10.3: Annuities

10.3.1: Calculating Annuities

Learning Objective

Calculate the present or future value of various annuities based on the information given

Key Points

• Annuities are basically loans that are paid back over a set period of time at a set interest rate with consistent payments each period.
• A mortgage or car loan are simple examples of an annuity. Borrowers agree to pay a given amount each month when borrowing capital to compensate for the risk and the time value of money.
• The six potential variables included in an annuity calculation are the present value, the future value, interest, time (number of periods), payment amount, and payment growth (if applicable).
• Through integrating each of these (excluding payment growth, if payments are consistent over time), it is simple to solve for the present of future value of a given annuity.

Key Term

annuity

A right to receive amounts of money regularly over a certain fixed period in repayment of a loan or investment (or perpetually, in the case of a perpetuity).

Annuities Defined

To understand how to calculate an annuity, it’s useful to understand the variables that impact the calculation. An annuity is essentially a loan, a multi-period investment that is paid back over a fixed (or perpetual, in the case of a perpetuity)  period of time. The amount paid back over time is relative to the amount of time it takes to pay it back, the interest rate being applied, and the principal (when creating the annuity, this is the present value).

Generally speaking, annuities and perpetuities will have consistent payments over time. However, it is also an option to scale payments up or down, for various reasons.

Variables

This gives us six simple variables to use in our calculations:

1. Present Value (PV) – This is the value of the annuity at time 0 (when the annuity is first created)
2. Future Value (FV) – This is the value of the annuity at time n (i.e. at the conclusion of the life of the annuity).
3. Payments (A) – Each period will require individual payments that will be represented by this amount.
4. Number of Payments (n) – The number of payments (A) will equate to the number of expected periods of payment over the life of the annuity.
5. Interest (i) – Annuities occur over time, and thus a given rate of return (interest) is applied to capture the time value of money.
6. Growth (g) – For annuities that have changes in payments, there is a growth rate applied to these payments over time.

Calculating Annuities

With all of the inputs above at hand, it’s fairly simply to value various types of annuities. Generally investors, lenders, and borrowers are interested in the present and future value of annuities.

Present Value

The present value of an annuity can be calculated as follows:

For a growth annuity (where the payment amount changes at a predetermined rate over the life of the annuity), the present value can be calculated as follows:

Future Value

The future value of an annuity can be determined using this equation:

In a situation where payments grow over time, the future value can be determined using this equation:

Various Formula Arrangements

It is also possible to use existing information to solve for missing information. Which is to say, if you know interest and time, you can solve for the following (given the following):

Annuities Equations

This table is a useful way to view the calculation of annuities variables from a number of directions. Understanding how to manipulate the formula will underline the relationship between the variables, and provide some conceptual clarity as to what annuities are.

This table is a useful way to view the calculation of annuities variables from a number of directions. Understanding how to manipulate the formula will underline the relationship between the variables, and provide some conceptual clarity as to what annuities are.

10.3.2: Present Value of Annuity

Learning Objective

Calculate the present value of annuities

Key Points

• The PV for both annuities-due and ordinary annuities can be calculated using the size of the payments, the interest rate, and number of periods.
• The PV of a perpetuity can be found by dividing the size of the payments by the interest rate.
• Payment size is represented as p, pmt, or A; interest rate by i or r; and number of periods by n or t.

Key Term

perpetuity

An annuity in which the periodic payments begin on a fixed date and continue indefinitely.

The Present Value (PV) of an annuity can be found by calculating the PV of each individual payment and then summing them up . As in the case of finding the Future Value (FV) of an annuity, it is important to note when each payment occurs. Annuities-due have payments at the beginning of each period, and ordinary annuities have them at the end.

Recall that the first payment of an annuity-due occurs at the start of the annuity, and the final payment occurs one period before the end. The PV of an annuity-due can be calculated as follows:

where
is the size of the payment (sometimes
or
),
is the interest rate, and
is the number of periods.

An ordinary annuity has annuity payments at the end of each period, so the formula is slightly different than for an annuity-due. An ordinary annuity has one full period before the first payment (so it must be discounted) and the last payment occurs at the termination of the annuity (so it must be discounted for one period more than the last period in an annuity-due). The formula is:

where, again,
,
, and
are the size of the payment, the interest rate, and the number of periods, respectively.

Both annuities-due and ordinary annuities have a finite number of payments, so it is possible, though cumbersome, to find the PV for each period. For perpetuities, however, there are an infinite number of periods, so we need a formula to find the PV. The formula for calculating the PV is the size of each payment divided by the interest rate.

Example 1

Suppose you have won a lottery that pays $1,000 per month for the next 20 years. But, you prefer to have the entire amount now. If the interest rate is 8%, how much will you accept?

Consider for argument purposes that two people, Mr. Cash, and Mr. Credit, have won the same lottery of $1,000 per month for the next 20 years. Now, Mr. Credit is happy with his $1,000 monthly payment, but Mr. Cash wants to have the entire amount now. Our job is to determine how much Mr. Cash should get. We reason as follows: If Mr. Cash accepts x dollars, then the x dollars deposited at 8% for 20 years should yield the same amount as the $1,000 monthly payments for 20 years. In other words, we are comparing the future values for both Mr. Cash and Mr. Credit, and we would like the future values to be equal.

Since Mr. Cash is receiving a lump sum of x dollars, its future value is given by the lump sum formula:

Since Mr. Credit is receiving a sequence of payments, or an annuity, of $1,000 per month, its future value is given by the annuity formula:

The only way Mr. Cash will agree to the amount he receives is if these two future values are equal. So we set them equal and solve for the unknown:

The reader should also note that if Mr. Cash takes his lump sum of $119,554.36 and invests it at 8% compounded monthly, he will have $589,020.41 in 20 years.

Example 2

Find the monthly payment for a car costing $15,000 if the loan is amortized over five years at an interest rate of 9%.

Again, consider the following scenario: Two people, Mr. Cash and Mr. Credit, go to buy the same car that costs $15,000. Mr. Cash pays cash and drives away, but Mr. Credit wants to make monthly payments for five years. Our job is to determine the amount of the monthly payment.

We reason as follows: If Mr. Credit pays x dollars per month, then the x dollar payment deposited each month at 9% for 5 years should yield the same amount as the $15,000 lump sum deposited for 5 years. Again, we are comparing the future values for both Mr. Cash and Mr. Credit, and we would like them to be the same.

Since Mr. Cash is paying a lump sum of $15,000, its future value is given by the lump sum formula:

Mr. Credit wishes to make a sequence of payments, or an annuity, of x dollars per month, and its future value is given by the annuity formula:

We set the two future amounts equal and solve for the unknown:

10.3.3: Future Value of Annuity

Learning Objective

Calculate the future value of different types of annuities

Key Points

• To find the FV, you need to know the payment amount, the interest rate of the account the payments are deposited in, the number of periods per year, and the time frame in years.
• The first and last payments of an annuity due both occur one period before they would in an ordinary annuity, so they have different values in the future.
• There are different formulas for annuities due and ordinary annuities because of when the first and last payments occur.

Key Terms

annuity-due

An investment with fixed-payments that occur at regular intervals, paid at the beginning of each period.

ordinary repair

expense accrued in normal maintenance of an asset

annuity-due

a stream of fixed payments where payments are made at the beginning of each period

ordinary annuity

An investment with fixed-payments that occur at regular intervals, paid at the end of each period.

The future value of an annuity is the sum of the future values of all of the payments in the annuity. It is possible to take the FV of all cash flows and add them together, but this isn’t really pragmatic if there are more than a couple of payments.

If you were to manually find the FV of all the payments, it would be important to be explicit about when the inception and termination of the annuity is. For an annuity-due, the payments occur at the beginning of each period, so the first payment is at the inception of the annuity, and the last one occurs one period before the termination.

For an ordinary annuity, however, the payments occur at the end of the period. This means the first payment is one period after the start of the annuity, and the last one occurs right at the end. There are different FV calculations for annuities due and ordinary annuities because of when the first and last payments occur.

There are some formulas to make calculating the FV of an annuity easier. For both of the formulas we will discuss, you need to know the payment amount (m, though often written as pmt or p), the interest rate of the account the payments are deposited in (r, though sometimes i), the number of periods per year (n), and the time frame in years (t).

The formula for an ordinary annuity is as follows:

where m is the payment amount, r is the interest rate, n is the number of periods per year, and t is the length of time in years.

In contrast, the formula for an annuity-due is as follows:

Provided you know m, r, n, and t, therefore, you can find the future value (FV) of an annuity.

10.3.4: Annuities

Learning Objective

Classify the different types of annuity

Key Points

• Annuities have payments of a fixed size paid at regular intervals.
• There are three types of annuities: annuities-due, ordinary annuities, and perpetuities.
• Annuities help both the creditor and debtor have predictable cash flows, and it spreads payments of the investment out over time.

Key Term

period

The length of time during which interest accrues.

An annuity is a type of multi-period investment where there is a certain principal deposited and then regular payments made over the course of the investment. The payments are all a fixed size. For example, a car loan may be an annuity: In order to get the car, you are given a loan to buy the car. In return you make an initial payment (down payment), and then payments each month of a fixed amount. There is still an interest rate implicitly charged in the loan. The sum of all the payments will be greater than the loan amount, just as with a regular loan, but the payment schedule is spread out over time.

Suppose you are the bank that makes the car loan. There are three advantages to making the loan an annuity. The first is that there is a regular, known cash flow. You know how much money you’ll be getting from the loan and when you’ll be getting them. The second is that it should be easier for the person you are loaning to to repay, because they are not expected to pay one large amount at once. The third reason why banks like to make annuity loans is that it helps them monitor the financial health of the debtor. If the debtor starts missing payments, the bank knows right away that there is a problem, and they could potentially amend the loan to make it better for both parties.

Similar advantages apply to the debtor. There are predictable payments, and paying smaller amounts over multiple periods may be advantageous over paying the whole loan plus interest and fees back at once.

Since annuities, by definition, extend over multiple periods, there are different types of annuities based on when in the period the payments are made. The three types are:

1. Annuity-due: Payments are made at the beginning of the period . For example, if a period is one month, payments are made on the first of each month.
2. Ordinary Annuity: Payments are made at the end of the period . If a period is one month, this means that payments are made on the 28th/30th/31st of each month. Mortgage payments are usually ordinary annuities.
3. Perpetuities: Payments continue forever. This is much rarer than the first two types.

10.4: Additional Detail on Present and Future Values

10.4.1: Loans and Loan Amortization

When borrowing money to be paid back via a number of installments over time, it is important to understand the time value of money and how to build an amortization schedule.

Learning Objective

Understand amortization schedules

Key Points

• Amortization of a loan is the process of identifying a payment amount for each period of repayment on a given outstanding debt.
• Repaying capital over time at an interest rate requires an amortization schedule, which both parties agree to prior to the exchange of capital. This schedule determines the repayment period, as well as the amount of repayment per period.
• Time value of money is a central concept to amortization. A dollar today, for example, is worth more than a dollar tomorrow due to the opportunity cost of other investments.
• When purchasing a home for $100,000 over 30 years at 8% interest (consistent payments each month), for example, the total amount of repayment is more than 2.5 times the original principal of $100,000.

Key Term

amortization

This is the process of scheduling intervals of payment over time to pay back an existing debt, taking into account the time value of money.

 When lending money (or borrowing, depending on your perspective), it is common to have multiple payback periods over time (i.e. multiple, smaller cash flow installments to pay back the larger borrowed sum). In these situations, an amortization schedule will be created. This will determine how much will be paid back each period, and how many periods of repayment will be required to cover the principal balance. This must be agreed upon prior to the initial borrowing occurs, and signed by both parties.

Time Value of Money

Now if you add up all of the separate payments in an amortization schedule, you’ll find the total exceeds the amount borrowed. This is because amortization schedules must take into account the time value of money. Time value of money is a fairly simple concept at it’s core: a dollar today is worth more than a dollar tomorrow.

Why? Because capital can be invested, and those investments can yield returns. Lending your money to someone means incurring the opportunity cost of the other things you could do with that money. This gets even more drastic as the scale of capital increases, as the returns on capital over time are expressed in a percentage of the capital invested. Say you spend $100 on some stock, and turn 10% on that investment. You now have $110, a profit of $10. Say instead of only a $100, you put in $10,000. Now you have $11,000, a profit of $1,000.

Principle and Interest

As a result of this calculation, amortization schedules charge interest over time as a percentage of the principal borrowed. The calculation will incorporate the number of payment periods (n), the principal (P), the amortization payment (A) and the interest rate (r).

To make this a bit more realistic, let’s insert some numbers. Let’s say you find a dream house, at the reasonable rate of $100,000. Unfortunately, a bit of irresponsible borrowing in your past means you must pay 8% interest over a 30 year loan, which will be paid via a monthly amortization schedule (12 months x 30 years = 360 payments total). If you do the math, you should find yourself paying $734 per month 360 times. 360 x 734 will leave you in the ballpark of $264,000 in total repayment. that means you are paying more than 2.5 times as much for this house due to time value of money! This bit of knowledge is absolutely critical for personal financial decisions, as well as for high level business decisions.

Amortization Schedule Example

This shows the first few installments in the example discussed above (i.e. borrowing $100,000 at 8% interest paid monthly over 30 years).

This shows the first few installments in the example discussed above (i.e. borrowing $100,000 at 8% interest paid monthly over 30 years).

10.4.2: Calculating Values for Fractional Time Periods

The value of money and the balance of the account may be different when considering fractional time periods.

Learning Objective

Calculate the future and present value of an account when a fraction of a compounding period has passed

Key Points

• The balance of an account only changes when interest is paid. To find the balance, round the fractional time period down to the period when interest was last accrued.
• To find the PV or FV, ignore when interest was last paid an use the fractional time period as the time period in the equation.
• The discount rate is really the cost of not having the money over time, so for PV/FV calculations, it doesn’t matter if the interest hasn’t been added to the account yet.

Key Terms

time period assumption

business profit or loses are measured on timely basis

compounding period

The length of time between the points at which interest is paid.

time value of money

the value of an asset accounting for a given amount of interest earned or inflation accrued over a given period

Up to this point, we have implicitly assumed that the number of periods in question matches to a multiple of the compounding period. That means that the point in the future is also a point where interest accrues. But what happens if we are dealing with fractional time periods?

Compounding periods can be any length of time, and the length of the period affects the rate at which interest accrues.

Compounding Interest

The effect of earning 20% annual interest on an initial $1,000 investment at various compounding frequencies.

Suppose the compounding period is one year, starting January1, 2012. If the problem asks you to find the value at June 1, 2014, there is a bit of a conundrum. The last time interest was actually paid was at January 1, 2014, but the time-value of money theory clearly suggests that it should be worth more in June than in January.

In the case of fractional time periods, the devil is in the details. The question could ask for the future value, present value, etc., or it could ask for the future balance, which have different answers.

Future/Present Value

If the problem asks for the future value (FV) or present value (PV), it doesn’t really matter that you are dealing with a fractional time period. You can plug in a fractional time period to the appropriate equation to find the FV or PV. The reasoning behind this is that the interest rate in the equation isn’t exactly the interest rate that is earned on the money. It is the same as that number, but more broadly, is the cost of not having the money for a time period. Since there is still a cost to not having the money for that fraction of a compounding period, the FV still rises.

Account Balance

The question could alternatively ask for the balance of the account. In this case, you need to find the amount of money that is actually in the account, so you round the number of periods down to the nearest whole number (assuming one period is the same as a compounding period; if not, round down to the nearest compounding period). Even if interest compounds every period, and you are asked to find the balance at the 6.9999^th period, you need to round down to 6. The last time the account actually accrued interest was at period 6; the interest for period 7 has not yet been paid.

If the account accrues interest continuously, there is no problem: there can’t be a fractional time period, so the balance of the account is always exactly the value of the money.

10.4.3: The Relationship Between Present and Future Value

Present value (PV) and future value (FV) measure how much the value of money has changed over time.

Learning Objective

Discuss the relationship between present value and future value

Key Points

• The future value (FV) measures the nominal future sum of money that a given sum of money is “worth” at a specified time in the future assuming a certain interest rate, or more generally, rate of return. The FV is calculated by multiplying the present value by the accumulation function.
• PV and FV vary jointly: when one increases, the other increases, assuming that the interest rate and number of periods remain constant.
• As the interest rate (discount rate) and number of periods increase, FV increases or PV decreases.

Key Terms

discounting

The process of finding the present value using the discount rate.

present value

a future amount of money that has been discounted to reflect its current value, as if it existed today

capitalization

The process of finding the future value of a sum by evaluating the present value.

The future value (FV) measures the nominal future sum of money that a given sum of money is “worth” at a specified time in the future assuming a certain interest rate, or more generally, rate of return. The FV is calculated by multiplying the present value by the accumulation function. The value does not include corrections for inflation or other factors that affect the true value of money in the future. The process of finding the FV is often called capitalization.

On the other hand, the present value (PV) is the value on a given date of a payment or series of payments made at other times. The process of finding the PV from the FV is called discounting.

PV and FV are related , which reflects compounding interest (simple interest has n multiplied by i, instead of as the exponent). Since it’s really rare to use simple interest, this formula is the important one.

FV of a single payment

The PV and FV are directly related.

PV and FV vary directly: when one increases, the other increases, assuming that the interest rate and number of periods remain constant.

The interest rate (or discount rate) and the number of periods are the two other variables that affect the FV and PV. The higher the interest rate, the lower the PV and the higher the FV. The same relationships apply for the number of periods. The more time that passes, or the more interest accrued per period, the higher the FV will be if the PV is constant, and vice versa.

The formula implicitly assumes that there is only a single payment. If there are multiple payments, the PV is the sum of the present values of each payment and the FV is the sum of the future values of each payment.

10.4.4: Comparing Interest Rates

Variables, such as compounding, inflation, and the cost of capital must be considered before comparing interest rates.

Learning Objective

Discuss the differences between effective interest rates, real interest rates, and cost of capital

Key Points

• A nominal interest rate that compounds has a different effective rate (EAR), because interest is accrued on interest.
• The Fisher Equation approximates the amount of interest accrued after accounting for inflation.
• A company will theoretically only invest if the expected return is higher than their cost of capital, even if the return has a high nominal value.

Key Term

inflation

An increase in the general level of prices or in the cost of living.

The amount of interest you would have to pay on a loan or would earn on an investment is clearly an important consideration when making any financial decisions. However, it is not enough to simply compare the nominal values of two interest rates to see which is higher.

Effective Interest Rates

The reason why the nominal interest rate is only part of the story is due to compounding. Since interest compounds, the amount of interest actually accrued may be different than the nominal amount. The last section went through one method for finding the amount of interest that actually accrues: the Effective Annual Rate (EAR).

The EAR is a calculation that account for interest that compounds more than one time per year. It provides an annual interest rate that accounts for compounded interest during the year. If two investments are otherwise identical, you would naturally pick the one with the higher EAR, even if the nominal rate is lower.

Real Interest Rates

Interest rates are charged for a number of reasons, but one is to ensure that the creditor lowers his or her exposure to inflation. Inflation causes a nominal amount of money in the present to have less purchasing power in the future. Expected inflation rates are an integral part of determining whether or not an interest rate is high enough for the creditor.

The Fisher Equation is a simple way of determining the real interest rate, or the interest rate accrued after accounting for inflation. To find the real interest rate, simply subtract the expected inflation rate from the nominal interest rate.

Fisher Equation

The nominal interest rate is approximately the sum of the real interest rate and inflation.

For example, suppose you have the option of choosing to invest in two companies. Company 1 will pay you 5% per year, but is in a country with an expected inflation rate of 4% per year. Company 2 will only pay 3% per year, but is in a country with an expected inflation of 1% per year. By the Fisher Equation, the real interest rates are 1% and 2% for Company 1 and Company 2, respectively. Thus, Company 2 is the better investment, even though Company 1 pays a higher nominal interest rate.

Cost of Capital

Another major consideration is whether or not the interest rate is higher than your cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. Many companies have a standard cost of capital that they use to determine whether or not an investment is worthwhile.

In theory, a company will never make an investment if the expected return on the investment is less than their cost of capital. Even if a 10% annual return sounds really nice, a company with a 13% cost of capital will not make that investment.

10.4.5: Calculating Values for Different Durations of Compounding Periods

Finding the Effective Annual Rate (EAR) accounts for compounding during the year, and is easily adjusted to different period durations.

Learning Objective

Calculate the present and future value of something that has different compounding periods

Key Points

• The units of the period (e.g. one year) must be the same as the units in the interest rate (e.g. 7% per year).
• When interest compounds more than once a year, the effective interest rate (EAR) is different from the nominal interest rate.
• The equation in skips the step of solving for EAR, and is directly usable to find the present or future value of a sum.

Key Terms

Future Value

The value of an asset at a specific date. It measures the nominal future sum of money that a given sum of money is “worth” at a specified time in the future, assuming a certain interest rate, or more generally, rate of return, it is the present value multiplied by the accumulation function.

present value

Also known as present discounted value, is the value on a given date of a payment or series of payments made at other times. If the payments are in the future, they are discounted to reflect the time value of money and other factors such as investment risk. If they are in the past, their value is correspondingly enhanced to reflect that those payments have been (or could have been) earning interest in the intervening time. Present value calculations are widely used in business and economics to provide a means to compare cash flows at different times on a meaningful “like to like” basis.

Sometimes, the units of the number of periods does not match the units in the interest rate. For example, the interest rate could be 12% compounded monthly, but one period is one year. Since the units have to be consistent to find the PV or FV, you could change one period to one month. But suppose you want to convert the interest rate into an annual rate. Since interest generally compounds, it is not as simple as multiplying 1% by 12 (1% compounded each month). This atom will discuss how to handle different compounding periods.

Effective Annual Rate

The effective annual rate (EAR) is a measurement of how much interest actually accrues per year if it compounds more than once per year. The EAR can be found through the formula in where i is the nominal interest rate and n is the number of times the interest compounds per year (for continuous compounding, see ). Once the EAR is solved, that becomes the interest rate that is used in any of the capitalization or discounting formulas.

EAR with Continuous Compounding

The effective rate when interest compounds continuously.

Calculating the effective annual rate

The effective annual rate for interest that compounds more than once per year.

For example, if there is 8% interest that compounds quarterly, you plug .08 in for i and 4 in for n. That calculates an EAR of .0824 or 8.24%. You can think of it as 2% interest accruing every quarter, but since the interest compounds, the amount of interest that actually accrues is slightly more than 8%. If you wanted to find the FV of a sum of money, you would have to use 8.24% not 8%.

Solving for Present and Future Values with Different Compounding Periods

Solving for the EAR and then using that number as the effective interest rate in present and future value (PV/FV) calculations is demonstrated here. Luckily, it’s possible to incorporate compounding periods into the standard time-value of money formula. The equation in is the same as the formulas we have used before, except with different notation. In this equation, A(t) corresponds to FV, A₀ corresponds to Present Value, r is the nominal interest rate, n is the number of compounding periods per year, and t is the number of years.

FV Periodic Compounding

Finding the FV (A(t)) given the PV (Ao), nominal interest rate (r), number of compounding periods per year (n), and number of years (t).

The equation follows the same logic as the standard formula. r/n is simply the nominal interest per compounding period, and nt represents the total number of compounding periods.

Solving for n

The last tricky part of using these formulas is figuring out how many periods there are. If PV, FV, and the interest rate are known, solving for the number of periods can be tricky because n is in the exponent. It makes solving for n manually messy. shows an easy way to solve for n. Remember that the units are important: the units on n must be consistent with the units of the interest rate (i).

Solving for n

This formula allows you to figure out how many periods are needed to achieve a certain future value, given a present value and an interest rate.

10.4.6: Calculating Perpetuities

The present value of a perpetuity is simply the payment size divided by the interest rate and there is no future value.

Learning Objective

Calculate the present value of a perpetuity

Key Points

• Perpetuities are a special type of annuity; a perpetuity is an annuity that has no end, or a stream of cash payments that continues forever.
• To find the future value of a perpetuity requires having a future date, which effectively converts the perpetuity to an ordinary annuity until that point.
• Perpetuities with growing payments are called Growing Perpetuities; the growth rate is subtracted from the interest rate in the present value equation.

Key Term

growth rate

The percentage by which the payments grow each period.

Perpetuities are a special type of annuity; a perpetuity is an annuity that has no end, or a stream of cash payments that continues forever. Essentially, they are ordinary annuities, but have no end date. There aren’t many actual perpetuities, but the United Kingdom has issued them in the past.

Since there is no end date, the annuity formulas we have explored don’t apply here. There is no end date, so there is no future value formula. To find the FV of a perpetuity would require setting a number of periods which would mean that the perpetuity up to that point can be treated as an ordinary annuity.

There is, however, a PV formula for perpetuities . The PV is simply the payment size (A) divided by the interest rate (r). Notice that there is no n, or number of periods. More accurately, is what results when you take the limit of the ordinary annuity PV formula as n → ∞.

It is also possible that an annuity has payments that grow at a certain rate per period. The rate at which the payments change is fittingly called the growth rate (g). The PV of a growing perpetuity is represented as
. It is essentially the same as in except that the growth rate is subtracted from the interest rate. Another way to think about it is that for a normal perpetuity, the growth rate is just 0, so the formula boils down to the payment size divided by r.

10.5: Yield

10.5.1: Calculating the Yield of a Single-Period Investment

The yield of a single period investment is simply
.

Learning Objective

Differentiate between the different methods of calculating yield of a single period investment

Key Points

• There are a number of ways to calculate yield, but the most common ones are to calculate the percent change from the initial investment, APR, and APY (or EAR).
• APR (annual percentage rate) is a commonly used calculation that figures out the nominal amount of interest accrued per year. It does not account for compounding interest.
• APY (annual percentage yield) is a way of using the nominal interest rate to calculate the effective interest rate per year. It accounts for compounding interest.
• EAR (effective annual rate) is a special type of APY that uses APR as the nominal interest rate.

Key Terms

effective-interest method

amortizing a debt according to the effective interest rate paid

Nominal Interest

The amount of interest accrued per year without accounting for compounding.

Effective Interest

The amount of interest accrued per year after accounting for compounding.

Determining Yield

The yield on an investment is the amount of money that is returned to the owner at the end of the term. In short, it’s how much you get back on your investment.

Naturally, this is a number that people care a lot about. The whole point of making an investment is to get a yield. There are a number of different ways to calculate an investment’s yield, though. You may get slightly different numbers using different methods, so it’s important to make sure that you use the same method when you are comparing yields. This section will address the yield calculation methods you are most likely to encounter, though there are many more.

Change-In-Value

The most basic type of yield calculation is the change-in-value calculation. This is simply the change in value (FV minus PV) divided by the PV times 100%. This calculation measures how different the FV is from the PV as a percentage of PV.

Percent Change

The percent change in value is the change in value from PV to FV (V2 to V1) divided by PV (V1) times 100%.

Annual Percentage Rate

Another common way of calculating yield is to determine the Annual Percentage Rate, or APR. You may have heard of APR from ads for car loans or credit cards. These generally have monthly loans or fees, but if you want to get an idea of how much you will accrue in interest per year, you need to calculate an APR. Nominal APR is simply the interest rate multiplied by the number of payment periods per year. However, since interest compounds, nominal APR is not a very accurate measure of the amount of interest you actually accrue.

Effective Annual Rate

To find the effective APR, the actual amount of interest you would accrue per year, we use the Effective Annual Rate, or EAR.

EAR

The Effective Annual Rate is the amount of interest actually accrued per year based on the APR. n is the number of compounding periods of APR per year.

For example, you may see an ad that says you can get a car loan at an APR of 10% compounded monthly. That means that APR=.10 and n=12 (the APR compounds 12 times per year). That means the EAR is 10.47%.

The EAR is a form of the Annual Percentage Yield (APY). APY may also be calculated using interest rates other than APR, so a more general formula is in . The logic behind calculating APY is the same as that used when calculating EAR: we want to know how much you actually accrue in interest per year. Interest usually compounds, so there is a difference between the nominal interest rate (e.g. monthly interest times 12) and the effective interest rate.

Annual Percentage Yield

The Annual Percentage Yield is a way or normalizing the nominal interest rate. Basically, it is a way to account for the time factor in order to get a more accurate number for the actual interest rate.inom is the nominal interest rate.N is the number of compounding periods per year.

10.5.2: Calculating the Yield of an Annuity

The yield of an annuity is commonly found using either the percent change in the value from PV to FV, or the internal rate of return.

Learning Objective

Calculate the yield of an annuity using the internal rate of return method

Key Points

• The yield of an annuity may be found by discounting to find the PV, and then finding the percentage change from the PV to the FV.
• The Internal Rate of Return (IRR) is the discount rate at which the NPV of an investment equals 0.
• The IRR calculates an annualized yield of an annuity.

Key Terms

Net Present Value (NPV)

The present value of a project or an investment decision determined by summing the discounted incoming and outgoing future cash flows resulting from the decision.

Internal Rate of Return (IRR)

The discount rate that will cause the NPV of an investment to equal 0.

yield

In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return. Yield applies to various stated rates of return on stocks (common and preferred, and convertible), fixed income instruments (bonds, notes, bills, strips, zero coupon), and some other investment type insurance products

The yield of annuity can be calculated in similar ways to the yield for a single payment, but two methods are most common.

The first is the standard percentage-change method. Just as for a single payment, this method calculated the percentage difference between the FV and the PV. Since annuities include multiple payments over the lifetime of the investment, the PV (or V₁ in is the present value of the entire investment, not just the first payment.

The second popular method is called the internal rate of return (IRR). The IRR is the interest rate (or discount rate) that causes the Net Present Value (NPV) of the annuity to equal 0. That means that the PV of the cash outflows equals the PV of the cash inflows. The higher the IRR, the more desirable is the investment. In theory, you should make investment with an IRR greater than the cost of capital.

Let’s take an example investment: It is not technically an annuity because the payments vary, but still is a good example for how to find IRR:

Suppose you have a potential investment that would require you to make a $4,000 investment today, but would return cash flows of $1,200, $1,410, $1,875, and $1,050 in the four successive years. This investment has an implicit rate of return, but you don’t know what it is. You plug the numbers into the NPV formula and set NPV equal to 0. You then solve for r, which is your IRR (it’s not easy to solve this problem by hand. You will likely need to use a business calculator or Excel). When r = 14.3%, NPV = 0, so therefore the IRR of the investment is 14.3%.

IRR Example

The setup to find the IRR of the investment with cash flows of -4000, 1200, 1410, 1875, and 1050. By setting NPV = 0 and solving for r, you can find the IRR of this investment.

10.6: Valuing Multiple Cash Flows

10.6.1: Present Value, Multiple Flows

The PV of multiple cash flows is simply the sum of the present values of each individual cash flow.

Learning Objective

Calculate the present value of an investment portfolio that has multiple cash flows

Key Points

• To find the PV of multiple cash flows, each cash flow much be discounted to a specific point in time and then added to the others.
• To discount annuities to a time prior to their start date, they must be discounted to the start date, and then discounted to the present as a single cash flow.
• Multiple cash flow investments that are not annuities unfortunately cannot be discounted by any other method but by discounting each cash flow and summing them together.

Key Terms

discount

To find the value of a sum of money at some earlier point in time. To find the present value.

net present value

the present value of a project or an investment decision determined by summing the discounted incoming and outgoing future cash flows resulting from the decision

The PV of multiple cash flows follows the same logic as the FV of multiple cash flows. The PV of multiple cash flows is simply the sum of the present values of each individual cash flow .

Sum FV

The PV of an investment is the sum of the present values of all its payments.

Each cash flow must be discounted to the same point in time. For example, you cannot sum the PV of two loans at the beginning of the loans if one starts in 2012 and one starts in 2014. If you want to find the PV in 2012, you need to discount the second loan an additional two years, even though it doesn’t start until 2014.

The calculations get markedly simpler if the cash flows make up an annuity. In order to be an annuity (and use the formulas explained in the annuity module), the cash flows need to have three traits:

1. Constant payment size
2. Payments occur at fixed intervals
3. A constant interest rate

Things may get slightly messy if there are multiple annuities, and you need to discount them to a date before the beginning of the payments.

Suppose there are two sets of cash flows which you determine are both annuities. The first extends from 1/1/14 to 1/1/16, and the second extends from 1/1/15 to 1/1/17. You want to find the total PV of all the cash flows on 1/1/13.

The annuity formulas are good for determining the PV at the date of the inception of the annuity. That means that it’s not enough to simply plug in the payment size, interest rate, and number of periods between 1/1/13 and the end of the annuities. If you do, that supposes that both annuities begin on 1/1/13, but neither do. Instead, you have to first find the PV of the first annuity on 1/1/14 and the second on 1/1/15 because that’s when the annuities begin.

You now have two present values, but both are still in the future. You then can discount those present values as if they were single sums to 1/1/13.

Unfortunately, if the cash flows do not fit the characteristics of an annuity, there isn’t a simple way to find the PV of multiple cash flows: each cash flow much be discounted and then all of the PVs must be summed together.

Example

A corporation must decide whether to introduce a new product line. The new product will have start-up expenditures, operational expenditures, and then it will have associated incoming cash receipts (sales) and disbursements (Cash paid for materials, supplies, direct labor, maintenance, repairs, and direct overhead) over 12 years. This project will have an immediate (t=0) cash outflow of 100,000 (which might include all cash paid for the machinery, transportation-in and set-up expenditures, and initial employee training disbursements. ) The annual net cash flow (receipts less disbursements) from this new line for years 1-12 is forecast as follows: -54672, -39161, 3054, 7128, 25927, 28838, 46088, 77076, 46726, 76852, 132332, 166047, reflecting two years of running deficits as experience and sales are built up, with net cash receipts forecast positive after that. At the end of the 12 years it’s estimated that the entire line becomes obsolete and its scrap value just covers all the removal and disposal expenditures. All values are after-tax, and the required rate of return is given to be 10%. (This also makes the simplifying assumption that the net cash received or paid is lumped into a single transaction occurring on the last day of each year. )

The present value (PV) can be calculated for each year:

T=0:

T=1:

T=2:

T=3:

T=4:

T=5:

T=6:

T=7:

T=8:

T=9:

T=10:

T=11:

T=12:

The sum of all these present values is the net present value, which equals 65,816.04. Since the NPV is greater than zero, it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is no alternative with a higher NPV.

10.6.2: Future Value, Multiple Flows

To find the FV of multiple cash flows, sum the FV of each cash flow.

Learning Objective

Calculate the Future Value of Multiple Annuities

Key Points

• The FV of multiple cash flows is the sum of the FV of each cash flow.
• To sum the FV of each cash flow, each must be calculated to the same point in the future.
• If the multiple cash flows are a fixed size, occur at regular intervals, and earn a constant interest rate, it is an annuity. There are formulas for calculating the FV of an annuity.

