Exam 3 Review
Lower-of-Cost-or-Market (LCM)
Chapters 9, 10, 11, 12
§  GAAP: Value inventory at
§  Cost (FIFO, LIFO, weighted-average)
§  Or current market value
§  Whichever is lower
1
Determining Market Value
2
Net Realizable Value
§  Market value middle of three values
§  Highest possible market value
§  Replacement cost
§  Net Realizable Value (NRV): Ceiling
§  NRV less Normal Profit: Floor
Selling price
– Completion and disposal costs
Net realizable value
3
Net Realizable Value
Net Realizable Value
§  For block of granite
Selling price
– Completion and disposal costs
Net realizable value
4
§  For a barrel of oil
Selling price
$30
– Completion and disposal costs
$0
$30
Selling price ($30) = Cost of goods sold ($30)
Net realizable value
5
$100
$20
$80
Selling price ($100) = Cost of goods sold ($80 + $20)
6
1
Net Realizable Value
NRV − Gross Profit
§  Highest possible market value
§  Net income ê at write down
§  Lowest possible market value
Selling price
§  Only impacts net income at write down
§  Net income unchanged at sale
§  Selling price = Cost of goods sold
§  Gross profit = $0
$20
$80
Net realizable value
§  Many companies use NRV as market
IFRS always uses NRV as market value
$100
– Completion and disposal costs
– Gross profit (Price × Gross profit %)
$30
Net realizable value − Normal profit
$50
7
NRV − Gross Profit
8
Determining Market Value
§  Lowest possible market value
§  Net income ê at write down
§  Net income é at sale
Net Realizable Value
(Ceiling)
Which value
should we use?
§  Recognize gross profit at time of sale
Net Realizable Value
less Normal Profit
(Floor)
9
Determining Market Value
10
Determining Market Value
§  Net Realizable Value (NRV): Ceiling
§  NRV less Normal Profit: Floor
§  Replacement cost
Net Realizable Value
(Ceiling)
Which value
should we use?
Middle value
§  Cost to replace inventory today
Pick middle value
11
Replacement
Cost
Net Realizable Value
less Normal Profit
(Floor)
12
2
Determining Market Value
Determining Market Value
Replacement
Cost
Net Realizable Value
(Ceiling)
Net Realizable Value
(Ceiling)
Which value
should we use?
Middle value
Net Realizable Value
less Normal Profit
(Floor)
Replacement
Cost
13
Lower-of-Cost-or-Market
FIFO
LIFO
Average
§  Inventory FIFO cost = $20 per unit
§  Determine market value
§  Selling price = $30
§  Cost to complete and dispose = $4
§  Replacement cost = $21.50
§  Normal profit margin of = $5
Ceiling = NRV
Market
14
Lower of Cost or Market
Pick middle value
Cost
Net Realizable Value
less Normal Profit
(Floor)
Which value
should we use?
Middle value
Replacement cost
Floor = NRV −Profit
GAAP
LCM
16
Lower of Cost or Market
Lower of Cost or Market
§  Compare market value to cost
§  Choose lower amount
Ceiling Calculation
Selling price
Less cost to complete
= Ceiling (NRV)
$30.00
$4.00
$26.00
Market Value (Replacement Cost)
Replacement Cost
$21.50
$21.50
Cost (FIFO Basis)
Floor Calculation
Ceiling (NRV)
Less gross profit
= Floor
$26.00
$5.00
$21.00
$20.00
17
18
3
Lower of Cost or Market
AJE: Adjusting Cost to Market
§  Inventory LIFO cost of $95.00 per unit
§  Determine market value (middle value)
§  Debit
§  Loss on LCM write-down OR
§  Cost of goods sold
§  Replacement cost = $80.00
§  NRV = $100.00
§  NRV reduced by normal profit = $85.00
Middle
Lower
NRV (Ceiling)
NRV less GP (Floor)
$100
$85
§  Credit
§  Inventory OR
§  Allowance for LCM write-down
Replacement
$80
Cost (LIFO Basis)
Market Value
$95
$85
19
20
AJE: Adjusting Cost to Market
Purchase Commitment #3
§  Write-off reduces net income
§  Market value becomes new book value
§  No write-up if values increase
Date
Description
Loss on LCM write-down
Debit
100,000
Allowance on LCM write-down
Date
Description
Cost of goods sold
§  October 1, 2011
No JE §  Signed commitment, requires purchase of
inventory for $500,000 by February 1, 2012
§  December 31, 2011
Credit
AJE
Debit
100,000
Inventory
JE
Credit
100,000
§  Market value of inventory, $400,000
§  February 1, 2012
100,000
§  Purchased inv, market value $530,000
21
22
§  October 1, 2011
No JE §  Signed commitment, requires purchase of
Purchase Commitment #3
inventory for $500,000 by February 1, 2012
§  December 31, 2011
§  October 1, 2011
AJE
No JE §  Signed commitment, requires purchase of
JE
§  December 31, 2011
AJE
§  Market value of inventory, $400,000
Date Description
12/31 Estimated loss purchase commit
Estimated liability purch comm
Debit
100,000
§  Market value of inventory, $400,000
§  February 1, 2012
inventory for $500,000 by February 1, 2012
Date
2/1
Credit
100,000
23
§  Purchased inv, market value $530,000
Description
Inventory
Cash
Estimated liability purch comm
Est. loss purchase commit
Debit
500,000
Credit
500,000
100,000
100,000
24
4
Gross Profit Method
Gross Profit Method
Last Year
§  Rewrite to solve for ending inventory
Beginning inventory
300
100%
CGS
210
70%
Beg Inventory
4.5
90
30%
Purchases
150
Gross profit
+
Purchases
=
Cost of goods available for sale
–
Cost of goods sold
=
Ending inventory
25
Gross Profit Method
Current Year
Sales
Sales
200
Sales
$ 200,000
Beginning inventory
$ 4,500
Purchases
150,000
Goods available for sale
154,500
Ending inventory
?
