Question
I'm in serious need of help in my accounting class (acc205) . I'm falling behind and I need help with this weeks assignment. for week
I'm in serious need of help in my accounting class (acc205) . I'm falling behind and I need help with this weeks assignment. for week three for the may-june month . can someone please help me . attached is the worksheet and the chapters with the assignment questions . The questions are at the end of the chapters and everything goes into the spreadsheet that I have attached as well. I hope someone can help me . thank you in advance
Complete the following problems and exercises:
Chapter Five, Exercise 1 Chapter Five, Problem 2 Chapter Six, Exercises 2 and 3 Chapter Six, Problem 2
Ashford University ACC Guidance Report Week Three LISTEN TO AUDIO/VIDEO EXPLAINING THE GUIDANCE REPORT Account to be changed Original Amount Ch 5 Ex 1 Inventory understated Questions 4,000 YOUR ANSWERS BASED UPON COURSE START DATE 20X3 Sales Cost of goods sold Gross profit Expenses Net income 20X4 Sales Cost of goods sold Gross profit Expenses Net income What is the effect of the error on ending owner's equity for 20X3 and 20X4? Account to be changed Ch 5 Pb 2 Sold Ending Inventory Questions FIFO Sales Purchases Ending inventory Cost of Goods Sold Gross Profit LIFO Sales Purchases Ending inventory Cost of Goods Sold Gross Profit Average Cost Sales Purchases Ending inventory Cost of Goods Sold Gross Profit Which of the three methods would be chosen if management's goal is to: Produce an up-to-date inventory valuation on the balance sheet? Approximate the physical flow of a sand and gravel dealer? Report low earnings (for tax purposes) for a separate electronics company that has been experiencing declining purchase prices? Original Amount 710 160 YOUR ANSWERS BASED UPON COURSE START DATE Account to be changed Ch 6 Ex 2 Purchase price Questions Original Amount 30000 YOUR ANSWERS BASED UPON COURSE START DATE Units-of-output Straight-line Double-declining-balance Account to be changed Ch 6 Ex 3 Cost Original Amount 1000 Questions YOUR ANSWERS BASED UPON COURSE START DATE The machine's book value on December 31, 20X5, assuming use of the straight-line depreciation method Depreciation expense for 20X4, assuming use of the units-ofoutput depreciation method. Actual washing cycles in 20X4 totaled 500. Accumulated depreciation on December 31, 20X5, assuming use of the double-declining-balance depreciation method. Account to be changed Original Amount Ch 6 Pb 2 Machine Part C Cost 50000 47800 YOUR ANSWERS BASED UPON COURSE START DATE Questions Straight line 20X3 20X4 20X5 20X6 20X7 Units-of-output 20X3 20X4 20X5 20X6 20X7 Double Declining Balance 20X3 20X4 20X5 20X6 20X7 On January 1, 20X5, management shortened the remaining service life of the machine to 20 months. Assuming use of the straight-line method, compute the company's depreciation expense for 20X5. Briefly describe what you would have done differently in part (a) if Aussie Imports had paid $47,800 for the machinery rather than $50,000 In addition, assume that the company incurred $800 of freight charges $1,400 for machine setup and testing, and $300 for insurance during the first year of use. Ashford University ACC205 Guidance Report Week Three YELLOW INDICATES ACCOUNT AMOUNTS CHANGED Change Account to: Based Upon Course Start Date Jan - Feb 5,000 Mar-Apr 6,000 May-Jun 7,000 Jul-Aug 8,000 Sept-Oct 9,000 Nov-Dec 10,000 720 150 730 140 740 130 750 120 760 110 770 100 31,000 32,000 33,000 34,000 35,000 36,000 1,100 1,200 1,300 1,400 1,500 1,600 55,000 52,800 60,000 57,800 65,000 62,800 70,000 67,800 75,000 72,800 80,000 77,800 chapter 5 Inventory Copyright Barbara Chase/Corbis/AP Images Learning Goals Know the basics of recording inventory purchases and sales. Understand the typical categories of inventory and their contents. Understand how an expanded income statement presentation can enhance reporting usefulness. Explain how inventory costs are allocated to inventory and cost of goods sold and the importance of this allocation to income measurement. Know how to apply FIFO, LIFO, and moving average inventory-costing assumptions. Apply specific identification, retail, and lower-of-cost-or-market concepts. waL80144_05_c05_111-134.indd 1 8/29/12 2:44 PM CHAPTER 5 Chapter Outline Chapter Outline 5.1 Categories of Inventory Inventory Costs Freight Expanded Income Reporting Consigned Goods Critical Thinking About Inventory Cost 5.2 Cost Assignment 5.3 Perpetual Systems First-In, First-Out Last-In, First-Out The Average Cost Approach 5.4 Comparing Methods Specific Identification The Retail Method Lower-of-Cost-or-Market Adjustments 5.5 The Importance of Accuracy H ow hard could it be to account for inventory? The basic concept is very simple. When you buy inventory, you record the purchase of the asset, like this: 2-10-XX Inventory 10,000.00 Accounts Payable 10,000.00 Purchased $10,000 of inventory on account Then, when the inventory is resold, two entries are neededone to record the sales proceeds and another to remove the inventory and charge it to an expense category called cost of goods sold: 3-15-XX Accounts Receivable 15,000.00 Sales 15,000.00 Sold merchandise on account 112 waL80144_05_c05_111-134.indd 2 8/29/12 2:44 PM CHAPTER 5 Section 5.1 Categories of Inventory 3-15-XX Cost of Goods Sold 10,000.00 Inventory 10,000.00 To record the cost of merchandise sold This very basic approach would result in the following income statement results: Sales Cost of goods sold Gross profit $15,000 10,000 $ 5,000 The gross profit is simply the net difference between the cost of inventory that has been sold and the sales proceeds. It is not the net income because it does not reflect all other costs of doing business. Of course, if inventory accounting was only this simple, there would be no need for a separate chapter. So, what issues could possibly arise to complicate the accounting for inventory? For starters, there are issues about what goods are appropriately included in inventory. What is the appropriate moment to conclude that a transaction has resulted in a sale? What costs, in addition to the direct purchase price, are to be placed into the inventory accounts? How do we attach costs to specific units sold when numerous identical units have been purchased at different costs on different dates, and we are not sure which physical units have actually been delivered to a customer? Suddenly, accounting for inventory appears to present a number of vexing challenges. This chapter helps sort out these issues and provides you with a sound understanding of the accounting principles you need to know to answer these types of questions and more. 5.1 Categories of Inventory T he very simple journal entry that opened this chapter contemplated a retail business model. The company bought goods from a supplier and resold those goods to customers at a higher price point. Retailing is a large segment of the economy but not the only segment. The goods must have been manufactured. Therefore, manufacturers also carry inventory on their books. A manufacturer's inventory may consist of goods in various stages of development. It may have raw materials consisting of components and parts that will eventually be put into production. The manufacturer may also have work-in-process inventory consisting of goods being manufactured but not yet completed. A third category of inventory is finished goods. These are completed goods awaiting sale. Consider that the manufacturer's process entails converting raw material into finished goods. During production, raw materials are converted via the addition of labor and other factors of production (such factory costs are called overhead). 