Key Terms

incremental cash flows

the additional money flowing in or out of a business due to a project

annuity

A specified income payable at stated intervals for a fixed or a contingent period, often for the recipient’s life, in consideration of a stipulated premium paid either in prior installment payments or in a single payment. For example, a retirement annuity paid to a public officer following his or her retirement.

cash flow

The sum of cash revenues and expenditures over a period of time.

Future Value, Multiple Cash Flows

Finding the future value (FV) of multiple cash flows means that there are more than one payment/investment, and a business wants to find the total FV at a certain point in time. These payments can have varying sizes, occur at varying times, and earn varying interest rates, but they all have a certain value at a specific time in the future.

The first step in finding the FV of multiple cash flows is to define when the future is. Once that is done, you can determine the FV of each cash flow using the formula in . Then, simply add all of the future values together.

FV of a single payment

The FV of multiple cash flows is the sum of the future values of each cash flow.

Manually calculating the FV of each cash flow and then summing them together can be a tedious process. If the cash flows are irregular, don’t happen at regular intervals, or earn different interest rates, there isn’t a special way to find the total FV.

However, if the cash flows do happen at regular intervals, are a fixed size, and earn a uniform interest rate, there is an easier way to find the total FV. Investments that have these three traits are called “annuities. “

There are formulas to find the FV of an annuity depending on some characteristics, such as whether the payments occur at the beginning or end of each period. There is a module that goes through exactly how to calculate the FV of annuities.

If the multiple cash flows are a part of an annuity, you’re in luck; there is a simple way to find the FV. If the cash flows aren’t uniform, don’t occur at fixed intervals, or earn different interest rates, the only way to find the FV is do find the FV of each cash flow and then add them together.

10.7: Present Value, Single Amount

10.7.1: The Discount Rate

Discounting is the procedure of finding what a future sum of money is worth today.

Learning Objective

Describe what real world costs to the investor comprise an investment’s interest rate

Key Points

• The discount rate represents some cost (or group of costs) to the investor or creditor.
• Some costs to the investor or creditor are opportunity cost, liquidity cost, risk, and inflation.
• The discount rate is used by both the creditor and debtor to find the present value of an amount of money.

Key Terms

discount rate

The interest rate used to discount future cash flows of a financial instrument; the annual interest rate used to decrease the amounts of future cash flow to yield their present value.

discounting

The process of finding the present value using the discount rate.

discount

to account for the time value of money

Another common name for finding present value (PV) is discounting. Discounting is the procedure of finding what a future sum of money is worth today. As you know from the previous sections, to find the PV of a payment you need to know the future value (FV), the number of time periods in question, and the interest rate. The interest rate, in this context, is more commonly called the discount rate.

The discount rate represents some cost (or group of costs) to the investor or creditor. The sum of these costs amounts to a percentage which becomes the interest rate (plus a small profit, sometimes). Here are some of the most significant costs from the investor/creditor’s point of view:

Borrowing and lending

Banks like HSBC take such costs into account when determining the terms of a loan for borrowers.

1. Opportunity Cost: The cost of not having the cash on hand at a certain point of time. If the investor/creditor had the cash s/he could spend it, but since it has been invested/loaned out, s/he incurs the cost of not being able to spend it.
2. Inflation: The real value of a single dollar decreases over time with inflation. That means that even if everything else is constant, a $100 item will retail for more than $100 in the future. Inflation is generally positive in most countries at most times (if it’s not, it’s called deflation, but it’s rare).
3. Risk: There is a chance that you will not get your money back because it is a bad investment, the debtor defaults. You require compensation for taking on that risk.
4. Liquidity: Investing or loaning out cash necessarily reduces your liquidity.

All of these costs combine to determine the interest rate on an account, and that interest rate in turn is the rate at which the sum is discounted.

The PV and the discount rate are related through the same formula we have been using,
.

If FV and n are held as constants, then as the discount rate (i) increases, PV decreases. PV and the discount rate, therefore, vary inversely, a fundamental relationship in finance. Suppose you expect $1,000 dollars in one year’s time (FV = $1,000) . To determine the present value, you would need to discount it by some interest rate (i). If this discount rate were 5%, the $1,000 in a year’s time would be the equivalent of $952.38 to you today (1000/[1.00 + 0.05]).

10.7.2: Number of Periods

The number of periods corresponds to the number of times the interest is accrued.

Learning Objective

Define what a period is in terms of present value calculations

Key Points

• A period is just a general term for a length of time. It can be anything- one month, one year, one decade- but it must be clearly defined and fixed.
• For both simple and compound interest, the number of periods varies jointly with FV and inversely with PV.
• The number of periods is also part of the units of the discount rate: if one period is one year, the discount rate must be defined as X% per year. If one period is one month, the discount rate must be X% per month.

Key Term

period

The length of time during which interest accrues.

In , nrepresents the number of periods. A period is just a general term for a length of time. It can be anything- one month, one year, one decade- but it must be clearly defined and fixed. The length of one period must be the same at the beginning of an investment and at the end. It is also part of the units of the discount rate: if one period is one year, the discount rate must be defined as X% per year. If one period is one month, the discount rate must be X% per month.

FV of a single payment

The PV and FV are directly related.

The number of periods corresponds to the number of times the interest is accrued. In the case of simple interest the number of periods, t, is multiplied by their interest rate. This makes sense because if you earn $30 of interest in the first period, you also earn $30 of interest in the last period, so the total amount of interest earned is simple t x $30.

Simple interest is rarely used in comparison to compound interest . In compound interest, the interest in one period is also paid on all interest accrued in previous periods. Therefore, there is an exponential relationship between PV and FV, which is reflected in (1+i)ⁿ .

Car

Car loans, mortgages, and student loans all generally have compound interest.

For both forms of interest, the number of periods varies jointly with FV and inversely with PV. Logically, if more time passes between the present and the future, the FV must be higher or the PV lower (assuming the discount rate remains constant).

10.7.3: Calculating Present Value

Calculating the present value (PV) is a matter of plugging FV, the interest rate, and the number of periods into an equation.

Learning Objective

Distinguish between the formula used for calculating present value with simple interest and the formula used for present value with compound interest

Key Points

• The first step is to identify if the interest is simple or compound. Most of the time, it is compound.
• The interest rate and number of periods must have consistent units.
• The PV is what a future sum is worth today given a specific interest rate (often called a “discount rate”).

Key Terms

compound interest

Interest, as on a loan or a bank account, that is calculated on the total on the principal plus accumulated unpaid interest.

simple interest

interest paid only on the principal.

Finding the present value (PV) of an amount of money is finding the amount of money today that is worth the same as an amount of money in the future, given a certain interest rate.

Calculating the present value (PV) of a single amount is a matter of combining all of the different parts we have already discussed. But first, you must determine whether the type of interest is simple or compound interest. If the interest is simple interest, you plug the numbers into the simple interest formula.

Simple Interest Formula

Simple interest is when interest is only paid on the amount you originally invested (the principal). You don’t earn interest on interest you previously earned.

If it is compound interest, you can rearrange the compound interest formula to calculate the present value.

Present Value Single Payment

Finding the PV is a matter of plugging in for the three other variables.

Inputs

• Future Value: The known value of the money at a declared point in the future.
• Interest Rate (Discount Rate): Represented as either i or r. This is the percentage of interest paid each period.
• Number of periods: Represented as n or t.

Once you know these three variables, you can plug them into the appropriate equation. If the problem doesn’t say otherwise, it’s safe to assume the interest compounds. If you happen to be using a program like Excel, the interest is compounded in the PV formula. Simple interest is pretty rare.

One area where there is often a mistake is in defining the number of periods and the interest rate. They have to have consistent units, which may require some work. For example, interest is often listed as X% per year. The problem may talk about finding the PV 24 months before the FV, but the number of periods must be in years since the interest rate is listed per year. Therefore, n = 2. As long as the units are consistent, however, finding the PV is done by plug-and-chug.

10.7.4: Multi-Period Investment

Multi-period investments require an understanding of compound interest, incorporating the time value of money over time.

Learning Objective

Calculate the return on a multi-period investment over time

Key Points

• A dollar today is worth more than a dollar tomorrow, and the time value of money must take into account foregone opportunities.
• Single period investments are relatively simple to calculate in terms of future value, applying the interest rate to a present value a single time.
• Multi-period investments require a slightly more complex equation, where interest gets compounded based on the number of periods the investment spans.
• As a result of multiple periods, it is usually a good idea to calculate the average rate of return (cumulatively) over the lifetime of the investment.

Key Term

Compound interest

An interest rate applied to multiple applications of interest during the lifetime of the investment.

When investing, the time value of money is a core concept investors simply cannot ignore. A dollar today is valued higher than a dollar tomorrow, and when utilizing the capital it is important to recognize the opportunity cost involved in what could have been invested in instead.

Single Period Investments

With single period investments, the concept of time value of money is relatively straightforward. The future value is simply the present value applied to the interest rate compounded one time. When comparing this to the opportunity costs involved, the rate of return of an alternative investment during the same time is similarly straightforward.

The variables involved in understanding the time value of money in these investments are:

• Present Value (PV)
• Future Value (FV)
• Interest Rate (i or r) [Note: for all formulas, express interest in its decimal form, not as a whole number. 7% is .07, 12% is .12, and so on. ]
• Number of Periods (t or n)

With these variables, a single period investment could be calculated as follows:

‘t’ in this equation would simply be 1, simplifying this equation to FV = PV(1+r).

Multi-period Investments

With multi-periods in mind, interest begins to compound. Compound interest simple means that the interest from the first period is added to the future present value, and the interest rate the next time around is now being applied to a larger amount. This turns into an exponential calculation of interest, calculated as follows:

This means that the interest rate of a given period may not be the same percentage as the interest rate over multiple periods (in most situations). A useful tool at this point is a way to create an average rate of return over the life of the investment, which can be derived with the following:

Conclusion

All and all, the difference from a time value of money perspective between single and multiple period investments is relatively straightforward. Normalizing expected returns in present value terms (or projecting future returns over multiple time periods of compounding interest) paints a clearer and more accurate picture of the actual worth of a given investment opportunity.

Time Value of Money

Time value of money requires an understanding of how return rates impact fixed values over time.

Time value of money requires an understanding of how return rates impact fixed values over time.

10.7.5: Single-Period Investment

When considering a single-period investment, n is one, so the PV is simply FV divided by 1+i.

Learning Objective

Calculate the present value of a future, single-period payment

Key Points

• A single period investment has the number of periods (n or t) equal to one.
• For both simple and compound interest, the PV is FV divided by 1+i.
• The time value of money framework says that money in the future is not worth as much as money in the present.

Key Terms

interest rate

The percentage of an amount of money charged for its use per some period of time. It can also be thought of as the cost of not having money for one period, or the amount paid on an investment per year.

period

The length of time during which interest accrues.

The time value of money framework says that money in the future is not worth as much as money in the present. Investors would prefer to have the money today because then they are able to spend it, save it, or invest it right now instead of having to wait to be able to use it.

The difference between what the money is worth today and what it will be worth at a point in the future can be quantified. The value of the money today is called the present value (PV), and the value of the money in the future is called the future value (FV). There is also a name for the cost of not having the money today: the interest rate or discount rate (i or r). For example, if the interest rate is 3% per year, it means that you would be willing to pay 3% of the money to have it one year sooner. The amount of time is also represented by a variable: the number of periods (n). One period could be any length of time, such as one day, one month, or one year, but it must be clearly defined, consistent with the time units in the interest rate, and constant throughout your calculations.

FV of a single payment

The FV is related to the PV by being i% more each period.

All of these variables are related through an equation that helps you find the PV of a single amount of money. That is, it tells you what a single payment is worth today, but not what a series of payments is worth today (that will come later). relates all of the variables together. In order to find the PV, you must know the FV, i, and n.

When considering a single-period investment, n is, by definition, one. That means that the PV is simply FV divided by 1+i. There is a cost to not having the money for one year, which is what the interest rate represents. Therefore, the PV is i% less than the FV.

9.3: Contingencies

9.3.1: Gain Contingencies

Learning Objective

Explain how a company reports a gain contingency on their financial statements

Key Points

• If a specific event that can cause the gain occurs, and the gain is realized, then the gain is accrued for and reported in the financial statements. It is also disclosed in the notes section.
• Probable and quantifiable gains are not accrued for reporting purposes, but they can be disclosed in the notes to the financial statements if they are material. If the gain is not probable or reasonably estimated, but could materially effect financial statements, the gain is disclosed in a note.
• The materiality concept states that if a gain contingency, that remains unrealized, affects the economic decision of statement users, it should be disclosed in the notes.
• Following conservative constraints for a gain contingency, only a realized gain should be accrued for and disclosed on an income statement.

Key Terms

Contingency

A possibility; something which may or may not happen. This also can mean a chance occurrence, especially in, unexpected expenses

unrealized

Not realized; possible to obtain, yet not obtained.

Gain Contingency

Gain contingencies, or the possible occurrences of a gain on a claim or obligation that involves the entity, are reported when realized (earned). If a specific event that can cause the gain occurs, and the gain is realized, then the gain is disclosed . If the gain is probable and quantifiable, the gain is not accrued for financial reporting purposes, but it can be disclosed in the notes to financial statements. If the gain is not probable or its amount cannot be reasonably estimated, but its effect could materially affect financial statements, a note disclosing the nature of the gain is also disclosed in the notes. Care should be taken that misleading language is not used regarding the potential for the gain to be realized. The disclosure of gain contingencies is affected by the materiality concept and the conservatism constraint.

Renovation

Renovation plans and projects can increase the value of a building and eventually bring about a gain. However these gains should only be accrued when the gain is realized.

Materiality

Materiality is a concept or convention within auditing and accounting that relates to the importance/significance of an amount, transaction, or discrepancy. For example, an auditor expresses an opinion on whether financial statements are prepared, in all material aspects, in conformity with generally accepted accounting principles (GAAP). Professional judgment is required to determine what is material and what isn’t. Generally, if the omission or misstatement of information can influence the economic decision of financial statement users, the missing or incorrect information is considered material. Thus, if a gain contingency, that remains unrealized, affects the economic decision of statement users, it should be disclosed in the notes.

Conservatism

Most accounting principles follow the conservative constraint, which encourages the immediate disclosure of losses and expenses on the income statement. This constraint also encourages the omission of revenues and gains until those gains are realized. Thus, for a gain contingency, only a realized gain is accrued for and disclosed on the income statement. A material gain contingency that is both probable and reasonably estimated can be disclosed in the notes to financial statements.

9.3.2: Loss Contingencies

Learning Objective

Summarize how a company would report a loss contingency on their financial statements

Key Points

• Due to conservative accounting principles, loss contingencies are reported on the balance sheet and footnotes on the financial statements, if they are probable and their quantity can be reasonably estimated.
• Unlike gain contingencies, losses are reported immediately as long as they are probable and reasonably estimated. They do not have to be realized in order to report them on the balance sheet.
• For losses that are material, but may not occur and their amounts can not be estimated, a note to the financial statements disclosing the loss contingency is reported.

Key Terms

incur

To render somebody liable or subject to.

probable

Likely or most likely to be true.

Definition of Loss Contingencies

A loss contingency is incurred by the entity based on the outcome of a future event, such as litigation. Due to conservative accounting principles, loss contingencies are reported on the balance sheet and footnotes on the financial statements, if they are probable and their quantity can be reasonably estimated. A footnote can also be included to describe the nature and intent of the loss. The likelihood of the loss is described as probable, reasonably possible, or remote. The ability to estimate a loss is described as known, reasonably estimable, or not reasonably estimable .

Calculating cash flow

The indirect method adjusts net income (rather than adjusting individual items in the income statement).

Contingent Liabilities for Losses

Loss contingencies can refer to contingent liabilities that may arise from discounted notes receivable, income tax disputes, or penalties that may be assessed because of some past action or failure of another party to pay a debt that a company has guaranteed. Unlike gain contingencies, losses are reported immediately as long as they are probable and reasonably estimated. They do not have to be realized in order to report them on the balance sheet. At least a minimum amount of the loss expected to be incurred is accrued. For losses that are material, but may not occur and their amounts cannot be estimated, a note to the financial statements disclosing the loss contingency is reported.

Example of a Disclosed Loss Contingency

A jury awarded $5.2 million to a former employee of the Company for an alleged breach of contract and wrongful termination of employment. The Company has appealed the judgment on the basis of errors in the judge’s instructions to the jury and insufficiency of evidence to support the amount of the jury’s award. The Company is vigorously pursuing the appeal. The Company and its subsidiaries are also involved in other litigation arising in the ordinary course of business. Since it presently is not possible to determine the outcome of these matters, no provision has been made in the financial statements for their ultimate resolution. The resolution of the appeal of the jury award could have a significant effect on the Company’s earnings in the year that a determination is made. However, in management’s opinion, the final resolution of all legal matters will not have a material adverse effect on the Company’s financial position.

9.4: Reporting and Analyzing Current Liabilities

9.4.1: Reporting Current Liabilities

Current liabilities are reported first in the liability section of the balance sheet because they have first claim on company assets.

Learning Objective

Explain how current liabilities are shown on the financial statements

Key Points

• Current liabilities are typically due and paid for during the current accounting period or within a one year period. They are paid off with assets or other current liabilities.
• For many companies, accounts payable is the first balance sheet account listed in the current liabilities section. Accounts payable includes goods, services, or supplies that were purchased with credit and for use in the operation of the business and payable within a one year period.
• Long-term liabilities are listed in a separate section after current debt; however, for all long-term liabilities, any amounts due in the current fiscal year are reported under the current liability section.

Key Terms

bond

Evidence of a long-term debt, by which the bond issuer (the borrower) is obliged to pay interest when due, and repay the principal at maturity, as specified on the face of the bond certificate. The rights of the holder are specified in the bond indenture, which contains the legal terms and conditions under which the bond was issued. Bonds are available in two forms: registered bonds and bearer bonds.

audit

An independent review and examination of records and activities to assess the adequacy of system controls, to ensure compliance with established policies and operational procedures, and to recommend necessary changes in controls, policies, or procedures

Current Liabilities in the Balance Sheet

The balance sheet, or statement of financial position, is a snapshot of a company’s assets, liabilities, and owner’s equity on a given date. The presentation of the balance sheet should support the accounting equation of assets = liabilities + owner’s equity. Liabilities are disclosed in a separate section that distinguishes between short-term and long-term liabilities. Short-term, or current liabilities, are listed first in the liability section of the statement because they have first claim on company assets. Current liabilities are typically due and paid for during the current accounting period or within a one year period. They are paid off with assets or other current liabilities .

Most current liabilities have a claim on cash or other assets.

Current liabilities is the first section reported under liabilities on the balance sheet.

Accounts Payable

For many companies, accounts payable is the first balance sheet account listed in the current liabilities section. For example, accounts payable for goods, services, or supplies that were purchased with credit and for use in the operation of the business and payable within a one-year period would be current liabilities. Accounts payable are typically due within 30 days. Amounts listed on a balance sheet as accounts payable represent all bills payable to vendors of a company, whether or not the bills are more or less than 30 days old. Therefore, late payments are not disclosed on the balance sheet for accounts payable. An aging schedule showing the amount of time certain amounts are past due may be presented in the notes to audited financial statements; however, this is not common accounting practice.

Other Liabilities

In addition to current liabilities, long-term liabilities are listed in a separate section after current debt. Long-term liabilities can include bonds, mortgages, and loans that are payable over a term exceeding one year. However, for all long-term liabilities, any amounts due in the current fiscal year are reported under the current liability section.

9.4.2: What Goes on the Balances Sheet and What Goes in the Notes

The balance sheet lists current liability accounts and their balances; the notes provide explanations for the balances, which are sometimes required.

Learning Objective

Explain why a company would use a note to the balance sheet

Key Points

• All liabilities are typically placed on the same side of the balance sheet as the owner’s equity because both those accounts have credit balances.
• Current liabilities and their account balances as of the date on the balance sheet are presented first on the balance sheet, in order by due date. The balances in these accounts are typically due in the current accounting period or within one year.
• Current liability information found in the notes to the financial statements provide additional explanation on the account balances and any circumstances affecting them. Accounting principles can sometimes require this type of disclosure.

Key Terms

LLP

Limited liability partnership.

pension

A regularly paid gratuity paid regularly as benefit due to a person in consideration of past services; notably to one retired from service, on account of retirement age, disability, or similar cause; especially, a regular stipend paid by a government to retired public officers, disabled soldiers; sometimes passed on to the heirs, or even specifically for them, as to the families of soldiers killed in service.

LLC

Limited liability company.

The Balance Sheet

In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership, a corporation, or other business organization, such as an LLC or an LLP. Assets, liabilities, and the equity of stockholders are listed as of a specific date, such as the end of a fiscal year or accounting period. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a company’s calendar year. Balance sheets are presented with assets in one section, and liabilities and equity in the other section, so that the two sections “balance. ” The fundamental accounting equation is: assets = liabilities + equity ([).

The Balance Sheet

If an error is found on a previous year’s financial statement, a correction must be made and the financials reissued.

Current Liabilities on the Balance Sheet

All liabilities are typically placed on the same side of the report page as the owner’s equity because both those accounts have credit balances (asset accounts, on the other hand, have debit balances). Current liabilities and their account balances as of the date on the balance sheet are presented first, in order by due date. The balances in these accounts are typically due in the current accounting period or within one year. Current liabilities can represent costs incurred for employee salaries and wages, production and build up of inventory, and acquisition of equipment which are needed and used up during normal business operations.

Information in the Notes

Current liability information found in the notes to the financial statements provide additional explanation on the liability balances and any circumstances affecting them. Accounting principles can sometimes require the disclosure of specific information for the benefit of the financial statement user. For example, companies that pay pension plan benefits require additional footnote disclosure that provide the user with additional details on pension costs and the assets used to fund it.

9.4.3: Reporting Contingencies

Contingencies are reported as liabilities if it is probable they will incur a loss, and their amounts can be reasonably estimated.

Learning Objective

Summarize how contingencies are reported on the financial statements

Key Points

• A loss contingency is not reported if it can not be recognized due to improbability (not more than 50% likely to occur) and/or the amount of the loss can not be reliably measured or estimated. Gain contingencies are reported on the income statement when they are realized (earned).
• A probable contingency is defined as more than 50% likely to occur because there was a past obligating event.
• If a probable loss can be estimated based on historical information, then it can be reliably measured.

Key Terms

product warranty

In retail, a guarantee of the reliability of a product under conditions of ordinary use; should the product malfunction within a stipulated amount of time after the purchase, the manufacturer or distributor is typically required to provide the customer with a replacement, repair, or refund.

obligation

A legal agreement stipulating a specified payment or action; the document containing such agreement.

Reporting Contingencies

Loss Contingencies and Liabilities

Contingencies are reported as liabilities on the balance sheet and/or disclosed in the notes to the financial statements when it is probable they will incur a loss and when the loss can be reasonably estimated.

Probability

Probable is defined as more than 50% likely to occur due to a past obligation. The past obligating event defines a future payment event as a payment due on a specific date from the company, who is linked to an obligating event by a specific agreement.

Loss Contingency

A loss contingency is not reported if:

• A loss contingency is less than 50% likely to occur due to a past obligation.
• The amount of the loss can not be reliably measured or estimated.

Gain Contingency

Gain contingencies are reported on the income statement when they are realized (earned).

Funds may be lost due to contingent liabilities.

Conservative accounting principles state that companies should report loss contingencies as they occur.

Estimating a Loss Contingency

Reliability

A probable loss contingency can be measured reliably if it can be estimated based on historical information. For example, to accrue a provision for product warranty costs, assume that minor repairs cost 5% of the total product sales and an estimated 5% of products may require minor repairs within 1 year of sale. Major repairs cost 20% and 1% of products may require major repairs in 3 years.

Car Repairs

Cars require regular maintenance. Such contingent liabilities can be estimated reliably based on historical cost and readily available information.

Provision Estimation

The provision is calculated by multiplying 5% of total product cost by 5% of products needing minor repair and then adding 20% of cost for major repair, multiplied by 1% of products needing major repair.

5% x 5% + 20 % x 1% (of budgeted total sales)

A warranty expense is debited for the provision amount that will offset product sales revenue in the income statement and a credit is posted to warranty provision liability. The amount for repairs occurring in year one is reported in the current liability section of the balance sheet; the portion relating to major repairs in three years is disclosed as long-term liability. As the warranty claims are made, the liability account is debited and cash is credited for the cost of the repair. The long-term liability warranty provision is moved to the current liability section in the accounting period occurring three years after the product sale.

9.4.4: Current Ratio

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.

Learning Objective

Explain how a company would use the current ratio

Key Points

• The current ratio is calculated by taking total current assets and dividing by total current liabilities. The ratio is an indication of a firm’s market liquidity and ability to meet creditor’s demands.
• Acceptable current ratios vary from industry to industry and are generally between 1.5% and 3% for healthy businesses. If a company’s current ratio is in this range, then it generally indicates good short-term financial strength.
• If the value of a current ratio is considered high, then the company may not be efficiently using its current assets, specifically cash, or its short-term financing options. A high current ratio can be a sign of problems in managing working capital.
• When a current ratio is low and current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations (current liabilities).

Key Terms

current ratio

current assets divided by current liabilities

current liabilities

obligations of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer

liquidity

An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.

creditor

A person to whom a debt is owed.

Current & Financial Ratios

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm’s current assets to its current liabilities. Along with other financial ratios, the current ratio is used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm’s creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10% .

Ratios can be used to analyze financial trends.

The current ratio can be use to evaluate a company’s liquidity.

The current ratio is calculated by taking total current assets and dividing by total current liabilities.

Uses for Current Ratio

The ratio is an indication of a firm’s market liquidity and ability to meet creditor’s demands. Acceptable current ratios vary from industry to industry and are generally between 1.5% and 3% for healthy businesses.

If a company’s current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations (current liabilities).

High vs. Low Current Ratio

If the value of a current ratio is considered high, then the company may not be efficiently using its current assets, specifically cash, or its short-term financing options. A high current ratio can be a sign of problems in managing working capital (what is leftover of current assets after deducting current liabilities). While a low current ratio may indicate a problem in meeting current obligations, it is not indicative of a serious problem. If an organization has good long-term revenue streams, it may be able to borrow against those prospects to meet current obligations. Some types of businesses usually operate with a current ratio of less than one. For example, when inventory turns over more rapidly than accounts payable becomes due, the current ratio will be less than one. This can allow a firm to operate with a low current ratio.

9.4.5: Acid Test Ratio

The acid-test, or quick ratio, measures the ability of a company to use its near cash or quick assets to pay off its current liabilities.

Learning Objective

Describe how a company uses the acid test ratio

Key Points

• The acid-test ratio is calculated by adding cash, cash equivalents, marketable securities, and accounts receivable. The sum is then divided by current liabilities.
• Generally, the acid test ratio should be 1:1 or higher; however, this varies widely by industry. In general, the higher the ratio is, the greater the company’s liquidity (i.e., the better able to meet current obligations using liquid assets).
• The acid-test ratio, like other financial ratios, is a test of viability for business entities but does not give a complete picture of a company’s health.

Key Terms

liquidity

An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.

inventory

A detailed list of all of the items on hand.

Acid-Test and Financial Ratios

The acid-test ratio, also known as the quick ratio, measures the ability of a company to use its near cash or quick assets to immediately extinguish or retire its current liabilities. Quick assets include the current assets that can presumably be quickly converted to cash at close to their book values. The numerator of the ratio includes “quick assets,” such as cash, cash equivalents, marketable securities, and accounts receivable.

The acid-test ratio, like other financial ratios, is a test of viability for business entities but does not give a complete picture of a company’s health. For example, if a business has large amounts in accounts receivable which are due for payment after a long period (say 120 days) and essential business expenses and accounts payable are due for immediate payment, the quick ratio may look healthy when the business is actually about to run out of cash. In contrast, if the business has negotiated fast payment terms with customers and long payment terms from suppliers, it may have a very low quick ratio yet good liquidity .

A low acid-test ratio may be a sign of poor use of cash by a business.

The acid-test ratio is similar to the current ratio except the value of inventory is omitted from the calculation.

Uses of Acid-Test Ratio

The acid-test ratio is calculated by adding cash, cash equivalents, marketable securities, and accounts receivable. The sum is then divided by current liabilities. Note that the calculation omits inventory and a different version of the formula involves subtracting inventory from current assets and dividing by current liabilities. Generally, the acid test ratio should be 1:1 or higher; however, this varies widely by industry. In general, the higher the ratio is, the greater the company’s liquidity (i.e., the better able to meet current obligations using liquid assets). A company with a quick ratio of less than 1 cannot currently pay back its short-term liabilities.

9.4.6: Working Capital Management Analysis

Working capital is a financial metric that represents the operational liquidity of a business, organization, or other entity.

Learning Objective

Identify working capital and discuss how a company would use it

Key Points

• Net working capital is calculated as current assets minus current liabilities. Positive working capital is required to ensure that a firm is able to continue its operations and has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.
• Cash flows can be evaluated using the cash conversion cycle — the net number of days from the outlay of cash for raw material to receiving payment from the customer.
• Profitability can be evaluated by looking at return on capital (ROC). This metric is determined by dividing relevant income for the 12 months by the cost of capital used. When ROC exceeds the cost of capital, firm value is enhanced and profits are expected in the short term.

Key Terms

discounted cash flows

A method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) — the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.

deficiency

Inadequacy or incompleteness.

Definition of Working Capital

Working capital (abbreviated WC) is a financial metric that represents the operational liquidity of a business, organization, or other entity. Along with fixed assets, such as property, plant, and equipment, working capital is considered a part of operating capital. Positive working capital is required to ensure that a firm is able to continue its operations and has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. A company can be endowed with assets and profitability but short on liquidity if its assets cannot be converted into cash .

If money grew on trees, companies would never have a working capital shortage.

Sufficient working capital ensures a company is able to meet its short term obligations.

Uses of Working Capital

Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital commonly used in valuation techniques such as discounted cash flows (DCFs). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. The ability to meet the current portion of debt (payable within 12 months) is critical because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit.

Managing Working Capital

Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Working capital management entails short-term decisions, usually relating to the next one-year period and are based in part on cash flows and/or profitability.

Evaluating Working Capital Management

Cash flows can be evaluated using the cash conversion cycle — the net number of days from the outlay of cash for raw material to receiving payment from the customer. Because this number effectively corresponds to the time that the firm’s cash is tied up in operations and unavailable for other activities, management generally aims for a low net count.

Profitability can be evaluated by looking at return on capital (ROC). This metric is determined by dividing relevant income for the 12 months by the cost of capital used. When ROC exceeds the cost of capital, firm value is enhanced and profits are expected in the short term.

8.3: Debt for Sale

8.3.1: Accounting for Sale of Debt

Learning Objective

Summarize how to record the sale of a held-to-maturity, trading security and available for sale debt

Key Points

• Because of fluctuations in market value, held-to-maturity debt is not periodically adjusted while owned. Recording the sale is simply a matter of recording how much cash was received and recording any gain or loss from the transaction.
• The book value of trading security debt changes based on its market value. Any increase or decrease in the value of the debt is recorded as an unrealized gain or loss in a company’s income statement. Any gain or loss from the sale is based on the current book value of the debt.
• The book value of available-for-sale debt changes based on market value. Any increase/decrease in the value of the debt is recorded as an unrealized gain/loss in equity. When debt is sold, the company should recognize all unrecognized gain/loss, and the gain/loss based on the current book value.

Key Terms

trading securities

any financial instrument an investor acquires and intends to resell in the short-term

available-for-sale

securities that do not qualify as “held-to-maturity” or as a “trading security”

Held-to-maturity

any security that an investor intends to retain until its term expires

Under FASB 115, a part of US GAAP (Generally Accepted Accounting Principles), a company must classify all of the debt securities it owns into one of three categories. If the company intends to hold the debt until it matures, it must be classified as a “held-to-maturity” security. If the company acquires the debt with the intent to resell it in the short-term, then it must be listed as a “trading security. ” If the debt is acquired without the intent to resell it in the short-term, nor the intent to hold it to maturity, it should be classified as “available-for-sale” . Each of these three classifications is treated differently for accounting purposes, both prior to sale and during the sale.

A bond certificate

A bond certificate issued via the South Carolina Consolidation Act of 1873. How the sale of a bond is recorded on a company’s books depends on how the debt is initially classified by the acquiring investor. Debt securities can be classified as “held-to-maturity,” a “trading security,” or “available-for-sale. “

Held-to-Maturity

When debt is acquired and is intended to be held until maturity, it is recorded first by debiting a “Debt Investment Account,” and then by crediting “Cash” for the amount the debt was purchased. For example, if a company purchased $1000 in debt securities, the transaction would be recorded like this:

Investments – Corporate Debt : $1000

Cash : $1000.

While the market value of the debt may vary over time, the company does not need to adjust the value of the debt on its books. Once the company sells the bond, it must report any gains or losses on the sale of the debt. So, in the example above, if the company sold the debt for $1200, it would need to make the following journal entry.

Investments : $1000

Net Gain on Sale : $200

Cash : $1200

If the company sold the debt for $800, it would need to make the following journal entry:

Investments : $1000

Cash : $800

Net Loss on Sale : $200

Trading Securities

If a company acquires debt that it intends to sell in the short-term, it must still record the sale. If a company acquired debt for $1000, and this debt is classified as a trading security, the company would still need to make the first journal entry in the aforementioned manner.That being said, the value of the debt on the owner’s books must be adjusted to match the market value of the debt. For example, if the market value of the debt declined $200 from its original value to $800, a company would need to make the following journal entry:

Unrealized loss on trading security : $200

Investments : $200

The unrealized loss would be included on the company’s income statement for the period it was recorded. If immediately after the accounting period, the company sold the debt for $800, it would need to make the following journal entry:

Cash : $800

Investments : $800

Because both the loss and the decrease in the debt asset’s value were already recorded in the prior accounting period, the company would not have to make any additional adjustments.

Available-for-Sale

If a company acquires debt that is available-for-sale, it would still need to make a first journal entry in the same way that it would if the debt was “held-to-maturity” or a “trading security. ” It would also need to adjust the value of its debt asset in relation to its current market value. Using the same example above, assume a debt asset was acquired for $1000 but declined in value by $200. In the case of an available-for-sale asset, the following journal entry should be made in the following accounts:

(Equity) Unrealized loss on security investment : $200

(Asset) Investments : $200

Unlike trading securities, the unrealized gain is recorded in the equity section of the balance sheet and does not effect the current year income statement at all. This is because, unlike trading securities, the loss from an available-for-sale security is not expected to be realized in the near future. Returning to the example, assume that the debt asset is sold immediately after the end of the accounting period where it first recognized the unrealized loss. The asset is sold for $800. In such a case, the following entries would be appropriate:

(Asset) Cash : $800

(Income Statement) Loss on Investment : $200

(Asset) Investments : $800

(Equity) Unrealized loss on security investment : $200

The result of the journal entry is that the unrealized loss is realized, so the company’s profit for the period is decreased by $200. The debt asset, as well as the unrealized loss, is removed from the company’s books.

