| What I Have Learned in This Class |
Chapter 10:
Types of Operational Assets:
Property, Plant, and Equipment (PP&E), which includes machines, buildings, land, automobiles, etc.
Intangible Assets - Patents, copyrights, trademarks, etc.
Natural Resources - Oil, Mineral Deposits, etc.
Costs to be Capitalized for Operational Assets:
- Any costs necessary to bring the asset to its desired location, in its desired condition, for its desired use.
- Common examples of capitalized items would be:
* Acquisition Cost
* Shipping and Shipping Insurance Paid
* Installation Costs (such as unpacking and assembly)
* Purchase Discounts/Rebates/Returns would all reduce the cost
* The purchase of related items required to make the asset work, such as cables to connect the machine or a hood for ventilating the machine.
* Initial Training if required to make machine operate (note: only INITIAL training and only if it is necessary)
* Test Run Products (assumming they will not be sold to paying customers, i.e. they are true Trial Rund Products)
- Common examples of items related to operating assets which are NOT capitalized:
* Insurance for the machine (for example a fire insurance policy for a pizza oven)
* Employee Training which is not the Initial Training on the Machine for the company
* The manager's or any other employee's salary, even if they are hired for the exclusive use or overseeing of the operational asset.
* Utility bills related to the operational asset.
* Subsequent Trial Run Products after the machine is in use (e.g. you have to test the machine each morning by running a trial run - this is now an expense as the operating asset is now in working order).
- When extension become larger and more expensive (such as a change to the building's structure or foundation to accomodate the machine, you should question if it is more appropriate to capitalize the expenditures to the operating asset's account, the building's account, or expense them.
- This area is often treated differently by theory and practice. Often in practice many of these expenditures are simpily expensed as it is easier for now and in the future and it will reduce the amount of tax paid in the current period.
Destinction Between Land and Land Improvements:
- Land
* Land is not depreciable.
* Expenditures toward land which should be capitalized are:
> Clearing (The removal of trees may be profitable. This activity may actually create a net positive, which would decrease the cost of the land on the books).
> Draining - The removal of a pond or swamp area to allow more land to build on.
> Filling - The adding (or removing) of extra sand/soil to even out a building site
> Removal of Old Buildings - This additional expenditure would be capitalized to the land account (less any procedes received for the building's scrap)
- Land Improvements
* Land improvements are depreciable and should be tracked separately and depreciated
* Common Expenditures for Land Improvements:
> Sprinkler System
> Fence
> Driveway/Private Road
> Parking Lot
> Lighting for Land
Capitalizing Natural Resource Expenditures:
- Acquistion Costs - Amount to buy rights to land or even rights just to search
- Exploration Costs - Expenditures associated with the search for natural resources
- Development Costs - Expenditures related to setting up the structure to extract the natural resources (tunnels, drilling, etc)
- Restoration Costs - Expenditures anticipated to return the land to a usable condition (preferably its original condition)
* Restoration Costs are an example of an Asset Retirement Obligation (ARO)
Asset Retirement Obligation (ARO):
- An Asset Retirement Obligation is the recording of an expected future expenditure as a result of a legal obligation.
- Characteristics of an ARO are:
* It must be due to a legal obligation
* An ARO Liability is credited for the Fair Value
* The Natural Resource (an Asset) is debited
* It is recorded at Fair Value (i.e. the expenditure in the future is recorded at present value [time value of money])
> After initial recording of the liability, this account grows each year by the rate at which you discounted it (remember we calculated it at its present value).
> To record this periodic entry, debit Accretion Expense and a credit to the ARO Liability account.
Intangible Assets:
- Patents - Exclusive right to manufacture a product or use a process. Lasts for 20 years.
- Copyright - Exclusive right to reproduce and sell works such as songs, films, paintings, books, photographs, etc. Lasts for life of creator plus 70 years
- Trademark - Exclusive right to display/use a slogan, emblem, symbol, etc. Lasts for 10 years and is renewable indefinitely
- Franchises - A contractual right given to the franchisee from the franchisor to use their patents, copyrights, and or trademark, etc. Lasts for length of Franchise agreement and is renewable.
- Goodwill - Arises out of a business acquistion
* Goodwill is an asset which is not amortized. It is checked at least annually for impairment (i.e. did the value of the goodwill decrease).
* Goodwill is created when the purchase price for a company exceeds the fair market value of the net assets (i.e. FMV of Assets - FMV of assumed liabilities).
* You cannot record 'negative goodwill. If the purchase price for a company is less than the fair market value of the net assets, then those assets should be recorded in a similar manner as the lumpsum purchase.
Lumpsum Purchase:
- If you purchase multiple assets together which have different useful lives, scrap values, non-depreciable assets (land), etc, then you have to divide the purchase price between each asset. To perform this as fair as possible we use the lumpsum purchase method.