Cost of goods sold (200,000 × 70%)
140,000
Gross profit
(200,000 × 30%)
$ 60,000
26
Convert Gross Profit %
Estimated ending inventory $14,500
($154,500 - $140,000)
Selling Price
Cost
Gross Profit
100
80
20
Gross Profit as a Percentage of Sales
20 / 100 = 20%
Sales
Beginning inventory
Purchases
Goods available for sale
Ending inventory
Cost of goods sold
Gross profit
Gross Profit as a Percentage of Cost
$ 200,000
$
20 / 80 = 25%
4,500
150,000
154,500
14,500
Harder: Textbook uses conversion formula
Easier: Make up numbers
$
140,000
60,000
27
Convert Gross Profit %
Retail Inventory Method
§  Given gross profit as % of cost, 25%
§  Convert to gross profit as % of sales
§  Developed for department stores
§  High-volume, many items, low prices
§  More accurate than gross profit method
Assume a gross profit of $1,
Cost × 25% = 1
Cost = 4
§  Uses current cost-to-retail % of goods
currently available for sale
Selling Price
Cost
Gross Profit
5
4
1
§  Accepted by
§  GAAP
§  IRS (tax purposes)
Gross Profit as a Percentage of Sales
1 / 5 = 20%
28
29
30
5
Step 1: Retail Inventory Method
Step 2: Retail Inventory Method
§  Keep track of each inventory item at
both cost and selling price (retail)
§  Determine cost of goods available at
Item
Cost
Retail
98395 Chair
74932 Table
$180
600
$390
900
39482 Sofa
450
870
§  Cost
§  Retail
§  Calculate cost-to-retail %
Goods available at purchase cost
Goods available at retail price
Cost-to-retail %
31
Step 3: Retail Inventory Method
32
Step 4: Retail Inventory Method
Goods available for sale at retail
– Sales at retail
Cost
Retail ending inv
Retail ×
Ending inventory at retail
= Cost ending inv
33
Retail Inventory Method
Retail Inventory Method
Cost
Retail
$27,000
$45,000
Net purchases
$180,000
$300,000
Goods available
$207,000
$345,000
Beginning inventory
Sales
34
Cost
Inventory, May 1
$ 27,000
Net purchases for May
180,000
Goods available for sale
207,000
Cost ratio:
(207,000 ÷ 345,000) = 60%
Sales for May
Ending inventory at retail
Ending inventory at cost
?
$310,000
Cost / Retail = 207 / 345 = 60%
35
$
$
Retail
45,000
300,000
345,000
(310,000)
35,000
36
6
Retail Inventory Method
Cost
Inventory, May 1
$ 27,000
Net purchases for May
180,000
Goods available for sale
207,000
Cost ratio:
(207,000 ÷ 345,000) = 60%
Sales for May
x
Ending inventory at retail
Ending inventory at cost
$ 21,000
?
$
$
Retail Inventory Method
Retail
45,000
300,000
345,000
§  Incorporate cost flow assumptions to
approximate
(310,000)
35,000
§  Average cost
§  Lower-of-average-cost-or-market
(conventional)
§  LIFO
§  FIFO (less frequently used)
37
Terminology
Term
Definition
Initial markup
Original amount of markup from
cost to selling price
Additional markup
Increase in selling price
subsequent to initial markup
Markup cancellation
Elimination of an additional markup
Markdown
Reduction in selling price
below the original selling price
38
Retail Inventory: Average Cost
§  Include markups and markdowns in the
computation of the Cost-to-Retail %
Beginning inventory + Net purchases
Cost-to-retail %
Markdown cancellation Elimination of a markdown
Begin inventory + Net purchases
+ Net Markups − Net Markdowns
Markup and markdown apply to selling price only, not cost
39
Retail Inventory: Average Cost
Cost
Beginning inventory
$21,000
$35,000
$200,000
$304,000
Goods available
$207,000
$345,000
Sales
Retail Inventory: Average Cost
Cost
Retail
Inventory, June 1
$ 21,000 $
35,000
Plus: Net Purchases
200,000
304,000
Net Markups
8,000
Less: Net Markdowns
(4,000)
Goods available for sale
221,000
343,000
Cost ratio:
(221,000 ÷ 343,000) = 64.43%
Less: Sales for June
(300,000)
Ending inventory at retail
$
43,000
Ending inventory at cost
?
Retail
Net purchases
$300,000
Net markups
$8,000
Net markdowns
$4,000
40
41
42
7
Retail Inventory: Average Cost
Avg Cost LCM: Conventional
Cost
Retail
Inventory, June 1
$ 21,000 $
35,000
200,000
304,000
Plus: Net Purchases
Net Markups
8,000
Less: Net Markdowns
(4,000)
221,000
343,000
Goods available for sale
Cost ratio:
(221,000 ÷ 343,000)
343,000) == 64.43%
(300,000)
Less: Sales for June
x
Ending inventory at retail
$
43,000
Ending inventory at cost
$ 27,705
?
§  GAAP: Value inventory at LCM
§  Method to approximate average LCM
§  When calculating cost-to-retail ratio
§  Include net markups
§  Do NOT include net markdowns
Beginning inventory + Net purchases
Cost-to-retail %
43
Avg Cost LCM: Conventional
Cost
Beginning inventory
Net purchases
$21,000
$35,000
$304,000
Sales
Inventory, June 1
Plus: Net Purchases
Net Markups
$300,000
Net markups
$8,000
Net markdowns
$4,000
Less: Net Markdowns
Goods Available for Sale
Cost ratio:
(221,000 ÷ 347,000) =
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
Exclude net markdowns from cost-to-retail percentage
(Larger denominator decreases cost percentage)
Include net markdowns in ending inventory at retail
$
Cost
Retail
21,000 $
35,000
200,000
304,000
8,000
347,000
(4,000)
221,000
343,000
63.69%
$
(300,000)
43,000
?
45
Avg Cost LCM: Conventional
Inventory, June 1
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods Available for Sale
Cost ratio:
(221,000 ÷ 347,000) =
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
$
§  Reason to use LIFO
§  Tax advantages
§  Better matching of costs and revenues
§  Two LIFO methods
§  Stable prices: LIFO Retail
§  Fluctuating prices: Dollar-Value LIFO Retail
63.69%
$
$
46
LIFO Inventory
Cost
Retail
35,000
21,000 $
304,000
200,000
8,000
347,000
(4,000)
343,000
221,000
x
44
Avg Cost LCM: Conventional
Retail
$200,000
Begin inventory + Net purchases
+ Net Markups − Net Markdowns
(300,000)
43,000
?