8.3.2: Accounting for Sale of Stock

Learning Objective

Summarize how to account for the sale of common stock, preferred stock and treasury stock

Key Points

• For common stock at par value, debit cash and credit common stock. For common stock sold above par, debit cash, credit common stock, and credit additional paid in capital.
• For preferred stock, debit cash and credit preferred stock.
• For sales of treasury stock, debit cash and credit treasury stock.

Key Terms

preferred

Preferred stock.

par value

The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.

Accounting for the Sale of Stock

Often times companies offer their stock for sale as a way to generate cash. How the stock sale is accounted for depends on the type of stock sold. Most stock sales involve common stock or preferred stock.

Sale of Stock.

Often times companies offer their stock for sale as a way to generate cash. How the stock sale is accounted for depends on the type of stock sold. Most stock sales involve common stock or preferred stock.

Common Stock-sold at par value

Journal
entry

Debit cash

Credit common stock

If the common stock is sold above par value the journal entry is slightly different.

Debit cash

Credit common stock

Credit additonal paid in capital (to account for the difference between par value and sell value)

Preferred Stock

The sale of preferred stock is similarly treated, but a separate accounts should be established to record preferred stock and any additional paid in capital for preferred stock sold at above par value.

Journal entry

Debit cash

Credit preferred stock

Credit additional paid in capital preferred stock (if needed)

Treasury stock

Treasury stock is issued stock that the company has bought back from its shareholders. Since a corporation can’t be its own shareholder, the “bought back” stocks are not considered assets of the corporation. Treasury stock also doesn’t have the right to vote, receive dividends or receive liquidation value.

If the company plans to re issue the shares in the future, it would hold them in treasury and report the reduction in stockholder’s equity on the balance sheet.

There are several reasons a company may purchase treasury stock, it may need it for employee compensation plans, to buy another company or to reduce the number of outstanding shares.

Journal entry

Debit treasury stock

Credit cash

When treasury stock is sold the accounts used to record the transaction will vary depending on whether the stock sold above or below the cost of purchase.

Sold above purchase cost

Debt cash

Credit treasury stock

Credit additional paid in capital (the difference between sale price and purchase price)

8.3.3: Assessing Fair Value

Learning Objective

Explain why a company calculates the fair market value of available for sale securities

Key Points

• The difference between the purchase price and the current fair market value results in a an unrealized gain or loss.
• Realized gains and losses are included in income; unrealized amounts are included in income (trading investments) or in other comprehensive income (available-for-sale investments).
• Unrealized holding gains (unrealized because asset is not sold yet)-increase in fair value of an asset while held.
• Realized holding gain (realized through sale) increase in fair value of an asset while held.

Key Term

unrealized

Not realized; possible to obtain, yet not obtained.

Fair Value Method

Often companies use excess cash to purchase stocks and bonds from other companies. If a company purchases stocks or bonds with the intent to sell these items at a future date when they need cash, these are referred to as “Available-for-sale securities”.

A company initially records the “available for sale securities” at cost. While holding onto the securities the company must calculate the fair market value for these securities at the end of each subsequent accounting period.

8.4: Holding Less than 20% of Shares

8.4.1: Fair Value Method

Learning Objective

Explain how the Fair Value Method is used to calculate the value of holding of less than 20%

Key Points

• Fair market value (FMV) is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market.
• An estimate of Fair Market Value is usually subjective due to the circumstances of place, time, the existence of comparable precedents, and the evaluation principles of each involved person.
• The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
• For assets carried at historical cost, the fair value of the asset is not used.

Key Terms

book value

The value of an asset as reflected on an entity’s accounting books, net of depreciation, but without accounting for market value appreciation.

fair market value

The price at which the buyer and seller are willing to do business.

eminent domain

(US) The right of a government over the lands within its jurisdiction. Usually invoked to compel land owners to sell their property in preparation for a major construction project such as a freeway.

Fair Value Method

The ownership of less than 20% creates an investment position carried at historic book value or fair value (if available for sale or held for trading) in the investor’s balance sheet.

In accounting, fair value (also knows as “fair market value”) is used as a certainty of the market value of an asset (or liability) for which a market price cannot be determined (usually because there is no established market for the asset). Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for assets carried at historical cost, the fair value of the asset is not used.

A gold nugget

Fair market value (FMV) is an estimate of the market value of a property.

Since market transactions are often not observable for assets such as privately held businesses and most personal and real property, fair value must be estimated. An estimate of fair value is usually subjective due to the circumstances of place, time, the existence of comparable precedents, and the evaluation principles of each involved person. Opinions on value are always based upon subjective interpretation of available information at the time of assessment. This is in contrast to an imposed value, in which a legal authority (law, tax regulation, court, etc.) sets an absolute value upon a product or a service.

A property sale, in lieu of an eminent domain taking, would not be considered a fair market transaction since one of the parties (i.e., the seller) was under undue pressure to enter into the transaction. Other examples of sales that would not meet the test of fair market value include a liquidation sale, deed in lieu of foreclosure, distressed sale, and similar types of transactions.

In United States tax law, the definition of fair value is found in the United States Supreme Court decision in the Cartwright case: the fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

The term fair market value is used throughout the Internal Revenue Code among other federal statutory laws in the USA including bankruptcy, many state laws, and several regulatory bodies.

8.4.2: Calculating Fair Value

Learning Objective

Summarize how to calculate fair value for holdings of less than 20%

Key Points

• Fair value, also called “fair price”, is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset.
• In accounting, a three-level framework is used to calculate an asset or liability’s fair value — Level 1 is based on quoted market prices, Level 2 is based on estimated market observables, and Level 3 uses unobservable inputs derived internally by the company.
• Under US GAAP, when purchasing less than 20% of a company’s stock, the cost method is used to account for the investment.
• As required by FAS 115, investments accounted for under the cost method should be adjusted to current fair value at the end of each accounting period, in cases where the fair value is readily determinable.

Key Terms

supply vs. demand

Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equilibrium of price and quantity.

return on capital

Return on capital (ROC) is a ratio used in finance, valuation, and accounting. The ratio is estimated by dividing the after-tax operating income (NOPAT) by the book value of invested capital.

Example

• An example of how to determine fair value can involve the purchase of company shares of less than 20% total equity — assume ABC Corporation purchases 10% of XYZ’s Corporation’s common stock, or 50,000 shares. The market price of the stock is USD 1. When purchasing less than 20% of a company’s stock, the cost method is used to account for the investment. ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000.

Determining Fair Value

Fair value, is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:

Fair value

Fair value is defined as a rational and unbiased estimate of the potential market price of a good, service, or asset.

• acquisition/production/distribution costs, replacement costs, or costs of close substitutes
• actual utility at a given level of development of social productive capability
• supply vs. demand
• subjective factors such as: risk characteristics; cost of and return on capital; individually perceived utility

In accounting, fair value is used as an approximation of the market value of an asset (or liability) for which a market price cannot be determined (usually because there is no established market for the asset). When an active market does not exist other methods have to be used to estimate the fair value. Assumptions used to estimate fair value should be from the perspective of an unrelated market participant. This necessitates identification of the market in which the asset or liability trades. If more than one market is available, the “most advantageous market” should be used. Both the price and costs to do the transaction must be considered in determining which market is the most advantageous market.

A three-level framework is used to determine an asset or liability’s fair value:

1. Level One — The preferred inputs to valuation are “quoted prices in active markets for identical assets or liabilities,” with the caveat that the reporting entity must have access to that market. An example would be a stock trade on the New York Stock Exchange. Information at this level is based on direct observations of transactions involving the identical assets or liabilities being valued.
2. Level Two — This valuation is based on market observables. FASB indicates that assumptions enter into models that use Level 2 inputs, a condition that reduces the precision of the outputs (estimated fair values), but nonetheless produces reliable numbers that are representationally faithful, verifiable and neutral.
3. Level Three — The FASB describes Level 3 inputs as “unobservable.” If observable inputs from levels 1 and 2 are not available, the entity may only rely on internal information if the cost and effort to obtain external information is too high. Within this level, fair value is also estimated using a valuation technique. Significant assumptions or inputs used in the valuation technique are based upon inputs that are not observable in the market and are based on internal information. This category allows “for situations in which there is little, if any, market activity for the asset or liability at the measurement date.

Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties or transferred to an equivalent party other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for assets carried at historical cost, the fair value of the asset is not used.

An example of how to determine fair value can involve the purchase of company shares of less than 20% total equity — assume ABC Corporation purchases 10% of XYZ’s Corporation’s common stock, or 50,000 shares. The market price of the stock is USD 1. When purchasing less than 20% of a company’s stock, the cost method is used to account for the investment. ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000.

Adjusting Fair Value

As required by FAS 115, investments accounted for under the cost method should be adjusted to current fair value at the end of each accounting period, in cases where the fair value is readily determinable. Adjustments are debited (for gains in fair value) or credited (for losses) to a fair value adjustment account that will adjust the investment account balance to its fair value at the end of the reporting period.

If the investment is considered a “trading security” or stock purchased for the purpose of selling it in the near term, the balancing debit or credit is charged to an unrealized loss or gain account. If the investment is an “available for sale” security, the balancing debit or credit also goes to an unrealized loss or gain account. For investments where the fair value is not readily determinable, the investment is carried at cost.

8.4.3: Reporting Fair Value

Learning Objective

Explain how to record stock investments of less than 20% using Fair Value

Key Points

• Fair value accounting, also known as mark-to-market accounting, can change values on the balance sheet as market conditions change. In contrast, historical cost accounting, based on the past transactions, is simpler, more stable, and easier to perform, but does not represent current market value.
• Ownership of less than 20% of a company’s stock dictates that the investor is not able to exercise significant influence in the company or participate in shareholder meetings where business decisions are made.
• Dividends declared on investments of less than 20% equity are reported as current assets on the balance sheet and other income on the income statement.

Key Terms

journal entry

A journal entry, in accounting, is a logging of transactions into accounting journal items. The journal entry can consist of several items, each of which is either a debit or a credit. The total of the debits must equal the total of the credits or the journal entry is said to be “unbalanced. ” Journal entries can record unique items or recurring items, such as depreciation or bond amortization.

dividend

A pro rata payment of money by a company to its shareholders, usually made periodically (eg, quarterly or annually).

Example

• The following is an example of how to report investments of less than 20% of shares — assume ABC Corporation purchases 10% of XYZ’s Corporation’s common stock, or 50,000 shares. The market price of the stock is USD 1. When purchasing less than 20% of a company’s stock, the cost method is used to account for the investment. ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000. The investment in XYZ Corporation is reported at cost in the asset section of the balance sheet. If the investee declares dividends, the investor records a journal entry for their share of the investment. Assume XYZ Corporation declares a dividend of USD 1 per share. ABC records a journal entry debiting Dividends Receivable for USD 50,000 and crediting Dividend Income for USD 50,000. The Dividend Receivable is reported on the balance sheet under current assets and Dividend Income is reported on the income statement under a section for other income.

Fair Value Accounting and Financial Statements

Fair value accounting, also known as mark-to-market accounting, can change values on the balance sheet as market conditions change. In contrast, historical cost accounting, based on past transactions, is simpler, more stable, and easier to perform, but does not represent current market value. It summarizes past transactions instead. Mark-to-market accounting can become inaccurate if market prices fluctuate greatly or change unpredictably. Buyers and sellers may claim a number of specific instances when this is the case, including inability to value the future income and expenses on the income statement accurately and collectively, often due to unreliable information, or overly-optimistic/ overly-pessimistic expectations.

Reporting Stock Investments of Less Than 20% of Shares

Ownership of less than 20% of a company’s stock dictates that the investor is not able to exercise significant influence in the company or participate in shareholder meetings where business decisions affecting the company are made. Ownership of this quantity of stock is recorded using the cost method.

The following is an example of how to report investments of less than 20% of shares — assume ABC Corporation purchases 10% of XYZ’s Corporation’s common stock, or 50,000 shares. The market price of the stock is USD 1. When purchasing less than 20% of a company’s stock, the cost method is used to account for the investment. ABC records a journal entry for the purchase by debiting Investment in XYZ Corp. for USD 50,000 and crediting Cash for USD 50,000. The investment in XYZ Corporation is reported at cost in the asset section of the balance sheet.

If the investee declares dividends, the investor records a journal entry for their share of the investment. Assume XYZ Corporation declares a dividend of USD 1 per share. ABC records a journal entry debiting Dividends Receivable for USD 50,000 and crediting Dividend Income for USD 50,000. The Dividend Receivable is reported on the balance sheet under current assets and Dividend Income is reported on the income statement under a section for other income.

Reporting Adjustments in Fair Value

As required by FAS 115, the value of an investment accounted for under the cost method should be adjusted to current fair value at the end of each accounting period, in cases where the fair value is readily determinable. Changes in fair value are debited (for gains in fair value) or credited (for losses) to a fair value adjustment account reported on the balance sheet to adjust the investment account balance to its end of period fair value.

If the investment is considered a “trading security” or stock purchased for the purpose of selling it in the near term, the balancing debit or credit is charged to an unrealized loss or gain reported on the income statement. If the investment is an “available for sale” security, the balancing debit or credit goes to an unrealized loss or gain account reported in the other comprehensive income section of owner’s equity on the balance sheet. When the investment is sold, all losses or gains from the transaction become realized and flow through into the income statement to adjust revenues for the period.

8.5: Holding 20-50% of Shares

8.5.1: Equity Method

Equity method is the process of treating equity investments (usually 20–50%) of companies. The investor keeps such equities as an asset.

Learning Objective

Summarize how a company uses the Equity Method to record their investment in another company

Key Points

• Equity method in accounting is the process of treating equity investments, usually 20–50%, in associate companies. The investor keeps such equities as an asset.
• The investor’s proportional share of the associate company’s net income increases the investment; net loss, and proportional payment of dividends, decreases it.
• Typically, equity holders receive voting rights on certain issues, residual rights, meaning that they share the company’s profits, and are allowed to recover some of the company’s assets in the event that it folds (although they generally have the lowest priority in recovering their investment).

Key Terms

Pension funds

A pension fund is any plan, fund, or scheme which provides retirement income.

mutual funds

A mutual fund is a type of professionally-managed collective investment vehicle that pools money from many investors to purchase securities.

Equity method in accounting is the process of treating equity investments, usually 20–50%, in associate companies. The investor keeps such equities as an asset. The investor’s proportional share of the associate company’s net income increases the investment; a net loss, or proportional payment of dividends, decreases the investment. In the investor’s income statement, the proportional share of the investee’s net income or net loss is reported as a single-line item .

Equity

Investors keep equities as assets using equity method.

An equity investment generally refers to the buying and holding of shares of stock by individuals and firms in anticipation of income from dividends and capital gains. Typically, equity holders receive voting rights, meaning that they can vote on candidates for the board of directors (shown on a proxy statement received by the investor) as well as certain major transactions. Equity holders also receive residual rights, meaning that they share the company’s profits, as well as the right to recover some of the company’s assets in the event that it folds—although they generally have the lowest priority in recovering their investment. It may also refer to the acquisition of equity (ownership) participation in a private (unlisted) company or a startup company. When the investment is in infant companies, it is referred to as venture capital investing and is generally regarded as a higher risk than investment in listed going-concern situations.

Equities held by private individuals are often held as mutual funds or as other forms of collective investment schemes, many of which have quoted prices that are listed in financial newspapers or magazines. Mutual funds are typically managed by prominent fund management firms, such as Schroders, Fidelity Investments, or The Vanguard Group. Such holdings allow individual investors to obtain diversification of the fund(s) and to make use of the skill of the professional fund managers in charge of the fund(s). An alternative, which is usually employed by large private investors and pension funds, is to hold shares directly. In the institutional environment, many clients who own portfolios have what are called segregated funds, as opposed to or in addition to the pooled mutual fund alternatives.

A calculation can be made to assess whether an equity is over- or under-priced, compared with a long-term government bond. This is called the Yield Gap or Yield Ratio. It is the ratio of the dividend yield of an equity and that of the long-term bond.

8.5.2: Assessing Control

20-50% of overall shares in a firm is referred to as a minority interest, which is a non-controlling position from a strategic frame.

Learning Objective

Understand the role minority interest shareholders hold in decision-making, and the accounting method used to report it

Key Points

• Holding company shares in an organization technically imparts voting rights to the shareholder, though the percentage of the organization owned impacts the scale of this influence.
• Ownership between 20-50% is referred to as a minority interest in the organization, and must be reported using the equity method.
• In regards to control, minority interest is a not a controlling position in the firm. In most situations, 51% ownership is required (majority).
• However, a minority interest stakeholder may be consulted on certain strategic decisions and may be on the board of directors.

Key Term

minority interest

Ownership between 20-50% in an organization.

Holding shares in an organization grants a certain level of voting rights and ownership of that organization. This becomes particularly relevant when ownership of the firm reaches or exceeds 20% of the overall value of the organization. Over 50% ownership indicates an actual transfer of ownership, often recorded as a subsidiary by the owning party.

The space between 20% and 50% has specific guidelines in regards to reporting, ownership, and the assessment of control. This is referred to as an associate company, and must be reported utilizing the equity method.

The Equity Method

This is the method used to record an investment at the level of an associate company (20-50% ownership). This is considered an asset on behalf of the investor, and reported accordingly. An investment’s percentage ownership of the company appreciates when the net income increases and depreciates when it decreases. This share is reported on the investor’s income statement as a single-line item.

Assessing Control

Control of an organization is in the hands of the owners. The owners, in most publicly traded situations, are represented by the individual who hold significant percentages of the overall organization’s value. In a situation where an individual or organization owns more than 20% and less than 50% of the overall shares, this control is referred to as a minority interest.

Minority Interest

Owning 50% or more of the shares is a majority interest, granting the owner volume control over significant organizational decisions. However, a minority interest is still a primary shareholder that will (in most situations) have influence on the decisions being made at the strategic level.

Generally speaking, minority interest is still non-controlling interest. 51% is required to make substantial decisions regarding the organization itself. That being said, a minority interest is still a significant share of the organization. As a result, it is not uncommon for minority interest shareholders to hold a seat on the board of directors, or to be consulted regarding the decisions.

Intel Board of Directors

This image is from Intel’s Board of Directors.

This image is from Intel’s Board of Directors.

8.5.3: Reporting Equity Investments

Investments recorded under the equity method usually consist of stock ownership of a company between 20% to 50%.

Learning Objective

Explain why a company would use the Equity Method to determine how to report their 20-50% investment

Key Points

• When the amount of stock purchased is between 20% and 50% of the common stock outstanding, the purchasing company’s influence over the acquired company is often significant and the investor participates in business decision-making.
• Under the equity method, the purchaser records its investment at the original cost. The balance of the investment increases by the pro-rata share of the investee’s income and decreases by the pro-rata share of dividends declared by the subsidiary.
• At the time of purchase, goodwill can arise from the difference between the cost of the investment and the book value of the underlying assets.

Key Terms

pro forma income

a statement of the company’s revenue while excluding “unusual and nonrecurring transactions” when stating how much money the company actually made

pro-rata

in proportion to some other factor, such as shares owned

FASB

The Financial Accounting Standards Board (FASB) is a private, not-for-profit organization whose primary purpose is to developgenerally accepted accounting principles (GAAP) within the United States in the public’s interest.

Reporting Stock Investments of 20-50% of Equity

When the amount of stock purchased is between 20% and 50% of the common stock outstanding, the purchasing company’s influence over the acquired company is often significant. The deciding factor, however, is significant influence or the ability for the investor to have a say in business decisions made by company owners. If other factors exist that reduce the influence, or if significant influence is gained at an ownership of less than 20%, the equity method may be appropriate. FASB interpretation 35 (FIN 35) underlines the circumstances where the investor is unable to exercise significant influence).

To account for this type of investment, the purchasing company uses the equity method. Under the equity method, the purchaser records its investment at the original cost. The balance of the investment increases by the pro-rata share of the investee’s income and decreases by the pro-rata share of dividends declared by the subsidiary.

An example of how to apply the equity method to a stock investment — assume ABC Corporation purchases 30% of XYZ Corporation (or 80,000 shares) and can exercise significant influence. The market price of the stock is USD 1. At the end of 201X, XYZ earns net income of 100,000 and declares a dividend of USD 1 per share. The following journal entries are made by ABC to record the investment in XYZ:

Journal entry for the stock investment purchase:

• DR – Investment in XYZ Corporation USD 80,000 (80,000 shares * USD 1 market price/share)
• CR – Cash USD 80,000

Journal entry to account for the pro-rata share of XYZ annual income:

• DR – Investment in XYZ Corporation USD 30,000 (100,000 net income * .30)
• CR – Equity in XYZ Corp. Income USD 30,000

Journal entry to account for the pro-rata share of XYZ dividends:

• DR – Dividends Receivable 80,000 (80,000 shares * USD 1 dividend per share)
• CR – Investment in XYZ Corporation 80,000

Goodwill and Equity Investments

At the time of purchase, goodwill can arise from the difference between the cost of the investment and the book value of the underlying assets. The component that can give rise to goodwill is: the difference between the fair market value of the underlying assets and their book value .

Goodwill

Goodwill is an accounting concept meaning the excess value of an asset acquired over its book value due to a company’s competitive advantages.

Goodwill is no longer amortized under U.S. GAAP (FAS 142) of June 2001. Companies objected to the removal of the option to use pooling-of-interests, so amortization was removed by the Financial Accounting Standards Board as a concession. As of January 1, 2005, it is also forbidden under International Financial Reporting Standards. Goodwill can now only be impaired under these GAAP standards.

To test goodwill for impairment, companies are now required to determine the fair value of the reporting units, using the present value of future cash flow, and compare it to their carrying value (book value of assets plus goodwill minus liabilities). If the fair value is less than carrying value (impaired), the goodwill value needs to be reduced so that the fair value is equal to the carrying value. The impairment loss is reported as a separate line item on the income statement, and the new adjusted value of goodwill is reported in the balance sheet.

8.6: Holding More than 50% of Shares (Ownership)

8.6.1: Reporting for a Combined Entity

When the amount of stock owned is >50% of common stock, a parent-subsidiary relationship is formed that requires consolidated reporting.

Learning Objective

Explain how to report for a combined entity

Key Points

• A subsidiary company, or daughter company is a company that is completely or partly owned and partly or wholly controlled by another company that owns more than half of the subsidiary’s stock.
• Consolidated financial statements show the parent and subsidiary as one single entity. During the year, the parent company uses the equity method to account for its investment. At the end of the year, a consolidation working paper eliminates intercompany transactions between parent and subsidiary.
• As of 2004, the acquisition method is the only allowable method that can be used to prepare consolidated financial statements for companies that combined after 2004. Other consolidation methods previously used were the purchase and the pooling of interests methods.

Key Term

state-owned enterprise

A government-owned corporation, state-owned company, state-owned entity, state enterprise, publicly owned corporation, government business enterprise, commercial government agency,public sector undertaking or parastatal is a legal entity created by a government to undertake commercial activities on behalf of an owner government.

Reporting for a Combined Entity

The ownership of more than 50% of voting stock creates a subsidiary. The financial statements of the parent and subsidiary are consolidated for reporting purposes.

A subsidiary company, or daughter company is a company that is completely or partly owned and partly or wholly controlled by another company that owns more than half of the subsidiary’s stock. The subsidiary can be a company, corporation, or limited liability company. In some cases it is a government or state-owned enterprise. The controlling entity is called its parent company, parent, or holding company.

An operating subsidiary is a business term frequently used within the United States’s railroad industry. In the case of a railroad, it refers to a company that is a subsidiary but operates with its own identity, locomotives, and rolling stock. In contrast, a non-operating subsidiary would exist on paper only (i.e. stocks, bonds, articles of incorporation) and would use the identity and rolling stock of the parent company.

When the amount of stock purchased is more than 50% of the outstanding common stock, the purchasing company usually has control over the acquired company. Control in this context is defined as ability to direct policies and management. In this type of relationship the controlling company is the parent and the controlled company is the subsidiary. The parent company needs to issue consolidated financial statements at the end of the year to reflect this relationship.

Consolidated financial statements show the parent and the subsidiary as one single entity. During the year, the parent company can use the equity or the cost method to account for its investment in the subsidiary. Each company keeps separate books. However, at the end of the year, a consolidation working paper is prepared to combine the separate balances and to eliminate the intercompany transactions between the parent and the subsidiary, along with the subsidiary’s stockholder equity and the parent’s subsidiary investment account. The result is one set of financial statements that reflect the financial results of the consolidated entity. As of 2004, the acquisition method is the only allowable method that can be used to prepare consolidated financial statements for companies that combined after 2004. Other consolidation methods previously used were the purchase and the pooling of interests methods .

The following is an example of how to calculate consolidated net income — assume ABC Corporation owns 80% of XYZ Corporation; the remaining 20% is a non-controlling ownership interest.

Net Income for 201X for ABC is USD 20,000 and for XYZ net income is USD 8,000. First, to arrive at consolidated net income for the two companies, ABC must eliminate the effect of the equity method used to account for its investment.

ABC’s net income for the year includes 80% of XYZ’s net income, or USD 6,400. This amount must be subtracted from the net income figure to arrive at 13,600 (20,000 – 6,400).

The consolidated net income for both companies after this adjustment is USD 21,600 (20,000 – 6,400 + XYZ’s total net income of 8,000). Second, the portion of net income attributed to the non-controlling ownership interest must be deducted, or USD 1,600 (8,000 * .20).

Therefore, consolidated income for ABC and its controlling interest in XYZ is USD 20,000 (21,600 – 1,600).

7.3: Intangible Asset Impairment

7.3.1: Limited-Life Impairment

Learning Objective

Summarize how to calculate the impairment on a limited life asset

Key Points

• Limited-life intangibles are intangible assets with a limited useful life, such as copyrights, patents and trademarks.
• Intangible assets are non-monetary assets that cannot be seen, touched or physically measured. Intangible assets are created through time and effort, and are identifiable as separate assets.
• Non-physical or “intangible” assets are amortized to reflect the change in their value due to use, expiration or obsolescence over time.

Key Terms

asset

Items of ownership convertible into cash; total resources of a person or business, as cash, notes and accounts receivable; securities and accounts receivable, securities, inventories, goodwill, fixtures, machinery, or real estate (as opposed to liabilities).

intangible

Incapable of being perceived by the senses; incorporeal.

amortization

The distribution of the cost of an intangible asset, such as an intellectual property right, over the projected useful life of the asset.

straight-line method of amortization

debt paid off with regular, equal sized payments

straight-line method

the company charges the same amount to depreciation each year over that period until the value shown for the asset has reduced from the original cost to the salvage value

Example

• A software company has a patent valued at $10 million with a useful life of 40 years. Due to market conditions, the company believes the patent’s value has decreased and tests it for impairment at the end of the year. Year end calculations reveal the patent is valued at $8 million and an impairment loss of $2 million is recorded as a debit to Loss on Patent Impairment on the income statement and a credit to Accumulated Impairment Losses on the balance sheet (disclosed as a contra asset account to the intangible asset). As a result of the impairment, the amortization expense on the patent should be adjusted to reflect the new value.

Limited-Life Impairment

Intangible assets are non-monetary assets that cannot be seen, touched, or physically measured. Intangible assets are created through time and effort, and are identifiable as separate assets. They are classified into categories: either purchased vs. internally created intangible assets; and limited-life or indefinite-life intangible assets.

The two primary forms of intangibles are legal intangibles, which includes trade secrets, copyrights, patents, and trademarks (also referred to as Intellectual Property) and competitive intangibles, which includes knowledge activities, collaboration activities, leverage activities, and structural activities. Limited-life intangibles are intangible assets with a limited useful life, such as copyrights, patents and trademarks

Intangible assets are amortized to reflect their consumption, expiry, obsolescence or other decline in value as a result of use or the passage of time, process which is similar to the deprecation process for tangible assets. Intangible assets can have either a limited or an indefinite useful life. Intangible assets with a limited-life are amortized on a straight-line basis over their economic or legal life, based on whichever is shorter. Examples of intangible assets with a limited-life include copyrights and patents. Only intangible assets with an indefinite life are reassessed each year for impairment.

Limited-life intangibles are systemically amortized throughout the useful life of the intangible asset using either units of activity method or straight-line method. The amortization amount is equal to the difference between the intangible asset cost and the asset residual value. That calculated amount is credited to either the appropriate intangible asset account or accumulated amortization account .

Amortization & depreciation in the accounting cycle

A bond’s discount amount must be amortized over the term of the bond.

Reversal of Impairment Loss

When an intangible asset’s impairment reverses and value is regained, the increase in value is recorded as a gain on the income statement and reduction to accumulated impairment loss on the balance sheet, up to the amount of impairment loss recorded in prior periods. Increases in value in excess of prior impairment loss are debited directly to the asset and credited to a revaluation reserve account in the equity section of the balance sheet. Asset amortization for future periods should be adjusted due to the increase in value.

7.3.2: Indefinite-Life Impairment

Learning Objective

Summarize how to impair indefinite life intangibles

Key Points

• Examples of Indefinite-life intangibles are goodwill, trademarks, and perpetual franchises.
• Instead of amortization, indefinite-life assets are evaluated for impairment yearly.
• The Impairment cost is calculated as: Carrying value – Recoverable amount.

Key Terms

intangible

Incapable of being perceived by the senses; incorporeal.

impairment

When the carrying value exceeds the fair value.

Indefinite

Without limit; forever, or until further notice; not definite

Example

• A software company has a trademark valued at $10 million with an indefinite useful life. Due to market conditions, the company believes the trademark’s value has decreased and tests it for impairment at the end of the year. Year end calculations reveal the trademark is valued at $8 million and an impairment loss of $2 million is recorded as a debit to Loss on Trademark Impairment on the income statement and a credit to Accumulated Impairment Losses on the balance sheet (disclosed as a contra asset account to the intangible asset).

Indefinite-Life Impairment

In accounting, intangible assets are defined as non-monetary assets that cannot be seen, touched or physically measured.

Under US GAAP, intangible assets are classified into: Purchased vs. internally created intangibles, and Limited-life vs. indefinite-life intangibles.

Since intangible assets are typically expensed according to their respective life expectancy, it is important to understand the difference between limited-life intangible assets and indefinite-life intangible assets. Intangible assets with identifiable useful lives (limited-life) include copyrights and patents. These items are amortized on a straight-line basis over their economic or legal life, whichever is shorter.

Some examples of indefinite-life intangibles are goodwill, trademarks, and perpetual franchises. Indefinite-life tangibles are not amortized because there is no foreseeable limit to the cash flows generated by those intangible assets. Instead of amortization, indefinite-life assets are evaluated for impairment yearly. If an impairment has occurred, then a loss must be recognized.

The purpose of the accounting cycle

Properly reporting items is important to the accounting cycle.

An Impairment cost must be included under expenses when the carrying value of a non-current asset exceeds the recoverable amount. The Impairment cost is calculated as:

Carrying value – Recoverable amount

The carrying amount is defined as the value of the asset as displayed on the balance sheet. The recoverable amount is the higher of either the asset’s future value for the company or the amount it can be sold for, minus any transaction cost.

Intangibles can also be classified as: legal intangibles or competitive intangibles. Legal intangibles are also known as Intellectual Property. They include trade secrets, copyrights, patents, and trademarks. Competitive intangibles comprise knowledge activities, know-how, collaboration activities, leverage activities, and structural activities.

Reversal of Impairment Loss

When an intangible asset’s impairment reverses and value is regained, the increase in value is recorded as a gain on the income statement and reduction to accumulated impairment loss on the balance sheet, up to the amount of impairment loss recorded in prior periods. Increases in value in excess of prior impairment loss is debited directly to the asset and credited to a revaluation reserve account in the equity section of the balance sheet. According to IAS 36, reversal of impairment losses for goodwill are not allowed.

7.3.3: Goodwill Impairment

Learning Objective

Explain how to calculate impairment on goodwill

Key Points

• Goodwill is the value of an asset that is considered intangible but has a quantifiable “prudent value” in a business.
• A firm’s reputation with its clients is an example of goodwill.
• If the fair value is less than carrying value (impaired), the goodwill value will need to be reduced so that the fair value is equal to the carrying value.

Key Terms

impairment

When the carrying value exceeds the fair value.

asset

Items of ownership convertible into cash; total resources of a person or business, as cash, notes and accounts receivable; securities and accounts receivable, securities, inventories, goodwill, fixtures, machinery, or real estate (as opposed to liabilities).

goodwill

The value of an asset that is considered intangible but has a quantifiable “value” in a business. For example, a reputation the firm enjoys with its clients.

Example

• A software company has net assets valued at $1 million, but the company’s overall value (including brand, customers, intellectual capital) is valued at $10 million. Upon purchase, the buyer records $9 million in goodwill and tests it for impairment at the end of the year. Year end calculations reveal the goodwill is valued at $8 million and an impairment loss of $1 million is recorded as a debit to Loss on Goodwill Impairment on the income statement and a credit to Accumulated Impairment Losses on the balance sheet (disclosed as a contra asset account to goodwill).

Business Goodwill

In accounting, goodwill is the value of an asset that is considered intangible but has a quantifiable “prudent value” in a business. For example, goodwill could be the reputation the firm enjoys with its clients. While goodwill is technically an intangible asset, it is usually listed as a separate item on a company’s balance sheet .

The Accounting Cycle

Correctly reporting intangible assets is important to the accounting cycle.

Accounting for Goodwill

Instead of deducting the value of goodwill annually over a period of maximal 40 years ( amortization ), companies are now required to determine the fair value of the reporting units, using the present value of future cash flow , and compare it to their carrying value (book value of assets + goodwill – liabilities. ).

If the fair value is less than carrying value (impaired), the goodwill value will need to be reduced so that the fair value is equal to carrying value. The impairment loss is reported as a separate line item on the income statement, and new adjusted value of goodwill is reported in the balance sheet.

Impairment of Goodwill

If there is an indication that the book value of goodwill is greater than the recoverable value of net assets, an assessment of the recoverable value is made, and if the suspicion is correct, then an impairment expense is recorded. Goodwill’s value on the balance sheet is reported at net of accumulated impairment loss, a contra asset account; the current impairment loss is reported on the income statement.

An impairment cost must be included under expenses when the carrying value of a non-current asset on the balance sheet exceeds the asset’s market value subtracted by any transaction costs (recoverable amount). The impairment cost is calculated as follows: carrying value – recoverable amount.

The carrying amount is defined as the value of the asset as it is displayed on the balance sheet. The recoverable amount is the higher of either the asset’s future value for the company or the amount it can be sold for, minus any transaction cost.

According IAS 36, reversal of goodwill impairment losses are not allowed.

7.4: Research & Development Cost

7.4.1: What Is R&D?

The primary function of R&D is to develop new products or discover and create new knowledge about scientific and technological topics.