113 waL80144_05_c05_111-134.indd 3 8/29/12 2:44 PM CHAPTER 5 Section 5.1 Categories of Inventory The process for correctly accumulating and attaching these costs to work in process requires substantial skill and is covered in depth in the managerial accounting course. For now, be aware that much more is to be learned about how costs attach to products in a manufacturing environment. Let's focus just on the general inventory-accounting principles that would be applicable to most businesses, using scenarios involving the purchase and resale of goods. Inventory Costs As a general rule, inventory should include all costs that are ordinary and necessary to put the goods in place and in condition for their resale. Inventory therefore includes the invoice price, shipping costs incurred when buying the goods, and similar costs. Costs like interest charges on money borrowed to buy inventory, storage costs, and insurance are not included in inventory accounts because they do not meet the general rule. Those costs are called carrying costs and are to be expensed in the period incurred. Freight Few people think deeply about how significant freight cost can be to the overall cost of bringing a product to market. It can be expressed in very simple terms. If you drive to the store for a gallon of milk costing $3 and spend $3 on gas to make the trip, how much did the milk actually cost? If you were trying to categorize your milk in the refrigerator as an asset on an accounting balance sheet, would your report its cost at $3 or $6? Because of its significance, accountants have been very careful to describe fully a framework for the handling of freight costs. To develop an understanding of this framework begins with specific knowledge about freight terms. FOB is a common freight nomenclature. It is an abbreviation for \"free on board.\" What that really means is the point at which the ownership of goods shifts from the seller to the buyer. Thus, goods may be sold FOB shipping point. Once goods are shipped, they are deemed the property of the buyer. Equally important, the buyer must assume responsibility for payment of freight to the destination. Conversely, FOB destination means that the seller owns the goods until they are delivered and must bear the cost of shipping. The implications of freight terms should not be underestimated. There are two highly significant inventory accounting considerations that are directly affected by the FOB terms. First, goods sold FOB destination do not belong to the purchaser until they arrive at their final destination. Therefore, goods that have been purchased but not yet received would not be carried in the buyer's balance sheet at the end of the accounting period. Similarly, no liability would be reported for the payment obligation. Conversely, goods purchased FOB shipping point that have been shipped by the seller should be reflected on the buyer's balance sheet, even though they may not be in the buyer's physical possession. In this case, the buyer needs to show both the inventory and related liability on its books. Accountants can face interesting challenges to determine the status of goods in transit at the end of each accounting period. 114 waL80144_05_c05_111-134.indd 4 8/29/12 2:44 PM CHAPTER 5 Section 5.1 Categories of Inventory The second major issue pertains to the freight cost. When the buyer assumes the freight cost (as with FOB shipping point), it is deemed to be an ordinary and necessary cost to put the goods in place and in condition for resale. As such, accountants will add freight-in to the cost of the inventory. Thus, the Inventory account will reflect both the invoice cost of the goods, along with any additional amounts for freight. You should be aware that freight-out incurred by a seller of goods faces a different accounting rule. Freight-out is treated like a sales expense and does not increase the cost of goods sold amount; instead, the freight out is subtracted from gross profit in calculating income. Expanded Income Reporting The foregoing issues begin to show why a merchant's income statement can be expanded. Merchants and others frequently present a multiple-step income statement. This format divides business results into separate categories. The first category clearly shows the difference between the selling price of the product and its cost. This difference is called gross profit. Following gross profit are the other expenses of doing business. This usually consists of the selling, general, and administrative expenses (SG&A) associated with running the business. These primary categories on the multiple-step income statement relate to the business's core performance. An investor would closely follow these numbers, especially noting trends and changes. Investors often compare cost categories to sales on a percentage basis. For instance, cost of goods sold may be 40%, 50%, or 60% of sales. Monitoring this percentage will reveal pricing power and how the potential impact increases or decreases sales. However, other business events can give rise to income statement effects. It is common for a business to have incidental transactions that contribute to profits and losses. Examples include the sale of corporate assets (not inventory), losses from catastrophes, and similar events. If significant, these items are typically presented after the SG&A section. Although potentially meaningful, the sometimes nonrecurring nature makes it easier to discount their ongoing impacts to the business. Finally, financing costs are frequently broken out from other expense components. The reason is that investors may wish to evaluate financial performance separate and apart from the cost of funds that are used to finance the business. This does not mean interest is not a real expense. Expense is a real cost, but its different character justifies clearly breaking it out within the income statement. This provides information needed to fully understand and evaluate the business's income generation capacity. Table 5.1 is an example an income statement reflecting these special considerations. 115 waL80144_05_c05_111-134.indd 5 8/29/12 2:44 PM CHAPTER 5 Section 5.1 Categories of Inventory Table 5.1: An example of an income statement that reflects special considerations INCOME STATEMENT Example Company For the Month Ending January 31, 20XX Sales $179,000 Cost of Goods Sold 100,000 Gross Profit $ 79,000 Selling Expenses Advertising $10,000 Freight-out 8,000 Depreciation 6,000 Salaries 3,000 $ 27,000 General and Administrative Salaries $14,000 Depreciation 5,000 Rent 2,000 Insurance 1,000 22,000 Other Loss on Sale of Stock Interest Expense $ 4,000 6,000 10,000 Income Before Taxes 59,000 $20,000 Income tax expense 6,500 Net income $13,500 Consigned Goods On occasion, a manufacturer may approach a merchant about stocking a particular product. The merchant may be reluctant, not wanting to invest in inventory that may not sell. This negotiation may result in a consignment of inventory. A consignment is an agreement whereby the inventory's owner, the consignor, places it with another party in the hope that the goods will be resold to an end consumer. The party holding physical possession is the consignee but not the legal owner. It must care for the goods and try to sell them to an end customer. The consignor surrenders physical custody but maintains legal ownership. The consignor would continue to carry the goods in its inventory records. Consigned goods pose a record keeping challenge. Because physical custody does not represent ownership, it becomes difficult for both consignees and consignors to maintain proper accountability over consigned inventory. When the consignee sells consigned 116 waL80144_05_c05_111-134.indd 6 8/29/12 2:44 PM CHAPTER 5 Section 5.1 Categories of Inventory goods to an end user, the consignee becomes obligated to remit a portion of the final sales price to the consignor. Otherwise, it is understood that the consignee reserves the right to return the inventory without obligation to make payment. Critical Thinking About Inventory Cost Consider that a business is likely to open a new accounting period with a carryover balance of inventory from the preceding period. This is probably rather obvious. Just because an accounting period has ended does not mean that unsold goods must be dumped. Instead, the ending balance of one period becomes the beginning inventory balance of the next. Exhibit 5.1 shows how a period's beginning inventory, plus additional purchases, can be combined