27,387
47
48
8
LIFO Methods
The LIFO Retail Method
§  One layer per year
§  Each layer has cost-to-retail percentage
§  Markups and markdowns in current
period are used to calculate cost-toretail percentage for current layer
§  Assume retail prices of goods stable
§  Establish a LIFO base layer (beginning
inventory) and add (or subtract) layer
from current period
§  Calculate cost-to-retail % each layer
49
50
The LIFO Retail Method
The LIFO Retail Method
§  Each layer has cost-to-retail %
Beginning inventory
Net purchases
Beginning inventory at cost
Cost-to-retail %
Sales
Begin inventory at retail
Net purchases at cost
Cost-to-retail %
Cost
Retail
$21,000
$35,000
$200,000
$304,000
$300,000
Net markups
$8,000
Net markdowns
$4,000
Calculate cost-to-retail percentage for each layer
Net purchases at retail
+ Net Markups − Net Markdowns
51
The LIFO Retail Method
Inventory, June 1 (60%)
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods Available (Less Beg. Inv.)
Goods Available (Incl. Beg. Inv.)
LIFO Cost ratio:
Requires a composite ratio
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
$
The LIFO Retail Method
Cost
Retail
21,000 $
35,000
200,000
304,000
8,000
(4,000)
200,000
308,000
221,000
343,000
$
52
Cost
Retail
Inventory, June 1 (60%)
$
21,000 $
35,000
Plus: Net Purchases
200,000
304,000
Net Markups
8,000
Beginning
inventory layer 21,000 / 35,000 = 60%
Less: Net Markdowns
(4,000)
Goods Available (Less Beg. Inv.)
200,000
308,000
Goods Available (Incl. Beg. Inv.)
221,000
343,000
LIFO Cost ratio:
Requires a composite ratio
Less: Sales for June
(300,000)
Ending inventory at retail
$
43,000
Ending inventory at cost
?
(300,000)
43,000
?
53
54
9
The LIFO Retail Method
The LIFO Retail Method
Cost
Retail
Inventory, June 1 (60%)
$
21,000 $
35,000
Plus: Net Purchases
200,000
304,000
Net Markups
8,000
Less: Net Markdowns
(4,000)
Goods Available (Less Beg. Inv.)
200,000
308,000
Goods Available (Incl. Beg. Inv.)
221,000
343,000
Purchases
layer 200,000 / 308,000 = 64.94%
LIFO Cost
ratio:
Requires a composite ratio
Less: Sales for June
(300,000)
Ending inventory at retail
$
43,000
Ending inventory at cost
?
Cost
Retail
Inventory, June 1 (60%)
$
21,000 $
35,000
Plus: Net Purchases
200,000
304,000
Net Markups
8,000
Less: Net Markdowns
(4,000)
Goods Available (Less Beg.
Inv.) layer at200,000
308,000
Added
retail
Goods Available (Incl. Beg.
Inv.)− 35,000 221,000
343,000
43,000
= 8,000
LIFO Cost ratio:
Requires a composite ratio
Less: Sales for June
(300,000)
Ending inventory at retail
$
43,000
Ending inventory at cost
?
55
The LIFO Retail Method
Current
Period
LIFO
Cost ratio:
Inventory,
June
1 (60%)
$
(200,000
÷ 308,000) =
64.94%
Plus:
Net Purchases
Retail
Net Markups
Beginning
$
35,000 x
Less: NetInventory
Markdowns
Current
Layer
8,000 x
GoodsPeriod's
Available
(Less Beg. Inv.)
Total Available (Incl. Beg.
$ Inv.)
43,000
Goods
* $21,000
÷ $35,000
LIFO Cost
ratio: = 60%
** rounded
Dollar-Value LIFO Retail
Cost
Retail
21,000 $
35,000
200,000
304,000
Cost
8,000
60%*
=
21,000
(4,000)
64.94% =
5,195 **
200,000
308,000
26,195
221,000
343,000
Requires
(200,000
a composite
÷ 308,000)ratio
= 64.94%
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
$
56
§  Eliminate effect of price changes before
we compare the ending inventory with
the beginning inventory
§  Price index based upon retail prices
Bisk 30 - 32, 44, 45
(300,000)
$
43,000
?26,195
57
Dollar-Value LIFO Retail
Cost
Beginning inventory
Net purchases
Dollar-Value LIFO Retail
Retail
$21,000
$35,000
$200,000
$304,000
Sales
Inventory, June 1 (60%)
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods Available (Less Beg. Inv.)
Goods Available (Incl. Beg. Inv.)
LIFO Cost ratio:
Requires a composite ratio
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
$300,000
Net markups
$8,000
Net markdowns
$4,000
Price index
§  Beginning of period 100
§  End of period 102
58
59
$
Cost
Retail
21,000 $
35,000
200,000
304,000
8,000
(4,000)
200,000
308,000
221,000
343,000
$
(300,000)
43,000
?