Learning Objective

Summarize research and developments role within a corporation

Key Points

• The primary function of R&D is to develop new products or discover and create new knowledge about scientific and technological topics for the purpose of uncovering and enabling development of valuable new products, processes, and services.
• New product design and development is more often than not a crucial factor in the survival of a company. In an industry that is changing fast, firms must continually revise their design and range of products.
• In the U.S., a typical ratio of research and development for an industrial company is about 3.5% of revenues. A high technology company such as a computer manufacturer might spend 7%.

Key Terms

research

Diligent inquiry or examination to seek or revise facts, principles, theories, and applications; laborious or continued search after truth.

ROI

The return on investment (ROI) is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested.

development

The process of developing; growth, directed change.

Example

• In the U.S., a typical ratio of research and development for an industrial company is about 3.5% of revenues. A high technology company such as a computer manufacturer might spend 7%. Although Allergan (a biotech company) tops the spending table with 43.4% investment, anything over 15% is remarkable and usually gains a reputation for being a high technology company. Companies in this category include pharmaceutical companies such as Merck & Co. (14.1%) or Novartis (15.1%), and engineering companies like Ericsson (24.9%). Such companies are often seen as credit risks because their spending ratios are so unusual.

What is R&D?

The term R&D or research and development refers to a specific group of activities within a business. The activities that are classified as R&D differ from company to company, but there are two primary models. In one model, the primary function of an R&D group is to develop new products; in the other model, the primary function of an R&D group is to discover and create new knowledge about scientific and technological topics for the purpose of uncovering and enabling development of valuable new products, processes, and services. Under both models, R&D differs from the vast majority of a company’s activities which are intended to yield nearly immediate profits or immediate improvements in operations and involve little uncertainty as to the return on investment (ROI). The first model of R&D is generally staffed by engineers while the second model may be staffed with industrial scientists. R&D activities are carried out by corporate and governmental entities.

A worker makes final checks

This is an example of R&D in action.

R&D’s Role

New product design and development is more often than not a crucial factor in the survival of a company. In an industry that is changing fast, firms must continually revise their design and range of products. This is necessary due to continuous technological change and development as well as other competitors and the changing preference of customers. Without an R&D program, a firm must rely on strategic alliances, acquisitions, and networks to tap into the innovations of others.

Microscopy lab

Research being carried out at the Microscopy lab of the Idaho National Laboratory.

In the U.S., a typical ratio of research and development for an industrial company is about 3.5% of revenues. A high technology company such as a computer manufacturer might spend 7%. Although Allergan (a biotech company) tops the spending table with 43.4% investment, anything over 15% is remarkable and usually gains a reputation for being a high technology company. Companies in this category include pharmaceutical companies such as Merck & Co. (14.1%) or Novartis (15.1%), and engineering companies like Ericsson (24.9%). Such companies are often seen as credit risks because their spending ratios are so unusual.

Generally such firms prosper only in markets whose customers have extreme needs, such as medicine, scientific instruments, safety-critical mechanisms (aircraft), or high technology military armaments. The extreme needs justify the high risk of failure and consequently high gross margins from 60% to 90% of revenues. Gross profits will be as much as 90% of the sales cost, with manufacturing costing only 10% of the product price, because so many individual projects yield no exploitable product. Most industrial companies get only 40% of revenues.

History of R&D

Research and development costs are costs incurred in a planned search for new knowledge and in translating such knowledge into new products or processes. Prior to 1975, businesses often capitalized research and development costs as intangible assets when future benefits were expected from their incurrence. Due to the difficulty of determining the costs applicable to future benefits, many companies expensed all such costs as incurred. Other companies capitalized those costs that related to proven products and expensed the rest as incurred.

As a result of these varied accounting practices, in 1974 the Financial Accounting Standards Board in Statement No. 2 ruled that firms must expense all research and development costs when incurred, unless they were directly reimbursable by government agencies and others. Immediate expensing is justified on the grounds that (1) the amount of costs applicable to the future cannot be measured with any high degree of precision; (2) doubt exists as to whether any future benefits will be received; and (3) even if benefits are expected, they cannot be measured. Thus, research and development costs no longer appear as intangible assets on the balance sheet. The Board applies the same line of reasoning to other costs associated with internally generated intangible assets, such as the internal costs of developing a patent.

7.4.2: Accounting for R&D Activity

Research and development costs no longer appear as intangible assets on the balance sheet, but as expenses on the income statement.

Key Points

• Research and development costs no longer appear as intangible assets on the balance sheet. The Board applies the same line of reasoning to other costs associated with internally generated intangible assets, such as the internal costs of developing a patent.
• Immediate expensing is justified on the following grounds: the amount of costs applicable to the future cannot be measured with any high degree of precision, doubt exists as to whether any future benefits will be received, and even if benefits are expected, they cannot be measured.
• In the U.S., a typical ratio of research and development for an industrial company is about 3.5% of revenues. A high technology company such as a computer manufacturer might spend 7%.

Key Terms

research

Diligent inquiry or examination to seek or revise facts, principles, theories, and applications; laborious or continued search after truth.

intangible

Incapable of being perceived by the senses; incorporeal.

incur

To render somebody liable or subject to.

Accounting for Research and Development Activity

In general, research and development (R&D) activities are conducted by specialized units or centers belonging to a company, or can be outsourced to contract research organizations, universities, or state agencies . In the context of commerce, research and development normally refers to future-oriented, long-term activities in science or technology, using similar techniques to scientific research but directed toward desired outcomes and with broad forecasts of commercial yield.

Cycle of Research and Development

Cycle of Research and Development, from “Research and Evaluation on Education in Science and Engineering (REESE), Program Solicitation NSF 09-601”

In the United States, a typical ratio of research and development for an industrial company is about 3.5% of revenues. A high technology company such as a computer manufacturer might spend 7%. Although Allergan (a biotech company) tops the spending table with 43.4% investment, anything over 15% is remarkable and usually gains a reputation for being a high technology company. Companies in this category include pharmaceutical companies such as Merck & Co. (14.1%) or Novartis (15.1%), and engineering companies like Ericsson (24.9%). Such companies are often seen as credit risks because their spending ratios are so unusual.

Research and development costs are the costs incurred in a planned search for new knowledge and in translating such knowledge into new products or processes. Prior to 1975, businesses often capitalized research and development costs as intangible assets when future benefits were expected from their incurrence. Due to the difficulty of determining the costs applicable to future benefits, many companies expensed all such costs as incurred. Other companies capitalized those costs that related to proven products and expensed the rest as incurred.

As a result of these varied accounting practices, in 1974 the Financial Accounting Standards Board in Statement No. 2 ruled that firms must expense all research and development costs when incurred, unless they were directly reimbursable by government agencies and others. Immediate expensing is justified on the following grounds:

1. The amount of costs applicable to the future cannot be measured with any high degree of precision
2. Doubt exists as to whether any future benefits will be received
3. Even if benefits are expected, they cannot be measured

Research and development costs thus no longer appear as intangible assets on the balance sheet. The Board applies the same line of reasoning to other costs associated with internally generated intangible assets, such as the internal costs of developing a patent.

R&D As an Administrative cost

Administrative costs are non-manufacturing costs that include the costs of top administrative functions and various staff departments such as accounting, data processing, and personnel. Executive salaries, clerical salaries, office expenses, office rent, donations, research and development costs, and legal costs are also administrative costs. As with selling costs, all organizations have administrative costs.

7.5: Reporting and Analyzing Intangibles

7.5.1: Reporting Intangibles

Intangible assets are either recorded at cost or expensed as they are created.

Learning Objective

Explain how to value an intangible asset for reporting purposes

Key Points

• The most common types of intangibles are patents, copyrights, franchises or licenses, trademarks or trade names, and goodwill.
• In most cases, intangible assets provide services over a period of years.
• Intangibles purchased from another party are recorded at cost.
• The cost of created intangibles is generally expensed as incurred.
• Intangible assets derive their value from the rights and privileges granted to the company using them.

Key Terms

Capitalized

To capitalize is to treat costs as capital not an expense. The capital expenditure costs are then amortized or depreciated over the life of the asset.

Intangibles

Things that are recognized but not easily quantified.

Intangibles

Intangible assets lack physical existence. Unlike tangible assets such as property, plant, and equipment, intangible assets derive their value from the rights and privileges granted to the company using them.

They are not financial instruments. Assets such as bank deposits, accounts receivable, and long-term investments in bonds and stocks lack physical substance, but are not classified as intangible assets. These assets are financial instruments and derive their value from the right or claim to receive cash or cash equivalents in the future.

In most cases, intangible assets provide services over a period of years. As a result, they are normally classified as long-term assets. The most common types of intangibles are patents, copyrights, franchises or licenses, trademarks or trade names, and goodwill.

Valuation and Accounting

Intangibles purchased from another party are recorded at cost . Cost includes all costs of acquisition and expenditures necessary to make the intangible asset ready for its intended use—for example, purchase price, legal fees, and other incidental expenses.

Reporting Intangibles

Valuation and Accounting

If intangibles are acquired for stock or in exchange for other assets, the cost of the intangible is the fair value of the consideration given or the fair value of the intangible received, whichever is more clearly evident.

The accounting treatment for purchased intangibles closely parallels that followed for purchased tangible assets. The cost of created intangibles is generally expensed as incurred. Therefore, even though a company may incur substantial research and development costs to create an intangible, these costs are expensed.

Various reasons are given for this approach. Some argue that the costs incurred internally to create intangibles bear no relationship to their real value. Therefore, expensing these costs is appropriate. Others note that with a purchased intangible, a reliable number for the cost of the intangible can be determined. With internally developed intangibles, it is difficult to associate costs with specific intangible assets. And others argue that due to the underlying subjectivity related to intangibles, a conservative approach should be followed—that is, expense as incurred.

The accounting for intangible assets depends on whether the intangible has a limited or an indefinite life. The costs of acquiring and defending a copyright may be capitalized, but the research and development costs involved must be expensed as incurred. Generally, the useful life of the copyright is less than its legal life. The costs of the copyright should be allocated to the years in which the benefits are expected to be received. The difficulty of determining the number of years over which benefits will be received normally encourages the company to write these costs off over a fairly short period of time.

7.5.2: Reporting R&D Cost

Expense R&D, unless items have alternative future uses, then allocate as consumed, or capitalize and depreciate as used.

Learning Objective

Summarize how to report research and development costs on the financials statements

Key Points

• R&D costs may be expensed. A cost which cannot be deducted in the year in which it is paid or incurred must be capitalized.
• If the acquired property’s useful life is longer than the taxable year, then the cost must be capitalized. The capital expenditure costs are then amortized or depreciated over the life of the asset.
• Choice of the appropriate accounting treatment should be guided by the degree of certainty of future benefits and the principle of matching revenues and expenses.

Key Terms

development

Development is the application of research findings to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services, before the start of commercial production or use.

research

Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.

Research and Development Defined

Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.

Development is the application of research findings to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems, or services, before the start of commercial production or use.

Reporting R&D Costs

R&D costs may be expensed. A cost which cannot be deducted in the year in which it is paid or incurred must be capitalized. The general rule is that if the acquired property’s useful life is longer than the taxable year, then the cost must be capitalized. The capital expenditure costs are then amortized or depreciated over the life of the asset. Choice of the appropriate accounting treatment for such costs should be guided by the degree of certainty of future benefits and the principle of matching revenues and expenses.

Some companies conduct R&D activities for other entities under a contractual arrangement. In this case, the contract usually specifies that all direct costs, certain specific indirect costs, plus a profit element, should be reimbursed to the enterprise performing the R&D work. Because reimbursement is expected, such R&D costs should be recorded as a receivable. It is the company for whom the work has been performed that reports these costs as R&D and expenses them as incurred.

It should be emphasized that R&D activities do not include routine or periodic alternatives to existing products, production lines, manufacturing processes, and other ongoing operations even though these alterations may represent improvements. For example, routine ongoing efforts to refine, enrich, or improve the qualities of an existing product are not considered R&D activities.

Reporting R&D Activities

The costs associated with R&D activities and the accounting treatment accorded them are as follows: expense the entire costs, unless the items have alternative future uses (in other R&D projects or otherwise), then carry as inventory and allocate as consumed, or capitalize and depreciate as used.

7.5.3: Analyzing Intangible Assets

Intangibles with identifiable useful lives are amortized on a straight-line basis over their economic or legal life, whichever is shorter.

Learning Objective

Explain how to report intangible assets on the financial statements

Key Points

• Intangible assets are typically expensed according to their respective life expectancy. Intangible assets have either an identifiable or indefinite useful life.
• Examples of intangible assets with identifiable useful lives include copyrights and patents.
• Intangible assets with indefinite useful lives are reassessed each year for impairment. If an impairment has occurred, then a loss must be recognized.
• Some costs with respect to intangible assets must be capitalized rather than treated as deductible expenses.

Key Terms

Amortized

Refers to expensing the acquisition cost in a systematic manner over economic or legal lives so as to reflect their consumption, expiry, obsolescence or other decline in value as a result of use or the passage of time.

goodwill

The value of an asset that is considered intangible but has a quantifiable “value” in a business. For example, a reputation the firm enjoys with its clients.

impairment

When the carrying value exceeds the fair value.

Analyzing Intangible Assets

Intangible assets are defined as identifiable non-monetary assets that cannot be seen, touched or physically measured. Intangible assets are created through time and effort, and are identifiable as a separate asset .

Analyzing Intangibles

How to Analyze Intangible Assets

Intangible assets are typically expensed according to their respective life expectancy. Intangible assets have either an identifiable or indefinite useful life. Those with identifiable useful lives are amortized on a straight-line basis over their economic or legal life, whichever one is shorter. Examples of intangible assets with identifiable useful lives include copyrights and patents.

Intangible assets with indefinite useful lives are reassessed each year for impairment. If an impairment has occurred, then a loss must be recognized. An impairment loss is determined by subtracting the asset’s fair value from the asset’s book or carrying value. Trademarks and goodwill are examples of intangible assets with indefinite useful lives. Goodwill has to be tested for impairment rather than amortized. If impaired, goodwill is reduced and loss is recognized in the Income statement.

Capitalization

Some costs with respect to intangible assets must be capitalized rather than treated as deductible expenses. Treasury regulations generally require capitalization of costs associated with acquiring, creating, or enhancing intangible assets. For example, an amount paid to obtain a trademark must be capitalized. Certain amounts paid to facilitate these transactions are also capitalized. Some types of intangible assets are categorized based on whether the asset is acquired from another party or created by the taxpayer. The regulations contain many provisions intended to make it easier to determine when capitalization is required.

Research and Development

Research and development (R&D) costs are not in and of themselves intangible assets. R&D activities frequently result in the development of something that is patented or copyrighted (such as a new product, process, idea, formula, composition, or literary work). Many businesses spend considerable sums of money on research and development to create new products or processes, improve present products, and discover new knowledge that may be valuable.

6.3: Valuing of Assets

6.3.1: Basic Components of Asset Valuation

Learning Objective

Differentiate between the absolute value, relative value, fair value and option pricing methods of valuing an asset

Key Points

• Absolute value models that determine the present value of an asset’s expected future cash flows. These kinds of models take two general forms: multi-period models (discounted cash flow models) or single-period models. These models rely on mathematics rather than price observation.
• Relative value models determine value based on the observation of market prices of similar assets.
• Option pricing models are used for certain types of financial assets (e.g., warrants, put options, call options, employee stock options, investments with embedded options such as a callable bond) and are a complex present value model.
• The book value of an asset is its recorded cost less accumulated depreciation. An old asset’s book value is usually not a valid indication of the new asset’s fair market value. However, if a better basis is not available, a firm could use the book value of the old asset.
• An appraised value is an expert’s opinion of an item’s fair market price if the item were sold. Appraisals are used often to value works of art, rare books, and antiques.

Key Terms

liability

An obligation, debt or responsibility owed to someone.

valuation

The process of estimating the market value of a financial asset or liability.

asset

Something or someone of any value; any portion of one’s property or effects so considered

Example

• Occasionally, a company receives an asset without giving up anything for it. For example, to attract industry to an area and provide jobs for local residents, a city may give a company a tract of land on which to build a factory. Although such a gift costs the recipient company nothing, it usually records the asset (land) at its fair market value. Accountants record gifts of plant assets at fair market value to provide information on all assets owned by the company. Omitting some assets may make information provided misleading. They would credit assets received as gifts to a stockholders’ equity account titled Paid-in Capital—Donations.

Basic Asset Valuation

In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

Overview

Valuation of financial assets is done using one or more of these types of models:

• Absolute value models that determine the present value of an asset’s expected future cash flows. These kinds of models take two general forms: multi-period models such as discounted cash flow models or single-period models such as the Gordon model. These models rely on mathematics rather than price observation.
• Relative value models determine value based on the observation of market prices of similar assets.
• Option pricing models are used for certain types of financial assets (e.g., warrants, put/call options, employee stock options, investments with embedded options such as a callable bond) and are a complex present value model. The most common option pricing models are the Black–Scholes-Merton models and lattice models.
• Fair value is used in accordance with US GAAP (FAS 157), where fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for fixed assets carried at historical cost (less accumulated depreciation), the fair value of the asset is not used.

Common terms for the value of an asset or liability are fair market value, fair value, and intrinsic value. The meanings of these terms differ. For instance, when an analyst believes a stock’s intrinsic value is greater (less) than its market price, an analyst makes a “buy” (“sell”) recommendation. Moreover, an asset’s intrinsic value may be subject to personal opinion and vary among analysts.

When a plant asset is purchased for cash, its acquisition cost is simply the agreed on cash price. However, when a business acquires plant assets in exchange for other non-cash assets (shares of stock, a customer’s note, or a tract of land) or as gifts, it is more difficult to establish a cash price. This section discusses three possible asset valuation bases.

Emerging Values: Environmentalism and Green Energy

Image of an energy plant.

The general rule on non-cash exchanges is to value the non-cash asset received at its fair market value or the fair market value of what was given up, whichever is more clearly evident. The reason for not using the book value of the old asset to value the new asset is that the asset being given up is often carried in the accounting records at historical cost. In the case of a fixed asset, its value on the balance sheet is historical cost less accumulated depreciation, or book value. Neither amount may adequately represent the actual fair market value of either asset. Therefore, if the fair market value of one asset is clearly evident, a firm should record this amount for the new asset at the time of the exchange.

Appraised Value

Sometimes, neither of the items exchanged has a clearly determinable fair market value. Then, accountants record exchanges of items at their appraised values as determined by a professional appraiser. An appraised value is an expert’s opinion of an item’s fair market price if the item were sold. Appraisals are used often to value works of art, rare books, antiques, and real estate.

Book Value

The book value of a fixed asset asset is its recorded cost less accumulated depreciation. An old asset’s book value is usually not a valid indication of the new asset’s fair market value. However, if a better basis is not available, a firm could use the book value of the old asset.

Occasionally, a company receives an asset without giving up anything for it. For example, to attract industry to an area and provide jobs for local residents, a city may give a company a tract of land on which to build a factory. Although such a gift costs the recipient company nothing, it usually records the asset (land) at its fair market value. Accountants record gifts of plant assets at fair market value to provide information on all assets owned by the company. Omitting some assets may make information provided misleading. They would credit assets received as gifts to a stockholders’ equity account titled Paid-in Capital—Donations.

6.3.2: Additional Factors to Consider

Key Points

• An important aspect of company valuation is determined when examining it in comparison to competitors. The company’s relative size compared with other businesses in its industry, relative product or service quality, etc. are important.
• When looking at management stability as a part of business valuation, one must consider if the management is skilled and experienced enough to maintain the company’s position and, potentially, improve it in the future.
• Consideration of financial strength entails a number of ratios, including a company’s total debt to assets, long-term debt to equity, current and quick ratios, interest coverage, and operating cycle.
• The book value of an asset is its recorded cost less accumulated depreciation. An old asset’s book value is usually not a valid indication of the new asset’s fair market value. However, if a better basis is not available, a firm could use the book value of the old asset.
• An appraised value is an expert’s opinion of an item’s fair market price if the item were sold. Appraisals are used often to value works of art, rare books, and antiques.

Key Terms

competitor

A person or organization against whom one is competing.

management

Administration; the process or practice of managing.

intangible

Incapable of being perceived by the senses; incorporeal.

Example

• An important aspect of company valuation is determined when examining it in comparison to competitors. For example: the company’s relative size compared with other businesses in its industry, relative product or service quality, product or service differentiation from others in the industry, market strengths, market size and share, competitiveness within its industry in terms of price and reputation, and copyright or patent protection.

Additional Factors to Consider

Competition

An important aspect of company valuation is determined when examining it in comparison to competitors. The company’s relative size compared with other businesses in its industry, relative product or service quality, product or service differentiation from others in the industry, market strengths, market size and share, competitiveness within its industry in terms of price and reputation, and copyright or patent protection of its products are all important in this examination.

• The most narrow form is direct competition (also called “category competition” or “brand competition”), where products which perform the same function compete against each other. For example, one brand of pick-up trucks competes with several other brands of pick-up trucks. Sometimes, two companies are rivals, and one adds new products to their line, which leads to the other company distributing the same new things, and in this manner they compete.
• The next form is substitute or indirect competition, where products which are close substitutes for one another compete. For example, butter competes with margarine, mayonnaise, and other various sauces and spreads.
• The broadest form of competition is typically called “budget competition. ” Included in this category is anything on which the consumer might want to spend their available money. For example, a family which has $20,000 available may choose to spend it on many different items, which can all be seen as competing with each other for the family’s expenditure. This form of competition is also sometimes described as a competition of “share of wallet. “

Management Ability

When examining this factor as a part of business valuation, one must consider if the management is skilled and experienced enough to maintain the company’s position, and potentially improve it in the future. Several factors can indicate management ability: accounts receivable, inventory, fixed assets, and total asset turnover; employee turnover; condition of the facilities; family involvement, if any; quality of books and records; and sales, as well as gross and operating profit.

Financial Strength

Consideration of financial strength entails a number of ratios, including a company’s total debt to assets, long-term debt to equity, current and quick ratios, interest coverage, and operating cycle.

1. Total debt to assets: total debt/total assets or total liability/total assets
2. Long term debt to equity: long term debt(liabilities)/equity
3. Current ratio: current assets/current liabilities

Profitability and Stability of Earnings

In accounting, profit is the difference between the purchase and the component costs of delivered goods and/or services and any operating or other expenses. This can help determine the financial stability of a company when viewing its profitability during its operating history, including the number of years the company has been in business, its sales and earnings trends, the life cycle of the industry as a whole, and returns on sales, assets and equity.

Other Factors

Along with the aforementioned considerations, a valuator must also keep in mind the economic conditions in which the company is operating, including the broad industry outlook and the impact of various IRS rulings and court cases that may affect the company’s value.

In addition, the valuator must analyze the values of comparable companies to determine their relationship to the company’s value. Intangible factors such as goodwill and non-compete agreements are important as well.

Finally, the valuator needs to consider the discount or capitalization rate of the company, specify what percentage of the company is being valued, and take into account any marketability or minority interest discounts.

Perhaps the most difficult part of the entire process is knowing how to combine all of these factors in a meaningful way to reach a value that will withstand any challenges by potential buyers, the IRS, dissatisfied partners or others.

Fair value should also be a consideration when valuing certain assets. Under US GAAP (FAS 157), fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for fixed assets carried at historical cost (less accumulated depreciation), the fair value of the asset is not used.

Apple is a successful company with considerable goodwill.

This is an example of an additional factor beyond book value that contributes to the overall valuation of a company.

6.3.3: Valuing Repairs, Maintenance, and Additions

Learning Objective

Explain what a capital expenditure is and how a company would account for it.

Key Points

• Because betterments or improvements add to the service-rendering ability of assets, firms charge them to the asset accounts.
• Occasionally, expenditures made on plant assets extend the quantity of services beyond the original estimate but do not improve the quality of the services. Since these expenditures benefit an increased number of future periods, accountants capitalize rather than expense them.
• Deferred maintenance is the practice of postponing maintenance activities such as repairs on both real property (i.e. infrastructure) and personal property (i.e. machinery) in order to save costs, meet budget funding levels, or realign available budget monies.

Key Terms

deferred maintenance

The failure to perform needed repairs could lead to asset deterioration and, ultimately, asset impairment.

capital expenditure

Funds spent by a company to acquire or upgrade a long-term asset.

depreciation

The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

additions and improvement

expense accrued to increase the productivity of an asset

Example

• For example, installing an air conditioner in an automobile that did not previously have one is a betterment. The debit for such an expenditure is to the asset account, Automobiles.

Valuing Repairs, Maintenance, and Additions

Betterments or improvements to existing plant assets are capital expenditures because they increase the quality of services obtained from the asset. Because these add to the service-rendering ability of assets, firms charge them to the asset accounts.

For example, installing an air conditioner in an automobile that did not previously have one is a betterment. The debit for such an expenditure is to the asset account, Automobiles.

Car Repairs

Cars require regular maintenance. Such contingent liabilities can be estimated reliably based on historical cost and readily available information.

Occasionally, expenditures made on plant assets extend the quantity of services beyond the original estimate but do not improve the quality of the services. Since these expenditures benefit an increased number of future periods, accountants capitalize rather than expense them. However, since there is no visible, tangible addition to, or improvement in, the quality of services, they charge the expenditures to the accumulated depreciation account, thus reducing the credit balance in that account. Such expenditures cancel a part of the existing accumulated depreciation; firms often call them extraordinary repairs.

If an expenditure that should be expensed is capitalized, the effects are more significant. Assume now that USD 6,000 in repairs expense is incurred for a plant asset that originally cost USD 40,000 and had a useful life of four years and no estimated salvage value. This asset had been depreciated using the straight-line method for one year and had a book value of USD 30,000 (USD 40,000 cost—USD 10,000 first-year depreciation) at the beginning of 2010. The company capitalized the USD 6,000 that should have been charged to repairs expense in 2010. The charge for depreciation should have remained at USD 10,000 for each of the next three years. With the incorrect entry, however, depreciation increases.

Deferred maintenance is the practice of postponing maintenance activities such as repairs on both real property (i.e. infrastructure) and personal property (i.e. machinery) in order to save costs, meet budget-funding levels, or realign available budget monies. The failure to perform needed repairs could lead to asset deterioration and, ultimately, asset impairment. Generally, a policy of continued deferred maintenance may result in higher costs, asset failure, and in some cases, health and safety implications.

Valuing Asset-Related Costs

Under US GAAP (FAS 157), fair value is the amount at which an asset and its related costs could be bought or sold in a current market transaction between willing parties or transferred to an equivalent party other than in a liquidation sale. Therefore, asset repairs and maintenance are expensed on the income statement at the market value paid for the services rendered. Asset additions/improvements are capitalized to their respective asset accounts on the balance sheet at the market value of the addition.

6.4: Depreciation of Assets

6.4.1: What Is Depreciation?

Depreciation is defined as the expensing of the cost of an asset involved in producing revenues throughout its useful life.

Learning Objective

Summarize the purpose of depreciating an asset

Key Points

• Depreciation expense reduces the book value of an asset and reduces an accounting period’s earnings. The expense is recognized throughout an asset’s useful life.
• The calculation of depreciation expense follows the matching principle, which requires that revenues earned in an accounting period be matched with related expenses.
• Depreciation expense can be calculated in a variety of ways; the method chosen should be appropriate to the asset type, the asset’s expected business use, and its estimated useful life.

Key Terms

residual value

In accounting, residual value is another name for salvage value, the remaining value of an asset after it has been fully depreciated.

accrual accounting

refers to the concept of recognizing and reporting revenues when earned and expenses when incurred, regardless of the effect on cash.

Definition of Depreciation

Depreciation is defined as the expensing of an asset involved in producing revenues throughout its useful life. Depreciation for accounting purposes refers the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching of revenues to expenses principle). Depreciation expense affects the values of businesses and entities because the accumulated depreciation disclosed for each asset will reduce its book value on the balance sheet. Depreciation expense also affects net income. Generally the cost is allocated as depreciation expense among the periods in which the asset is expected to be used. Such expense is recognized by businesses for financial reporting and tax purposes.

Depreciation reflects the wear and tear experienced by an asset in use.

Cars depreciate in value throughout their useful life.

Depreciation and the Matching Principle

Depreciation expense reduces an accounting period’s income even though the expense does not require a cash or credit payment. The reason for the expense is to comply with the matching principle required by accrual accounting. According to the principle, expenses are recognized regardless of cash payment when obligations are:

1. incurred (usually when goods are transferred (sold) or services rendered),
2. generated by expenses involved in the earning of the accounting period’s revenues.

Depreciation Expense Calculation

Depreciation expense can be calculated using a variety of methods. The depreciation method chosen should be appropriate to the asset type, its expected business use, its estimated useful life, and the asset’s residual value. The expense is recognized and reported when the asset is placed into use and is calculated for each accounting period and reported under Accumulated Depreciation on the balance sheet and Depreciation Expense on the income statement. The amount reduces both the asset’s value and the accounting period’s income. A depreciation method commonly used to calculate depreciation expense is the straight line method.

6.4.2: Factors for Calculating Depreciation

There are four main factors that affect the calculation of depreciation expense: asset cost, salvage value, useful life, and obsolescence.

Learning Objective

Summarize how a company would determine the appropriate depreciation method to use

Key Points

• A company is free to adopt the most appropriate depreciation method for its business operations.
• Companies can choose a method that allocates asset cost to accounting periods according to benefits received from the use of the asset.
• The depreciation method used should allocate asset cost to accounting periods in a systematic and rational manner.

Key Term

obsolescence

The process of becoming obsolete, outmoded, or out of date.

Factors Affecting Depreciation Expense

There are four main factors to consider when calculating depreciation expense:

1. The cost of the asset
2. The estimated salvage value of the asset. Salvage value (or residual value) is the amount of money the company expects to recover, less disposal costs, on the date the asset is scrapped, sold, or traded in.
3. Estimated useful life of the asset. Useful life refers to the window of time that a company plans to use an asset. Useful life can be expressed in years, months, working hours, or units produced.
4. Obsolescence should be considered when determining an asset’s useful life and will affect the calculation of depreciation. For example, a machine capable of producing units for 20 years may be obsolete in six years; therefore, the asset’s useful life is six years.

Factors Affecting the Depreciation Method

A company is free to adopt the most appropriate depreciation method for its business operations. Accounting theory suggests that companies use a depreciation method that closely reflects the operations’ economic circumstances. So, companies can choose a method that allocates asset cost to accounting periods according to benefits received from the use of the asset. Most companies use the straight-line method for financial reporting purposes, but they may also use different methods for different assets. The most important criteria to follow: Use a depreciation method that allocates asset cost to accounting periods in a systematic and rational manner.

Types of Depreciation Methods

The following four methods allocate asset cost in a systematic and rational manner: straight line, units of production, sum-of-years-digits, and double-declining balance.

Examples of Depreciation Expense Calculations

Here is an example of how to calculate depreciation expense under the straight-line method. Assume a purchased truck is valued at $10,000, has a residual value of $5,000, and a useful life of 5 years. Its depreciation expense for year 1 is
. The journal entry for this transaction is a debit to Depreciation Expense for $1,000 and a credit to Accumulated Depreciation for $1,000. The depreciation expense is reported on the income statement as a reduction to revenues and accumulated depreciation is reported as a contra account to its related Delivery Truck asset account (reduces the asset’s cost to its book value) on the balance sheet.

Here is an example of how to calculate depreciation expense under the units of production. Assume a piece of machinery, purchased for $100,000 with a residual value of $40,000, is expected to produce 10,000 units over its useful life. First, calculate the depreciation per unit:

The depreciation expense for the period is the per unit amount multiplied by the period’s production amount: if 1,000 units were produced, the depreciation expense is
. This amount is disclosed on the income statement and is part of the asset’s accumulated depreciation on the balance sheet.

Here is an example of how to calculate depreciation expense under the sum-of-years-digits. Assume a piece of machinery is purchased for USD 100,000 with a residual value of $40,000 and a useful life of 5 years. First, calculate the depreciation rate by adding the years of useful life, or
. Second, calculate the depreciation expense for year 5:

For year 4, the calculation uses the asset’s book value  (
) subtracted by its residual value (
) and multiplied by the rate for year 4
.

To calculate depreciation using the double-declining method, its possible to double the amount of depreciation expense under the straight-line method. To do this, divide 100 per cent by the number of years of useful life of the asset. Then, multiply this rate by 2. Next, apply the resulting double-declining rate to the declining book value of the asset (cost subtracted by accumulated depreciation). Ignore salvage value in making the calculations. At the point where book value is equal to the salvage value, no more depreciation is taken.

6.4.3: Methods of Depreciation

There are various methods that can calculate depreciation expense for the period; the method used should reflect the asset’s business use.

Learning Objective

Differentiate between the straight-line, units of production, sum of the years digits and double declining methods of calculating depreciation

Key Points

• Straight-line depreciation is the simplest and most popular method; it charges an equal amount of depreciation to each accounting period.
• The units-of-production depreciation method assigns an equal amount of expense to each unit produced or service rendered by the asset.
• The sum-of-the-years digits method determines annual depreciation by multiplying the asset’s depreciable cost by a series of fractions based on the sum of the asset’s useful life digits.
• The double-declining balance is a type of accelerated depreciation method that calculates a higher depreciation charge in the first year of an asset’s life and gradually decreases depreciation expense in subsequent years.

Key Terms

salvage value

also known as residual value; the remaining value of an asset after it has been fully depreciated.

historical cost

The original monetary value of an economic item and based on the stable measuring unit assumption. Improvements may be added to an asset’s cost.

useful life

the length of time, typically in years, that an asset is expected to function and be useful.

Methods of Depreciation

Some of the most common methods used to calculate depreciation are straight-line, units-of-production, sum-of-years digits, and double-declining balance, an accelerated depreciation method. The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation system used in the United States .

There are several asset depreciation methods to choose from.

The depreciation method for an automobile should reflect the asset’s use throughout its life.

Straight-Line

Straight-line depreciation has been the most widely used depreciation method in the U.S. for many years due to its simplicity. To apply the straight-line method, a company charges an equal amount of the asset’s cost to each accounting period. The straight-line formula used to calculate depreciation expense is: (asset’s historical cost – the asset’s estimated salvage value) / the asset’s useful life.

An example of how to calculate depreciation expense under the straight-line method — assume a purchased truck is valued at USD 10,000, has a residual value of USD 5,000, and a useful life of 5 years. Its depreciation expense for year 1 is USD 1,000 (10,000 – 5,000 / 5). The journal entry for this transaction is a debit to Depreciation Expense for USD 1,000 and a credit to Accumulated Depreciation for USD 1,000. The depreciation expense is reported on the income statement as a reduction to revenues and accumulated depreciation is reported as a contra account to its related Delivery Truck asset account (reduces the asset’s cost to its book value).

Units of Production

The units-of-production depreciation method assigns an equal amount of expense to each unit produced or service rendered by the asset. This method is typically applied to assets used in the production line. The formula to calculate depreciation expense involves two steps: (1) determine depreciation per unit ((asset’s historical cost – estimated salvage value) / estimated total units of production during the asset’s useful life); (2) determine the expense for the accounting period (depreciation per unit X number of units produced in the period).