to represent the total goods available for sale. Some of the goods available for sale are sold and become cost of goods sold, and the unsold portion represents the ending inventory (which will carry forward into the next accounting period). Exhibit 5.1: Goods available for sale Beginning inventory + Net purchases Ending inventory + Goods available for sale Cost of goods sold Exhibit 5.1 shows how goods available for sale must be split between ending inventory and cost of goods sold. Though a picture may be worth a thousand words, it is also true that accountants rarely communicate with pictures. Thus, the drawing is usually converted to a calculation format such as the following (all amounts are assumed for the time being): Beginning inventory Plus: Purchases Goods available for sale Less: Ending inventory Cost of goods sold $100,000 450,000 $550,000 50,000 $500,000 In the drawing, the units appear as physical units, but the natural commingling of homogenous inventory sometimes makes it difficult or impossible to truly know which units are which. Accountants therefore express inventory on the balance sheet in units of money rather than physical quantity descriptions. A critical factor in determining income is the allocation of the cost of goods available for sale between ending inventory and cost of goods sold. Accountants have a significant task to assess what cost attaches to ending inventory and what cost attaches to cost of goods sold, especially in light of the fact that the exact physical flow of goods is probably unknown. 117 waL80144_05_c05_111-134.indd 7 8/29/12 2:44 PM CHAPTER 5 Section 5.3 Perpetual Systems 5.2 Cost Assignment I t is unlikely that each unit of inventory will have the exact same cost. It can be impractical to trace the exact cost of each unit; even when possible, accountants do not require this association. Instead, accountants use inventory cost flow assumptions. These assumptions do not need to relate to the physical flow of the inventory. Thus, the inventory cost allocation approach is just a systematic approach for dealing with the question of what cost is to be attached to ending inventory and cost of goods sold. To illustrate this point, consider the case of Umps Baseball Supply. Umps maintains a storage bin full of balls. As customers purchase balls, Umps randomly selects them from the bin. As Umps restocks, they dump newly purchased balls into the bin. The balls are constantly being mixed up such that Umps has no way of knowing the exact purchase date or price of any particular ball remaining in the bin. During a recent period, the bin had an opening supply of 500 balls and was restocked two different times. At each restocking, 500 balls were added. The balls in beginning inventory cost $2 per ball. The first restocking had a unit cost of $2.25. The final restocking was at $2.75. The bin was never allowed to empty completely. At the end of the period, the bin contains 125 balls, probably including some from beginning inventory and each restocking event. What is the cost of the ending inventory? The answer to this important question will directly impact the calculation of not only ending inventory but also cost of goods sold (and therefore income). Umps must adopt an inventory-costing method. There are several cost flow assumptions to choose from. One is a first-in, first-out (FIFO) approach. Another is the last-in, first-out (LIFO) approach. The third method reflects a more complex average cost approach. The complexity arises because the average cost method is not just the simple average of the per-unit price but instead weights the cost by the num-ber of units purchased at each price point. Thus, it is also known as a weightedaverage cost concept. In the average cost example that follows, the weighted-average cost is recalculated each time there is a new purchase, resulting in a further refinement of its moniker as the moving-average method. 5.3 Perpetual Systems B efore more closely examining the accounting for Umps's inventory under the FIFO, LIFO, and average cost approaches, it is first necessary to point out that inventory costs can be accumulated on either a real-time perpetual inventory system or occasional updating via a periodic inventory system. As the name suggests, a perpetual system is one in which inventory records are continuously updated for all inventory changes. As inventory is purchased, it is added into the Inventory account. As inventory is sold, it is subtracted from the Inventory accounts. A periodic system is one in which the Inventory accounts are only updated on designated intervals, such as at the end of each accounting period. At one time, accumulating and assigning costs on a perpetual basis was exceedingly difficult because of the extraordinarily tedious recordkeeping that ensues. Then, companies necessarily resorted to simplifying techniques that only periodically updated inventory records. Modern computers have allowed companies to adopt more sophisticated real-time, or perpetual, tracking of inventory. These systems greatly improve asset accountability and business decision making. With a perpetual system, each inventory purchase or sale transaction triggers an update of the inventory records and corporate 118 waL80144_05_c05_111-134.indd 8 8/29/12 2:44 PM CHAPTER 5 Section 5.3 Perpetual Systems general ledger. To begin to see how this operates, closely examine the details about Umps's inventory purchases in Table 5.2. Table 5.2: Umps's inventory purchases Date Quantity Purchased Cost per Unit Total Cost Beginning balance July 1 500 $2.00 $1,000 Purchase 2 July 15 500 $2.25 $1,125 Purchase 3 July 24 500 $2.75 $1,375 In addition to information about the purchasing activity, we also need detailed information about Umps's sales. Table 5.3 provides detailed sales data: Table 5.3: Umps's sales data Date Quantity Sold Sales Price per Unit Total Sales Sale 1 July 9 400 $4.00 $1,600 Sale 2 July 20 550 $4.50 $2,475 Sale 3 July 28 425 $5.00 $2,125 Overall, you will notice that Umps had 1,500 units available (500 500 500) and sold 1,375 units (400 550 425), leaving the remaining ending inventory on hand at the end of July at 125 units. We mustn't lose sight of our accounting goals: to determine the total sales, total cost of goods sold, gross profit, and ending inventory balances to report in the financial statements. To make this determination will require an inventory cost flow assumption. Importantly, the cost flow assumption is used to describe the flow of the cost of goods through the accounting system. It is not necessary that a cost flow assumption actually correspond to a physical flow, but it useful to visual a cost flow assumption by thinking about physical flow. If you owned a convenience store, you would probably sell milk on a FIFO basis. To minimize spoilage, you would sell the oldest milk first. This is logical. On the other hand, if you sold crushed rock that was dumped in large stacks as it was processed and delivered via a loader scooping from the pile as it was sold, you can likely understand the LIFO cost flow concept. We will first perform Umps's inventory calculations using a perpetual FIFO method. First-In, First-Out Table 5.4 shows the level of detail that is necessary to track the inventory correctly. Study this very carefully. Perhaps you can follow the logic by only tracking amounts in the table; if not, additional explanatory details are provided below the table. Remember, this is a FIFO example. When a sale occurs, the assumption is that the units sold were from the first, or earliest, available units: first-in, first-out. 119 waL80144_05_c05_111-134.indd 9 8/29/12 2:44 PM CHAPTER 5 Section 5.3 Perpetual Systems Table 5.4: FIFO inventory tracking Date Purchases Sales Cost of Goods Sold July 1 July 9 500 , $2.00 5 $1,000.00 400 , $4.00 5 $1,600.00 400 , $2.00 5 $800.00 July 15 500 , $2.25 5 $1,125.00 July 20 Remaining Inventory Balance 100 , $2.00 5 $200.00 100 , $2.00 5 $ 200.00 500 , $2.25 5 1,125.00 $1,325.00 550 , $4.50 5 $2,475.00 100 , $2.00 5 $ 200.00 50 , $2.25 5 $112.50 450 , $2.25 5 1,012.50 $1,212.50 July 24 