Start with ending inventory at retail
60
10
Ending Inventory
at Year-end Retail
Prices
$
43,000
(Determined earlier)
Include in Cost-to-Retail %
Step 1
Ending Inventory at Base
Year Retail Prices
$ 43,000 ÷ 1.02 = $ 42,157
Step 2
Step 3
Inventory Layers
Converted to LIFO
Cost
Inventory Layers at Base Year
Retail Prices
$ 42,157
35,000 x 1.00 x
60.00% =
7,157 x 1.02 x
64.94% =
Total Ending Inventory at Dollar
Value LIFO Retail Cost
$
21,000.00
4,740.71
$
25,740.71
Term
Cost
Retail
Freight-in
Add
No entry
Purchase returns
Deduct
Deduct
Purchase discounts taken Deduct
(gross method only)
No entry
Abnormal shortages
(breakage, theft)
Deduct
Deduct
Transfers-in
Add
Add
61
62
Chapter Overview
Not Included: Cost-to-Retail %
§  Chapter 10
§  Valuation at date of acquisition
§  Disposition of assets
§  Capitalization of interest
Term
Cost
Retail
Normal shortages
(breakage, theft)
No entry
Deduct
Employee discounts
No entry
Deduct
Sales returns
No entry
Reduces net sales
Sales discounts
(gross method only)
No entry
No entry
§  Chapter 11
§  Allocation of cost over time (depreciation)
§  Impairment of operational assets
§  Chapter 12
63
Costs Capitalized: Equipment
Description
Self-Constructed Assets
§  All costs necessary to make asset ready
for use, including
$100,000
Less discount (2/10 n/30) [always net]
(2,000)
Transportation and insurance
6,000
Construction of platform (labor, materials)
14,000
Plumbing, electrical (labor, materials)
Testing (labor, materials)
16,000
20,000
Total
Cash
64
Amount
Purchase cost
Description
Equipment
§  Intangible assets (patents, goodwill)
Debit
154,000
§  Direct labor
§  Direct materials
§  Fees and permits
§  Interest during construction period
§  Overhead (applied on rational basis)
$154,000
Credit
154,000
65
66
11
Self-Constructed Assets
Interest Capitalization
Description
Amount
Architectural fee
700,000
Building permits
150,000
Direct labor, materials (contractor cost)
3,250,000
Application of overhead
900,000
Interest
600,000
Total
Description
§  Depreciate expense higher
§  Lower gain on sale (higher loss on sale)
5,600,000
Debit
Construction-in-progress
§  Interest is debited to asset account
(construction-in-progress)
§  Interest increases the cost of asset
Interest is considered cost of constructing asset
just as direct material, direct labor and overhead
Credit
5,600,000
Cash
5,600,000
67
68
Disclosure of
Capitalized Interest
Interest Capitalization
§  Disclosure
§  Required each period of capitalization
§  Total interest costs
§  Total capitalized
69
70
Interest Not Capitalized
Interest revenue and expense
§  Inventories routinely manufactured in
large quantities on a repetitive basis
§  Assets in use or ready for intended use
§  If money borrowed to finance
construction of asset is invested and
earns interest revenue should interest
revenue be netted against interest exp?
§  No
§  List interest revenue on income stmt
§  Capitalize interest exp if criteria met
71
72
12
Interest Capitalization
Vocabulary
§  Qualifying asset
§  Specific and general borrowing
§  Actual interest costs
§  Avoidable interest
§  Interest capitalized
§  Qualifying expenses
§  Average Accumulated Expenditures
§  Weighted average cost of debt
Qualifying Asset
§  Assets built for a company’s own use
§  Intel builds manufacturing equipment
§  Disney builds Hong Kong Disneyland
§  Assets constructed as projects for sale
§  Goetz Boats http://goetzboats.com/
§  IBM builds supercomputer for UC Berkeley
73
74
Actual Interest Costs
Borrowing: Specific, General
§  Total interest expense of all borrowing
§  Specific debt
§  Specific borrowing
§  $200,000, 12%, 3-year note payable
§  Exclusively for self-constructed asset
§  General debt
§  General borrowing
§  $500,000, 14%, 10-year bonds payable
§  $300,000, 10%, 5-year note payable
§  Unrelated to self-constructed asset
§  Occurred in current or previous year
Actual Total Interest Expense for Year
75
Avoidable Interest
Specific debt
$200,000 × 12% × 1 =
$24,000
General debt
$500,000 × 14% × 1 =
$70,000
General debt
$300,000 × 10% × 1 =
Total
$30,000
$124,000
76
Interest Capitalized
§  Concept
§  Capitalize the lesser of:
§  Interest expense that would not have
occurred if asset were not constructed and
the money used to retire debt
1.  Actual interest costs
2.  Avoidable interest
Either actual interest or avoidable interest
can be smaller amount; always perform test
§  Amount
§  Calculated using complex formula
§  Avoidable interest based on AAE,
Average Accumulated Expenditures
77
78
13
Qualifying Expenses
Conditions for Capitalization
§  Construction has begun
§  Labor, material, overhead incurred in
current period on self-constructed asset
§  Capitalize interest when all true
1.  Qualifying expenses incurred
§  Construction has begun
§  Labor, material, overhead incurred
2.  Activities are currently in progress
3.  Interest is incurred
§  Specific borrowings for construction
§  General purpose borrowings
79
Capitalization Ends
If any one of these conditions not true do not capitalize
80
Avg Accumulated Expenditure
§  Capitalize ends when
§  Expenditures weighted for the number
of months outstanding during the
current accounting period
1.  Asset substantially complete and ready
for use
OR
2.  Interest costs no longer incurred
Avoidable interest based on AAE
81
82
Avg Accumulated Expenditure
Qualifying Expenditures
§  If given expenditure for year
§  Constructing a building for our own use
§  Construction activities
§  Assume expenditures occur evenly
throughout year