An example of how to calculate depreciation expense under the units of production — assume a piece of machinery, purchased for USD 100,000 with a residual value of 40,000, is expected to produce 10,000 units over its useful life. First, calculate the depreciation per unit — 100,000 – 40,000 / 10,000, or USD 6 per unit. The depreciation expense for the period is the per unit amount multiplied by the period’s production amount — if 1,000 units were produced, depreciation expense equals USD 6,000 (1,000 * 6). This amount is disclosed on the income statement and is part of the asset’s accumulated depreciation on the balance sheet.

Sum-of-years-digits

Sum-of-years’ digits is a depreciation method that results in a more accelerated write-off than straight line, but less accelerated than that of the double-declining balance method. Under this method, annual depreciation is determined by multiplying the depreciable cost by a series of fractions based on the sum of the asset’s useful life digits. The sum of the digits can be determined by using the formula (n²+n)/2, where n is equal to the useful life of the asset.

To calculate depreciation expense under the sum-of-years-digits — assume a piece of machinery is purchased for USD 100,000 with a residual value of 40,000 and a useful life of 5 years. First, calculate the depreciation rate by adding the years of useful life, or 1+2+3+4+5 (equal to 15). Second, calculate the depreciation expense for year 5 — 100,000 – 40,000 * 5/15, or USD 20,000. For year 4, the calculation uses the asset’s book value (100,000 – 20,000) subtracted by its residual value (40,000) and multiplied by the rate for year 4 (4/15).

Double-declining Balance

The double-declining balance method is a type of accelerated depreciation method that calculates a higher depreciation charge in the first year of an asset’s life and gradually decreases depreciation expense in subsequent years.

To calculate depreciation expense, use double the straight-line rate. For example, suppose a business has an asset with a cost of 1,000, 100 salvage value, and 5 years useful life. First, calculate the straight-line depreciation rate. Since the asset has 5 years useful life, the straight-line depreciation rate equals (100% / 5) or 20% per year. With double-declining-balance, double that rate to arrive at 40%. Apply the rate to the book value of the asset (cost subtracted by accumulated depreciation) and ignore salvage value. At the point where book value is equal to the salvage value, no more depreciation is taken.

MACRS

Under MACRS, the capitalized cost (basis) of tangible property is recovered by annual deductions for depreciation over a specified life. The lives are specified in the Internal Revenue Service’s (IRS) Tax Co de. The IRS publishes detailed tables of asset lives by asset class. The deduction for depreciation is computed under one of two methods (declining balance switched to straight line or only straight line ) at the election of the taxpayer. Certain limitations may apply.

6.4.4: Impact of Depreciation Method

The choice of depreciation method can impact revenues on the income statement and assets on the balance sheet.

Learning Objective

Explain how the choice of depreciation method affects a company’s revenue

Key Points

• These four methods of depreciation (straight line, units of production, sum-of-years-digits, and double-declining balance) impact revenues and assets in different ways.
• The effect of the straight-line method is a stable and uniform reduction in revenues and asset values in every accounting period of the asset’s useful life.
• Depreciation expense under units-of-production, based on units produced in the period, will be lower or higher and have a greater or lesser effect on revenues and assets.
• Sum-of-years digits is a depreciation method that results in a more accelerated write off of the asset than straight line but less than declining-balance method.
• For the double-declining balance method, revenues and assets will be reduced more in the early years of an asset’s life, due to the higher depreciation expense, and less in the later years.

Key Terms

accelerated-depreciation method

a company, for ‘financial accounting’ or tax purposes, depreciates a fixed asset in such a way that the amount of depreciation taken each year is higher during the earlier years of an asset’s life

accelerated depreciation

Accelerated depreciation methods calculate a higher depreciation charge in the first year of an asset’s life, with gradually decreasing charges in subsequent years. This may be a more realistic reflection of an asset’s actual expected benefit based on the use of the asset; many assets are most useful when they are new.

income statement

A calculation which shows the profit or loss of an accounting unit (company, municipality, foundation, etc.) during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses.

balance sheet

A summary of a person’s or organization’s assets, liabilities. and equity as of a specific date.

declining-balance method

depreciation is based on a percent of the asset’s previous year ending book value

Impact of Depreciation Methods

Depreciation is a required expense for all business with fixed assets, excluding land. The choice of the depreciation method can impact revenues on the income statement and assets on the balance sheet. The four most common methods of depreciation that impact revenues and assets are: straight line, units of production, sum-of-years-digits, and double-declining balance.

Different depreciation methods have different effects on revenues and assets.

The depreciation method used to depreciate a car calculates an expense that reduces income.

Straight Line

When using the straight-line method, a company charges the same depreciation expense every accounting period throughout an asset’s useful life, so the effect is a stable and uniform reduction in revenues and asset values in every accounting period of the asset’s useful life.

Here is an example of how to calculate depreciation expense under the straight-line method. Assume a purchased truck is valued at $10,000, has a residual value of $5,000, and a useful life of 5 years. Its depreciation expense for year 1 is
. The journal entry for this transaction is a debit to Depreciation Expense for 1,000 and a credit to Accumulated Depreciation for 1,000. The depreciation expense is reported on the income statement as a reduction to revenues and accumulated depreciation is reported as a contra account to its related Delivery Truck asset account (reduces the asset’s cost to its book value).

Units of Production

The units-of-production method is calculated based on the units produced in the accounting period. Depreciation expense will be lower or higher and have a greater or lesser effect on revenues and assets based on the units produced in the period.

Here is an example of how to calculate depreciation expense under the units of production. Assume a piece of machinery, purchased for $100,000 with a residual value of $40,000, is expected to produce 10,000 units over its useful life. First, calculate the depreciation per unit:

The depreciation expense for the period is the per unit amount multiplied by the period’s production amount: if 1,000 units were produced, the depreciation expense is
. This amount is disclosed on the income statement and is part of the asset’s accumulated depreciation on the balance sheet.

Sum-Of-Years-Digits

Sum-of-years-digits depreciation is determined by multiplying the asset’s depreciable cost by a series of fractions based on the sum of the asset’s useful life digits. Sum-of-years digits is a depreciation method that results in a more accelerated write off of the asset than straight line but less than double-declining balance method. This method will reduce revenues and assets more rapidly than the straight-line method but not as rapidly as the double-declining method.

Here is an example of how to calculate depreciation expense under the sum-of-years-digits. Assume a piece of machinery is purchased for USD 100,000 with a residual value of $40,000 and a useful life of 5 years. First, calculate the depreciation rate by adding the years of useful life, or
. Second, calculate the depreciation expense for year 5:

For year 4, the calculation uses the asset’s book value  (
) subtracted by its residual value (
) and multiplied by the rate for year 4
.

Double-Declining Balance

Double-declining balance is a type of accelerated depreciation method. This method records higher amounts of depreciation during the early years of an asset’s life and lower amounts during the asset’s later years. Thus, in the early years, revenues and assets will be reduced more due to the higher depreciation expense. In later years, a lower depreciation expense can have a minimal impact on revenues and assets. However, revenues may be impacted by higher costs related to asset maintenance and repairs.

To calculate depreciation using the double-declining method, its possible to double the amount of depreciation expense under the straight-line method. To do this, divide 100 per cent by the number of years of useful life of the asset. Then, multiply this rate by 2. Next, apply the resulting double-declining rate to the declining book value of the asset (cost subtracted by accumulated depreciation). Ignore salvage value in making the calculations. At the point where book value is equal to the salvage value, no more depreciation is taken.

6.5: Impairment of Assets

6.5.1: Impairment Recognition

An impairment loss is recognized and accrued through a journal entry to record and reevaluate the asset’s value.

Learning Objective

Explain how to assess an asset for impairment

Key Points

• Business assets should be tested for impairment when a situation occurs that causes the asset to lose value. Certain intangible assets, such as goodwill, are tested for impairment on an annual basis.
• Impairment losses can occur for a variety of reasons: physical damage to the asset, a permanent reduction in market value, legal issues against the asset, and early asset disposal.
• An impairment loss is recognized through a journal entry that debits Loss on Impairment, debits the asset’s Accumulated Depreciation and credits the Asset to reflect its new lower value.

Key Terms

depreciation

The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

accrue

To increase, to augment; to come to by way of increase; to arise or spring as a growth or result; to be added as increase, profit, or damage, especially as the produce of money lent.

Impairment Recognition

Business assets should be tested for impairment when a situation occurs that causes the asset to lose value. An impairment loss is recognized and accrued to record the asset’s revaluation. Once an asset has been revalued, fluctuations in market value are calculated periodically. Certain intangible assets, such as goodwill, are tested for impairment on an annual basis. Impairment losses can occur for a variety of reasons:

• when an asset is badly damaged (negative change in physical condition)
• the asset’s market price has been significantly reduced
• legal issues have had a negative impact on the asset
• the asset is set for disposal before the end of its useful life A loss on impairment is recognized as a debit to Loss on Impairment (the difference between the new fair market value and current book value of the asset) and a credit to the asset. The loss will reduce income in the income statement and reduce total assets on the balance sheet.

A loss on impairment is recognized as a debit to Loss on Impairment (the difference between the new fair market value and current book value of the asset) and a credit to the asset.The loss will reduce income in the income statement and reduce total assets on the balance sheet.

The impairment of an asset reduces its value on the balance sheet.

The cost of an impaired building beyond repair is disclosed as a loss on the income statement.

For an example, take a retail store that is recorded on the owner’s balance sheet as a non-current asset worth USD 20,000 (book value or carrying value is USD 20,000). Based on the asset’s book value, assume the store has a historical cost of USD 25,000 and accumulated depreciation of USD 5,000. A hurricane sweeps through the town and damages the store’s building. After assessing the amount of the damage, the owner calculates that the building’s market value has fallen to USD 12,000.

The Loss on Impairment is calculated to be USD 8,000 (20,000 book value – 12,000 market value)

The journal entry to recognize the Loss on Impairment:

• Debit Loss on Impairment for USD 8,000
• Debit Store Building-Accumulated Depreciation for USD 5,000
• Credit Store Building for USD 13,000

The Loss on Impairment for USD 8,000 is recognized on the income statement as a reduction to the period’s income and the asset Store Building is recognized at its reduced value of USD 12,000 on the balance sheet (25,000 historical cost – 8,000 impairment loss – 5,000 accumulated depreciation). After the impairment, depreciation expense is calculated using the asset’s new value.

6.5.2: Impairment Measurement

Business assets that have suffered a loss in value are given two tests to measure and recognize the amount of the loss.

Learning Objective

Summarize the steps a company takes to measure an assets impairment

Key Points

• Two tests are performed to determine the amount of an impairment loss: recoverability and measurement.
• The recoverability test evaluates if an asset’s undiscounted future cash flows are less than the asset’s book value. When cash flows are less, the loss is measured.
• The measurement test uses the difference between the asset’s market value and book value to calculate the amount of the impairment loss.

Key Terms

intangible asset

Any valuable property of a business that does not appear on the balance sheet, including intellectual property, customer lists, and goodwill.

cash flows

cash received or paid by a company for its business activities.

recoverability

The property of being able to recover.

Business assets that have suffered a loss in value are subject to impairment testing to measure and recognize the amount of the loss.

Physical damage to an asset can result in an impairment loss.

The impairment of a building is measured by determining the amount of value the asset has lost.

To measure the amount of the loss involves two steps:

• Perform a recoverability test is to determine if an impairment loss has occurred by evaluating whether the future value of the asset’s undiscounted cash flows is less than the book value of the asset. If the cash flows are less than book value, the loss is measured.
• Measure the impairment loss by calculating the difference between the book value and the market value of the asset.

The use of undiscounted cash flows in determining impairment loss assumes that the cash flows are certain and risk-free, and the timing of the cash flows is ignored. For example, assume a new USD 20,000 sewing machine, with a useful of life of 3 years, is damaged and has a new book value of USD 10,000.

The expected undiscounted cash flows generated by the machine after the damage are:

• USD 2,000 in Year1
• USD 2,000 in Year2
• USD 2,000 in Year3

Since the asset’s future undiscounted cash flows are USD 6,000, less than the USD 10,000 book value, an impairment loss has occurred. Use the market value of the sewing machine, USD 20,000, and deduct the USD 10,000 book value to arrive at an impairment loss of USD 10,000.

Certain assets with indefinite lives require an annual test for impairment. Trademarks and Goodwill are examples of intangible assets that are tested for impairment on an annual basis.

6.5.3: Loss Restoration

Fixed asset values can be revised to reflect an increase or decrease in value; upward revisions can recover earlier impairment losses.

Learning Objective

Explain when it would be applicable to revalue an impaired asset

Key Points

• A revaluation that increases or decreases an asset’s value can be accounted for with a journal entry that will debit or credit the asset account.
• An increase in the asset’s value should not be reported on the income statement; instead an equity account is credited and called a “Revaluation Surplus”.
• The revaluation surplus account accounts for increases in asset value and it also offsets any downward revisions, such as an impairment loss, in asset value.
• When the credit balance in the revaluation surplus account zeros out, an impairment loss is reported on the income statement.
• Under US GAAP, once an asset is impaired, its value cannot be increased regardless of its fair market value. Once the value of an asset is decreased, it stays at that value unless its market value declines again.

Key Terms

International Financial Reporting Standards

International Financial Reporting Standards (IFRS) are designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries

Comprehensive Income

The change in a company’s owner’s equity [net assets] due to transactions and other events and circumstances from non-owner sources. Comprehensive income is the sum of net income and other items that must bypass the income statement because they have not been realized

Asset Revaluation and Impairment Loss

Under US GAAP, once an asset is impaired its value cannot be increased regardless of what its fair market value is; once the value of an asset is decreased, it stays at that value unless its market value declines again. US GAAP does require that a business impair its assets if its fair market value decreases.

Under International Financial Reporting Standards, once a fixed asset has been revalued its book value can be adjusted periodically to market value using the cost model or the revaluation model. The cost model records an asset at its historical cost. If an asset becomes impaired and an impairment loss results, the asset can fall under the revaluation model that allows periodic adjustments to the asset’s book value. Future upward revisions to the value of the asset can recover losses from prior years under the revaluation model.

An upward revision to an asset’s value can recover prior impairment losses

Only assets accounted for under the revaluation model can have their book value adjusted to market value.

Revaluation Surplus

A revaluation that increases or decreases an asset’s value can be accounted for with a journal entry. The asset account is debited (increased) for the increase in value or credited (decreased) for a decrease in value. An increase in the asset’s value should not be reported on the income statement; instead an equity account is credited called “Revaluation Surplus. ” Revaluation surplus is reported in the other comprehensive income sub-section of the owner’s equity section in the balance sheet. The revaluation surplus account accounts for increases in asset value, and it also offsets any downward revisions, such as an impairment loss, in asset value. When the credit balance in the revaluation surplus account zeros out, an impairment loss is reported on the income statement.

Revaluation and Depreciation

After an asset have been revalued, the asset’s depreciation expense must change to reflect the new value. The asset’s new book value can be divided by its remaining useful life to adjust the amount of depreciation expense reported on the income statement after the revaluation.

6.6: Disposal of Assets

6.6.1: Sale

The disposal sale of an asset is similar to a regular asset sale, where cash proceeds are received and a loss or gain may be realized.

Learning Objective

Summarize how a company records the sale of an asset for disposal purposes

Key Points

• When an asset set for disposal is sold, depreciation expense must be computed up to the sale date to adjust the asset to its current book value.
• Compare the cash proceeds received from the sale with the asset’s book value to determine if a gain or loss on disposal has been realized. The gain or loss should be reported on the income statement.
• The asset account and its accumulated depreciation account are removed off the balance sheet when the disposal sale takes place.

Key Terms

book value

The value of an asset as reflected on an entity’s accounting books, net of depreciation, but without accounting for market value appreciation.

depreciation

The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

realize

To acquire as an actual possession; to obtain as the result of plans and efforts; to gain; to get.

Disposal of an Asset via Sale

The sale of an asset for disposal purposes is similar to a regular asset sale. Unlike a regular disposal of an asset, where the asset is abandoned and written off the accounting records, an asset disposal sale involves a receipt of cash or other proceeds. When the sale takes places, a journal entry is recorded that (1) updates depreciation expense, (2) removes the asset and its accumulated depreciation account off the balance sheet, (3) increases cash or other asset with the amount of proceeds received, and (4) records a gain or loss on the sale.

Depreciation Expense at Disposal

At the time of disposal, depreciation expense should be recorded to update the asset’s book value. A journal entry is recorded to increase (debit) depreciation expense and increase (credit) accumulated depreciation. Depreciation expense is reported on the income statement as a reduction to income. The increase in the accumulated depreciation account reduces the asset to its current book value .

An Asset for Sale — one way of disposing an asset is by selling it.

A business disposing of a building through a sale receives cash proceeds and may realize a gain or loss.

Proceeds Received and Loss/Gain at Disposal

The proceeds received on the asset sale are compared to the asset’s book value to determine if a gain or loss on disposal has been realized. If the proceeds are less than book value, a loss on disposal has been realized. If the proceeds are more than book value, the result is a gain. The proceeds from the sale will increase (debit) cash or other asset account. Depending on whether a loss or gain on disposal was realized, a loss on disposal is debited or a gain on disposal is credited. The loss or gain is reported on the income statement. The loss reduces income, while the gain increases it.

Asset Disposal and the Balance Sheet

The entry to remove the asset and its contra account off the balance sheet involves decreasing (crediting) the asset’s account by its cost and decreasing (crediting) the accumulated depreciation account by its account balance. Prior to zeroing out their account balances, these accounts should reflect the updated depreciation expense computed up to the disposal sale date.

6.6.2: Involuntary Conversion

Involuntary conversion of assets occurs when disposal is due to unforeseen circumstances, such as theft or casualty.

Learning Objective

Explain how a company accounts for the involuntary conversion of an asset

Key Points

• The forced disposal of the asset may result in cash proceeds from the filing and payment of an insurance claim on the asset or the receipt of a casualty award. A gain or loss on disposal can result.
• Involuntary conversion of assets can involve an asset exchange for monetary or non-monetary assets.
• An involuntary conversion involving an exchange for monetary assets is accounted for the same way as a sales transaction, with a gain or loss reported on the income statement.
• An exchange between non-monetary assets should be analyzed to determine if the exchange has commercial substance. An asset exchange with commercial substance will cause future cash flows to materially change.
• A non-monetary asset exchange with commercial substance may result in a gain or loss reported on the income statement. An exchange without commercial substance does not recognize gains or losses.

Key Terms

depreciation

The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

condemnation

The process by which a public entity exercises its powers of eminent domain.

casualty

Something that happens by chance, especially an unfortunate event; an accident, a disaster.

Definition of Involuntary Conversion

The involuntary conversion of an asset occurs when an asset must be disposed of due to unforeseen circumstances, such as theft, casualty, or condemnation. The forced disposal of the asset may result in cash proceeds from the filing and payment of an insurance claim on the asset or the receipt of a casualty award. If the monetary exchange is more than the asset’s book value, updated for depreciation up to the disposal date, a gain on disposal results; if the proceeds are less, the disposal realizes a loss. Unlike a voluntary sale, involuntary conversion of assets can involve an asset exchange for monetary or non-monetary assets .

An involuntary conversion is the forced disposal of an asset.

An airplane manufacturer’s involuntary conversion of a plane can result in a loss or gain on the income statement.

Exchange for Monetary Assets

Monetary assets consist of cash or cash-equivalent assets. An involuntary conversion involving an exchange for monetary assets is accounted for the same way as a typical sales transaction, with a gain or loss reported in the income statement in the period the conversion took place. The gain or loss is the difference between the proceeds received and the book value of the asset disposed of, updated for current depreciation expense.

Exchange for Non-Monetary Assets

Non-monetary assets are not easily converted to cash, such as equipment. An exchange between non-monetary assets should be analyzed to determine if the exchange has commercial substance. An asset exchange with commercial substance will cause future cash flows to materially change. If the exchange has commercial substance, the asset received is recorded on the balance sheet at either (1) the market value (purchase price) of the asset received or (2) the market value of the asset given up plus any cash paid. If the value of the new asset exceeds the book value of the old asset, a gain is recognized. If the new asset’s value is less, a loss is recognized.

For non-monetary asset exchanges without commercial substance, the expectation is that the exchange will not materially alter future cash flows. This type of exchange usually involves like-kind property, such as exchanging a truck for another truck. The asset received is recorded on the balance sheet at the book value of the asset given up plus any cash paid. Gains or losses on these transactions are not recognized.

6.7: Depletion of Assets

6.7.1: Depletion Base

The depletion base is the total cost of a natural resource and includes acquisition, exploration, development, and restoration costs.

Learning Objective

Differentiate between percentage depletion and cost depletion

Key Points

• Two methods are used to calculate depletion: percentage and cost.
• Percentage depletion is calculated by multiplying a certain percentage, specified for each mineral, by your gross income from the property during the year.
• Cost depletion is computed by (1) estimating the total quantity of mineral or resources acquired,(2) assigning a proportionate amount of the total resource cost to the quantity extracted in the period (total cost of the property/(the quantity extracted in the period/total estimated production).
• Industries involved in mining, timber, petroleum, and the extraction or use of natural resources are the types of businesses most affected by depletion.

Key Terms

depreciation

The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

adjusted basis

The net cost of an asset after adjusting for various tax-related items.

Example

• This example calculates depletion expense using cost depletion: Big Texas Oil, Co. discovers a large reserve of oil. The company has estimated the oil well will produce 200,000 barrels of oil. The company invests $100,000 to extract the oil, and they extract 10,000 barrels the first year. Therefore, the depletion deduction is $5,000 ($100,000 X 10,000/200,000).

Definition of Depletion

Depletion is a method of recording the use of natural resources over time. It is the amount of resources used in each accounting period that is expensed for U.S. tax and financial reporting purposes. Depletion is similar to depreciation, in that it is a cost recovery system for accounting and tax reporting. Industries involved in mining, timber, petroleum, and the extraction or use of natural resources are the types of businesses most affected by depletion. The depletion base is the total cost of the natural resource. It can include costs related to the acquisition of the asset, exploration, development and preparation of the asset for use, and performance of restoration work .

The depletion base for oil reserves includes all the costs incurred to put the asset into use.

Types of costs include acquisition, exploration, development, and restoration costs.

Methods to Calculate Depletion

Percentage Depletion:

To calculate, multiply a certain percentage, specified for each mineral, by your gross income from the property during the tax year. For this purpose, the term “property” means each separate interest business owned in each mineral deposit in each separate tract or parcel of land. Businesses can treat two or more separate interests as one property or as separate properties.

Cost Depletion:

This is an accounting method by which costs of natural resources are allocated to depletion over the period that make up the life of the asset. Cost depletion is computed by (1) estimating the total quantity of mineral or other resources acquired and (2) assigning a proportionate amount of the total resource cost to the quantity extracted in the period.Cost Depletion FormulaAccording to the IRS Newswire, over 50 percent of oil and gas extraction businesses use cost depletion to figure their depletion expense. Mineral property includes oil and gas wells, mines, and other natural deposits (including geothermal deposits). The cost depletion formula for financial reporting purposes is the total investment cost of the property / (the quantity extracted during the period / the property’s total estimated production). When calculating cost depletion for tax purposes, multiply the formula by the property’s adjusted basis or the property’s historical cost subtracted by depletion expense for prior years.

6.7.2: Resource Cost Write-Off

The term write-off describes removing an asset whose value is zero and is no longer in use from the balance sheet.

Learning Objective

Explain how to write off a natural resource asset

Key Points

• When a natural resource has been depleted to a value of zero, the asset’s remaining book value, as calculated by the original historical cost minus the depletion of prior years, is removed from the balance sheet through a write-off journal entry.
• The write-off journal entry will credit the asset’s account balance and debit the balance in the accumulated depletion account. The asset’s book value is the amount debited to an expense or loss account reported on the income statement.
• Write-offs should not be confused with impairment. A write-off journal entry removes an asset not in use and its related contra account from the balance sheet. An entry to record impairment merely reduces the asset’s value.

Key Terms

contra asset account

an account that corresponds to another is affected when a transaction is recorded

impairment

A downward revaluation, a write-down.

journal entry

A journal entry, in accounting, is a logging of transactions into accounting journal items. The journal entry can consist of several items, each of which is either a debit or a credit. The total of the debits must equal the total of the credits or the journal entry is said to be “unbalanced. ” Journal entries can record unique items or recurring items, such as depreciation or bond amortization.

salvage value

also known as residual value; the remaining value of an asset after it has been fully depreciated.

Example

• Assume that in 2010 a company paid USD 650,000 for a tract of land containing ore deposits. Preliminary study results indicated that approximately 900,000 tons of ore can be removed economically from the land, after which the land will be worth USD 50,000. To record the land purchase, Land is debited for USD 50,000 along with Ore Deposits for USD 600,000 and a credit is posted to Cash for USD 650,000. After mining begins, it is deemed impossible to extract the ore and the Ore Deposits account must be written off by debiting Loss on Ore Deposits for USD 600,000 and crediting Ore Deposits for USD 600,000.

Definition of Asset Write-offs:

The term write-off describes a reduction in recognized value. In accounting terminology, it refers to recognition of the reduced or zero value of an asset no longer in use. Assets that are natural resources, which are used throughout the course of business, are subject to periodic depletion. When the asset has been depleted to a value of zero or its value has dropped to less than its salvage value, the asset’s remaining book value, as calculated by the original historical cost minus the depletion of prior years, is removed from the balance sheet through a write-off.

When natural resources have their value reduced to zero they are written off.

An asset write-off removes an asset’s cost off the balance sheet and expenses it on the income statement.

Writing Off Assets with No Value

An asset is written off the balance sheet by recording a journal entry. The write-off journal entry moves the asset’s book value to the income statement, where it is reported as an expense or loss and reduces the accounting period’s income. The journal entry will credit (decrease) the asset’s account balance (equal to its historical cost) and debit (decrease) the balance in the accumulated depletion account. The asset’s book value (historical cost minus accumulated depletion) is the amount debited (increased) to an expense or loss account reported on the income statement for the accounting period. The decrease in the asset and accumulated depletion accounts reduces the balance to zero and removes the account from the balance sheet.

Asset Write-offs Vs. Impairment

Asset write-offs should not be confused with impairment. A write-off journal entry removes an asset not in use and its related contra account (accumulated depletion) from the balance sheet. If the asset has suffered a permanent reduction in value, the amount of the asset impairment is expensed on the income statement as a reduction to the accounting period’s income. The asset’s balance is reduced by the impairment amount to reflect the asset’s new economic value and the account remains on the balance sheet.

6.7.3: Recoverable Reserves

Recoverable reserves are the amount of a natural resource present and their value is used to compute the resource’s depletion expense.

Learning Objective

Explain how to calculate a natural resources recoverable reserve

Key Points

• On the balance sheet, natural resources are part of non-current assets and classified as separate groups, such as oil reserves.
• The natural reserves recovered involve several costs related to acquisition, exploration, development, and restoration of the natural resources.
• Natural reserve costs are reported on the balance sheet and assigned to the asset in question, such as “timber stands” or “oil reserves. ” They are reported at their total cost, less accumulated depletion.
• Depletion expense allows a business to account for the reduction in value of natural reserves. Similar to depreciation, depletion reflects the use and reduction of value of an asset over the course of time.

Key Terms

non-current assets

Also known as fixed assets, a non-current asset is a term used in accounting for assets and property which cannot easily be converted into cash.

depreciation

The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

Example

• Big Texas Oil Co. discovers a large reserve of oil and pays USD 500,000 to acquire the land. The company spends USD 100,000 to explore and develop the land and will spend USD 200,000 to restore the land after it no longer produces oil and is estimated to be valued at USD 20,000. The cost of the recoverable oil reserves are USD 780,000 (500,000 – 20,000 value of land +100,000 + 200,000). This cost is subject to depletion –the company has estimated the oil well will produce 200,000 barrels of oil. After they extract 10,000 barrels the first year, the depletion deduction is USD 39,000 (USD 780,000 X 10,000/200,000). The recoverable oil reserves account is valued at 741,000 (780,000 – 39,000) after one year of extraction activity.

Accounting for Natural Reserves

Natural reserves supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas deposits, and timber stands, are natural resources or wasting assets. Natural resources represent inventories of raw materials that are consumed (exhausted) through extraction or removal from their natural setting (e.g. removing oil from the ground). On the balance sheet, natural resources are part of non-current assets and classified as separate groups, such as oil reserves .

Recoverable copper reserves include the amount of the current copper deposits present.

The amount of recoverable reserves are used to compute an asset’s depletion.

The Recovery of Natural Reserves

Businesses that are involved in the recovery of natural resources, such as mining, growing timber, and extracting petroleum will incur costs related to the resource recovery. The natural reserves recovered involve several costs related to acquisition, exploration, development, and restoration of the natural resources. These costs are reported on the balance sheet and assigned to the asset in question, such as “timber stands” or “oil reserves. ” They are reported at their total cost, less accumulated depletion.

The Effect of Depletion

As these natural resources are used throughout the course of business, their value will be reduced by periodic depletion. Depletion expense allows a business to account for the reduction in value of natural reserves. Similar to depreciation, depletion reflects the use and reduction of value of an asset over the course of time. Two methods are available to calculate depletion: the cost and percentage method. Cost depletion is the most commonly used by oil and gas companies. The depletion amount can also vary when calculating it for financial reporting and tax purposes, so it can have a different effect on the accounting period’s income and income tax expense.

6.8: Natural Resources

6.8.1: Special Considerations for Acquisition and Depletion of Natural Resources

Resources supplied by nature are subject to special accounting conventions to calculate cost and depletion.

Learning Objective

Define a natural resource and how to properly account for its depletion

Key Points

• Resources supplied by nature, such as ore deposits, mineral deposits, and timberstands, are natural resources or wasting assets. Natural resources represent inventories of raw materials that can be consumed (exhausted) through extraction or removal from their natural setting.
• Typically, we record natural resources at their cost of acquisition plus exploration and development costs; on the balance sheet, we report them at total cost less accumulated depletion.
• Depletion is the exhaustion that results from the physical removal of a part of a natural resource. In each accounting period, the depletion recognized is an estimate of the cost of the natural resource that was removed from its natural setting during the period.
• To record depletion, debit a depletion account and credit an accumulated depletion account, which is a contra account to the natural resource asset account.

Key Terms

depletion

The act of depleting, or the state of being depleted; exhaustion.

natural resource

Any source of wealth that occurs naturally, especially minerals, fossil fuels, timber, etc.

asset

Something or someone of any value; any portion of one’s property or effects so considered

Example

• Kerr-McGee Corporation is a global energy and chemical company engaged in oil and gas exploration and production and the production and marketing of titanium dioxide pigment. In notes to its financial statements, Kerr-McGee states that the company’s geologists and engineers in accordance with the Securities and Exchange Commission definitions have prepared estimates of proved reserves. These estimates include reserves that may be obtained in the future by improved recovery methods now in operation or for which successful testing has been exhibited.

Natural Resources

Resources supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas deposits, and timberstands, are natural resources or wasting assets. Natural resources represent inventories of raw materials that can be consumed (exhausted) through extraction or removal from their natural setting (e.g., removing oil from the ground).

On the balance sheet, we classify natural resources as a separate group among noncurrent assets under headings such as “timber stands” and “oil reserves. ” Typically, we record natural resources at their cost of acquisition plus exploration and development costs; on the balance sheet, we report them at total cost less accumulated depletion. (Accumulated depletion is similar to the accumulated depreciation used for plant assets. ) When analyzing the financial condition of companies owning natural resources, exercise caution because the historical costs reported for the natural resources may be only a small fraction of their current value.

Carson Fall, Mt. Kinabalu in Malaysia

Carson Fall in Mount Kinabalu, Malaysia is an example of an undisturbed natural resource. Waterfalls provide spring water for humans, animals, and plants for survival and also provides habitat for marine organisms. The water current can be used to turn turbines for hydroelectric generation.

Rainforest Fatu Hiva

The rainforest on Fatu Hiva, Marquesas Islands is an example of an undisturbed natural resource. Forest provides timber for humans and food and shelter for flora and fauna. The nutrient cycle between organisms form food chains and biodiversity of species.

Depletion is the exhaustion that results from the physical removal of a part of a natural resource. In each accounting period, the depletion recognized is an estimate of the cost of the natural resource that was removed from its natural setting during the period. To record depletion, debit a depletion account and credit an accumulated depletion account, which is a contra account to the natural resource asset account.

By crediting the accumulated depletion account instead of the asset account, the original cost of the entire natural resource is continues to be reported on the financial statements. Thus, statement users can see the percentage of the resource that has been removed. To determine the total cost of the resource available, combine this depletion cost with other extraction, mining, or removal costs. Then assign this total cost to either the cost of natural resources sold or the inventory of the natural resource still on hand. Thus, all, some, or none of the depletion and removal costs recognized in an accounting period can be expensed, depending on the portion sold. If all of the resource is sold, expense all of the depletion and removal costs. The cost of any portion not yet sold is part of the cost of inventory.

Computing Periodic Depletion Cost

To compute depletion charges, companies usually use the units-of-production method. They divide total cost by the estimated number of units–tons, barrels, or board feet–that can be economically extracted from the property. This calculation provides a per-unit depletion cost.

For example, assume that in 2010 a company paid $650,000 for a tract of land containing ore deposits and $100,000 in exploration costs. The results indicated that approximately 900,000 tons of ore can be removed economically from the land, after which the land will be worth $50,000. The company incurred costs of $200,000 to develop the site, including the cost of running power lines and building roads. Total cost subject to depletion is the net cost assignable to the natural resource, plus the exploration and development costs. When the property is purchased, a journal entry assigns the purchase price to the two assets purchased–the natural resource and the land.

In some instances, companies buy only the right to extract the natural resource from someone else’s land. When the land is not purchased, its residual value is irrelevant and should be ignored. If there is an obligation to restore the land to a usable condition, the firm adds these estimated restoration costs to the costs to develop the site. In the example where the land was purchased, the total costs of the mineral deposits equal the cost of the site ($650,000) (minus the residual value of land and $50,000) plus costs to develop the site ($300,000), or a total of $900,000. The unit (per ton) depletion charge is
per ton.

6.9: Reporting and Analyzing Assets

6.9.1: Reporting Assets

A business must report an asset’s acquisition cost, how it is depreciated, any subsequent expenditures tied to it, and how it is disposed.

Learning Objective

Explain how to value and report an asset from its acquisition to its disposal

Key Points

• An asset’s value on a business balance sheet equals its acquisition cost, or the amount of cash and other property given up to acquire it and place it into operation.
• When determining how to depreciate an asset, a business should consider the cost of the asset, its residual value, its useful life, and what depreciation method it wants to use.
• If a business improves an asset’s ability to provide a service, it increases the asset’s value. If a business somehow extends a asset’s useful life, the asset’s value remains the same but its accumulated depreciation is decreased.
• When disposing of an asset, the business must ensure that the asset’s depreciation accounts is up to date and then off the asset balance and its accumulated depreciation balance. It must also record any cash or property it received for the disposed asset and record any gain or loss it incurred.