500 , $2.75 5 $1,375.00 50 , $2.25 5 500 , $2.75 5 $ 112.50 1,375.00 $1,487.50 July 28 425 , $5.00 5 $2,125.00 50 , $2.25 5 $ 112.50 125 , $2.75 5 $343.75 375 , $2.75 5 1,031.25 $1,143.75 Notice that a significant amount of detail is in tracking inventory using a perpetual approach; without computers, this becomes nearly impossible to do correctly when vast inventories and large volumes of transactions are involved. However, given a properly programmed computer, the task is inconsequential. Many businesses have a sufficient level of sophistication that inventory records are being updated as each sale is recorded at a point-of-sale terminal. Be sure to note exactly what is occurring on each date. For example, on July 20, 50 units remain after selling 550 units. This is determined by first noting that 600 units were on hand prior to the sale transaction (consisting of 100 units that are assumed to cost $2.00 each and 500 units that are assumed to cost $2.25 each). After removing 550 units from stock (assumed to consist of 100 units costing $2.00 and 450 units costing $2.25), only 50 remain at an assumed unit cost of $2.25. This cost analysis and allocation process must be repeated with each transaction that results in increasing or decreasing the inventory balance. With FIFO, keep in mind that the layers of inventory assumed to be sold are based on the chronological order in which they were purchased. The analysis provided within Table 5.4 provides a basis for actually recording the transactions into the general journal. Be sure to trace the amounts in the entries back into Table 5.4. Remember, Inventory is debited as purchases occur and credited as sales occur. Following are the necessary entries to record July's activity: 120 waL80144_05_c05_111-134.indd 10 8/29/12 2:44 PM CHAPTER 5 Section 5.3 Perpetual Systems 7-9-XX Accounts Receivable 1,600.00 Sales 1,600.00 Sold inventory on account 7-9-XX Cost of Goods Sold 800.00 Inventory 800.00 To record the cost of goods sold 7-15-XX Inventory 1,125.00 Accounts Payable 1,125.00 Purchased inventory on account 7-20-XX Accounts Receivable 2,475.00 Sales 2,475.00 Sold inventory on account 7-20-XX Cost of Goods Sold 1,212.50 Inventory 1,212.50 To record the cost of goods sold 7-24-XX Inventory 1,375.00 Accounts Payable 1,375.00 Purchased inventory on account 7-28-XX Accounts Receivable 2,125.00 Sales 2,125.00 Sold inventory on account 7-28-XX Cost of Goods Sold 1,143.75 Inventory 1,143.75 To record the cost of goods sold Using selected T-accounts in Table 5.5, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($3,156.25), and the ending inventory ($343.75). 121 waL80144_05_c05_111-134.indd 11 8/29/12 2:44 PM CHAPTER 5 Section 5.3 Perpetual Systems Table 5.5: T-accounts for sales, cost of goods sold, and inventory (FIFO) Sales Cost of Goods Sold Inventory 1,000.00 1,600.00 800.00 800.00 1,125.00 2,475.00 1,212.50 1,212.50 1,375.00 2,125.00 1,143.75 6,200.00 3,156.25 1,143.75 343.75 Last-In, First-Out Table 5.6 repeats the preceding facts but with the calculations applied on a LIFO basis. When a sale occurs, the assumption is that the units sold were from the last, or most recent, available units: last-in, first-out. Table 5.6: LIFO inventory tracking Date Purchases Sales Cost of Goods Sold July 1 July 9 500 , $2.00 5 $1,000.00 400 , $4.00 5 $1,600.00 400 , $2.00 5 $800.00 July 15 500 , $2.25 5 $1,125.00 July 20 100 , $2.00 5 $200.00 100 , $2.00 5 $ 200.00 500 , $2.25 5 1,125.00 $1,325.00 550 , $4.50 5 $2,475.00 500 , $2.25 5 $1,125.00 50 , $2.00 5 $100.00 50 , $2.00 5 100.00 $1,225.00 July 24 500 , $2.75 5 $1,375.00 July 28 Remaining Inventory Balance 50 , $2.00 5 $ 100.00 500 , $2.75 5 1,375.00 $1,475.00 425 , $5.00 5 $2,125.00 425 , $2.75 5 $1,168.75 50 , $2.00 5 75 , $2.75 5 $100.00 206.25 $306.25 Again, carefully observe the action on each date. For example, the 50 remaining units on July 20 consist of those from the very beginning stock (at $2.00 each) because it is assumed under LIFO that goods from the recent purchases are the ones being sold. With LIFO, the layers of inventory are assumed to be sold are based on the reverse order in which they were purchased. Following are the necessary entries to record July's LIFO-based activity: 122 waL80144_05_c05_111-134.indd 12 8/29/12 2:44 PM CHAPTER 5 Section 5.3 Perpetual Systems 7-9-XX Accounts Receivable 1,600.00 Sales 1,600.00 Sold inventory on account 7-9-XX Cost of Goods Sold 800.00 Inventory 800.00 To record the cost of goods sold 7-15-XX Inventory 1,125.00 Accounts Payable 1,125.00 Purchased inventory on account 7-20-XX Accounts Receivable 2,475.00 Sales 2,475.00 Sold inventory on account 7-20-XX Cost of Goods Sold 1,225.00 Inventory 1,225.00 To record the cost of goods sold 7-24-XX Inventory 1,375.00 Accounts Payable 1,375.00 Purchased inventory on account 7-28-XX Accounts Receivable 2,125.00 Sales 2,125.00 Sold inventory on account 7-28-XX Cost of Goods Sold 1,168.75 Inventory 1,168.75 To record the cost of goods sold Using selected T-accounts in Table 5.7, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($3,193.75), and the ending inventory ($306.25). 123 waL80144_05_c05_111-134.indd 13 8/29/12 2:44 PM CHAPTER 5 Section 5.3 Perpetual Systems Table 5.7: T-accounts for sales, cost of goods sold, and inventory (FIFO) Sales Cost of Goods Sold Inventory 1,000.00 1,600.00 800.00 800.00 1,125.00 2,475.00 1,212.50 1,225.00 1,375.00 2,125.00 1,168.75 6,200.00 3,193.75 1,168.75 306.25 The Average Cost Approach If Umps had instead applied the average cost approach, its cost allocation would appear as shown in Table 5.8. In reviewing this data, be sure to notice how the average cost of the total remaining supply of inventory must be recalculated with each purchase of inventory. The decimals associated with the pennies can become very important because the average unit cost is often multiplied times thousands of units (so don't round significantly!). Another important aspect of these calculations is that you cannot just average the three unit cost values ($2.00, $2.25, and $2.75) because that would fail to weight the cost by the number of units acquired or held at each cost point. Table 5.8: Cost allocation Date Beginning Inventory July 1 500 @ $2.00 Purchases July 28 500 @ $2.00 = $1,000.00 400 @ $4.00 = $1,600.00 400 @ $2.00 = $800.00 100 @ $2.00 = $200.00 100 @ $2.00 = 500 @ $2.25 = $200.00 1,125.00 $1,325.00 $1,325.00/600 units =$2.2083 average 500 @ $2.25 = $1,125.00 July 20 July 24 Cost of Goods Sold Remaining Inventory Balance 500 @ $2.00 = $1,000.00 July 9 July 15 Sales 550 @ $4.50 = $2,475.00 550 @ $2.2083 = 1,214.58 50 @ $2.2083 =$110.4217 50 @ $2.2083 = $ 110.42 500 @ $2.7500 = 1,375.00 $1,485.42 $1,458.42/550 units = $2.7008 average 500 @ $2.75 = $1,375.00 425 @ $5.00 = $2,125.00 425 @ $2.7008 = $1,147.82 125 @ $2.7008 =$337.60 CHAPTER 5 Section 5.3 Perpetual Systems Following are the revised journal entries necessary to reflect the average cost flow assumption. The account titles are not changed, only the amounts. 