§  AAE = Total Expenditures / 2
§  Began May 1
§  Ended December 31
§  If given expenditures for month, quarter
Qualifying Expenditures
§  Use weighted average for year
§  For each period calculate
§  Expenditure × time
83
May 1
$125,000
July 31
$160,000
October 1
$200,000
December 1
$300,000
84
14
Avg Accumulated Expenditure
Specific Borrowing
Multiply qualifying expenditure by time
§  Borrowed $1,000,000 on May 1
§  For 10 years
§  At 10%
§  To finance construction
Count months carefully
Average Accumulated Expenditures
Date
Amount
Time
AAE
May 1
$125,000
× 8/12 =
$83,333
July 31
$160,000
× 5/12 =
$66,667
October 1
$200,000
× 3/12 =
$50,000
December 1
$300,000
× 1/12 =
$25,000
Total
$785,000
Actual Total Interest Expense, May 1 – Dec 31
Specific debt
$1,000,000 × 10% × 8/12 =
$66,667
$225,000
AAE
85
86
Calculate Avoidable Interest
Interest Capitalized
§  If specific borrowing > AAE use specific
borrowing rate only
§  $1,000,000 specific borrowing sufficient
to cover $225,000 of AAE
§  Use specific borrowing rate of 10% to
determine avoidable interest
§  Pick lower of two amounts
§  Avoidable interest
§  Actual total interest expense
Avoidable Interest = AAE × Specific Borrowing Rate
Avoidable Interest = $225,000 × 10% = $22,500
87
Interest Capitalized
Adjusting Journal Entry
Pick lower of two amounts
Description
Construction-in-progress
Avoidable Interest = AAE × Specific Borrowing Rate
Interest = $225,000 × 10% = $22,500
$1,000,000 × 10% × 8/12 =
Debit
Credit
22,500
Interest expense
Actual Total Interest Expense, May 1 – Dec 31
Specific debt
88
22,500
Reverse interest expense to capitalize
Assume previous entry
debited interest expense and credited cash
$66,667
Capitalize $22,500
89
90
15
Borrowing: Specific, General
Weighted Average All Debt
§  Specific borrowing not required
§  If specific borrowing
§  If no specific borrowing calculate
avoidable interest using weightedaverage interest on all debt
§  Use specific rate first
§  Up to amount of specific borrowing
principal or AAE, whichever is smaller
§  If no specific borrowing or if specific
borrowing principal is less than AAE
§  Use weighted average cost of debt for AAE
not covered by specific borrowing principal
91
92
Calculate Avoidable Interest
Using Specific, General Debt
§  Weighted-average rate on all debt, 12%
§  If AAE > specific borrowing, to calculate
avoidable interest
Avoidable Interest = AAE × Average Borrowing Rate
§  First use specific borrowing rate, up to
amount of specific borrowing
§  Then use weighted-average rate on other
debt up to amount of other debt or AAE,
whichever comes first
Avoidable Interest = $225,000 × 12% = $27,000
93
§  January 1, 2011
Using Specific, General Debt
§  Borrowed $200,000 at 12% for specific
purpose of constructing equipment
Calculate avoidable interest
when specific borrowing < AAE
Capitalize using
weighted-average
cost of debt
Capitalize using
specific borrowing rate
94
§  Other general debt on January 1, 2011
§  $500,000, 14%, 10-year bonds payable
§  $300,000, 10%, 5-year note payable
Other
debt
Actual Total Interest Expense for Year
AAE
Specific
borrowing
95
Specific debt
$200,000 × 12% × 1 =
$24,000
General debt
$500,000 × 14% × 1 =
$70,000
General debt
$300,000 × 10% × 1 =
Total
$30,000
$124,000
96
16
Actual Expenditures
Actual Total Interest Expense for Year
Specific debt
$200,000 × 12% × 1 =
$24,000
General debt
$500,000 × 14% × 1 =
$70,000
General debt
$300,000 × 10% × 1 =
Total
General debt
$30,000
Date
$124,000
January 1, 2011
Weighted rate
70,000 + 30,000
500,000 + 300,000
= 12.5%
Amount
$100,000
April 30, 2011
150,000
November 1, 2011
300,000
December 31, 2011
100,000
Total expenditures
$650,000
97
Compute Avg Accum Expend
(AAE)
Date
Amount
January 1, 2011
Time
Avoidable Interest
AAE
April 30, 2011
150,000 × 8/12 =
100,000
November 1, 2011
300,000 × 2/12 =
50,000
Total expenditures
100,000 × 0/12 =
$650,000
Rate
Avoidable
interest
Specific
$200,000 × 12.0% =
$24,000
General
50,000 × 12.5% =
Borrowing
$100,000 × 12/12 = $100,000
December 31, 2011
98
Accumulated
expenditures
$250,000
0
$250,000
6,250
$30,250
First charge interest to specific borrowing, then charge
remainder to weighted-average of general borrowing
AAE
99
Interest to Capitalize
Methods of Disposal
§  Capitalize lesser of
§  Sell for cash or discard
§  Avoidable interest
§  Actual interest
Avoidable interest
Actual interest
Description
Construction-in-progress
Interest expense
100
(1) Sell asset for cash
(2) Discard asset and receive no value
§  Exchange asset for another asset
$ 30,250
(3) Commercial substance, FMV known
(4) Commercial substance, FMV unknown
(5) No commercial substance
124,000
Debit
Credit
30,250
§  Three cases depending on cash received
30,250
101
102
17
In All Cases
Sale of Plant Assets for Cash
§  Bring depreciation up-to-date
§  Take asset off books
§  Bring depreciation up-to-date
§  Credit asset account
§  Debit accumulated depreciation
§  Debit cash for cash received (if any)
§  Credit gain or debit loss on sale
§  Credit asset account
§  Take related accumulated dep off books
§  Debit accumulated depreciation
Cash is called “Boot”
“Boot received” means we received cash
“Boot paid” means we paid cash
103
Sale for Cash: Calc Gain (Loss)
104
Sale of Plant Assets for Cash
Calculation of Book Value
Cost
− Accumulated depreciation
§  Value received > value given = gain
§  Value received < value given = loss
Book value
Calculation of Gain (Loss)
Cash received
− Book value
Gain (loss)
Value received = Cash
Value given = NBV (Cost – Acc. Dep.)