Key Term

depreciation

The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

Reporting Assets

One section of the balance sheet consists solely of the business’s property, plant, and equipment . To be included in this section of the balance sheet, the asset must last longer than a year, be tangible, be used in business operations, and cannot be held for resale. Common examples of items that would be included are buildings, machinery, and delivery vehicles. Accounting for these types of assets involves following four steps.

Factory Workers Assembling an Engine

The equipment and plant used to product a business’s product must be recorded on its balance sheet.

Record the Acquisition Cost

The acquisition cost is how the asset is valued on a business’s balance sheet. The acquisition cost equals the amount of cash and other property given up to acquire it and place it into operation. All expenses that are normal, reasonable, and necessary to obtain and place the property into use are included in the acquisition cost. Costs associated with fixing used property so it can be used by the company are included in the acquisition costs. Unnecessary costs associated with initially transporting the property to where it needs to go is not included in the acquisition cost.

Record Depreciation

The act of using an asset can often cause it to lose value because it physically wears out the property. Or an asset can be inadequate for future needs or become obsolete. In all of these cases, the underlying value of the asset decreases over time. Depreciation is a measure of how property values decrease. Depreciation does not apply to assets that do not lose value over time, such as land.

Depreciation can be calculated different ways for different types of asset. However, there are four things that a business must consider when determining how it will depreciate the asset. The first is the cost of the asset. Next, how much will the company be able to sell the asset for when it is of no longer of use to the company, or its residual value? The value could be based on its scrap value or the fact that the asset may have value to others as is. The company should also determine how long it will be able to use the asset. This period is known as the asset’s useful life.

Finally a business must choose a depreciation method. The most common depreciation method type is “straight-line,” where the depreciation rate is calculated by subtracting the asset’s residual value from its acquisition cost and dividing the result by its useful life.

To insure that the balance sheet reflects the accurate value of its assets, a business will not decrease the value of each asset as it depreciates. Instead, it will record a negative asset balance called accumulated depreciation. By adding the accumulated depreciation with the asset’s value, a person reading the balance sheet will be able to determine the asset’s current value.

Record Subsequent Expenditures on the Asset

A business can spend money on an asset that will increase its overall value in one of two ways. The first is if the business improves the asset in some way that makes it more valuable. A way an asset may become more valuable is if the business somehow enhances the asset’s ability to provide services. For example, if a business installs GPS into one of its trucks so it can make deliveries more efficiently, the expenditure has improved the value of the asset. In that case, the cost of acquiring the improvement is added to the value of the asset account.

A business can also spend money on an asset that does not improve its ability to provide a benefit to the business but extends the asset’s useful life. For example, a business may give one of its trucks an overhaul so that it will last another five years instead of another two. In this case, the value of the asset account is not adjusted but its accumulated depreciation account is decreased.

Account for Disposal of Asset

Recording the disposal of an asset requires taking several steps. First, the business must ensure that the asset’s depreciation account is up to date. Then the business must write off the asset balance as well as its accumulated depreciation balance. Then it must record any cash or property it received in exchange for the asset. Finally, it must record any gain or loss it sustained on the disposal of the property.

6.9.2: Return on Assets

The Return on Total Assets ratio measures how effectively a company uses its assets to generate its net income.

Learning Objective

State the formula to calculate return on total assets

Key Points

• \frac { Net\quad Income }{ Average\quad Value\quad of\quad Total\quad Assets\quad for\quad Accounting\quad Period } = Total Return on Net Assets.
• \quad \frac { Net\quad Income }{ Average\quad of\quad Fixed\quad Assets }= Total Return on Net Fixed Assets.
• The greater the value of the ratio, the better a company is performing. To accurately gauge a company’s performance, you need to put the value in context by comparing the ratio to the company’s past performance or to a competitor’s return on assets.

Key Terms

net income

Net income also referred to as the bottom line, net profit, or net earnings is an entity’s income minus expenses for an accounting period.

fixed asset

Asset or property which cannot easily be converted into cash, such as land, buildings, and machinery.

The Return on Total Assets ratio is similar to the Asset Turnover Ratio in that both measure how effective a business’s assets are in generating returns for the business. But while the asset turnover ratio is focused on the business’s sales, return on assets is focused on net income. Sales is a measure of how much money the company can generate while net income is a measure of how much the business earns after its pays all of its financial obligations.

A Sample Income Statement

Expenses are listed on a company’s income statement.

Return on Total Assets

Return on total assets equals the total net income the business earns in a given accounting period divided by the average value of the business’s total assets for the same period. You calculate the average value of the total assets by adding the value of the business’s total assets at the beginning of the period and the value of the business’s total assets at the end of the period. You then divide the sum by two.

Return on Total Fixed Assets

Return on Total Fixed Assets equals the business’s net income divided by the average value of the business’s total fixed assets for the accounting period. You calculate the average value of the business’s fixed assets by adding the value of the business’s total fixed assets at the beginning of the accounting period to the value of the total fixed assets at the end of the period. You then divide the sum by two.

Using Return on Assets to Assess Company Performance

The greater the value of the ratio, the better a company is performing. However, merely determining a business’s return on asset ratio is insufficient to get a good understanding on how a business is doing. To accurately gauge a company’s performance, you need to put the value in context. This is generally done by comparing the current return on assets ratio to the company’s past performance or to a competitor’s ratio.

6.9.3: Asset Turnover Ratio

The asset turnover ratio is a measure of how well a business is using all of its assets to generate sales.

Learning Objective

State the formula to calculate the asset turnover ratio

Key Points

• Asset\quad Turnover\quad =\frac { Net\quad Sales\quad Revenue }{ Average\quad Total\quad Assets }.
• \quad \frac { Net\quad Sales }{ Average\quad Net\quad Fixed\quad Assets } = Fixed Asset Turnover Ratio.
• All Asset Turnover Ratios must be judged in context. This is generally done by comparing the ratio’s value to the business’s ratios in prior accounting periods or to its competitors’ asset turnover ratios.

Key Term

fixed asset

Asset or property which cannot easily be converted into cash, such as land, buildings, and machinery.

Balance Sheet

The balance sheet is where you will find information regarding the value of the business’s assets, which is necessary to calculate the business’s asset turnover ratio.

It can be difficult to review a company’s balance sheet and get much meaning out of it with just a glance. While it may be impressive that a business has millions of dollars worth of equipment, it is hard to determine what that means from a business perspective.

One way of putting those values into context is to use them to generate ratios. One ratio that analysts use to evaluate a company’s strength is the asset turnover ratio.

Asset Turnover Ratio

The asset turnover ratio is a measure of how well a business is using all of its assets to generate sales. The ratio is calculated by dividing the total sales for the accounting period by the average value of the assets the business owned during the year. The average value is calculated by adding the value of assets the business owned at the beginning of the period to the value of the assets owned at the end of the period, and then dividing by two.

Fixed-Asset Turnover Ratio

The fixed-asset turnover ratio is calculated in a similar manner, except instead of focusing all of the business’s assets, the ratio is calculated using the business’s fixed assets. This ratio measures how well a business is using its fixed assets to generate sales. To calculate the fixed asset turnover ratio, divide the total sales for the accounting period by the average fixed asset balance for the accounting period. The average fixed asset balance equals the beginning balance of fixed assets for the period plus the ending balance of fixed assets for the period, then dividing by two.

How to Use These Ratios

The higher the ratio, the better the business is performing in terms of sales. However, these ratios generally need context to better understand them. While a ratio may appear low by itself, it may actually be doing well overall. Generally, an analyst will compare a business’s asset turnover ratio to the business’s ratios from prior accounting periods or to the business’s competitor’s asset turnover ratio for the same period.

5.3: Valuing Inventory

5.3.1: Costing Methods Overview

Learning Objective

Review the differences between the four cost accounting methods and demonstrate how to calculate the cost of goods sold

Key Points

• Cost accounting is regarded as the process of collecting, analyzing, summarizing, and evaluating various alternative courses of action involving costs and advising the management on the most appropriate course of action based on the cost efficiency and capability of the management.
• The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory items such as cars.
• The FIFO (first-in, first-out) method of inventory costing assumes that the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods.
• The LIFO (last-in, first-out) method of inventory costing assumes that the costs of the most recent purchases are the first costs charged to cost of goods sold when the company actually sells the goods.
• The weighted-average method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the weighted-average method to determine a cost for units that are basically the same.
• Beginning Inventory + Purchases = Available for Sale – Ending Inventory = Cost of Good Sold.

Key Terms

inventory

A detailed list of all of the items on hand.

costing

The estimation of the cost of a process or product.

raw materials

A raw material is the basic material from which a product is manufactured or made.

Costing Methods Overview

Cost accounting information is designed for managers. Since managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information from other organizations. Instead, the important criterion is that the information must be relevant for decisions that managers, operating in a particular environment of business including strategy, make. Cost accounting information is commonly used in financial accounting information, but first we are concentrating on its use by managers to take decisions. The accountants who handle the cost accounting information add value by providing good information to managers who are making decisions. Among the better decisions, is the better performance of one’s organization, regardless if it is a manufacturing company, a bank, a non-profit organization, a government agency, a school club or even a business school. The cost-accounting system is the result of decisions made by managers of an organization and the environment in which they make them .

Efficient use of inventory is critical for businesses.

Inventory at a business.

Cost accounting is regarded as the process of collecting, analyzing, summarizing, and evaluating various alternative courses of action involving costs and advising the management on the most appropriate course of action based on the cost efficiency and capability of the management.

The following are different cost accounting approaches:

• standardized or standard cost accounting
• lean accounting
• activity-based costing
• resource consumption accounting
• throughput accounting
• marginal costing/cost-volume-profit analysis

Classical cost elements for a manufacturing business are:

• Raw materials

• Labor
• Indirect expenses/overhead

Accepted Financial Costing Methods

There are four accepted methods of costing inventory items:

1. specific identification;
2. first-in, first-out (FIFO);
3. last-in, first-out (LIFO); and
4. weighted-average.

Each method has advantages and disadvantages. Note that a manufacturing business’s inventory will consist of work in process, or unfinished goods, and finished inventory; the costs of unfinished and finished inventory contain a combination of costs related to raw materials, labor, and overhead. On the other hand, a retailer’s inventory consists of all finished products purchased from a wholesaler or manufacturer; the costs of their units are based on their acquisition cost rather than the costs associated with manufacturing units.

Specific Identification

The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory items such as cars. Under the specific identification method, the firm must identify each unit in inventory, unless it is unique, with a serial number or identification tag.

FIFO (first-in, first-out)

The FIFO (first-in, first-out) method of inventory costing assumes that the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods. This method assumes the first goods purchased are the first goods sold. In some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage. Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis. In these cases, an assumed first-in, first-out flow corresponds with the actual physical flow of goods.

LIFO (last-in, first-out)

The LIFO (last-in, first-out) method of inventory costing assumes that the costs of the most recent purchases are the first costs charged to cost of goods sold when the company actually sells the goods.

Weighted-average

The weighted-average method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the weighted-average method to determine a cost for units that are basically the same, such as identical games in a toy store or identical electrical tools in a hardware store. Since the units are alike, firms can assign the same unit cost to them.

Calculating Cost of Goods Sold (periodic method)

Beginning Inventory + Purchases = Available for Sale

Available – Ending Inventory = Cost of Good Sold

5.3.2: Specific Identification Method

Learning Objective

Describe how a company would use the specific identification method to value inventory

Key Points

• Specific identification is a method of finding out ending inventory cost. It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year end inventory.
• In theory, this method is the best method, since it relates the ending inventory goods directly to the specific price they were bought for. However, management can easily manipulate ending inventory cost, since they can choose to report that cheaper goods were sold first, ultimately raising income.
• Alternatively, management can choose to report lower income, to reduce the taxes they needed to pay.

Key Terms

serial number

A unique number, assigned to a particular unit of some product, to identify it.

inventory

A detailed list of all of the items on hand.

accounting

The development and use of a system for recording and analyzing the financial transactions and financial status of a business or other organization.

specific identification method

inventory measurement based on the exact number of goods in inventory and their purchase price

Example

• Assume that the company in can identify the 20 units on hand at year-end as 10 units from the August 12 purchase and 10 units from the December 21 purchase. The company computes the ending inventory as shown in. It subtracts the USD 181 ending inventory cost from the USD 690 cost of goods available for sale to obtain the USD 509 cost of goods sold. Note that you can also determine the cost of goods sold for the year by recording the cost of each unit sold. The USD 509 cost of goods sold is an expense on the income statement, and the USD 181 ending inventory is a current asset on the balance sheet. The specific identification costing method attaches cost to an identifiable unit of inventory. The method does not involve any assumptions about the flow of the costs as in the other inventory costing methods. Conceptually, the method matches the cost to the physical flow of the inventory and eliminates the emphasis on the timing of the cost determination. Therefore, periodic and perpetual inventory procedures produce the same results for the specific identification method.

Types of Accounting Methods

The merchandise inventory figure used by accountants depends on the quantity of inventory items and the cost of the items. There are four accepted methods of costing the items: (1) specific identification; (2) first-in, first-out (FIFO); (3) last-in, first-out (LIFO); and (4) weighted-average. Each method has advantages and disadvantages.

General Information

Specific identification is a method of finding out ending inventory cost. It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year-end inventory. When this information is found, the amount of goods is multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost.

In theory, this method is the best method because it relates the ending inventory goods directly to the specific price they were bought for. However, this method allows management to easily manipulate ending inventory cost, since they can choose to report that the cheaper goods were sold first, therefore increasing ending inventory cost and lowering cost of goods sold. This will increase the income.

Alternatively, management can choose to report lower income, to reduce the taxes they needed to pay. This method is also a very hard to use on interchangeable goods. For example, it is hard to relate shipping and storage costs to a specific inventory item. These numbers will need to be estimated and reducing the specific identification’s benefit of being extremely specific.

Using Specific Identification

The specific identification method of inventory costing attaches the actual cost to an identifiable unit of product. Firms find this method easy to apply when purchasing and selling large inventory items such as cars. Under the specific identification method, the firm must identify each unit in inventory, unless it is unique, with a serial number or identification tag.

To illustrate, assume that the company in can identify the 20 units on hand at year-end as 10 units from the August 12 purchase and 10 units from the December 21 purchase. The company computes the ending inventory as shown in ; it subtracts the USD 181 ending inventory cost from the USD 690 cost of goods available for sale to obtain the USD 509 cost of goods sold. Note that you can also determine the cost of goods sold for the year by recording the cost of each unit sold. The USD 509 cost of goods sold is an expense on the income statement, and the USD 181 ending inventory is a current asset on the balance sheet. The specific identification costing method attaches cost to an identifiable unit of inventory. The method does not involve any assumptions about the flow of the costs as in the other inventory costing methods. Conceptually, the method matches the cost to the physical flow of the inventory and eliminates the emphasis on the timing of the cost determination. Therefore, periodic and perpetual inventory procedures produce the same results for the specific identification method.

Specific Identification

Determining ending inventory under specific identification

5.3.3: Cost Flow Assumptions

Learning Objective

Explain how a company’s inventory cost flow assumptions dictate which method it will use for inventory valuation

Key Points

• Companies make certain assumptions about which goods are sold and which goods remain in inventory (resulting in different accounting methodologies).
• The only requirement, regardless of method is that: The total cost of goods sold plus the cost of the goods remaining in ending inventory for financial and tax purposes is equal to the actual cost of goods available.
• Cost flow assumptions are for financial reporting and tax purposes only and do not have to agree with the actual movement of goods.

Key Terms

inventory

A detailed list of all of the items on hand.

assumption

The thing supposed; a postulate, or proposition assumed; a supposition.

COGS

COGS (cost of goods sold) is the inventory costs of those goods a business has sold during a particular period.

Example

• FIFO assigns first costs incurred to COGS (cost of goods sold) on the income statement. This disallows manipulation by management and cost flow agrees with ideal, physical flow of goods. Some may argue that the agreement of cost flow and ideal, physical flow of goods is not important. FIFO also uses the least relevant cost for the income statement and underestimates or overestimates the cost of goods sold if prices are rising or falling, respectively.

Cost Flow Assumptions

Inventory cost flow assumptions are necessary to determine the cost of goods sold and ending inventory. Companies make certain assumptions about which goods are sold and which goods remain in inventory (resulting in different accounting methodologies). This is for financial reporting and tax purposes only and does not have to agree with the actual movement of goods (companies typically choose a method because of its particular benefits, such as lower taxes) .

Efficient use of inventory is critical for businesses.

Picture of inventory at a business.

The only requirement, regardless of method is that: The total cost of goods sold plus the cost of the goods remaining in the ending inventory for financial and tax purposes is equal to the actual cost of goods available.

Specific Identification

Characteristics of the specific identification method include:

• Keeps track of the cost of each, specific good sold
• Perfect matching of costs of goods to goods sold
• Often impossible or too costly and allows manipulation by management

FIFO

Characteristics of the FIFO method include:

• Assigns first costs incurred to COGS (cost of goods sold) on the income statement
• Disallows manipulation by management and cost flow agrees with ideal, physical flow of goods, though the agreement of cost flow and ideal, physical flow of goods is arguably not important
• Uses the least relevant cost for the income statement and underestimates or overestimates the cost of goods sold if prices are rising or falling, respectively

LIFO

Characteristics of the LIFO method include:

• Assigns last costs incurred to COGS on the income statement
• Disallows manipulation by management and uses the most relevant cost for the income statement
• Underestimates or overestimates cost of goods sold if prices are falling or rising, respectively and cost flow disagrees with ideal, physical flow of goods, though the agreement of cost flow and ideal, physical flow of goods is arguably not important

Weighted Average

Characteristics of the weighted average method include:

• Assigns average cost incurred to COGS on the income statement
• Disallows manipulation by management and better estimation of the cost of goods sold than FIFO or LIFO if prices are rising or falling
• Tends to ignore extreme costs of inventory and there is no theoretical reasoning for using this method

Additional Notes

LIFO and weighted average cost flow assumptions may yield different end inventories and COGS in a perpetual inventory system than in a periodic inventory system due to the timing of the calculations. In the perpetual system, some of the oldest units calculated in the periodic units-on-hand ending inventory may get expended during a near inventory exhausting individual sale. In the LIFO system, the weighted average system, and the perpetual system, each sale moves the weighted average, so it is a moving weighted average for each sale. In contrast, in the periodic system, it is only the weighted average of the cost of the beginning inventory, the sum cost of all the purchases, less than the cost of the inventory, divided by the sum of the beginning units and the total units purchased.

5.3.4: Average Cost Method

Learning Objective

Explain how a company uses the average cost method to value their inventory

Key Points

• Under the average cost method, it is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period.The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale.
• The weighted-average method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the weighted-average method to determine a cost for units that are basically the same, such as identical games in a toy store.
• Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and beginning inventory cost are known. From them the Cost per Unit of Beginning Inventory can be calculated.

Key Terms

COGS

COGS (cost of goods sold) is the inventory costs of those goods a business has sold during a particular period.

weighted average

An arithmetic mean of values biased according to agreed weightings.

average collection period

365 divided by the receivables turnover ratio

inventory

A detailed list of all of the items on hand.

depreciable cost

original cost minus salvage value

Example

• To see how a company uses the weighted-average method to determine inventory costs using periodic inventory procedure, look at. Note that we compute weighted average cost per unit by dividing the cost of units available for sale, $690, by the total number of units available for sale, 80. Thus, the weighted-average cost per unit is $8.625, meaning that each unit sold or remaining in inventory is valued at $8.625.

Average Cost Method

Under the average cost method, it is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period. The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale. This gives a weighted-average unit cost that is applied to the units in the ending inventory. There are two commonly used average cost methods: Simple Weighted Average Cost method and Moving-Average Cost method.

The following is an example of the weighted average cost method:

• On 12/31/12, Furniture Palace has cost of goods available for sale (beginning inventory and purchases) of USD 5,000; 200 units available for sale; sales of 50 units; and an ending inventory of 150 units.
• The per unit cost of inventory is USD 25 (5,000 / 200 units). The value of the ending inventory on the balance sheet is USD 3,750 (150 units * USD 25). The cost of goods sold on the income statement is USD 1,250 (50 units * USD 25).

Moving Average Cost

Moving-Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and Beginning Inventory Cost are known. From them, the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Each time, purchase costs are added to Beginning Inventory Cost to get Cost of Current Inventory. Similarly, the number of units bought is added to Beginning Inventory to get Current Goods Available for Sale. After each purchase, Cost of Current Inventory is divided by Current Goods Available for Sale to get Current Cost per Unit on Goods.

Also during the year, multiple sales happen. The Current Goods Available for Sale is deducted by the amount of goods sold (COGS), and the Cost of Current Inventory is deducted by the amount of goods sold times the latest (before this sale) Current Cost per Unit on Goods. This deducted amount is added to Cost of Goods Sold. At the end of the year, the last Cost per Unit on Goods, along with a physical count, is used to determine ending inventory cost.

The following is an example of the moving-average cost method:

On 12/29/12, Furniture Palace has beginning inventory of $5,000 and 200 units available for sale. The current cost per unit is
.

On 12/30/12, a purchase of 50 units is made for $250. The new cost per unit after the purchase is
.

On 12/31/12, sales for the period were 50 units and ending inventory is 150 units. The value of the ending inventory on the balance sheet is
. The cost of goods sold on the income statement is
.

Weighted-Average under Periodic Inventory Procedure

The Weighted-Average Method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the Weighted-Average Method to determine a cost for units that are basically the same, such as identical games in a toy store or identical electrical tools in a hardware store. Since the units are alike, firms can assign the same unit cost to them. Under periodic inventory procedure, a company determines the average cost at the end of the accounting period by dividing the total units purchased plus those in beginning inventory into total cost of goods available for sale. The ending inventory is carried at this per unit cost.

Advantages and Disadvantages of Weighted-Average Method

When a company uses the Weighted-Average Method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is also not as badly understated as under LIFO, but it is not as up-to-date as under FIFO. Weighted-average costing takes a middle-of-the-road approach. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying.

Determining ending inventory

Determining ending inventory under weighted-average method using periodic inventory procedure

5.3.5: FIFO Method

Learning Objective

Describe how a company would value inventory under the FIFO method

Key Points

• This method assumes the first goods purchased are the first goods sold. In some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage.
• In periods of rising prices (Inflation) FIFO has higher value of inventory and lower cost of goods sold; in periods of falling prices (deflation) it has lower value of inventory and higher cost of goods sold.
• Because a company using FIFO assumes the older units are sold first and the newer units are still on hand, the ending inventory consists of the most recent purchases.

Key Terms

accounting

The development and use of a system for recording and analyzing the financial transactions and financial status of a business or other organization.

inflation

An increase in the quantity of money, leading to a devaluation of existing money.

FIFO

First in, first out (accounting).

Example

• An example of how to calculate the ending inventory balance and cost of goods sold of the period using FIFO — assume the following inventory is on hand and purchased on the following dates: Inventory of Product X -Purchase date: 10/1/12 — 10 units at a cost of USD 5 Purchase date: 10/5/12 — 5 units at a cost of USD 6 On 12/30/12, a sale is made of Product X for 11 units. Under FIFO, it is assumed that 10 units purchased on 10/1/12 (the sale also eliminates this inventory layer) and 1 unit purchased on 10/5/12 were sold The ending inventory balance on the 12/31/12 balance sheet is 4 units at a cost of USD 6, or USD 24 and cost of goods sold on the income statement is USD 56 (10 units * USD 5 + 1 unit * USD 6)

What Is FIFO

FIFO stands for “first-in, first-out”, and is a method of inventory costing which assumes that the costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods.

FIFO and LIFO methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks. These methods are used to manage assumptions of cost flows related to inventory, stock repurchases (if purchased at different prices), and various other accounting purposes .

Inventory

Inventory in a warehouse

Assumptions of FIFO

This method assumes the first goods purchased are the first goods sold. In some companies, the first units in (bought) must be the first units out (sold) to avoid large losses from spoilage. Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis. In these cases, an assumed first-in, first-out flow corresponds with the actual physical flow of goods.

Because a company using FIFO assumes the older units are sold first and the newer units are still on hand, the ending inventory consists of the most recent purchases. When using periodic inventory procedure to determine the cost of the ending inventory at the end of the period under FIFO, you would begin by listing the cost of the most recent purchase. If the ending inventory contains more units than acquired in the most recent purchase, it also includes units from the next-to-the-latest purchase at the unit cost incurred, and so on. You would list these units from the latest purchases until that number agrees with the units in the ending inventory.

How is it different?

Different accounting methods produce different results, because their flow of costs are based upon different assumptions. The FIFO method bases its cost flow on the chronological order purchases are made, while the LIFO method bases it cost flow in a reverse chronological order. The average cost method produces a cost flow based on a weighted average of unit costs.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the “LIFO reserve. ” This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

How to Calculate Ending Inventory Using FIFO

Ending inventory = beginning inventory + net purchases – cost of goods sold

Keep in mind the FIFO assumption: Costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods.

When Using FIFO

• Periods of Rising Prices (Inflation)FIFO (+) Higher value of inventory (-) Lower cost of goods sold
• Periods of Falling Prices (Deflation)FIFO (-) Lower value of inventory (+) Higher cost of goods sold

5.3.6: LIFO Method

Learning Objective

Summarize how using the LIFO method affects a company’s financial statements

Key Points

• FIFO and LIFO Methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks.
• LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first.
• The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the “LIFO reserve. ” This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

Key Terms

inventory

A detailed list of all of the items on hand.

income statement

A calculation which shows the profit or loss of an accounting unit (company, municipality, foundation, etc.) during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses.

LIFO

Last-in, first-out (accounting).

Example

• LIFO under perpetual inventory procedure: Under this procedure, the inventory composition and balance are updated with each purchase and sale. Each time a sale occurs, the items sold are assumed to be the most recent ones acquired. Despite numerous purchases and sales during the year, the ending inventory still includes the units from beginning inventory. Applying LIFO on a perpetual basis during the accounting period, results in different ending inventory and cost of goods sold figures than applying LIFO only at year-end using periodic inventory procedure. For this reason, if LIFO is applied on a perpetual basis during the period, special inventory adjustments are sometimes necessary at year-end to take full advantage of using LIFO for tax purposes.

Accounting Methods

A merchandising company can prepare an accurate income statement, statements of retained earnings, and balance sheets only if its inventory is correctly valued. On the income statement, a company using periodic inventory procedure takes a physical inventory to determine the cost of goods sold. Since the cost of goods sold figure affects the company’s net income, it also affects the balance of retained earnings on the statement of retained earnings. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings. Inventories appear on the balance sheet under the heading “Current Assets,” which reports current assets in a descending order of liquidity. Because inventories are consumed or converted into cash within a year or one operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet.

FIFO and LIFO methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks. These methods are used to manage assumptions of cost flows related to inventory, stock repurchases (if purchased at different prices), and various other accounting purposes.

LIFO

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the United States. The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the “LIFO reserve. ” This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

LIFO inventory method

Determining LIFO cost of ending inventory under periodic inventory procedure.

LIFO Flowchart

LIFO flow of costs under periodic inventory procedure

The following is an example of the LIFO inventory costing method (assume the following inventory of Product
 is on hand and purchased on the following dates).

• Purchase date 10/1/12: 10 units at a cost of USD 5
• Purchase date 10/5/12: 5 units at a cost of USD 6
• On 12/30/12, 11 units of Product
  are sold. When the sale is made, it is assumed that the 5 units purchased on 10/5/12 (the sale eliminates this inventory layer) and 6 units purchased on 10/1/12 were sold.

The ending inventory balance on 12/31/12 balance sheet is
, and the cost of goods sold on the income statement is
.

LIFO Under Perpetual Inventory Procedure

Under this procedure, the inventory composition and balance are updated with each purchase and sale. Each time a sale occurs, the items sold are assumed to be the most recent ones acquired. Despite numerous purchases and sales during the year, the ending inventory still includes the units from beginning inventory.

Applying LIFO on a perpetual basis during the accounting period, results in different ending inventory and cost of goods sold figures than applying LIFO only at year-end using periodic inventory procedure. For this reason, if LIFO is applied on a perpetual basis during the period, special inventory adjustments are sometimes necessary at year-end to take full advantage of using LIFO for tax purposes.

5.3.7: Gross Profit Method

Learning Objective

Explain how a company would use the Gross Profit Method to value inventory

Key Points

• There a two methods to estimate inventory cost the retail inventory method and the gross profit method.
• If taking a physical inventory is impossible or impractical, it is necessary to estimate the inventory cost.
• Keep in mind the gross profit method assumes that gross profit ratio remains stable during the period.

Key Terms

monetary

Of, pertaining to, or consisting of money.

gross profit

The difference between net sales and the cost of goods sold.

Valuing Inventory

An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions.

A company will chose an inventory accounting system, either perpetual or periodic. In perpetual inventory the accounting records must show the amount of inventory on hand at all times. Periodic inventory is not updated on a regular basis.

Methods Used to Estimate Inventory Cost

While the best way to value inventory is to perform a physical inventory, in certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. There are two methods to estimate inventory cost, the retail inventory method and the gross profit method.

Both methods can be used to calculate the inventory amount for the monthly financial statements, or estimate the amount of missing inventory due to theft, fire or other disaster. Either of these methods should never be used as a substitute for performing an annual physical inventory.

Gross Profit Method

The gross profit (or gross margin) method uses the previous year’s average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory. Keep in mind the gross profit method assumes that gross profit ratio remains stable during the period.

Inventory.

The gross profit (or gross margin) method uses the previous year’s average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory.

To prepare the inventory value via the gross profit method:

• Calculate the cost of goods available for sale as the sum of the cost of beginning inventory and cost of net purchases.
• Determine the gross profit ratio. Gross profit ratio equals gross profit divided by sales. Use projected gross profit ratio or historical gross profit ratio whichever is more accurate and reliable.
• Multiply sales made during the period by gross profit ratio to obtain estimated cost of goods sold.
• Calculate the cost of ending inventory as the difference of cost of goods available for sale and estimated cost of goods sold.

Example

The following is an example on how to calculate ending inventory using the gross profit method.

Furniture Palace has cost of goods available for sale of $5000. Sales were $1000. 

The company has projected a gross profit ratio of 25%.

The estimated cost of goods sold on the income statement for the period is
.

The ending inventory on the balance sheet is
.

5.3.8: Selecting an Inventory Method

Learning Objective

Summarize the differences between LIFO, FIFO and Specific Identification and explain how a company would use that information to select an inventory method

Key Points

• Specific identification provides the most precise matching of costs and revenues and is, therefore, the most theoretically sound method.
• The FIFO method has four major advantages: (1) it is easy to apply, (2) the assumed flow of costs corresponds with the normal physical flow of goods, (3) no manipulation of income is possible, and (4) the balance sheet amount for inventory is likely to approximate the current market value.
• During periods of inflation, LIFO shows the largest cost of goods sold (COGS) of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs.
• When a company uses the weighted-average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO.

Key Terms

inventory

A detailed list of all of the items on hand.

balance sheet

A summary of a person’s or organization’s assets, liabilities. and equity as of a specific date.

Example

• Specific Identification: Assume that a company bought three identical units of a given product at different prices. One unit cost USD 2,000, the second cost USD 2,100, and the third cost USD 2,200. The company sold one unit for USD 2,800. The units are alike, so the customer does not care which of the identical units the company ships. However, the gross margin on the sale could be either USD 800, USD 700, or USD 600, depending on which unit the company ships.

Advantages and Disadvantages of Specific Identification

Companies that use the specific identification method of ‘inventory costing’ state their cost of goods sold and ending inventory as the actual cost of specific units sold and on hand. Some accountants argue that this method provides the most precise matching of costs and revenues and is therefore the most theoretically sound method. This statement is true for some one-of-a-kind items, such as autos or real estate. For these items, use of any other method would seem illogical. However, one disadvantage of the specific identification method is that it permits the manipulation of income.

Advantages and Disadvantages of FIFO

The FIFO method has four major advantages:

1. It is easy to apply.
2. The assumed flow of costs corresponds with the normal physical flow of goods.
3. No manipulation of income is possible.
4. The balance sheet amount for inventory is likely to approximate the current market value.

All the advantages of FIFO occur because when a company sells goods, the first cost it removes from inventory are the oldest unit costs. The cost attached to the unit sold is always the oldest cost. Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income ([fig:11053]]). The disadvantages of FIFO include the recognition of paper profits and a heavier tax burden if used for tax purposes in periods of inflation.

An example of how to calculate the ending inventory balance of the period using FIFO — assume the following inventory is on hand and purchased on the following dates:

• Inventory of Product X –
• Purchase date: 10/1/12 — 10 units at a cost of USD 5
• Purchase date: 10/5/12 — 5 units at a cost of USD 6
• On 12/30/12, a sale of Product X is made for 11 units
• When the sale is made, it is assumed that the 10 units purchased on 10/1/12 and 1 unit purchased on 10/5/12 were sold
• The ending inventory balance on 12/31/12 balance sheet is 4 units at a cost of USD 6, or USD 24. The cost of goods sold on the income statement is USD 56 (10 units * USD 5 + 1 unit * USD 6).

Advantages and disadvantages of LIFO

During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs. The larger the cost of goods sold, the smaller the net income. Those who favor LIFO argue that its use leads to a better matching of costs and revenues than the other methods. When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in current dollars. The resulting gross margin is a better indicator of management’s ability to generate income than gross margin computed using FIFO, which may include substantial inventory (paper) profits.

An example of how to calculate the ending inventory balance of the period using LIFO — assume the following inventory is on hand and purchases are made on the following dates:

• Inventory of Product X –
• Purchase date: 10/1/12 — 10 units at a cost of USD 5
• Purchase date: 10/5/12 — 5 units at a cost of USD 6
• On 12/30/12, a sale of Product X is made for 11 units. When the sale is made, it is assumed that the 5 units purchased on 10/5/12 and 6 units purchased on 10/1/12 were sold.
• The ending inventory balance on 12/31/12, is 4 units at a cost of USD 5, or USD 20. The cost of good sold on the income statement is USD 60 (5 units * USD 6 + 6 units * USD 5).

Advantages and Disadvantages of Weighted-Average

When a company uses the weighted-average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is not as understated as under LIFO, but it is not as up-to-date as under FIFO. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying.

The following is an example of the weighted average cost method:

• On 12/31/12, Furniture Palace has cost of goods available for sale of USD 5,000; 200 units available for sale; sales of 50 units; and an ending inventory of 150 units.
• The per unit cost of inventory is USD 25 (5,000 / 200 units). The value of the ending inventory on the balance sheet is USD 3,750 (150 units * USD 25). The cost of goods sold on the income statement is USD 1,250 (50 units * USD 25).