7-9-XX Accounts Receivable 1,600.00 Sales 1,600.00 Sold inventory on account 7-9-XX Cost of Goods Sold 800.00 Inventory 800.00 To record the cost of goods sold 7-15-XX Inventory 1,125.00 Accounts Payable 1,125.00 Purchased inventory on account 7-20-XX Accounts Receivable 2,475.00 Sales 2,475.00 Sold inventory on account 7-20-XX Cost of Goods Sold 1,214.57 Inventory 1,214.58 To record the cost of goods sold 7-24-XX Inventory 1,375.00 Accounts Payable 1,375.00 Purchased inventory on account 7-28-XX Accounts Receivable 2,125.00 Sales 2,125.00 Sold inventory on account 7-28-XX Cost of Goods Sold 1,147.84 Inventory 1,147.82 To record the cost of goods sold Using selected T-accounts in Table 5.9, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($3,162.40), and the ending inventory balances ($337.60). Let's see how these entries impact certain ledger accounts and the resulting financial statements: 125 waL80144_05_c05_111-134.indd 15 8/29/12 2:44 PM CHAPTER 5 Section 5.4 Comparing Methods Table 5.9: T-accounts for sales, cost of goods sold, and inventory (average costing) Sales Cost of Goods Sold Inventory 1,000.00 1,600.00 800.00 800.00 1,125.00 2,475.00 1,214.58 1,214.57 1,375.00 2,125.00 1,147.82 6,200.00 3,162.40 1,147.84 337.59 5.4 Comparing Methods A t this juncture, it is essential to see that alternative accounting methods result in different reported results for specific periods. With FIFO, Umps would report a gross profit of $3,043.75 ($6,200.00 sales 2 $3,156.25). With LIFO, Umps would report a gross profit of $3,006.25 ($6,200.00 sales 2 $3,193.75). With average costing, the gross profit amounted to $3,037.60 ($6,200.00 sales 2 $3,162.40). This outcome is consistent with a general rule of thumb that states LIFO will produce the lowest profits during a period of rising prices. Obviously, income is being charged with higher recent costs. Thus, many companies prefer to use LIFO because it reduces income on which taxes may be assessed. You will probably find it interesting to note that many countries outside of the United States do not permit the LIFO method. Some may find fault with allowing accounting choices of this nature. Before reaching a conclusion, consider that these differences in income are usually only temporary. If (when) the inventory is completely liquidated, the differences will reverse, and the lifetime income of the firm will equal out between the methods. For Umps the annual income difference is not very material; in some cases, accounting methods produce significantly different results, and sometimes they do not. The takeaway message is that a financial statement user should clearly examine financial statements and related disclosures to determine the methods in use. This is particularly important when trying to compare the performance of two firms, especially when each uses a different set of accounting methods and assumptions. Specific Identification In lieu of an inventory cost flow assumption like FIFO or weighted-average, some businesses may instead elect to use the specific identification method. The business must be able to match each unit of inventory with its actual cost. The item's cost remains in the Inventory account until it is sold, at which point it is assigned to Cost of Goods Sold. You can immediately discern that specific identification requires tedious record keeping and would be useful only for inventories with a fairly high per-unit cost and unique identifying characteristics. For example, an automobile dealership might find the technique practical and useful. 126 waL80144_05_c05_111-134.indd 16 8/29/12 2:44 PM CHAPTER 5 Section 5.5 The Importance of Accuracy The Retail Method A particular variation of the specific identification logic can be employed by retailers. It is known as the retail method. First and foremost, the retail method relies on an assumption that a company's markup is constant across all items of inventory. If this is true, the process for determining the cost of ending inventory would be to physically count all goods on hand at the end of the accounting period and determine their retail selling value (perhaps by simple reference to their marked selling prices). Then the total inventory at retail would be multiplied by the cost-to-retail percentage. The amount so determined would represent the cost of the inventory and establish the amount to report as inventory at the end of the accounting period. Lower-of-Cost-or-Market Adjustments Notwithstanding the cost flow assumption or other inventory valuation technique in use, it is imperative that a company not overstate the reported inventory value on the balance sheet. Sometimes a company may find that it is holding inventory that it cannot sell for its reported value. Obsolescence, defects, cost declines, and similar issues can impair the realizable value of selected inventory items. Accountants are required to periodically assess inventory on hand to ensure that it is not reported for more than its market value. This testing is known as a lower-of-cost-or-market method review. In other words, although accountants normally report assets at cost, they also avoid reporting them at more than their market value. That is, the accounting principle is to report the asset at the lower of its original cost or current market value. If the accountant finds that inventory is being carried in the accounting records at more than market value, a downward reduction in recorded valuations may be in order. These so-called write-downs, or impairments, from the recorded cost to the lower market value would be made by crediting the Inventory account and a debiting a Loss for Reduction in Market Value. This loss reduces income. In the context of inventory testing, market value is generally but not always considered to be the cost that it would take to replace the goods. This is not the same as expected selling price. Basically, if the inventory on hand can be replaced for a new investment amount that is below reported cost, an impairment reduction is in order. Once a reduction has been recorded, subsequent recoveries in value are not recognized. In essence, the reduced value becomes the new accounting amount to carry in inventory going forward. 5.5 The Importance of Accuracy W hat is the effect of a company's failure to reduce the carrying value of impaired inventory? Or, what is the effect of failing to adjust inventory records for goods that are shown to exist but cannot be physically located? In general, why does it matter that inventory records accurately reflect the goods on hand, as measured under generally accepted accounting principles? The general rule is that overstatements of ending inventory cause overstatements of income, whereas understatements of ending inventory cause understatements of income. Before giving consideration to offsetting tax effects, this 127 waL80144_05_c05_111-134.indd 17 8/29/12 2:44 PM CHAPTER 5 Concept Check offset is \"dollar for dollar.\" In other words, if inventory is overstated by $1, so is income for that year. Remember, the total cost of goods available for sale is ultimately allocated either to Cost of Goods Sold or Inventory (i.e., if the cost is not in Inventory, then it must be assigned to Cost of Goods Sold, thereby reducing income). Despite a company's best efforts to maintain an accurate perpetual inventory accounting system, errors and discrepancies will invariably creep into the accounting system. Goods may be lost, damaged, or stolen, or transactions may be recorded incorrectly. Therefore, a company should physically examine its inventory on hand at least once each year. This is a highly significant point. Perhaps you have worked for a company and been involved in taking the physical inventory. A physical inventory is the process of actually counting and valuing the inventory on hand. Discrepancies should be investigated, and the accounting records should be updated to reflect the balance that is finally determined to be correctthus the need for accuracy. Employees are often unaware of the connection between a careful count and the final measure of a firm's income. Concept Check The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 235.) 1. Because \u0007 of a mathematical error, the 20X8 ending inventory included goods at a $170 figure that had actually cost $710. As a result of this error, a. net income for 20X8 is overstated. b. net income for 20X8 is understated. c. operating expenses for 20X8 are understated. d. total liabilities at the end of 20X8 are overstated. 2. The \u0007 inventory cost flow assumption in which the oldest costs incurred become part of cost of goods sold when units are sold is a. LIFO. b. FIFO. c. the weighted average. d. retail. 3. The LIFO inventory valuation method a. is acceptable only if a company sells its newest goods first. b. will result in higher income levels than FIFO in periods of rising prices. c. \u0007will result in a match of fairly current inventory costs against recent selling prices on the income statement. d. cannot be used with a periodic inventory system. 