1) Sum up the fair market values of each individual asset.
2) Divide each fair market value by the total you calculated from step #1. This gives you a percentage value for each asset.
3) Multiple the purchase price by each assets percentage value from step #2 to find how much to capitalize on the balance sheet.
- The journal entry would be to debit your asset accounts and credit your method of payment (e.g. cash or note payable)
Donated Assets:
- Sometimes a company may receive a donated asset to entice a certain action. For example a small city may offer to give a company 5 acres of land if they agree to build a factory as this will increase the city's income and community's employment opportunities.
- Donated assets should be recorded as revenue
- Debit the asset account for the donated asset and credit revenue.
Selling an Asset:
- If you sell an asset for cash you will most likely recognize a gain or loss.
- Do not forget to remove the full asset (i.e. the asset account and its associated accumulated depreciation)
- Example Journal Entry:
* Debit Cash $$
* Debit Accumulated Depreciation
* Debit Loss (if applicable)
> Credit Asset Account for Historic Cost
> Credit Gain (if applicable)
- Sometimes you just trade in one asset for another one. For example, you trade in your old car plus a little cash for a new car.
- If you know the fair market value of the new asset (or at least new to you), then you will have a gain loss.
- If you do not know the fair market value of the new asset, then there will not be a gain or loss, but rather you will calculate what the value of the new asset must be to make the equation balance.
- Example of Journal Entry:
* Debit New Asset Account
* Debit Old Asset's Accumulated Depreciation
* Debit Cash (if YOU received any cash in the transaction)
* Debit Loss (if applicable)
> Credit Old Asset Account for Historic Value
> Credit Gain (if applicable)
Self-Constructed Asset and Interest Capitalization:
- If you are construction an asset for your own company's use or it is a non-inventory, discrete (separately tracked) item then you may be able to capitalize certain expenditures: overhead allocations and interest expense
- Two theories for overhead allocation:
* Incremental - Only capitalize expenditures which occur only as a result of undertaking this project (i.e. using an existing resource, such as an architect on staff, would not be capitalized as that person would be on staff whether you undertook the project or not.
* Full-Cost - Capitalize expenditures that are allocatable to the project whether they are incremental or not, similar to how we would for non-self-constructed assets.
> The Full-Cost Method is the method which won between the two theories.
For interest capitalization:
- You must actually have outstanding debt, although it does not need to be specifically tied to the asset being constructed (it can be old debt and generic in nature)
- You must calculate the weighted average expenditures for the year. This is done by multiplying each expenditure by the portion of the year it was outstanding. (For example, an expenditure of $120,000 on April 1, 2008, would be outstanding for 9 of the 12 months, therefore the weighted average expenditure is $90,000 [120,000*9/12])
- Compare the total amount of weighted average expenditures to the total amount of outstanding debt. You cannot capitalize more interest than was actually paid (i.e. you are capped by the amount of debt you have outstanding).
- To determine the amount of interest you can capitalize, use the specifically tied debt first at the stated interest rate.
- If the weighted average expenditures exceeds the amount of specifically tied debt, then use the other outstanding debt at its weighted average interest rate (if there are various outstanding debt amounts at different interest rates, you must calculate a weighted average interest rate by dividing total interest expense of all non-specifically tied debt by the total of all non-specifically tied debt).
- Any amount of interest expense capitalized should be debited to the asset's account rather than the interest expense account.
- The net effect of this activity is to raise the value of the assets and decrease interest expense for the period
* Remember, you will either capitalize the interest expenditure or expense it
* Remeber, you must stop capitalizing interest when the project is complete and ready for use.
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Chapter 11
Depreciation Methods:
Straight-line Depreciation:
Formula: (Historic Cost - Scrap Value) / Useful Life in Years
Simplest, very commonly used. Not an accelerated method.
Units-of-Production Method:
Formula: (Historic Cost - Scrap Value) / Useful Life in Output (such as pizzas, miles, etc.)
Matches depcreciation expense to the actual usage of the asset
Double Declining Balance Method:
Formula: Multiply the Beginning Book Value of the Asset by (200%/useful life in years)
* Trick - Do not forget to stop at the scrap value
* Trick - Do not forget that it is Beginning Book Value (Historic Cost - Accumulated Depreciation) for each year and therefore this number is always decreasing year to year.
Sum-of-the-Years' Digits Method:
Formula: Multiple the Depreciable Base (Historic Cost - Scrap Value) by (number of years remaining / the sum of all the years)
Example to Explain if you had a problem with 5 years of useful life
Year 1) Depreciable Base * 5 / (5+4+3+2+1)
Year 2) Depreciable Base * 4 / (5+4+3+2+1)
Intangible Assets:
- If you go to court to defend an intangible and win - capitalize your legal fees into your intangible
- If you go to court to defend an intangible and lose - expense you legal fees and (most likely) write-off your intangible too
* Remember Research and Development is expensed! It is not included in the value of an intangible asset.