5.3.9: Impacts of Costing Methods on Financial Statements

Learning Objective

Differentiate between the FIFO, LIFO and Average Cost inventory valuation methods

Key Points

• Without inflation all three inventory valuation methods would produce the same results. However, prices do tend to rise over the years, and the company’s method costing method affects the valuation ratios.
• The FIFO method assumes that the first unit in inventory is the first until sold. FIFO gives a more accurate value for ending inventory on the balance sheet. On the other hand, FIFO increases net income and increased net income can increase taxes owed.
• The LIFO method assumes the last item entering inventory is the first sold. During periods of inflation LIFO shows ending inventory on the balance sheet much lower than what the inventory is truly worth at current prices, this means lower net income due to a higher cost of goods sold.
• The average cost method takes a weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory.

Key Terms

ending inventory

Ending inventory is the amount of inventory a company have in stock at the end of this fiscal year.

net income

Gross profit minus operating expenses and taxes.

Inventory Valuation

The method a company uses to determine it cost of inventory (inventory valuation) directly impacts the financial statements. The three main methods for inventory costing are First-in, First-Out (FIFO), Last-in, Last-Out (LIFO) and Average cost.

Inventory valuation method.

The inventory valuation method a company chooses directly effects its financial statements.

First-in, First-Out

The FIFO method assumes that the first unit in inventory is the first until sold. For example, during the week a factory produces items. On Monday the items cost is $5 per unit to make, on Tuesday it is a $5.50 per unit. When the item is sold on Wednesday FIFO records the cost of goods sold for those items as $5. So, the balance sheet has the cost of goods sold at $1 and the balance sheet retains the remaining inventory at $5.50.

Last-in, First-out

The LIFO method assumes the opposite, that the last item entering inventory is the first sold. That means the factory would record the Wednesday cost of goods sold as $5.50 and the remaining inventory at $5.

Average Cost

This method is the most easy to calculate; it takes a weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. Assuming the factory made a total of 100 units the price per unit would be
.

Impact on the Financial Statements

Without inflation, all three inventory valuation methods would produce the same results. Unfortunately, prices do tend to rise over the years, and the company’s method costing method affects the valuation ratios.

During periods of inflation, the FIFO gives a more accurate value for ending inventory on the balance sheet. On the other hand, FIFO increases net income (due to the age of the inventory being used in cost of goods sold) and Increased net income can increase taxes owed.

Using LIFO during periods of inflation tend to show and ending inventory amount on the balance sheet that is much lower than what the inventory is truly worth at current prices, this means lower net income due to a higher cost of goods sold.

With average cost, the results fall in between FIFO and LIFO. Keep in mind deflation (falling prices) have an opposite effect on each method.

5.4: Detail on Using LIFO

5.4.1: The LIFO Reserve

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve.

Learning Objective

Summarize the purpose of a LIFO Reserve

Key Points

• The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.
• During times of increasing costs, the balance in the LIFO reserve account will have a credit balance, meaning that less cost reported in inventory. Remember, under LIFO the latest (higher) costs are expensed to the cost of goods sold, while the older (lower) costs remain in inventory.
• The credit balance in the LIFO reserve reports the difference in the inventory costs under LIFO versus FIFO since the time that LIFO was adopted. The change in the balance during the current year represents the current year’s inflation in costs.
• LIFO reserve = FIFO inventory – LIFO inventory.

Key Terms

LIFO

Last-in, first-out (accounting).

inventory

A detailed list of all of the items on hand.

inflation

An increase in the quantity of money, leading to a devaluation of existing money.

The LIFO Reserve

Last-In First-Out (LIFO) is the opposite of First-In First-Out (FIFO). Some systems permit determining the costs of goods at the time acquired or made, but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. Such a reserve (an asset or a contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions.

Seasonal Inventory

Valuing inventory using the LIFO method.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

LIFO Reserve in Action

Suppose a company uses FIFO for its internal accounting system, but wants to use LIFO for financial and income tax reporting (due to continuous inflation of its costs). In this instance, the LIFO reserve is a contra inventory account that will reflect the difference between the FIFO cost and LIFO cost of its inventory.

During times of increasing costs, the balance in the LIFO reserve account will have a credit balance, meaning that less cost is reported in inventory. Remember, under LIFO the latest (higher) costs are expensed to the cost of goods sold, while the older (lower) costs remain in inventory.

The credit balance in the LIFO reserve reports the difference in the inventory costs under LIFO versus FIFO since the time that LIFO was adopted. The change in the balance during the current year represents the current year’s inflation in costs.

Benefits

• The change in the balance in the LIFO reserve will also increase the current year’s cost of goods sold. This in turn reduces the company’s profits and therefore, taxable income.
• The change in the balance of the LIFO reserve during the current year times the income tax rate results in the difference in the income tax for the year. Changing this formula slightly, one can find the difference in income tax since LIFO was adopted (the balance in the LIFO reserve times the income tax rate).
• The disclosure of the LIFO reserve is better for comparing the profits and ratios of a company using LIFO with the profits and ratios of a company using FIFO.

Additional Information

The accounting profession has discouraged the use of the word reserve in financial reporting, so LIFO reserve may sometimes be called: Revaluation to LIFO, Excess of FIFO over LIFO cost, or LIFO allowance.

LIFO reserve = FIFO inventory – LIFO inventory

FIFO inventory = LIFO inventory + LIFO reserve

5.4.2: Comparability

If a company uses LIFO, the recorded amount of inventory is not an accurate reflection of cost, reducing comparability to companies using FIFO.

Learning Objective

Explain why comparability is important for valuing a company

Key Points

• The LIFO method results in lower ending (and beginning) inventory on a company’s balance sheet because the oldest (and therefore usually less expensive due to inflation) items remain in the inventory.
• If a company uses LIFO, recorded inventory is not an accurate reflection of cost of the current period. This low valuation affects the computation and evaluation of current assets and any financial ratios that include inventory, reducing comparability between companies using different methods.
• The most common normalization adjustments fall into the following four categories: Comparability Adjustments, Non-operating Adjustments, Non-recurring Adjustments, and Discretionary Adjustments.

Key Terms

valuation

The process of estimating the market value of a financial asset or liability.

adjustment

a small change; a minor correction; a modification

comparability

Comparison or equivalence.

Why Comparability is Important

Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to perfect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to:

• estate and gift taxation,
• divorce litigation,
• allocating business purchase price among business assets,
• establishing a formula for estimating the value of partners’ ownership interest for buy-sell agreements,
• and many other business and legal purposes.

Seasonal Inventory

Valuing inventory using the LIFO method.

Inventory Valuation with LIFO

The LIFO method results in lower ending (and beginning) inventory on a company’s balance sheet because the oldest (and therefore usually less expensive due to inflation) items remain in the inventory. Based off of this information, one can assume that if a company uses LIFO, the recorded amount of inventory is not an accurate reflection of cost of the current period. This low valuation affects the computation and evaluation of current assets and any financial ratios that include inventory, resulting in reduced comparability between companies using LIFO and others using FIFO.

Normalization (adjustment) methods

Comparability Adjustments

The valuer may adjust the subject company’s financial statements to facilitate a comparison between the subject company and other businesses in the same industry or geographic location. These adjustments are intended to eliminate differences between the way that published industry data is presented and the way that the subject company’s data is presented in its financial statements.

Non-operating Adjustments

It is reasonable to assume that if a business were sold in a hypothetical sales transaction (which is the underlying premise of the fair market value standard), the seller would retain any assets which were not related to the production of earnings or price those non-operating assets separately. For this reason, non-operating assets (such as excess cash) are usually eliminated from the balance sheet.

Non-recurring Adjustments

The subject company’s financial statements may be affected by events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense. These non-recurring items are adjusted so that the financial statements will better reflect the management’s expectations of future performance.

Discretionary Adjustments

The owners of private companies may be paid at variance from the market level of compensation that similar executives in the industry might command. In order to determine fair market value, the owner’s compensation, benefits, perquisites and distributions must be adjusted to industry standards. Similarly, the rent paid by the subject business for the use of property owned by the company’s owners individually may be scrutinized.

5.4.3: Liquidation

In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed.

Learning Objective

Explain the process of liquidating a company

Key Points

• Liquidation may either be compulsory (sometimes referred to as a creditors’ liquidation) or voluntary (sometimes referred to as a shareholders’ liquidation, although some voluntary liquidations are controlled by the creditors).
• After the removal of all assets which are subject to retention of title arrangements, fixed security, or are otherwise subject to proprietary claims of others, the liquidator will pay the claims against the company’s assets.
• LIFO liquidation refers to when a company using LIFO accounting methods liquidates their older LIFO inventory. This occurs if current sales are higher than current purchases, and consequently inventory not sold in previous periods must be liquidated.
• Due to inflation, the amount of money companies pay for inventory will usually increase over time. If a company decides to undergo LIFO liquidation, the old costs of inventory will be matched with the current, higher sales prices resulting in a higher tax liability.

Key Terms

liquidation

The selling of the assets of a business as part of the process of dissolving it.

LIFO

Last-in, first-out (accounting).

creditor

A person to whom a debt is owed.

What is Liquidation?

In law, liquidation is the process by which a company (or part of a company) is brought to an end, and the assets and property of the company are redistributed. Liquidation is sometimes referred to as ‘winding-up’ or ‘dissolution’, although dissolution technically refers to the last stage of liquidation. The process of liquidation arises when customs, or an authority or agency in a country responsible for collecting and safeguarding customs duties, determines the final computation, ascertainment of the duties, or drawback accruing on an entry.

Liquidation may either be compulsory (sometimes referred to as a ‘creditors’ liquidation’) or voluntary (sometimes referred to as a ‘shareholders’ liquidation’, although some voluntary liquidations are controlled by the creditors) .

Plane liquidation

Alitalia — Compagnia Aerea Italiana S.p.A. (Italian for Alitalia – Italian Air Company), is an Italian airline, which bought some assets from the liquidation process of the old Alitalia-Linee Aeree Italiane and the entire Air One.

Parties Entitled to Liquidation

The parties who are entitled by law to petition for the compulsory liquidation of a company vary from jurisdiction to jurisdiction, but generally, a petition may be lodged with the court for the compulsory liquidation of a company by:

• The company itself
• Any creditor who establishes a prima facie case
• Contributories
• The Secretary of State
• The Official Receiver

Priority of Claims

After the removal of all assets which are subject to retention of title arrangements, fixed security, or are otherwise subject to proprietary claims of others, the liquidator will pay the claims against the company’s assets. Generally, the priority of claims on the company’s assets will be determined in the following order:

1. Liquidators costs
2. Creditors with fixed charge over assets
3. Costs incurred by an administrator
4. Amounts owing to employees for wages/superannuation (director limit: $2000)
5. Payments owing in respect of workers’s injuries
6. Amounts owing to employees for leave (director limit: $1500)
7. Retrenchment payments owing to employees
8. Creditors with floating charge over assets
9. Creditors without security over assets
10. Shareholders

Grounds for Liquidation

The grounds upon which one can apply for a compulsory liquidation also vary between jurisdictions, but the normal grounds to enable an application to the court for an order to compulsorily wind-up the company are:

• The company has so resolved
• The company was incorporated as a corporation, and has not been issued with a trading certificate (or equivalent) within 12 months of registration
• It is an “old public company” (i.e. one that has not re-registered as a public company or become a private company under more recent companies legislation requiring this)
• It has not commenced business within the statutorily prescribed time (normally one year) of its incorporation, or has not carried on business for a statutorily prescribed amount of time
• The number of members has fallen below the minimum prescribed by statute
• The company is unable to pay its debts as they fall due
• It is just and equitable to wind up the company

LIFO Liquidation

LIFO liquidation refers to when a company using LIFO accounting methods liquidates their older LIFO inventory. This occurs if current sales are higher than current purchases, and consequently inventory not sold in previous periods must be liquidated.

Due to inflation and general price increases, the amount of money companies pay for inventory will usually increase over time. If a company decides to undergo LIFO liquidation, the old costs of inventory will be matched with the current, higher sales prices. As a result, this cost has a higher tax liability if prices have risen since the LIFO method was adopted.

5.4.4: Dollar-Value LIFO

Dollar value LIFO (last-in, first-out) is calculated with all figures in dollar amounts, rather than inventory units.

Learning Objective

Summarize the advantages to using dollar-value LIFO inventory valuation

Key Points

• Dollar value LIFO uses this approach with all figures in dollar amounts, rather than inventory units. As a result, companies have a different view of their balance sheets than under other methods (such as FIFO).
• If inflation did not affect the statements of companies, dollar-value and non-dollar-value accounting methods would have the same results.
• However, because inflation does occur and thus, costs change over time, the dollar-value method presents data that show an increased cost of goods sold (COGS) when prices are rising, and a lower net income.
• This can, in turn, reduce a company’s taxes but make shareholders unhappy due to a lower net income on reports.

Key Terms

shareholder

One who owns shares of stock.

inflation

An increase in the quantity of money, leading to a devaluation of existing money.

LIFO

Last-in, first-out (accounting).

Dollar-value LIFO

This inventory method follows LIFO (last-in, first-out). Dollar value LIFO uses this approach with all figures in dollar amounts, rather than inventory units. As a result, companies have a different view of their balance sheets than under other methods, such as FIFO (first-in, first-out).

If inflation did not affect the statements of companies, dollar-value and non-dollar-value accounting methods would have the same results. However, because it does occur and thus costs change over time, the dollar-value method presents data that show an increased cost of goods sold (COGS) when prices are rising, and a lower net income. This can, in turn, reduce a company’s taxes, but can make shareholders unhappy due to a lower net income on reports.

Dollar-value in the Decision-making Process

Managers apply the concepts of interest, future value, and present value in making business decisions. Therefore, accountants need to understand these concepts to properly record certain business transactions.

The time value of money

The concept of the time value of money stems from the logical reference for a dollar today rather than a dollar at any future date. Most individuals prefer having a dollar today rather than at some future date because:

1. the risk exists that the future dollar will never be received; and
2. if the dollar is on hand now, it can be invested, resulting in an increase in total dollars possessed at that future date.

Most business decisions involve a comparison of cash flows in and out of the company. To be useful in decision making, such comparisons must be in dollars of the same point in time. That is, the dollars held now must be accumulated or rolled forward, or future dollars must be discounted or brought back to the present dollar value, before comparisons are valid. Such comparisons involve future value and present value concepts.

Future value

The future value or worth of any investment is the amount to which a sum of money invested today grows during a stated period of time at a specified interest rate. The interest involved may be simple or compound.

Simple interest is interest on principal only. For example, $1000 invested today for two years at 12% simple interest grows to $1240 since interest is $120 per year. The principal of $1,000, plus
, is equal to $1240.

Compound interest is interest on principal and on interest of prior periods. For example, $1000 invested for two years at 12% compounded annually grows to $1254.40 as follows: 

Principal or present value:

 

Value at end of year 1:

Value at end of year 2 (future value):

5.4.5: Advantages of LIFO

Using LIFO accounting for inventory, a company generally pays lower taxes in periods of inflation.

Learning Objective

Describe how using the LIFO method of valuing inventory would benefit a company

Key Points

• LIFO recovers cost from production because actual cost of material is charged to production.
• Production is charged at the recent prices because materials are issued from the latest consignment. Therefore, the effect of current market prices of materials is reflected in the cost of sales if the materials are recently purchased.
• In times of rising prices (inflation), LIFO is suitable because materials are issued at current market prices (which are high). This method helps in showing a lower profit because of increased charge to production during periods of rising prices and reduces income tax.
• LIFO is simple to operate and is useful when there are not too many transactions with fairly steady prices.

Key Terms

inventory

A detailed list of all of the items on hand.

market price

The price at which a product, financial instrument, service or other tradable item can be bought and sold at an open market; the going price.

LIFO

Last-in, first-out (accounting).

Example

• LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the U.S.

Accounting Methods

FIFO and LIFO Methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks. These methods are used to manage assumptions of cost flows related to inventory , stock repurchases (if purchased at different prices), and various other accounting purposes.

Inventory Template

Example of inventory template.

1. FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold.
2. LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the U.S.

In Periods of Rising Prices (Inflation)

• FIFO: (+) Higher value of inventory (-) Lower cost of goods sold
• LIFO: (-) Lower value of inventory (+) Higher cost of goods sold

In Periods of Falling Prices (Deflation)

• FIFO: (-) Lower value of inventory (+) Higher cost of goods sold
• LIFO: (+) Higher value on inventory (-) Lower cost on goods sold

Benefits of LIFO

LIFO considers the last unit arriving in inventory as the first one sold. Which method an accountant selects can have a significant effect on net income and book value and, in turn, on taxation. Using LIFO accounting for inventory, a company generally reports lower net income and lower book value, due to the effects of inflation. This generally results in lower taxation. Due to LIFO’s potential to skew inventory value, UK GAAP and IAS have effectively banned LIFO inventory accounting.

5.4.6: Disadvantages of LIFO

LIFO is facing pressures from international standards boards that may result in its possible complete elimination.

Learning Objective

Summarize the disadvantages of using LIFO

Key Points

• LIFO is facing pressures from international standards boards that may result in its possible complete elimination.
• Most of the developed countries, such as Australia, New Zealand, Canada and the European Community Union, have adapted IFRS by the year 2011.Under IFRS rules, LIFO is not a permitted acceptable accounting method. 
• The use of LIFO disrupts the theoretical foundation of the IFRS and if plans proceed as expected, complete phase-out of LIFO will occur in the near future.

Key Term

LIFO

Last-in, first-out (accounting).

LIFO is facing pressures from both the International Reporting Standards Board in cooperation with the SEC and the U.S. Congress for its possible complete elimination. On November 15, 2007, the Securities and Exchange Commission (SEC) exempted foreign firms from including reconciliation from International Financial Reporting Standards (IFRS) to U.S. Generally Accepted Accounting Principles (U.S. GAAP) when filing on U.S. Stock exchanges. Foreign public firms are now permitted to file using the International Financial Reporting Standards (IFRS) without reconciliation to U.S. GAAP as previously required. This move has created a mandate to converge IFRS and U.S. GAAP and financial statement requirements (SEC, 2007).

Inventory

Inventory in a warehouse.

On June, 18, 2008, the SEC issued a press release stating that the world’s securities regulators are uniting to increase their oversight of international accounting standards. Most of the developed countries, such as Australia, New Zealand, Canada and the European Community Union, have adapted IFRS by the year 2011.Under IFRS rules, LIFO is not a permitted acceptable accounting method. IFRS is balance sheet oriented and, on this basis, disallows LIFO as an inventory method. The use of LIFO disrupts the theoretical foundation of the IFRS and if plans proceed as expected, complete phase-out of LIFO will occur in the near future. More importantly is the current tax position on LIFO. In prior budgets, the Obama Administration has proposed to repeal LIFO altogether in an attempt to generate greater tax revenues.

5.5: Additional Topics in Inventory Valuation

5.5.1: Lower of Cost or Market

In lower of cost or market (LCM), inventory items are written down to market value when the market value is less than the cost of the items.

Learning Objective

Explain how a would use the Lower of Cost or Market to value inventory

Key Points

• The basic assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or will fall.
• Ending inventory is normally stated at historical cost (what was paid to obtain it), but there are times when the original cost of the ending inventory is greater than the cost of replacement. Thus, the inventory has lost value.
• Any loss resulting from the decline in the value of inventory is charged to cost of goods sold (COGS) if non-material, or loss on the reduction of inventory to LCM if material.

Key Terms

market value

The price which a seller or insurer might reasonably expect to fetch for goods, services or securities on the open market.

historical cost

The original monetary value of an economic item and based on the stable measuring unit assumption. Improvements may be added to an asset’s cost.

stated value

par value

purchase price

The price at which something is actually purchased, especially from the point of view of the purchaser.

Example

• For example, assume that the market value of the inventory is USD 39,600 and its cost is USD 40,000. The company would then record a USD 400 loss because the inventory has lost some of its revenue-generating ability.

Lower Of Cost or Market

Lower of cost or market (LCM) is an approach to valuing and reporting inventory. Ending inventory is normally stated at historical cost (what was paid to obtain it), but there are times when the original cost of the ending inventory is greater than the cost of replacement. Thus, the inventory has lost value. If the inventory has decreased in value below historical cost, then its carrying value is reduced and reported on the balance sheet. The criterion for reporting this is the current market value. Any loss resulting from the decline in the value of inventory is charged to cost of goods sold (COGS) if non-material, or loss on the reduction of inventory to LCM if material.

The basic assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or will fall.

LCM In Practice

Under LCM, inventory items are written down to market value when the market value is less than the cost of the items. For example, assume that the market value of the inventory is USD 39,600 and its cost is USD 40,000. The company would then record a USD 400 loss because the inventory has lost some of its revenue-generating ability. Employees should check the stock of certain items to maintain an accurate record for dollars of inventory in stock .

Friedrich Von Hayek

Austrian economist Friedrich von Hayek, along with University of Chicago economist Milton Friedman are two classic liberal economists attributed with the return of laissez-faire economics and deregulation.

The company must recognize the loss in the period the loss occurred. On the other hand, if ending inventory has a market value of USD 45,000 and a cost of USD 40,000, the company would not recognize this increase in value. To do so would recognize revenue before the time of sale. A company may apply LCM to each inventory item (such as Monopoly), each inventory class (such as games), or total inventory.

Under the class method, a company applies LCM to the total cost and total market for each class of items compared. One class might be games, while another might be toys. The company then values each class at lower its cost or market amount.

Business Insight

Procter & Gamble markets a broad range of laundry, cleaning, paper, beauty care, health care, food, and beverage products around the world. Procter & Gamble’s footnote in its Notes to Consolidated Financial Statements in its annual report illustrates that companies often disclose LCM in their notes to financial statements.

Inventories are valued at cost, which is not in excess of current market price. Cost is primarily determined by either the average cost or the first-in, first-out method. The replacement cost of last-in, first-out inventories exceeds carrying value by approximately USD 169 million.

Businesses need to manage their inventories.

Here a woman is checking stock of certain items to maintain an accurate record for dollars of inventory in stock.

5.5.2: Methods in Retail Inventory

For some companies, taking a physical inventory is impossible or impractical so the Retail Inventory Method is used to estimate.

Learning Objective

Explain how to calculate inventory using the retail inventory method

Key Points

• In certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost through methods such as RMA.
• The advantage of the RMA method is that companies can estimate ending inventory (at cost) without taking a physical inventory. Thus, the use of this estimate permits the preparation of interim financial statements (monthly or quarterly) without taking a physical inventory.
• Because RIM/RMA only provides an approximation of inventory value, physical inventory must also be performed periodically to ensure the accuracy of inventory estimates due to issues such as shoplifting.

Key Terms

inventory

A detailed list of all of the items on hand.

gross profit

The difference between net sales and the cost of goods sold.

shortage

a lack or deficiency

Retail Inventory Method (RIM or RMA)

In certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. Two very popular methods are:

1. Retail inventory method, and
2. Gross profit (or gross margin) method.

Businesses need to manage their inventories.

Here a woman is checking stock of certain items to maintain an accurate record for dollars of inventory in stock.

The retail inventory method uses a cost to retail price ratio. The physical inventory is valued at retail, and it is multiplied by the cost ratio (or percentage) to determine the estimated cost of the ending inventory. Note that both the gross margin and the retail inventory methods can help you detect inventory shortages.

Advantages

The advantage of this method is that companies can estimate ending inventory (at cost) without taking a physical inventory. Thus, the use of this estimate permits the preparation of interim financial statements (monthly or quarterly) without taking a physical inventory.

Disadvantages

Because RIM only provides an approximation of inventory value, physical inventory must also be performed periodically to ensure the accuracy of inventory estimates due to issues such as shoplifting.

How to find the ending inventory with RMA

The steps for finding the ending inventory by the retail inventory method are:

1. Total the beginning inventory and the net amount of goods purchased during the period at both cost and retail prices.
2. Divide the cost of goods available for sale by the retail price of the goods available for sale to find the cost/retail price ratio.
3. Deduct the retail sales from the retail price of the goods available for sale to determine ending inventory at retail.
4. Multiply the cost/retail price ratio or percentage by the ending inventory at retail prices to reduce it to the ending inventory at cost.

Example

To illustrate how you can determine inventory shortages using the retail method, assume that a physical inventory taken at year end, showed only $62,000 of retail-priced goods in the store. Assume that use of the retail method for the fourth quarter showed that $66,000 of goods should be on hand, thus indicating a $4000 inventory shortage at retail. After converting the $4000 to $2400 of cost (
) you would report this as a “Loss from inventory shortage” in the income statement. Knowledge of such shortages may lead management to reduce or prevent them, by increasing security or improving the training of employees.

5.6: Assessing Inventory Management

5.6.1: Efficiency Metrics

Efficiency ratios for inventory measure how effectively a business uses its inventory resources.

Learning Objective

Describe how a company uses efficiency metrics to monitor inventory

Key Points

• An efficiency metric or ratio, sometimes referred to as an activity ratio, is a type of financial ratio. The inventory turnover rate is a type of efficiency metric.
• Financial ratios evaluate the overall financial condition of a corporation or other organization in comparison to its industry and competitors.
• A low inventory turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort.
• A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.

Key Terms

Cost of Goods Sold

refers to the inventory costs of the goods a business has sold during a particular period (sometimes abbreviated as COGS).

obsolescence

The process of becoming obsolete, outmoded, or out of date.

Efficiency Metrics (Ratios)

An efficiency metric or ratio, sometimes referred to as an activity ratio, is a type of financial ratio. Management, financial analysts, and the investment community evaluate financial ratios when trying to evaluate the overall financial condition of a corporation or other organization. Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1. Efficiency ratios for inventory are used to measure how effectively a business uses its inventory resources in comparison to its industry or competitors.

Efficient use of inventory is critical for businesses.

Picture of inventory at a business.

Inventory Efficiency

It’s important for organizations to strike the right balance on their inventory levels. If inventory levels are too low, the company runs the risk of losing out on sales and not meeting customer demand. This can lead customers to give their business to the company’s competitors. When there is excess inventory, a company can have higher operating costs due to greater inventory storage requirements, which will decrease profits. In addition, excess inventory increases the risk of losses due to price declines or inventory obsolescence.

Types of Efficiency Metrics (Ratios)

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory (to calculate average inventory, add the balances of beginning and ending inventory and divide by 2)

The inventory turnover ratio is a measure of the number of times inventory is sold or used in a time period, such as a year. A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.

Inventory Conversion Ratio = 365 Days / Inventory Turnover Ratio

The inventory conversion ratio is a measure of the number of days in a year it takes to sell inventory or convert it into cash.

5.6.2: Impact of Inventory Method on Financial Statement Analysis

The inventory method chosen will affect the amount of current assets and gross profit income statement, especially when prices are changing.

Learning Objective

Explain how a company’s choice of inventory method affects their financial statements

Key Points

• There are five types of inventory methods — FIFO, LIFO, Dollar Value LIFO, Retail Inventory, and Average Cost.
• The choice of inventory method should reflect a company’s economic circumstances in order to create accurate financial statements.
• When prices are falling, FIFO will result in lower current assets and lower gross profit. LIFO will result in higher current assets and higher gross profit.
• When prices are rising, FIFO will result in higher current assets and higher gross profit. LIFO will result in lower current assets and lower gross profit.

Key Terms

balance sheet

A balance sheet is often described as a “snapshot of a company’s financial condition. ” A standard company balance sheet has three parts: assets, liabilities, and ownership equity.

income statement

Displays the revenues recognized for a specific period and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the reporting period.

Types of Inventory Methods

Inventories are valued in the “Current Assets” section of the balance sheet using one of the following five methods. It’s important to note that these methods will be affected by the system used to update inventory – “perpetual” or “periodic”. A perpetual system updates inventory every time a change in inventory occurs, and a periodic system updates inventory at the end of the accounting period.

Businesses need to manage their inventories.

Here a woman is checking stock of certain items to maintain an accurate record for dollars of inventory in stock.

First-In First-Out (FIFO) assumes that the items purchased or produced first are sold first. Costs of inventory per unit or item are determined at the time made or acquired. The oldest cost (i.e., the first in) is then matched against revenue and assigned to cost of goods sold. The ending inventory balance reflects recent inventory costs.

Last-In First-Out (LIFO) is the reverse of FIFO; the latest cost (i.e., the last in) is assigned to cost of goods sold and matched against revenue. Some systems permit determining the costs of goods at the time acquired or made but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. The LIFO reserve (an asset or contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions. Such amount may be different for financial reporting and tax purposes in the United States.

Dollar Value LIFO is a variation of LIFO. Any increases or decreases in the LIFO reserve are determined based on dollar values rather than quantities.

The Retail Inventory method is typically used by resellers of goods to simplify record keeping. The calculated cost of goods on hand at the end of a period is the ratio of cost of goods acquired to the retail value of the goods times the retail value of goods on hand. Cost of goods acquired includes beginning inventory as previously valued plus purchases. Cost of goods sold is then beginning inventory plus purchases less the calculated cost of goods on hand at the end of the period.

The Average Cost method relies on average unit cost to calculate cost of goods sold and ending inventory. Several variations on the calculation may be used, including weighted average and moving average.

Impact on Financial Statements

The choice of inventory method should reflect a company’s economic circumstances in order to create accurate financial statements. In addition to the inventory method chosen, use of a perpetual or periodic inventory system will affect the amount of current assets in the balance sheet and gross profit in the income statement, especially when prices are changing.

Period of Rising Prices

Under FIFO: Ending Inventory is higher, and Total Current Assets are higher; cost of goods sold is lower, and gross profit is higher.

Under LIFO: Ending Inventory is lower, and total current assets are lower; cost of goods sold is higher, and gross profit is lower.

Period of Falling Prices

Under FIFO: Ending Inventory is lower, and total current assets are lower; cost of goods sold is higher, and gross profit is lower.

Under LIFO: Ending Inventory is higher, and total current assets are higher; cost of goods sold is lower, and gross profit is higher.

5.7: Reporting and Analyzing Inventories

5.7.1: Reporting Inventories

Inventory is an asset and its ending balance should be reported as a current asset on the balance sheet.

Learning Objective

Describe how a company reports inventory on the financial statements

Key Points

• In a business accounting context, the word inventory is used to describe the goods and materials that a business holds for the ultimate purpose of resale.
• Companies must choose a method to track inventory.
• The change in inventory is a component of in the calculation of cost of goods sold, which is reported on the income statement.

Key Term

inventory

Inventory includes goods ready for sale, as well as raw material and partially completed products that will be for sale when they are completed.

Inventory

In a business accounting context, the word inventory is used to describe the goods and materials that a business holds for the ultimate purpose of resale.

Inventory Accounting Systems

Companies must choose a method to track inventory. There are ways to account for inventory, periodic and perpetual. The perpetual inventory system requires accounting records to show the amount of inventory on hand at all times. It maintains a separate account in the subsidiary ledger for each good in stock, and the account is updated each time a quantity is added or taken out.

In the periodic inventory system, sales are recorded as they occur but the inventory is not updated. A physical inventory must be taken at the end of the year to determine the cost of goods.

Regardless of what inventory accounting system is used, it is good practice to perform a physical inventory at least once a year.

Reporting Inventory

Inventory itself is not an income statement account. Inventory is an asset and its ending balance should be reported as a current asset on the balance sheet. However, the change in inventory is a component of in the calculation of cost of goods sold, which is reported on the income statement.

Inventory

Inventory appears as an asset on the balance sheet.

Depending on the format of the income statement it may show the calculation of Cost of Goods Sold as Beginning Inventory + Net Purchases = Goods Available – Ending Inventory. In that situation the beginning and ending inventory does appear on the income statement.

5.7.2: Inventory Turnover Ratio

Inventory turnover is the measure of the number of times inventory is sold or used in a time period such as a year.

Learning Objective

Explain how a company would calculate their inventory turnover ratio

Key Points

• The equation for inventory turnover is the cost of goods sold (COGS) divided by the average inventory.
• A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort.
• A high turnover rate may indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low.

Key Terms

COGS

COGS (cost of goods sold) is the inventory costs of those goods a business has sold during a particular period.

liquidity

An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.

turnover

The number of times a stock is replaced after being used or sold, a worker is replaced after leaving, or a property changes hands

Inventory Turnover Defined

In accounting, the inventory turnover is a measure of the number of times inventory is sold or used in a time period such as a year. This ratio tests whether a company is generating a sufficient volume of business based on its inventory. The equation forinventory turnover is the cost of goods sold (COGS) divided by the average inventory. Inventory turnover is also known as inventory turns, stockturn, stock turns, turns, and stock turnover.

Businesses need to manage their inventories.

Here a woman is checking stock of certain items to maintain an accurate record for dollars of inventory in stock.

Significance Of Turnover Rates

The turnover rate has several significant implications:

• Inventory turnover measures the efficiency of the firm in managing and selling inventory: thus, it gauges the liquidity of the firm’s inventory.
• A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. However, in some instances a low rate may be appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or expected market shortages.
• A high turnover rate may conversely indicate inadequate inventory levels, which may lead to a loss in business as the inventory is too low. This often can result in stock shortages.

In assessing inventory turnover, analysts also consider the type of industry. When making comparisons among firms, they check the cost-flow assumption used to value inventory and the cost of products sold.

Differences In Calculations

Some compilers of industry data (e.g., Dun & Bradstreet) use sales as the numerator instead of the cost of sales. The cost of sales yields a more realistic turnover ratio, but it is often necessary to use sales for purposes of comparative analysis. The cost of sales is considered to be more realistic because of the difference in which sales and the cost of sales are recorded.

Sales are generally recorded at market value, which is the value at which the marketplace paid for the good or service provided by the firm. In the event that the firm had an exceptional year and the market paid a premium for the firm’s goods and services, the numerator may be an inaccurate measure. However, the cost of sales is recorded by the firm at what the firm actually paid for the materials available for sale. Additionally, firms may reduce prices to generate sales in an effort to cycle inventory. In this article, the terms “cost of sales” and “cost of goods sold” are synonymous.

Example Of Calculating Inventory Turnover

Abercrombie & Fitch reported the following financial data for 2000 (in thousands):

• Cost of goods sold: $728,229
• Beginning inventory: $75,262
• Ending inventory: $120,997

Their inventory turnover is: 

5.7.3: Adjusting for LIFO Reserve

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve.

Learning Objective

Explain how the LIFO reserve is calculated and how to report it on the financial statements

Key Points

• The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.
• When dealing with valuing a company using ratios, one must also convert all numbers to FIFO method for easy comparison. This means that, for example, when calculating the current ratio, the LIFO reserve should be added back into the numerator of the equation, resulting in a FIFO inventory.
• The SEC requires that all registered companies that use LIFO report their LIFO reserves for the start and end of the year. A company can always convert from LIFO to FIFO, which is important if you are trying to compare companies when they use different accounting methods.

Key Terms

LIFO

Last-in, first-out (accounting).