128 waL80144_05_c05_111-134.indd 18 8/29/12 2:44 PM CHAPTER 5 Critical Thinking Questions 4. Stanley \u0007 Company sells two different products. The following information is available at year-end: Inventory Item A B Units 100 200 Cost per Unit $4 5 Market Value per Unit $6 3 Applying the lower-of-cost-or-market rule to each item, what will be Stanley's ending inventory balance? a. $1,000 b. $1,200 c. $1,400 d. Some other amount 5. Which \u0007 of the following accounting systems maintains a running (continuous) record of merchandising purchases and sales by inventory item? a. Perpetual b. Gross profit c. Periodic d. Retail Critical Thinking Questions 1. What \u0007 items are reported as inventory for (a) merchandising companies and (b) manufacturing companies? 2. The Potter Company purchased the following merchandise on December 28: Supplier Pax Company James Manufacturing Terms FOB destination FOB shipping point Amount $1,800 2,500 Both purchases were shipped December 30, but neither had been received by December 31. Should the purchases be included in Potter's December 31 ending inventory? Explain. 3. What are goods on consignment? Who has title to goods on consignment? 4. \u0007Why is it necessary to take a physical count of inventory at the end of each accounting period? 5. Why is the specific identification method of inventory valuation used infrequently? 6. Discuss the difference between the physical flow of goods and a cost flow assumption. 7. \u0007In a period of rising prices, which inventory valuation method (LIFO or FIFO) tends to result in the following? a. Highest cost of goods sold b. Lowest inventory valuation c. Highest income taxes 129 waL80144_05_c05_111-134.indd 19 8/29/12 2:44 PM CHAPTER 5 Key Terms 8. Discuss \u0007 the advantages of a perpetual inventory system when compared with a periodic system. 9. \u0007Which type of inventory system, periodic or perpetual, is increasing in popularity? Briefly explain. 10. \u0007Why are two journal entries required to record a sale under a perpetual inventory system? Key Terms average cost A cost flow assumption. lower-of-cost-or-market method A method whereby inventories are accounted for at acquisition cost or market value, whichever is lower. consignment of inventory An agreement whereby the owner of inventory places it with another party in the hope that it will resell the goods to an end consumer. multiple-step income statement A statement format that divides business results into separate categories. cost flow assumptions Inventory-costing methods such as first-in, first-out; last-in, last-out; or average cost. periodic inventory system An updating system in which inventory accounts are only updated on designated intervals, such as at the end of each accounting period. FIFO See first-in, first-out. first-in, first-out (FIFO) An inventorycosting method, the assumption is that the units are sold from the first, or earliest, available units. FOB (free on board) A common freight nomenclature indicating the point at which the ownership of goods shifts from the seller to the buyer. perpetual inventory system An updating system in which inventory records are continuously updated for all inventory changes. physical inventory The process of actually counting and valuing inventory on hand. FOB destination A common freight nomenclature indicating that the seller owns goods until they are delivered and must bear the cost of shipping. retail method An inventory-costing method that relies on the assumption that a company's markup is constant across all items of inventory. FOB shipping point A common freight nomenclature indicating that once goods are shipped, they are deemed the buyer's property. specific identification The method in which a business must match each unit of inventory with its actual cost. 130 waL80144_05_c05_111-134.indd 20 8/29/12 2:44 PM CHAPTER 5 Exercises Exercises 1. \u0007Inventory errors and income measurement. The income statements of Keagle Company for 20X3 and 20X4 follow. Sales 20X3 20X4 $ 100,000 $109,000 62,000 74,000 $ 38,000 $ 35,000 26,000 22,000 $ 12,000 $ 13,000 Cost of goods sold Gross profit Expenses Net income A recent review of the accounting records discovered that the 20X3 ending inventory had been understated by $4,000. a.\tPrepare corrected 20X3 and 20X4 income statements. b. What is the effect of the error on ending owner's equity for 20X3 and 20X4? 2. \u0007Specific identification method. Boston Galleries uses the specific identification method for inventory valuation. Inventory information for several oil paintings follows. Painting Cost Woods $11,000 4/19 Purchase Sunset 21,800 6/7 Purchase Earth 31,200 12/16 Purchase Moon 4,000 1/2 Beginning inventory Woods and Moon were sold during the year for a total of $35,000. Determine the firm's a. cost of goods sold. b. gross profit. c. ending inventory. 3. \u0007Inventory valuation methods: basic computations. The January beginning inventory of the White Company consisted of 300 units costing $40 each. During the first quarter, the company purchased two batches of goods: 700 units at $44 on February 21 and 800 units at $50 on March 28. Sales during the first quarter were 1,400 units at $75 per unit. The White Company uses a periodic inventory system. 131 waL80144_05_c05_111-134.indd 21 8/29/12 2:44 PM CHAPTER 5 Exercises Using the White Company data, fill in the following chart to compare the results obtained under the FIFO, LIFO, and weighted-average inventory methods. FIFO LIFO Weighted Average $ $ $ Goods available for sale Ending inventory, March 31 Cost of goods sold 4. \u0007Analysis of LIFO versus FIFO. Indicate whether LIFO or FIFO best describes each of the following: a.\tGives highest profits when prices fall. b.\tYields lowest income taxes when prices rise. c.\t\u0007Generates an ending inventory valuation that somewhat approximates replacement cost. d.\tMatches recent costs against current selling prices on the income statement. e.\u0007\tComes closest to approximating the physical flow of goods of a fruit and vegetable dealer. f.\tResults in lowest cost of goods sold in inflationary periods. 5. \u0007Perpetual inventory system: journal entries. At the beginning of 20X3, Beehler Company implemented a computerized perpetual inventory system. The first transactions that occurred during 20X3 follow. Purchases on account: 500 units , $4 5 $2,000 Sales on account: 300 of the above units 5 $2,550 Returns on account: 75 of the above unsold units The company president examined the computer-generated journal entries for these transactions and was confused by the absence of a Purchases account. a.\tDuplicate the journal entries that would have appeared on the computer printout. b.\tCalculate the balance in the firm's Inventory account. c.\tBriefly explain the absence of the Purchases account to the company president. 132 waL80144_05_c05_111-134.indd 22 8/29/12 2:44 PM CHAPTER 5 Problems Problems 1. \u0007Inventory errors. The income statements of Diamond Company for the years ended December 31, 20X1 and 20X2, follow. Net sales Cost of goods sold Beginning inventory Add: Net purchases Goods available for sale Less: Ending inventory Cost of goods sold Gross profit Operating expenses Net income 20X1 $440,000 $ 95,000 380,000 $475,000 109,000 20X2 $483,000 $109,000 404,000 $513,000 127,000 366,000 $ 74,000 58,000 $ 16,000 386,000 $ 97,000 67,000 $ 30,000 Diamond uses a periodic inventory system. A detailed review of the accounting records disclosed the following: A \u0007 review of 20X1 purchase invoices revealed that a clerk had incorrectly recorded a $12,600 purchase as $1,260. \u0007A $4,800 purchase was made on December 30, 20X2, terms FOB shipping point. The invoice was not recorded in 20X2, nor were the goods included in the 20X2 ending physical inventory count. Both the goods and invoice were received in early 20X3, with the invoice being recorded at that time. \u0007Goods costing $3,000 were accidentally excluded from the 20X1 ending physical inventory count. These goods were sold during 20X2, and all aspects of the sale were properly recorded. Instructions a.\tPrepare corrected income statements for 20X1 and 20X2. b.\t\u0007Determine the impact of the preceding errors on the December 31, 20X2, owner's equity balance. 