Half-Year Convention:
* For practicality purposes, the half-year convention is often used to depreciate assets.
* No matter at what point you bought the asset in the year (January 14th or December 14th), you will take a half year of depreciation expense in that year.
* If using an accelerated depreciation method (as compared to straight-line depreciation, where there is not a difference in depreciation expense year to year):
> You must calculate the annual depreciation as if you purchased the asset on January 1st (i.e. calculate a full year's amount of depreciation)
> In Year 1 - You will take 1/2 of the first annual depreciation amount
> In Year 2 - You will take 1/2 of the first annual depreciation amount and 1/2 of the second annual depreciation amount
> In Year 3 - You will take 1/2 of the second annual depreciation amount and 1/2 of the third annual depreciation amount
* This method is not applicable / does not affect the units of production method
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Chapter 12:
There are three types of classification for investments:
- Trading Securities
> Debt Instruments or Equity
> Unrealized Gain/Loss included in Net Income
> Mark-to-Market (You want the Investment Account to reflect the current market value of the investment)
- Held-to-Maturity
> Debt Instruments onle
> Amortize the Cost (Term for decreasing the Discount on Bond or Premium on Bond account until they reach the face value of the bond at maturity)
> This method does not care about Mark-to-Market or about unrealized gain/losses
- Available for Sale
> Debt Instruments or Equity
> Unrealized Holding Gain/Loss is an equity account, it does not affect net income
> Unrealized Holding Gain/Loss is one of the few items which affect Comprehensive income
* Net Income + Other Adjustments to Owner's Equity = Comprehensive Income
* Unrealized Holding Gain/Loss is an "Other Adjustment to Owner's Equity"
> Investments do follow Mark-to-Market and the investment account should be equal to the fair market value of the investment
Bonds:
Three Types of Bonds:
* Par: Face Value = Amount Paid for the Bond Initially
* Premium: Face Value < Amount Paid for the Bond Initially
* Discount: Face Value > Amount Paid for the Bond Initially
Record the Purchase of a Bond:
Bond Receivable $1,000 (record the sum of the Face Values for all of the bonds)
Premium on Bond $ XXX (If the bond is a Premium Bond)
Discount on Bond $ XXX (if the bond is a Discount Bond)
Cash $ XXXX (Total amount paid initially for the bond)
Other Considerations
* Unless otherwise stated, the invester should know that the face value of the bond is $1,000 each
* Net Bond Receivable = Bond Receivable + Premium on Bond (if Applicable) - Discount on Bond (if applicable)
* Coupon Rate is the amount of interest stated on the Bond - this is used to determine the cash payments of the bonds
* Market Rate is the amount of interest the market is offering on similar types of bonds at the time you are purchasing your bond.
* The Market Rate does not matter after the initial purchase if the investment is Held-to-Maturity
Interest Payment Calculation (The amount you will receive in cash):
Cash Received = Face Value * Coupon Rate * Time
Interest Revenue Calculation (The amount you will record as revenue):
Interest Revenue = Net Bond Receivable * Market Rate * Time
If there is a difference between the payment calculation and the interest revenue, the balancing debit or credit would be to Discount on Bond or Premium on Bond, respectively.
<20% - Cost Method
20% to 50% - Equity Method (The point at which you most likely have significant influence over the company)
>50% - Consolidation
Equity Method:
* You may make the argument to use the equity method under 20% if you can show that you have significant influence
* You may make the argument NOT to use the equity method if between 20 and 50% if you can sho that you do not have significant influence
Record the purchase of the Investment the same either way:
Invest in X Corp $$$$
Cash $$$$
For Equity Method:
* Record the portion of the net income attributable to your ownership:
> X Corp's Net Income * My Ownership Percentage of X Corp
> Your journal entry will affect Investment Revenue and the Investment account
* Record the portion of the dividends attributable to your ownership:
> X Corp's Dividends * My Ownership Pecentage of X Corp
> Your journal entry should increase cash and decrease the Investment account
* The change in market value of the account does not matter
Cost Method:
* You do not care about the net income of the company
* You record received dividends by a debit to cash and a credit to Dividend Revenue
* You Mark-to- Market the investment account based on the current market value
Changing Between Methods:
From Equity Method to Cost Method - Treat Prospectively
From Cost Method to Equity Method - Treat Retrospectively (like the investment always used the Equity Method all along)
This has been a GREAT class. Thank you so much!
Good Luck on the Exam!
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