LIFO reserve

The amount by which an entity’s taxable income has been deferred by using the LIFO method.LIFO Reserve = FIFO Valuation – LIFO Valuation

FIFO

First in, first out (accounting).

What is the LIFO Reserve?

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

LIFO Reserve = FIFO Valuation – LIFO Valuation

SEC Requirements

The SEC requires that all registered companies that use LIFO report their LIFO reserves for the start and end of the year. A company can always convert from LIFO to FIFO, which is important if you are trying to compare companies when they use different accounting methods.

Making Adjustments

When dealing with valuing a company using ratios, one must also convert all numbers to FIFO method for easy comparison. This means that, for example, when calculating the current ratio, the LIFO reserve should be added back into the numerator of the equation.

4.3: Overview of Receivables

4.3.1: What Is a Receivable?

Learning Objective

Identify a receivable

Key Points

• Accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer.
• A receivable represents money owed to the firm on the sale of products or services on credit.
• Receivables must be paid within an established time frame, called credit terms or payment terms.

Key Terms

revenue

Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.

asset

Items of ownership convertible into cash; total resources of a person or business, as cash, notes and accounts receivable; securities and accounts receivable, securities, inventories, goodwill, fixtures, machinery, or real estate (as opposed to liabilities).

receivable

Represents money owed to a business for the sale of products or services on credit.

What is a Receivable?

A receivable is money owed to a business by its clients and shown on its balance sheet as an asset. It is one of a series of accounting transactions dealing with the billing of a customer for goods and services that the customer has ordered. Accounts receivable is an asset which is the result of accrual accounting. In this case, the firm has delivered products or rendered services (hence, revenue has been recognized), but no cash has been received, as the firm is allowing the customer to pay at a later point in time.

Sales on Credit

Receivables represent money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer; who, in turn, must pay it within an established time frame. This is called credit terms or payment terms.

Use of Ledger

The accounts receivable departments use the sales ledger. This is because a sales ledger normally records:

• The sales a business has made.
• The amount of money received for goods or services.-
• The amount of money owed at the end of each month varies (debtors).

Accounts Receivable Department

The accounts receivable team is in charge of receiving funds on behalf of a company and applying it towards their current pending balances. Collections and cashiering teams are part of the accounts receivable department. While the collection’s department seeks the debtor, the cashiering team applies the monies received.

Money

Factoring makes it possible for a business to readily convert a substantial portion of its accounts receivable into cash.

4.3.2: Types of Receivables

Learning Objective

Differentiate between accounts receivable, notes receivable and other receivables

Key Points

• Accounts receivable are amounts that customers owe the company for normal credit purchases.
• Notes receivable are amounts owed to the company by customers or others who have signed formal promissory notes in acknowledgment of their debts.
• Accounts receivable and notes receivable that result from company sales are called trade receivables, but there are other types of receivables as well.

Key Terms

accounts receivable

Amounts that customers owe the company for normal credit purchases.

Notes Receivable

Amounts owed to the company by customers or others who have signed formal promissory notes in acknowledgment of their debts.

Receivables can be classified as accounts receivables, notes receivable and other receivables ( loans, settlement amounts due for non-current asset sales, rent receivable, term deposits). Other receivables can be divided according to whether they are expected to be received within the current accounting period or 12 months (current receivables), or received greater than 12 months ( non-current receivables).

Accounts Receivable

Accounts receivable are amounts that customers owe the company for normal credit purchases . Since accounts receivable are generally collected within two months of the sale, they are considered a current asset. Accounts receivable usually appear on balance sheets below short-term investments and above inventory.

Types of Receivables

Classifying receivables…

Notes Receivable

Notes receivable are amounts owed to the company by customers or others who have signed formal promissory notes in acknowledgment of their debts. Promissory notes strengthen a company’s legal claim against those who fail to pay as promised. The maturity date of a note determines whether it is placed with current assets or long-term assets on the balance sheet. Notes that are due in one year or less are considered current assets, while notes that are due in more than one year are considered long-term assets.

Other Receivables

Accounts receivable and notes receivable that result from company sales are called trade receivables, but there are other types of receivables as well. For example, interest revenue from notes or other interest-bearing assets is accrued at the end of each accounting period and placed in an account named interest receivable. Wage advances, formal loans to employees, or loans to other companies create other types of receivables. If significant, these nontrade receivables are usually listed in separate categories on the balance sheet because each type of nontrade receivable has distinct risk factors and liquidity characteristics.

4.3.3: Recognizing Accounts Receivable

Learning Objective

Describe the journal entry to record an accounts receivable transaction

Key Points

• Since not all customer debts will be collected, businesses typically estimate the amount of debts to be paid and then record an allowance for doubtful accounts.
• An example of a common payment term is Net 30, which means that payment is due at the end of 30 days from the date of invoice.
• Account receivables are classified as current assets assuming that they are due within one year.

Key Terms

Allowance for Doubtful Accounts

An estimated amount of bad debts to be subtracted from a balance sheet’s accounts.

Payment Terms

Forms of trade credit which specify that the net amount (the total outstanding on the invoice) is expected to be payment received in full 10, 15, 30, or 60 days after the goods are dispatched by the seller, or 10, 15, 30 or 60 days after the service is completed. Net 30 or Net 60 terms are often coupled with a credit for early payment.

payment date

the day when the dividend checks will actually be mailed to the shareholders of a company or credited to brokerage accounts

Example

• The following example shows how accounts receivable is recognized — assume company Furniture Palace sells a sofa to Customer Jane on credit for $1,000. Assuming Furniture Palace uses the accrual method of accounting, a journal entry is recorded for the sale of the item and the extension of credit to the customer. The journal entry debits Accounts Receivable for $1,000 and credits Furniture Sales for $1,000.

Recognition of Accounts Receivables

If you are operating under the accrual basis, you record transactions irrespective of any changes in cash. This is the system under which you record an account receivable. In addition, there is a risk that the customer will not pay you. If so, you can either charge these losses to expense when they occur, known as the direct write-off method, or you can anticipate the amount of such losses and charge an estimated amount to expense, known as the allowance method .

Using the Balance Sheet

The balance sheet is one of the financial reports included in a company’s annual report.

Booking a receivable is accomplished by a simple accounting transaction. However, the process of maintaining and collecting payments on the accounts receivable is more complex. Depending on the industry in practice, accounts receivable payments can be received up to 10 – 15 days after the due date has been reached. These types of payment practices are sometimes developed by industry standards, corporate policy, or because of the financial condition of the client.

Account receivables are classified as current assets assuming that they are due within one year. To record a journal entry for a sale on account, one must debit a receivable and credit a revenue account. When the customer pays off their accounts, one debits cash and credits the receivable in the journal entry. The ending balance on the trial balance sheet for accounts receivable is always debit.

Payment Terms

An example of a common payment term is Net 30, which means that payment is due at the end of 30 days from the date of invoice. The debtor is free to pay before the due date; businesses can offer a discount for early payment. Other common payment terms include Net 45, Net 60, and 30 days end of month.

Allowance for Doubtful Accounts

Since not all customer debts will be collected, businesses typically estimate the amount of and then record an allowance for doubtful accounts which appears on the balance sheet as a contra account that offsets total accounts receivable. Two methods are available to calculate the amount of bad debt expense and allowance of doubtful accounts at the end of an accounting period — percentage of accounts receivable or percentage of sales. When accounts receivables are not paid, some companies turn them over to third party collection agencies or collection attorneys who will attempt to recover the debt via negotiating payment plans, settlement offers or pursuing other legal action.

Examples of Allowance Calculation

An example of how to calculate the allowance for doubtful accounts using the percentage of receivables method — Assume Furniture Palace has an ending accounts receivable balance of USD 10,000 and estimates that 5% of receivables are doubtful. To adjust the allowance account for the new estimate, debit Bad Debt Expense for USD 500 (10,000 *0.05) and credit Allowance for Doubtful Accounts for USD 500.

To calculate the allowance for doubtful accounts using the percentage of total sales, estimate the percentage of sales that will be uncollectible. Furniture Palace estimates that 10% of the period’s USD 20,000 total sales may not be collected. To adjust the allowance account for the new period’s estimate, debit Bad Debt Expense for USD 2,000 (20,000 *0.10) and credit Allowance for Doubtful Accounts for USD 2,000.

4.3.4: Valuing Accounts Receivable

Learning Objective

Differentiate between the direct write-off method and the allowance method of accounts receivable valuation

Key Points

• Uncollectible accounts are called bad debts.
• Companies use two methods to account for bad debts: the direct write-off method and the allowance method.
• Business owners know that some customers who receive credit will never pay their account balances.
• GAAP requires companies to use the Allowance Method.

Key Terms

direct write-off method

a way of reducing accounts receivable to its net realizable value through a single entry

Direct Write-Off

Bad debts are recognized only after the company is certain the debt will not be paid.

Allowance Method

An adjustment is made at the end of each accounting period to estimate bad debts based on the business activity from that accounting period.

direct method

a way to construct the cash flow statement by reporting major classes of gross cash receipts and payments

Valuation

Receivables of all types are normally reported on the balance sheet at their net realizable value, which is the amount the company expects to receive in cash .

Valuing Receivables

Receivables are recorded at net realizable value.

Business owners know that some customers who receive credit will never pay their account balances. These uncollectible accounts are called bad debts. Companies use two methods to account for bad debts: the direct write-off method and the allowance method.

Direct Write-Off Method

For tax purposes, companies must use the direct write-off method, under which bad debts are recognized only after the company is certain the debt will not be paid. Before determining that an account balance is not collectible, a company generally makes several attempts to collect the debt from the customer.

Recognizing the bad debt requires a journal entry that increases a bad debts expense account and decreases accounts receivable. If a customer named J. Smith fails to pay a $100 balance, for example, the company records the write-off by debiting bad debts expense and crediting accounts receivable from J. Smith.

Allowance Method

Under the allowance method, an adjustment is made at the end of each accounting period to estimate bad debts based on the business activity from that accounting period. Established companies rely on past experience to estimate unrealized bad debts, but new companies must rely on published industry averages until they have sufficient experience to make their own estimates.

The adjusting entry to estimate the expected value of bad debts does not reduce accounts receivable directly. Accounts receivable is a control account that must have the same balance as the combined balance of every individual account in the accounts receivable subsidiary ledger.

Since the specific customer accounts that will become uncollectible are not yet known when the adjusting entry is made, a contra-asset account named allowance for bad debts, which is sometimes called allowance for doubtful accounts, is subtracted from accounts receivable to show the net realizable value of accounts receivable on the balance sheet.

4.4: Notes Receivable

4.4.1: Components of a Note

Notes Receivable represents claims for which formal instruments of credit are issued as evidence of debt, such as a promissory note.

Learning Objective

Explain the purpose of a note receivable and its format

Key Points

• A notes receivable normally requires the debtor to pay interest and extends for time periods of 30 days or longer.
• Often a business will allow a customer to convert their overdue accounts into a notes receivable. Doing so gives the debtor more time to pay.
• The principle is the face value of the note. The principle equals the initial amount of credit provided.
• The maker of a note is the party who receives the credit and promises to pay the note’s holder.
• Notes generally specify an interest rate, which is used to determine how much interest the maker of the note must pay in addition to the principal.

Key Terms

debtor

One who owes another anything, or is under obligation, arising from express agreement, implication of law, or principles of natural justice, to pay money or to fulfill some other obligation; in bankruptcy or similar proceedings, the person who is the subject of the proceeding.

promissory

Stipulating the future actions required of the parties to an insurance policy or other business agreement.

promissory note

a document saying that someone owes a specific amount of money to someone else, often with the deadline and interest fees

maker

the party issuing a promisory note

payee

the party receiving the promisory note

Notes Receivable

Notes Receivable represents claims for which formal instruments of credit are issued as evidence of debt, such as a promissory note. Often a business will allow a customer to convert their overdue accounts into a notes receivable. Doing so gives the debtor more time to pay. Occasionally, the notes receivable will include a personal guarantee by the owner of the debtor.

A notes receivable normally requires the debtor to pay interest and extends for time periods of 30 days or longer. Notes receivable are considered current assets if they are to be paid within 1 year and non-current if they are expected to be paid after one year.

Confederate Note Receivable

A One Hundred Dollar Confederate States of America banknote dated December 22, 1862. Issued during the American Civil War (1861–1865).

Components of a Note Receivable

Principle-the principle is the face value of the note. The principle equals the initial amount of credit provided.

Maker-the maker of a note is the party who receives the credit and promises to pay the note’s holder. The maker classifies the note as a note payable.

Payee-the payee is the party that holds the note and receives payment from the maker when the note is due. The payee classifies the note as a note receivable.

Interest-notes generally specify an interest rate, which is used to determine how much interest the maker of the note must pay in addition to the principal.

Calculating interest-interest on short-term notes is calculated according to the following formula:

principle x annual interest rate x time period in years = interest

Example: interest on a four-month, 9%, $1,000 note equals $30

4.4.2: Recognizing Notes Receivable

In accounting, notes receivables are accounts to keep track of accrued assets that have been earned but not yet received.

Learning Objective

Describe the difference between using the allowance method vs. the write off method when recording a note receivable

Key Points

• To record a journal entry for a sale on account, one must debit a receivable and credit a revenue account.
• When the receivable is payed off, debit the cash account and credit the receivable account.
• To estimate the net value of accounts receivable, subtract the balance of an allowance account from the accounts receivable account.
• Account for bad debts by either the allowance method or the direct write-off method.

Key Terms

journal entry

A journal entry, in accounting, is a logging of transactions into accounting journal items. The journal entry can consist of several items, each of which is either a debit or a credit. The total of the debits must equal the total of the credits or the journal entry is said to be “unbalanced. ” Journal entries can record unique items or recurring items, such as depreciation or bond amortization.

bad debt

A debt which cannot be recovered from the debtor, either because the debtor doesn’t have the money to pay or because the debtor cannot be found and/or forced to pay.

balance sheet

A summary of a person’s or organization’s assets, liabilities. and equity as of a specific date.

In accounting, notes receivables are accounts to keep track of accrued assets that have been earned but not yet received.

Accrued Assets

Accrued assets are assets, such as interest receivable or accounts receivable, that have not been recorded by the end of an accounting period. These assets represent rights to receive future payments that are not due at the balance sheet date. To present an accurate picture of the affairs of the business on the balance sheet, firms recognize these rights at the end of an accounting period by preparing an adjusting entry to correct the account balances. To indicate the dual nature of these adjustments, they record a related revenue in addition to the asset. We also call these adjustments ‘accrued revenues’ because the revenues must be recorded.

Recognizing and Reporting Notes Receivable

To record a journal entry for a sale on account, one must debit a receivable and credit a revenue account. When the customer pays off their accounts, one debits cash and credits the receivable in the journal entry. For example, a sale on account would be recorded similarly to the following interest receivable journal entry:

Notes Receivable Example

Recording an interest receivable journal entry

The ending balance on the trial balance sheet for accounts receivable is usually a debit. Business organizations which have become too large to perform such tasks by hand (or small ones that could but prefer not to) will generally use accounting software on a computer to perform this task. Companies have two methods available to them for measuring the net value of accounts receivable, which is generally computed by subtracting the balance of an allowance account from the accounts receivable account.

Allowance method

The first method is the allowance method, which establishes a contra-asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable.

The amount of the bad debt provision can be computed in two ways, either (1) by reviewing each individual debt and deciding whether it is doubtful (a specific provision); or (2) by providing for a fixed percentage (e.g. 2%) of total debtors (a general provision). The change in the bad debt provision from year to year is posted to the bad debt expense account in the income statement.

Direct write-off method

This second method is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger.

The two methods are not mutually exclusive, and some businesses will have a provision for doubtful debts, writing off specific debts that they know to be bad (for example, if the debtor has gone into liquidation. )

4.4.3: Valuing Notes Receivable

Companies have two methods available to them for measuring the net value of accounts receivable: the allowance method and the direct write-off method.

Learning Objective

Differentiate between the allowance method and the write off method for valuing notes receivable

Key Points

• Notes Receivable represents claims for which formal instruments of credit are issued as evidence of debt, such as a promissory note.
• The direct write-off method is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value.
• The allowance method, which establishes a contra-asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable.
• The two methods are not mutually exclusive, and some businesses will have a provision for doubtful debts, writing off specific debts that they know to be bad.

Key Terms

write-off

To remove a portion of a debt or an amount of an account owed to you counting it as a loss (as a gesture of goodwill for example)

revenue

Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.

Notes Receivable

Notes Receivable represents claims for which formal instruments of credit are issued as evidence of debt, such as a promissory note. The credit instrument normally requires the debtor to pay interest and extends for time periods of 30 days or longer. Notes receivable are considered current assets if they are to be paid within 1 year and non-current if they are expected to be paid after one year.

Compound Interest Treasury Note

Notes are short-term investment vehicles.

Reporting of Cash and Receivables

Accrued revenue (or accrued assets) is an asset such as proceeds from a delivery of goods or services, at which such income item is earned and the related revenue item is recognized, while cash for them is to be received in a latter accounting period. At that point its amount is deducted from accrued revenues.

Valuing Notes/Accounts Receivable

Companies have two methods available to them for measuring the net value of accounts receivable–the allowance method and the direct write-off method.

The Allowance Method

The first method is the allowance method, which establishes a contra-asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable. The amount of the bad debt provision can be computed in two ways:

1. by reviewing each individual debt and deciding whether it is doubtful (a specific provision)
2. by providing for a fixed percentage (e.g. 2%) of total debtors (a general provision)

The Direct Write Off Method

The second method is the direct write off method. It is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger.

4.4.4: Write-Offs

Companies use two methods for handling uncollectible accounts: the allowance method and the direct write-off method.

Learning Objective

Explain how to write off an uncollectible account using both the direct write-off and the allowance method.

Key Points

• The direct write-off method is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value.
• When using the allowance method, an estimate is made at the end of each fiscal year of the amount of bad debt.
• The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called Allowance for Doubtful Accounts.
• At the end of each accounting cycle, adjusting entries are made to charge uncollectible receivable as expense.
• The actual amount of uncollectible receivables is written off as an expense from Allowance for Doubtful Accounts.

Key Terms

write-off

The cancellation of an item; the amount cancelled or lost.

uncollectible

Receivables that cannot be collected.

Write-offs

Because customers do not always keep their promises to pay, companies must provide for these uncollectible accounts in their records. This phenomenon is known, in the realm of accounting, as bad debt.

Companies use two methods for handling uncollectible accounts: the direct write-off method and the allowance method. The direct write-off method is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger. The bad debt is recognized as an expense at the point when judged to be uncollectible.

When using the allowance method, an estimate is made at the end of each fiscal year of the amount of bad debt. This amount is accumulated in a provision, which is then used to reduce specific receivable accounts when necessary. Note that the allowance method is the required method for federal income tax purposes (GAAP).

Uncollectibles

Interesting Facts About Collection Agencies.

Because of the matching principle of accounting, revenues and expenses should be recorded in the period in which they are incurred. When a sale is made on account, revenue is recorded along with account receivable. Because there is an inherent risk that clients might default on payment, accounts receivable have to be recorded at net realizable value. The portion of the account receivable that is estimated to be not collectible is set aside in a contra-asset account called Allowance for Doubtful Accounts. At the end of each accounting cycle, adjusting entries are made to charge uncollectible receivable as expense. The actual amount of uncollectible receivables is written off as an expense from Allowance for Doubtful Accounts.

Allowance Method Example

As time passes and a firm considers a specific customer’s account to be uncollectible, it writes that account off. It debits the Allowance for Doubtful Accounts. The credit is to the Accounts Receivable control account in the general ledger and to the customer’s account in the accounts receivable subsidiary ledger. For example, assume Smith’s USD 750 account has been determined to be uncollectible. The entry to write off this account is:

Allowance for Uncollectible Accounts (-SE) 750

Accounts Receivable—Smith (-A) 750

The credit balance in Allowance for Doubtful Accounts before making this entry represented potential uncollectible accounts not yet specifically identified. Debiting the allowance account and crediting Accounts Receivable shows that the firm has identified Smith’s account as uncollectible. Notice that the debit in the entry to write off an account receivable does not involve recording an expense. The company recognized the uncollectible accounts expense in the same accounting period as the sale. If Smith’s USD 750 uncollectible account were recorded in Uncollectible Accounts Expense again, it would be counted as an expense twice.

A write-off does not affect the net realizable value of accounts receivable. For example, suppose that Amos Company has total accounts receivable of USD 50,000 and an allowance of USD 3,000 before the previous entry; the net realizable value of the accounts receivable is USD 47,000. After posting that entry, accounts receivable are USD 49,250, and the allowance is USD 2,250; net realizable value is still USD 47,000, as shown here:

Before Write-Off // Entry for After Write-Off // Write-Off

Accounts receivable 50,000 Dr. // 750 Cr. // $ 49,250 Dr.

Allowance for uncollectible accounts 3,000 Cr. // 750 Dr. // 2,250 Cr.

Net realizable value 47,000 Dr. // $47,000

You might wonder how the allowance account can develop a debit balance before adjustment. To explain this, assume that Jenkins Company began business on January 1, 2009, and decided to use the allowance method and make the adjusting entry for uncollectible accounts only at year-end. Thus, the allowance account would not have any balance at the beginning of 2009. If the company wrote off any uncollectible accounts during 2009, it would debit Allowance for Uncollectible Accounts and cause a debit balance in that account. At the end of 2009, the company would debit Uncollectible Accounts Expense and credit Allowance for Uncollectible Accounts. This adjusting entry would cause the allowance account to have a credit balance.

During 2010, the company would again begin debiting the allowance account for any write-offs of uncollectible accounts. Even if the adjustment at the end of 2009 was adequate to cover all accounts receivable existing at that time that would later become uncollectible, some accounts receivable from 2010 sales may be written off before the end of 2010. If so, the allowance account would again develop a debit balance before the end-of-year 2010 adjustment.

4.5: Basics of Receivables Management

4.5.1: Activities to Manage Receivables

Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit.

Learning Objective

Summarize how a company manages its accounts receivable

Key Points

• Collections and cashiering teams are part of the accounts receivable department. While the collection’s department seeks the debtor, the cashiering team applies the monies received.
• An example of a common payment term is Net 30, which means that payment is due at the end of 30 days from the date of invoice.
• The first method of bookkeeping is the allowance method. It establishes a contra-asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable.
• The second method of bookkeeping is the direct write-off method. It is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value (debiting a bad debt expense account and crediting the respective accounts receivable).

Key Terms

debtor

One who owes another anything, or is under obligation, arising from express agreement, implication of law, or principles of natural justice, to pay money or to fulfill some other obligation; in bankruptcy or similar proceedings, the person who is the subject of the proceeding.

receivable

A debt owed, usually to a business, from the perspective of that business.

Basics of Accounts Receivables

Accounts receivable (or debtors) represent money owed to a business by its clients (customers). It is shown on its balance sheet as an asset. It is one of a series of accounts dealing with the billing of a customer for goods and services that the customer has ordered.

Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established time-frame, called credit terms or payment terms.

The accounts receivable departments use the sales ledger. This is because a sales ledger normally records:

• The sales a business has made.
• The amount of money received for goods or services.
• The amount of money owed at the end of each month varies (debtors).

The accounts receivable team is in charge of receiving funds on behalf of a company and applying it towards their current pending balances.

Collections and cashiering teams are part of the accounts receivable department. While the collection’s department seeks the debtor, the cashiering team applies the monies received.

Payment Terms

An example of a common payment term is Net 30, which means that payment is due at the end of 30 days from the date of invoice. The debtor is free to pay before the due date. Businesses can offer a discount for early payment. Other common payment terms include Net 45, Net 60, and 30 days end of month.

Bookkeeping

Account receivables are classified as current assets assuming that they are due within one year. To record a journal entry for a sale on account, one must debit a receivable and credit a revenue account. When the customer pays off their accounts, one debits cash and credits the receivable in the journal entry. The ending balance on the trial balance sheet for accounts receivable is usually a debit .

General Accounting Cycle

Figure shows the accounting cycle.

Two Methods

The first method is the allowance method, which establishes a contra-asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable. The amount of the bad debt provision can be computed in two ways, either (1) by reviewing each individual debt and deciding whether it is doubtful (a specific provision) or (2) by providing for a fixed percentage (e.g. 2%) of total debtors (a general provision). The change in the bad debt provision from year to year is posted to the bad debt expense account in the income statement.

The second method is the direct write-off method. It is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger.

4.5.2: Managing to Prevent Fraud

To help prevent fraudulent activities, management must implement internal controls/structure and know what situations to look for.

Learning Objective

Explain how a company can prevent fraud by establishing internal controls

Key Points

• Employees are more likely to commit fraud when under situational or financial pressure, and when the opportunity to commit fraud is present.
• One of the main factors of an effective internal control system is segregation of duties. To segregate duties, a company can involve more than one person in the financial statement preparation process. For fraud to occur in this situation, two employees must collude to perpetrate the crime.
• A strong control environment (top management control) involves enlisting management to demonstrate ethical behavior.
• Outside parties performing annual examinations of financial statements can prevent management from committing fraud.

Key Terms

accounting

The development and use of a system for recording and analyzing the financial transactions and financial status of a business or other organization.

fraud

Any act of deception carried out for the purpose of unfair, undeserved, and/or unlawful gain.

control

A security mechanism, policy, or procedure that can counter system attack, reduce risks, and resolve vulnerabilities, synonymous with safeguard and counter-measure.

Example

• To meet financial goals for the company managers may be tempted to “cook the books. ” To help prevent management from adjusting financial statements, an independent auditor should examine financial statements on an annual basis.

Failure to Prevent Fraud

Failure to implement adequate internal controls can result in financial statement fraud (purposely misstated financial statements) or embezzlement (theft). This is when the services of a forensic accountant may be necessary. Forensic accounting is the application of accounting methodology to legal issues. It is frequently associated with the investigation of civil or criminal white-collar crime such as fraud, embezzlement, and general abuse of funds issues. Typical tools used in forensic accounting are bank records, personal financial statements, interviews, and credit reports. The forensic accountant’s responsibility is to gather and analyze the evidence and deliver clear, accurate, and unbiased reports reflecting the results of the investigation.

Ways to Prevent Fraud

Educate Management

Financial statement fraud involves the intentional publishing of false information in any portion of a financial statement.

To help prevent fraudulent activities, management must implement internal controls/structure, and know what situations to look for. Employees are more likely to commit fraud when under situational or financial pressure, and when the opportunity to commit fraud is present .

Occupy Wall Street – Fraud

Occupy Wall Street protester with a sign defining fraud.

Separate Accounting Functions

One of the main factors of an effective internal control system is segregation of duties. Management helps to prevent fraud by reducing the incentives of fraud.

One incentive, the opportunity to commit fraud, can be reduced when accounting functions are separated. The act of segregating duties separates the record-keeping, authorization, and review functions in the accounting process. To segregate duties, a company can involve more than one person in the financial statement preparation process. For fraud to occur in this situation, two employees must collude to perpetrate the crime.

Control Environment

A strong control environment (top management control) involves enlisting management to demonstrate ethical behavior. Whatever tone management sets will have a trickle-down effect to the employees. A strong tone is developed by establishing and complying with a written set of policies which are concise and include consequences when procedures are disobeyed. In addition, one of the easiest ways to establish a strong moral tone for an organization is to hire employees with strong ethics/morals.

External Controls

Outside parties performing annual examinations of financial statements can prevent management from committing fraud. To meet financial goals for the company managers may be tempted to “cook the books. ” To help prevent management from adjusting financial statements, an independent auditor should examine financial statements on an annual basis.

4.6: Reporting and Analyzing Receivables

4.6.1: Classifying Receivables

Receivables can be classified as accounts receivables, trade debtors, bills receivable, and other receivables.

Learning Objective

Distinguish between accounts receivable, trade debtors, bills receivables and other receivables

Key Points

• Accounts receivable is the money owed to that company by entities outside of the company. Trade debtors are the receivables owed by the company’s customers.
• Other receivables can be divided according to whether they are expected to be received within the current accounting period or 12 months (current receivables), or received greater than 12 months (non-current receivables).
• Not all accounts receivables will be paid, and an allowance has to be made for bad debts. The allowance for bad debts can be calculated either as the percentage of net credit sales or by the ageing method of estimating bad debts.

Key Term

allowance for bad debts

Since not all customer debts will be collected, businesses typically estimate the amount of and then record an allowance for doubtful accounts which appears on the balance sheet as a contra accounts that offsets total accounts receivable. When accounts receivable are not paid, some companies turn them over to third party collection agencies or collection attorneys who will attempt to recover the debt via negotiating payment plans, settlement offers or pursuing other legal action.

Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer. In turn, the customer must pay it within an established time frame, which is called the credit terms or payment terms.

An example of a common payment term is Net 30, which means that payment is due at the end of 30 days from the date of invoice. The debtor is free to pay before the due date. To encourage this, businesses can offer a discount for early payment. Other common payment terms include Net 45, Net 60, and 30 days end of month.

On a company’s balance sheet, receivables can be classified as accounts receivables or trade debtors, bills receivable, and other receivables (loans, settlement amounts due for non-current asset sales, rent receivables, term deposits). Accounts receivable is the money owed to that company by entities outside of the company. Trade receivables are the receivables owed by the company’s customers. Other receivables can be divided according to whether they are expected to be received within the current accounting period or 12 months (current receivables), or received greater than 12 months (non-current receivables) .

Balance sheet

Sample balance sheet

Not all accounts receivables will be paid, and an allowance has to be made for bad debts. The allowance for bad debts can be calculated either as the percentage of net credit sales or by the ageing method of estimating bad debts. These are determined by historical accounting information. Accounts receivable therefore can be classified according to their age. The Accounts Receivable Age Analysis Printout, also known as the Debtors Book is divided in categories for current, 30 days, 60 days, 90 days, 120 days, 150 days,180 days, and overdue.

4.6.2: Dealing with Foreign Currency and Bad Debts

To deal with foreign currency and bad debts, we have a “gain or loss” account and methods to measure the net value of accounts receivable.

Learning Objective

Explain how the “gain or loss” account is used for foreign currency transactions and bad debts

Key Points

• On a company’s balance sheet, accounts receivable is the money owed to that company by entities outside of the company.
• To deal with foreign currency, companies have a “foreign currency transaction gain or loss” that typically is included in arriving at earnings in the income statement for the period in which the exchange rate is changed.
• To deal with bad debts, companies have two methods available to them for measuring the net value of accounts receivable, which is generally computed by subtracting the balance of an allowance account from the accounts receivable account, namely the allowance method and the write-off method.

Key Term

functional currency

Functional currency refers to the main currency used by a business or unit of a business. It is the monetary unit of account of the principal economic environment in which an economic entity operates.

On a company’s balance sheet, accounts receivable is the money owed to that company by entities outside of the company. The receivables owed by the company’s customers are called trade receivables. Account receivables are classified as current assets, assuming that they are due within one calendar year or fiscal year.

A foreign currency transaction requires settlement in a currency other than the functional currency. A change in exchange rates between the functional currency and the currency in which a transaction is denominated increases or decreases the expected amount of functional currency cash flows upon settlement of the transaction. This change in expected functional currency cash flows is a “foreign currency transaction gain or loss” that typically is included in arriving at earnings in the income statement for the period in which the exchange rate is changed.

To deal with bad debts, companies have two methods available to them for measuring the net value of accounts receivable, which is generally computed by subtracting the balance of an allowance account from the accounts receivable account.

The first method is the allowance method, which establishes a contra-asset account, allowance for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for accounts receivable. The allowance for bad debt/doubtful accounts is a permanent account. While the corresponding bad debt expense account is a temporary account that is zeroed out annually.

The amount of the bad debt provision can be computed in two ways: either by reviewing each individual debt and deciding whether it is doubtful (a specific provision), or by providing for a fixed percentage (e.g. 2%) of total debtors (a general provision). The change in the bad debt provision from year to year is posted to the bad debt expense account in the income statement .

Allowance for Doubtful Accounts

Allowance for Doubtful Accounts (the allowance method)

The second method is the direct write-off method. It is simpler than the allowance method in that it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry would consist of debiting a bad debt expense account and crediting the respective accounts receivable in the sales ledger.

4.6.3: Reporting Receivables

Accounts receivable are reported as a line item on the balance sheet and in a more detailed again report.

Learning Objective

Review the purpose of the accounts receivable aging report

Key Points

• An accounts receivable aging report summarizes receivables based on their age—that is, how long they have been outstanding.
• The accounts receivable age analysis, also known as the Debtors Book, is divided in categories—current, 30 days, 60 days, 90 days, 120 days, 150 days, 180 days, and overdue—that are produced in modern accounting systems.
• The aging report can help a business identify issues soon after they arise and prevent larger problems from occurring later on.

Key Terms

aging the accounts receivable

dividing the account receivable according the days until due ranging from current to overdue

General Ledger

General Ledger is the final repository of the accounting records and data. In modern accounting softwares, the general ledger works as a central repository for accounting data transferred from all sub-ledgers or modules like accounts payable, accounts recievable, cash management, fixed assets, purchasing and projects. General ledger is the backbone of any accounting system which holds financial and non-financial data for an organization.

Accounts receivable are reported as a line item on the balance sheet. Supplementary reports, such as the accounts receivable aging report, provide further detail.

Balance sheet

Accounts receivable are a line item in a balance sheet.

The aging report, for example, shows how long invoices from each customer have been outstanding. Generally the accounts in an aging report are subdivided into categories based on how overdue the invoices are.

An accounts receivable aging report summarizes receivables based on their age—how long they have been outstanding. The accounts receivable age analysis, also known as the Debtors Book, is divided into categories for current, 30 days, 60 days, 90 days, 120 days, 150 days, 180 days, and overdue that are produced in modern accounting systems. For example, all the unpaid invoices posted in the past month are current, all the unpaid invoices from the prior month are over 30 days, the unpaid invoices from two months ago are over 60 days, etc. The aging report can help a business identify issues soon after they arise and prevent larger problems from occurring later on.

4.6.4: Using the Receivables Turnover Ratio

The receivables turnover ratio measures how efficiently a firm uses its assets.

Learning Objective

Summarize the importance of the receivables turnover ratio

Key Points

• The receivables turnover ratio measures how efficiently a firm gives credit and collects debts.
• The receivables turnover ratio is also used in calculating the days’ sales in receivables, the average collection period, the average debtor collection period, and the average payment period in days.

Receivables Turnover Ratio

The receivables turnover ratio, also called the debtor’s turnover ratio, is an accounting measure used to measure how effective a company is in extending credit as well as collecting debts. The receivables turnover ratio is an activity ratio, measuring how efficiently a firm uses its assets.

The formula of the receivables turnover ratio is:

A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient; in contrast, a low ratio implies the company is not making the timely collection of credit.

Other Uses

Sometimes the receivables turnover ratio is expressed as the “days’ sales in receivables”:

The average collection period can be calculated as follows:

The average debtor collection period can be calculated as follows:

Finally, the average creditor payment period can be calculated as follows: