useful life remaining, and that is the new annual depreciation (you do not adjust prior years’ depreciation expenses) Derecognition – occurs when property, plant and equipment is either no longer useful or has been sold. When this occurs, the related accounts are removed from the company’s books and a gain or a loss is recorded. Before accounting for the disposal, the business should bring depreciation up to date to record the expense up to the date of sale and measure the assets final carrying amount -to account for disposal, remove the asset and its related accumulated depreciation from the books i.e. suppose M&M meats disposes of store fixtures that cost $4000, ‘junking’ them before they are fully depreciated. Accumulated depreciation is $3000, and the carrying amount is therefore $1000. Junking these fixtures results in a loss as follows: Accumulated Depreciation – store fixtures $3000 Loss on disposal of store fixtures $1000 Store fixtures $4000 -this occurs because M&M meats got rid of an asset with a $1000 carrying amount and received nothing,. The loss is reported as an expense on the income tatement i.e. 2 Suppose that M&M meats sells fixtures on Sept 30 2010 that cost $10 000 when purchased on January 1 2007, and have been depreciated on a straight line basis. They estimated a 10 year useful life and no residual value. First they must update the depreciation: Depreciation expense ($10 000 / 10 years x (9/12)) 750 Accumulated Depreciation – fixtures 750 The accumulated depreciation account now sits at $3750 Suppose they sell the fixtures of $7000 cash. The gain on the sale is $750, determined as follows: Cash received from the sale of asset 7000 Carrying amount of asset sold: Cost $10000 Accumulated Depreciation (3750) $6250 6250 $750 The entry is: Cash 7000 Accumulated Depreciation 3750 Gain on sale of fixtures 750 Fixtures 10 000 Impairment occurs when the carrying amount exceeds its recoverable amount. Recoverable amount is determined to be the higher of an asset’s fair value and its value in use. Impairment may be caused by factors including obsolescence, physical damage, loss in market value, etc. The journal entry to record impairment is: Loss on impairment XXX Accumulated Depreciation XXX Intangibles fall into two categories: -intangibles with finite lives that can be measured. We record amortization for these intangibles -intangibles with indefinite lives. Record no amortization, an example is goodwill. Goodwill – the excess of the cost of purchasing another company over the sum of the market values of its net assets (assets minus liabilities) i.e. Canadian Tire acquires Mark’s work warehouse for a purchase price of $110.8 million. The fair value of the assets was $189.8 million, and the fair value of the liabilities was $97.9 million, so Canadian tire paid $18.9 million for goodwill (110.8 – (189.8 – 97.9)) Assets 189 800 000 Goodwill 18 900 000 Liabilities 97 900 000 Cash 110 800 000 Chapter 8 – Liabilities Current liabilities – obligations due within one year or within the company’s normal operating cycle if longer. Includes of known amounts (accounts payable, short term notes payable, accrued liabilities, current portion of long term debt etc) and of unknown amounts i.e. estimated warranty payable i.e. A company purchases $8000 worth of inventory by issuing a six-month, 10% note payable on Oct 1 Inventory $8000 Note Payable, short term $8000 At year end (dec 31) the company must accrue interest expense for Oct through Dec: Interest expense ($8000 x .10 x 3/12) $200 Interest Payable $200 At Mar 31, the company pays the note and its interest: Note payable, short term $8000 Interest Payable 200 Interest Expense 200 Cash $8400 GST payable – is a current liability as it is payable annually, quarterly, or monthly. It is a value added tax borne by the final consumer of a GST taxable product. Entities farther up the supply chain from the final consumer pay GST on their purchase put get an input tax credit (ITC) equal to the GST they have paid i.e. Kitchen Hardware Ltd. Purchases lawn rakes for $3000 plus 5% GST for a total of $3150. They then sell the rakes for $6000 plus GST of $300. The entries are: Inventory $3000 GST ITC 150 Accounts Payable $3150 Accounts Receivable $6300 Cost of Goods Sold 3000 Sales $6000 Inventory 3000 GST payable 300 GST payable $300 GST ITC 150 Cash 150 Sales tax payable – PST is levied at the point of sale to the final consumer, unlike GST Harmonized sales tax payable – the final consumer of an HST taxable product/service bears the tax, and entities farther up the supply chain pay HST but get an ITC equal to the HST that they pay Accrued liabilities – an accrued liability usually results from an expense the business has incurred but not yet paid ie. Salary/wages payable, interest payable, income taxes payable Payroll liabilities – salary expense represents gross pay, and creates several payroll entries, expenses and liabilities, including salary payable to employ
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