2. \u0007Inventory valuation methods: computations and concepts. Wave Riders Surfboard Company began business on January 1 of the current year. Purchases of surfboards were as follows: 1/3: 100 boards , $125 3/17: 50 boards , $130 5/9: 246 boards , $140 7/3: 400 boards , $150 10/23: 74 boards , $160 133 waL80144_05_c05_111-134.indd 23 8/29/12 2:44 PM CHAPTER 5 Problems Wave Riders sold 710 boards at an average price of $250 per board. The company uses a periodic inventory system. Instructions a.\t\u0007Calculate cost of goods sold, ending inventory, and gross profit under each of the following inventory valuation methods: First-in, first-out Last-in, first-out Weighted average b.\tWhich of the three methods would be chosen if management's goal is to (1) produce an up-to-date inventory valuation on the balance sheet? (2) approximate the physical flow of a sand and gravel dealer? (3) \u0007report low earnings (for tax purposes) for a separate electronics company that has been experiencing declining purchase prices? 3. \u0007Lower-of-cost-or-market method. Davenport Opticians began business on September 1 of the current year. The following purchases were made during the first few months of operation: Reading Glasses Sunglasses Contact Lenses 9/2 1,000 , $20 450 , $10 2,500 , $5 10/15 750 , $22 200 , $15 2,000 , $6 12/6 300 , $25 1,500 , $7 The December 31 physical inventory count revealed the following items on hand: 650 reading glasses, 400 sunglasses, and 1,000 contact lenses. Total sales through year-end were $85,000, and operating expenses (excluding cost of goods sold) totaled $17,800. Davenport uses the FIFO inventory valuation method coupled with a periodic inventory system. Instructions a.\t\u0007Compute the company's inventory as of December 31. In addition, calculate cost of goods sold and net income through the end of the year. b.\t\u0007Assume that the manufacturer of contact lenses announced a price decrease to $6.50. Determine the impact of the announcement on the firm's ending inventory valuation. c.\t\u0007Prepare the journal entry necessary to value the inventory at the lower-of-cost-ormarket value. 134 waL80144_05_c05_111-134.indd 24 8/29/12 2:44 PM chapter 6 Plant Assets Copyright Barbara Chase/Corbis/AP Images Learning Goals waL80144_06_c06_135-154.indd 1 Apply the principles of ordinary and necessary cost, along with other special rules related to capitalization of expenditures. Understand conceptual and applied issues pertaining to alternative depreciation methods. Know the principles that govern the accounting for asset-related expenditures subsequent to acquisition. Record transactions related to the disposal of assets. Understand the basic elements of accounting for natural resources and related depletion. Understand the basic elements of accounting for intangibles and related amortization. 8/29/12 2:44 PM CHAPTER 6 Chapter Outline Chapter Outline 6.1 Ordinary and Necessary Costs Special Rules Materiality Issues Depreciation 6.2 Depreciation Methods The Straight-Line Method of Depreciation The Double-Declining-Balance Method of Depreciation The Units-of-Output Method of Depreciation Revisions in Depreciation Two Sets of Books? 6.3 Asset-Related Costs Subsequent to Acquisition Sale or Abandonment of Property, Plant, and Equipment Impairment Taking a \"Big Bath\" Natural Resources Intangible Assets Research and Development Costs Goodwill R emember that a classified balance sheet includes a separate category entitled Property, Plant, and Equipment. This section typically follows the Long-Term Investments section. Property, Plant, and Equipment (PP&E) should reflect only the physical assets that are used in the business's production activities. This would include land, buildings, and equipment. Idle facilities or assets acquired for speculative purposes should be shown in long-term investments. Within the PP&E section, assets are usually listed according to their useful lives. Land is listed first because it has a permanent life and is followed by buildings, then equipment. Table 6.1 shows a typical balance sheet disclosure. Table 6.1: A typical balance sheet disclosure Land Buildings $ 250,000 $ 600,000 Less: Accumulated depreciation (150,000) Equipment $850,000 Less: Accumulated depreciation (550,000) 450,000 300,000 $1,000,000 This balance sheet section would appear within a company's balance sheet, similar to Exhibit 6.1. 136 waL80144_06_c06_135-154.indd 2 8/29/12 2:44 PM waL80144_06_c06_135-154.indd 3 (150,000) $ 850,000 (550,000) Less: Accumulated depreciation Equipment Less: Accumulated depreciation Total Assets Receivable from employee Other Assets Goodwill Intangible Assets $ 600,000 Building and equipment Land Property, Plant, & Equip. Cash value of insurance Stock investments Long-term Investments 300,000 450,000 $ 250,000 40,000 $100,000 10,000 140,000 Inventories Prepaid insurance 250,000 Accounts receivable $ 100,000 10,000 350,000 1,000,000 140,000 500,000 $ 2,000,000 $ Total Liabilities and Equity Total stockholder's Equity Retained earnings Capital stock Stockholder's equity Total Liabilites Mortgage liabity Note payable Long-term Liabilities Current portion of note Taxes payable Interest payable Accounts payable Current Liabilities Current Assets Cash Liabilities Assets Mega Company Balance Sheet December 31, 20XX 980,000 $ 400,000 135,000 $ 235,000 119,000 12,000 5,000 $ 114,000 2,000,000 1,380,000 $ 620,000 370,000 $ 250,000 Section 6.1 Ordinary and Necessary Costs CHAPTER 6 Exhibit 6.1: Mega Company balance sheet 6.1 Ordinary and Necessary Costs T he amount of cost reported for an item of PP&E is the ordinary and necessary cost to get the item in place and in condition for its intended use. These costs are referred to as capital expenditures. Capital expenditures include the direct purchase price and the cost of permits, sales tax, freight, installation, and other usual costs to prepare the item for use. Costs that are not ordinary and necessary, such as repairing damage caused by an accident during installation of equipment, would be expensed. Sometimes, new 137 8/29/12 2:44 PM CHAPTER 6 Section 6.1 Ordinary and Necessary Costs machinery requires employee training on its use. Although there are a few exceptions, such costs are normally expensed as incurred. Equipment often has a list price, but the actual negotiated purchase price may be reduced by discounts and rebates. Perhaps you have purchased a car at less than the amount listed on the window sticker. Accountants use the negotiated price as the basis for accounting measurement, as will be apparent in the following example. The following journal entry illustrates the recording of a purchase of a new item of equipment. The equipment had a list price of $500,000 but a negotiated purchase price of $425,000. Sales tax was $3,000. Freight and normal installation costs totaled $25,000. The item was dropped during installation, and an additional $10,000 was spent to repair damage. 05-14-X3 Equipment 453,000.00 Repair Expense 10,000.00 Cash 463,000.00 Purchased equipment Special Rules If the preceding transaction was financed with debt rather than cash (i.e., credit Notes Payable), none of the interest cost would be added to the asset. Instead, interest is usually charged to Interest Expense as incurred. There is an exception for interest costs associated with debt that is used to finance construction of a particular asset; interest incurred during the active period of construction is added to the cost of the account (it is deemed to be an ordinary and necessary cost associated with the asset's acquisition). The interest capitalization rules can be quite complex and are usually covered in advanced accounting courses. Certain costs normally accompany the acquisition of land, like title fees, legal fees, and surveys. Additional costs may be needed to ready the land for its intended use. Examples include zoning costs, drainage, and grading. Because these costs are ordinary and necessary, they may be added to the Land account. To illustrate, assume that Quantum Realty acquired a tract of land that it intended to develop into land for commercial use. A creek that meandered across the property adversely impacted the land. Quantum paid $1,000,000 for the land and incurred surveying costs of $40,000. It was necessary to obtain a floodplain permit costing $10,000, and an additional $150,000 was spent rerouting the creek into a channel. All these costs are considered to be ordinary and necessary to get the land in condition for its intended use, and the land should be recorded into the Land account as follows: 138 waL80144_06_c06_135-154.indd 4 8/29/12 2:44 PM CHAPTER 6 Section 6.2 Depreciation Methods 04-15-X5 Land 1,200,000.00 Cash 1,200,000.00 To record cost of land, including costs associated with surveys, permits, and grading Materiality Issues Look around your room and consider how many expenditures were for long-lived assets that were relatively minor in valueperhaps a trashcan, a telephone, a picture on the wall, and so forth. If your room were a business, would you capitalize those expenditures and depreciate them over their useful life? Or would you decide that the cost of record keeping exceeded the benefit? If so, you might choose to simply expense the cost as incurred (as many businesses do). The reason is materiality; no matter which way that you account for the cost, it is not apt to bear on anyone's process about the company. Depreciation Once an asset's cost has been appropriately determined, recorded, and appropriately posted to the ledger, it becomes necessary to depreciate the asset. As you may recall from Chapter 3, depreciation is not intended to value or revalue the asset. Instead, depreciation is the process of allocating an asset's cost to all accounting periods benefited by the asset's use (i.e., spread the cost over the asset's service life). The number of periods benefited is known as the service life of the asset. Your determination of the service life of an asset will depend on professional judgment, taking into account facets such as the rate of the asset's physical deterioration and the possibility of obsolescence. You should observe that service life might be completely different from physical life. For example, how many computers have you owned, and why did you replace an old one? In all likelihood, its service life to you had been exhausted, even though it was still physically functional. Some assets like land have a permanent life and are rarely depreciated. 6.2 Depreciation Methods R ecall from Chapter 5 that companies can use different inventory methods. This is also true for depreciation. The cost of an asset and its service life are important factors that will drive the depreciation amount, but you must also select a specific depreciation method. The method reflects the pattern by which the cost is allocated to specific periods. We will look at three specific techniques: (1) straight line, (2) double-declining balance, and (3) units of output. Before looking at the unique features of these methods, it is first necessary to learn a few more terms. You have already been made familiar with the concepts of cost and service life. You also need to know about salvage value. Salvage value is also called residual value and is the amount one expects to receive when selling or trading at the end of an asset's service life. Salvage value is excluded from the amount to be depreciated. As such, the 139 waL80144_06_c06_135-154.indd 5 8/29/12 2:44 PM CHAPTER 6 Section 6.2 Depreciation Methods depreciable base is equal to cost minus the salvage value. At any point in time, an asset's total cost minus accumulated depreciation to date can be referred to as the remaining net book value. The Straight-Line Method of Depreciation The straight-line method spreads the depreciable base over the service life, with an equal amount of depreciation assigned to each period. Each accounting period should bear an appropriate amount of depreciation. If the business produces monthly financial statements, this means that 1/12th of the annual amount should be allocated to each month for purposes of calculating business income. The following examples illustrate calculations of the annual depreciation expense, assuming the asset is acquired on the first day of the year. For assets not acquired on the first day of a year (i.e., most assets), a convention must be adopted. Thus, some business treat all assets acquired in the first half of the year as being acquired on the first day of the year (and assets acquired in the last half of the year as not being acquired until the last moment of the year). Other businesses are far more precise and allocate depreciation down to the number of days in use in a particular period. The annual charge for depreciation is determined by dividing the depreciable base by the service life. If an asset has a $550,000 cost, $50,000 salvage value, and a 5-year life, then annual depreciation would be equal to $100,000 [($550,000 2 $50,000)/5 years 5 $100,000]. Table 6.2 lists the amounts reported for each of the 5 years. Table 6.2: Annual depreciation expense and accumulated depreciation for 5 years Annual Depreciation Expense Accumulated Depreciation Year 1 $100,000 $100,000 Year 2 100,000 200,000 Year 3 100,000 300,000 Year 4 100,000 400,000 Year 5 100,000 500,000 The appropriate journal entry for each year would be as follows: 12-31-XX Depreciation Expense 100,000.00 Accumulated Depreciation 100,000.00 To record annual depreciation expense As a general rule, the annual depreciation would be included in each period's income determination. Remember that Depreciation Expense is a temporary account that is closed each year. In contrast, Accumulated Depreciation is a real account appearing on the balance sheet. Its value builds over time (because the account is not closed), and the appropriate balance sheet presentation would be as follows at the end of year 4: 140 waL80144_06_c06_135-154.indd 6 8/29/12 2:44 PM CHAPTER 6 Section 6.2 Depreciation Methods Equipment $550,000 Less: Accumulated depreciation 400,000 $150,000 The Double-Declining-Balance Method of Depreciation The double-declining-balance (DDB) method \"front loads\" depreciation to the early periods of an asset's service life. It is sometimes used when the service quality produced by an asset declines over time or if repair and maintenance costs tend to rise as an asset ages (i.e., the reducing depreciation charge is offset with a rising maintenance charge). Annual depreciation under the DDB method is determined by multiplying the beginningof-year net book value of an asset by twice the straight-line rate. Because net book value is decreasing, so is the annual depreciation charge. The mechanics of the DDB method is best shown with a simple example. Let's return to our $550,000 asset with a 5-year life. First, the straight-line rate is 20% per year (one fifth each year), and twice that rate is 40%. Thus, the first year's double-declining depreciation is 40% of $550,000 (we initially ignore salvage value with the DDB method), or $220,000. This leaves a remaining net book value of $330,000 ($550,000 2 $220,000), and the second year's depreciation expense is only $132,000 ($330,000 3 40%). Table 6.3 lists the entire pattern of depreciation. Table 6.3: Entire pattern of depreciation Annual Depreciation Expense Accumulated Depreciation Illustrative Calculation Year 1 $220,000 $220,000 Year 2 132,000 352,000 ($550,000 2 $220,000) 3 40% Year 3 79,200 431,200 ($550,000 2 $352,000) 3 40% Year 4 47,520 478,720 ($550,000 2 $431,200) 3 40% Year 5 21,280 500,000 See text. $550,000 3 40% You probably noted how salvage was not reduced against the balance each year in the fundamental calculation of the DDB method. However, it is not ignored completely. In the year when calculated accumulated depreciation begins to exceed the depreciable base, depreciation is discontinued. In our example, this did not occur until the final year 5. Only $21,280 of depreciation was recorded in the final year (despite the fact that the DDB calculations return a higher value). The suspStep by Step Solution
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