105
Sale of Plant Assets for Cash
106
Sell for Cash, Loss on Sale
§  Cash > book value asset sold = gain
§  Cash < book value asset sold = loss
Cost of furniture
Gains increase net income
Losses decrease net income
$4,000
Book value
$6,000
Cash received
$5,000
Cash received from sale of asset
$5,000
Book value of asset sold:
Cost
Included in operating income
Less accumulated depreciation
107
$10,000
Accumulated depreciation
Gain (loss) on sale
$10,000
4,000
6,000
($1,000)
108
18
Sell for Cash, Loss on Sale
Cost of furniture
Accumulated depreciation
Sell for Cash, Gain on Sale
$10,000
$4,000
Cost of furniture
Accumulated depreciation
$10,000
$4,000
Book value
$6,000
Book value
$6,000
Cash received
$5,000
Cash received
$8,000
Cash received from sale of asset
$8,000
Description
Cash
Accumulated depreciation
Loss on sale
Furniture
Debit
5,000
4,000
1,000
Credit
Book value of asset sold:
Cost
Less accumulated depreciation
10,000 109
Sell for Cash, Gain on Sale
Cost of furniture
$10,000
4,000
Gain (loss) on sale
6,000
$2,000
Discard for No Value, Loss
$10,000
Cost of furniture
$10,000
Accumulated depreciation
$4,000
Accumulated depreciation
$4,000
Book value
$6,000
Book value
$6,000
Cash received
$8,000
Cash received
$
0
Cash received from sale of asset
$
0
Description
Cash
Debit
8,000
Accumulated depreciation
Gain on sale
4,000
110
Credit
Book value of asset sold:
Cost
Less accumulated depreciation
2,000
Furniture
10,000 111
$10,000
4,000
Gain (loss) on sale
6,000
($6,000)
112
Involuntary Conversions
Discard for No Value, Loss
§  Use of asset terminated involuntarily
Cost of furniture
$10,000
Accumulated depreciation
$4,000
Book value
$6,000
Cash received
$
Description
Accumulated depreciation
Debit
4,000
Loss on sale
6,000
Furniture
§  Act of nature: Fire, flood, tornado
§  Act of government: Expropriation,
condemnation, eminent domain
§  Theft
0
§  If insurance settlement received, record
value received (usually cash)
§  Calculate gain or loss as if sold for cash
Credit
10,000
113
May be extraordinary if unusual and infrequent in nature
114
19
Exchange: Calc Gain (Loss)
Exchange: Calc Gain (Loss)
Warning
(3) Commercial substance, FMV known
§  Recognize both gains and losses
Warning
(4) Commercial substance, FMV unknown
§  Do not recognize gains or losses
Warning
(5) No commercial substance
Gain (loss) ≠ FMV asset received − BV
§  Three cases depending on cash received
Gain (loss) = Fair value asset given − BV
115
Test: Commercial Substance
116
No Commercial Substance
§  Two conditions must be met
§  Fraudulently inflate earning
§  When FMV > book value
§  Exchange assets
§  Both companies recognize gains
1.  Change in future cash flows expected
2.  Expected change significant relative to fair
value of assets exchanged
117
No Commercial Substance
Starbucks
118
No Commercial Substance
Peet’s
§  If assets exchanged both companies
recognize gain, but no change in
operational assets, future profits or
future cash flows
Exchange asset for asset (same entry both companies)
Two companies have identical equipment
Cost
Accumulated depreciation
Book value
Fair value
$200,000
150,000
50,000
80,000
119
Description
New asset
Accumulated depreciation
Old asset
Gain on exchange
Debit
80,000
150,000
Credit
200,000
30,000
120
20
No Commercial Substance
Exchange: Calc Gain (Loss)
§  To discourage trades of appreciated
assets solely to recognize gains,
fair values only used in legitimate
exchanges with commercial substance
Type of Exchange
Record Transaction
Commercial substance:
FMV known
Recognize gains and losses
immediately
Commercial substance:
FMV unknown
No recognition of gains and losses
No commercial substance, no cash
received
Defer gains by reducing basis of
incoming asset; recognize losses
immediately
No commercial substance, cash
received less than 25% of fair value
Recognize partial gain; recognize
losses immediately
No commercial substance, cash
received 25% or more of fair value
Recognize gains and losses
immediately
121
122
Recognition of Losses
FASB to IFRS
§  Recognize loss immediately
(except commercial sub: FMV unknown)
§  Unlikely transaction entered into solely
to generate loss
§  If the loss were deferred, assets would
be overstated
§  Companies should not value assets at
more than their cash equivalent price
§  Type of assets exchanged not relevant
§  In past FASB had different treatment
depending on whether assets
exchanged were similar or dissimilar
§  FASB rule changed to conform to IFRS
123
Exchanges with Comm Sub
124
Exchanges with Comm Sub
§  Two fair market values in exchange
§  If FMV of asset given up and FMV of
asset acquired both known
§  FMV of asset given up (outgoing)
§  FMV of asset acquired (incoming)
§  Record cost of asset acquired (incoming)
at fair value of asset given up (outgoing),
adjusted for cash exchanged
§  Immediately recognize gain or loss
§  Use more reliable, objective FVM
§  Plug for other asset FMV value
§  Adjusted for cash exchanged
§  Cash exchanged equalizes FVM of assets
125
126
21
Gain (Loss) on Exchanges
Exchanges with Comm Sub
§  Use more reliable, objective FVM
§  Adjusted for cash exchanged
§  Plug for other asset FMV
Calculation of Gain (Loss) on Exchange
FMV of outgoing asset
− Book value of outgoing asset (Cost − Acc Dep)
Gain (Loss) on exchange
Ignore cash exchanged and FMV of incoming asset
FMV given up + cash paid
FMV given up − cash received
= FMV acquired
= FMV acquired
FMV acquired − cash paid
FMV acquired + cash received
= FMV given up
= FMV given up
127
Exchange 1
Loss, Receive Cash
128
Exchange 1
Loss, Receive Cash
§  Exchange machine for computer
§  Asset received, Computer
§  FMV of machine (asset given) known
§  FMV computer (asset received) unknown
§  FMV computer unknown (or less reliable)
§  We received $8,000 cash in exchange
§  We received $8,000 in cash
Cost of machine
$65,000
Accumulated depreciation
$45,000
Book value
Fair value of asset given
$20,000
$17,000
Gain (loss) on exchange
($3,000)
FMV given up − cash received
$17,000
− $8,000
= FMV acquired
=
$9,000
130
Exchange 2
Gain, Receive Cash
§  Exchange furniture for truck
Exchanged machine for computer
Debit
8,000
9,000
45,000
3,000
= FMV acquired
= FMV acquired
129
Exchange 1
Loss, Receive Cash
Description
Cash
Computer
Accumulated depreciation
Loss on exchange
Machinery
FMV given up + cash paid
FMV given up − cash received
§  FMV of furniture (asset given) known
§  FMV truck (asset received) unknown
Credit
§  We received $16,000 in cash
Cost of furniture
65,000
131
$130,000
Accumulated depreciation
$90,000
Book value
$40,000
Fair value asset given
Gain (loss) on exchange
$48,000
$8,000
132
22
Exchange 2
Gain, Receive Cash
Exchange 2
Gain, Receive Cash
§  Asset received, Truck
Exchanged furniture for truck
§  FMV truck unknown (or less reliable)
Description
Cash
Trucks
Accumulated depreciation
Furniture
Gain on exchange
§  We received $16,000 cash in exchange
FMV given up + cash paid
FMV given up − cash received
= FMV acquired
= FMV acquired
FMV given up − cash received
$48,000
− $16,000
= FMV acquired
=
$32,000
Debit
16,000
32,000
90,000
Credit
130,000
8,000
133
Exchange 3
Loss, Pay Cash
Exchange 3
Loss, Pay Cash
§  Exchange patent for land
§  Asset received, Land
§  FMV of patent (asset given) unknown
§  FMV land (asset received) known
§  Fair value
§  We paid $40,000 in cash
Cost of patent
$90,000
Accumulated amortization
$10,000
Book value
Fair value of asset given
$80,000
Unknown
Gain (loss) on exchange
Unknown
$70,000
FMV acquired − cash paid
FMV acquired + cash received
= FMV given up
= FMV given up
FMV acquired − cash paid
$70,000 − $40,000
= FMV given up
= $30,000
135
Exchange 3
Loss, Pay Cash
136
Exchange 3
Loss, Pay Cash
§  Exchange patent for land
Exchanged patent for land
§  FMV of patent (asset given) calculated
§  FMV land (asset received) known
Description
Land
Accumulated amortization
Loss on exchange
Patent
Cash
§  We paid $40,000 in cash
Cost of patent
$90,000
Accumulated amortization
$10,000
Book value
$80,000
Fair value
Loss on exchange
134
$30,000
($50,000)
137
Debit
70,000
10,000
50,000
Credit
90,000
40,000
138
23
Trade-In Allowance
Exceptions: Do Not Use FMV
§  Reduces cash paid
§  In exchange of operational assets fair
value is used except in rare situations
Effect of Trade-In Allowance
§  Neither fair value can be determined
§  Exchange lacks commercial substance
Invoice price of incoming asset (FMV)
− Trade-in allowance on outgoing asset
Cash paid
Even though these two cases are rare exceptions
many CPA exam questions may be on these topics
Effect of Trade-In Allowance
$10,000 Invoice price of new machine (FMV)
−
3,000 Allowance for old machine
139
$ 7,000 Cash paid
Exchange 4: FMV Unknown
Exchanges: FMV Unknown
§  Exchange building for land
§  Cannot determine FMV of either asset
§  Fair values cannot be determined
§  No gain (loss) is recognized
§  Asset acquired valued at
§  Book value of asset given up
§  Plus cash given (or minus cash received)
141
Exchange 4: FMV Unknown
$600,000
Accumulated depreciation
$400,000
Book value
$200,000
We paid cash
$100,000
Book value given + cash paid
$200,000
+ 100,000
= FMV acquired
=
300,000
142
No Commercial Substance
§  To discourage trades of appreciated
assets solely to recognize gains,
fair values only used in legitimate
exchanges with commercial substance
Exchanged building for land,
FMV of both assets unknown
Debit
300,000
400,000
Cost of building
Book value given + cash paid
= FMV acquired
Book value given − cash received = FMV acquired
Book value given + cash paid
= FMV acquired
Book value given − cash received = FMV acquired
Description
Land (new)
Accumulated depreciation
Building (old)
Cash
140
Credit
600,000
100,000
No recognition of gain or loss
143
144
24
No Commercial Substance
Test: Commercial Substance
§  Fraudulently inflate earning
§  When FMV > book value
§  Exchange assets
§  Both companies recognize gains
Both conditions must be met:
1.  Change in future cash flows expected
2.  Expected change significant relative to
fair value of assets exchanged
145
146
No Commercial Substance
No Cash Received
Exchange: Calc Gain (Loss)
Type of Exchange
Record Transaction
No commercial substance, no cash
received
Defer gains by reducing basis of
incoming asset; recognize losses
immediately
No commercial substance, cash
received less than 25% of fair value
Recognize partial gain; recognize
losses immediately
No commercial substance, cash
received 25% or more of fair value
Recognize all gains and losses
immediately
§  No gain recognized
§  Loss may be recognized
§  If gain, asset acquired valued at
Same
Always recognize losses immediately
Difference is in treatment of gains
§  BV plus cash given
§  Actual FMV asset received − gain
Book value given + cash paid
= FMV acquired
147
Exchange 5: No Commercial
Substance, No Cash Received
JE Below Not Allowed
§  Exchange truck for truck (identical)
Cost of truck
$50,000
Accumulated depreciation
$40,000
Book value
$10,000
Fair value asset given
$25,000
Gain on exchange (not allowed)
$15,000
148
Exchange identical truck for truck,
both companies recognize gain
Description
Truck (new)
FMV
Accumulated depreciation
Truck (old)
Gain on exchange
Recognition of gain not allowed
149
Debit
25,000
40,000
Credit
50,000
15,000
Because FMV > book value for both trucks
both companies will show gain if they exchange assets
even though there is no economic benefit to the exchange
150
25
Exchange 5: No Commercial
Substance, No Cash Received
Exchange 5: No Commercial
Substance, No Cash Received
Exchange identical truck for truck,
no gain recognized
Description
Truck (new)
FMV − gain
Accumulated depreciation
Truck (old)
Gain on exchange
Debit
10,000
40,000
Exchange identical truck for truck,
no gain recognized
Credit
Description
Truck (new)
FMV − gain
Accumulated depreciation
Truck (old)
Gain on exchange
50,000
15,000
Do not recognize gain
Reduce basis of incoming asset by amount of gain
New asset = FMV − gain
New asset = Book value old asset
151
Record Transaction
No commercial substance, no cash
received
Defer gains by reducing basis of
incoming asset; recognize losses
immediately
No commercial substance, cash
received less than 25% of fair value
Recognize partial gain; recognize
losses immediately
No commercial substance, cash
received 25% or more of fair value
Recognize all gains and losses
immediately
153
§  Exchange old truck for new machine
$110,000
$50,000
Book value
$60,000
Fair value
$40,000
Fair value of machine received
$90,000
Received cash (boot) in exchange
$10,000
§  Transaction part cash sale, part exchange
§  Recognize gain on cash sale portion
§  Boot received represents portion sold
Gain (loss) on exchange
$40,000
Fair value of machine received
$90,000
Received cash (boot) in exchange
$10,000
152
154
Formula to Recognize Gain
Cash received (Boot)
Cash received (Boot) + FV asset received
$100,000
Gain (loss) on exchange
Lower value of incoming asset leads to
lower depreciation expense in future periods
which raises net income (allocates gain over life of asset)
Exchange 6: No Comm. Sub.,
Cash Received < 25%
Exchange 6: No Comm. Sub.,
Cash Received < 25%
Accumulated amortization
50,000
15,000
§  No commercial substance
§  Cash received < 25% of fair value
§  Loss recognized
§  Recognize portion of gain
§  Reason for partial recognition of gain
Always recognize losses immediately
Difference is in treatment of gains
Cost of truck given
Credit
No Commercial Substance
Cash Received < 25%
Exchange: Calc Gain (Loss)
Type of Exchange
Debit
10,000
40,000
×
Total
=
gain
Gain
recognized
Formula to Recognize Gain
10,000
10,000 + 90,000
155
×
40,000
=
4,000
Gain deferred = $40,000 − $4,000 = $36,000
156
26
Exchange 6: No Comm. Sub.,
Cash Received < 25%
Exchange 6: No Comm. Sub.,
Cash Received < 25%
Book value of outgoing asset
$60,000
Fair value of machine received
$90,000
Book value of asset given (truck)
Calculation of basis of incoming asset
Received cash (boot) in exchange
$10,000
Portion of book value sold
$ 6,000
Basis of new machine
$54,000
$60,000
Formula to Recognize Book Value Sold
Cash received (Boot)
Cash received (Boot) + FV asset received
×
Book
Value
Calculation of basis of incoming asset
Book value
sold
=
Formula to Recognize Book Value Sold
10,000
10,000 + 90,000
×
60,000
=
6,000
Fair value of asset received (machine)
$90,000
Less gain deferred
$36,000
Basis of new machine
$54,000
157
Exchange 6: No Comm. Sub.,
Cash Received < 25%
158
Summary of Exchange Entries
Record exchange, recognize part of gain
Description
Cash
Machine (incoming asset)
Accumulated depreciation (truck)
Truck (outgoing asset)
Gain on sale of truck
Debit
10,000
54,000
50,000
Credit
110,000
4,000
159
Information Required
160
Depreciable Cost
§  Cash flows
Asset’s cost
§  Cost: Outflow at time of purchase
§  Salvage value: Estimated inflow when sold
− Estimated salvage value
§  Estimated life
§  Allocation method
Depreciable cost
Net cash flow allocated over life of asset
161
162
27
Book Value
Remaining Depreciation
Asset’s cost
Asset’s cost
− Salvage value
− Accumulated depreciation
− Accumulated depreciation
Book value
Remaining depreciation
163
164
Use of Depreciation Methods
Allocation Methods
Recent Survey of Large Public Companies (Sample of 684)
§  Time-based methods
41
§  Straight-line
§  Accelerated: Sum-of-the-years’ digits
§  Accelerated: Declining balance
22
30 4
7
Straight Line
§  Activity-based methods
Declining Balance
§  Units-of-production method
Sum-of-the-years' digits
Other Accelerated
§  Tax depreciation (MACRS)
Systematic and rational allocation of cost
to periods that benefit from use of asset
Units of Production
Other
580
165
166
Depreciation Overview
Depreciation Example
§  All methods provide same total
depreciation over lifetime of assets
§  Activity-based methods are theoretically
superior to time-based methods, but
often are infeasible or too costly to use
§  Most companies use
Depreciation Variables
Cost
$41,000 Life (time)
5 years
Salvage value
Depreciable cost
1,000 Life (units)
$40,000
100,000 units
§  Straight-line for book purposes
§  MACRS for tax purposes
167
168
28
Straight-line depreciation
Straight-line depreciation
Depreciation Variables
Cost
Salvage value
Depreciable cost
Depreciation Variables
$41,000 Life (time)
5 years
1,000 Life (units)
100,000 units
$40,000
Depreciation per year =
Cost
Salvage value
Depreciable cost
Cost − Salvage value
$41,000 Life (time)
5 years
1,000 Life (units)
100,000 units
$40,000
Depreciation per year
Useful life
= $41,000 − $1,000
=
Cost − Salvage value
Useful life
Useful life
5
= $8,000
Date
1
= Cost − Salvage value ×
1
= Cost − Salvage value ×
Description
Debit
Depreciation expense
8,000
Credit
Accumulated depreciation
8,000
5
= Depreciable cost
169
×
20%
170
Straight-line depreciation schedule
Accelerated Methods
Depreciation Variables
Cost
Salvage value
Depreciable cost
$41,000 Life (time)
5 years
1,000 Life (units)
100,000 units
§  More depreciation in the early years
§  Less depreciation in later years
§  Total depreciation same as straight-line
$40,000
Total dep.
Rate
1
40,000
20%
Dep. Exp. Acc. dep.
8,000
8,000
33,000
NBV
2
40,000
20%
8,000
16,000
25,000
3
40,000
20%
8,000
24,000
17,000
4
40,000
20%
8,000
32,000
9,000
5
40,000
20%
8,000
40,000
1,000
Ending check figures
Acc Dep = Dep Cost
NBV = Salvage value
171
172
Sum-of-the-years’ digits depreciation schedule
Sum-of-the-Years’ Digits
Depreciation Variables
Cost
Salvage value
Depreciable cost
(Cost − Salvage value)
×
173
5 years
1,000 Life (units)
100,000 units
$40,000
1
Total dep.
40,000
Rate
5/15
2
40,000
4/15
10,667
24,000
17,000
3
40,000
3/15
8,000
32,000
9,000
4
5
40,000
2/15
5,333
37,333
3,667
40,000
1/15
2,667
40,000
1,000
Remaining life
Sum of years of life
$41,000 Life (time)
Dep. Exp. Acc. Dep.
13,333
13,333
NBV
27,667
Ending check figures
Acc Dep = Dep Cost
NBV = Salvage value
174
29
Declining-Balance Methods
Double-declining Balance
§  Based on the straight-line rate multiplied
by an acceleration factor
§  Factor is 1, 1.25, 1.5, 1.75, or 2
(Cost – acc. dep.) × 2
§  Initially ignore residual value
§  Ending book value = salvage value
§  Total depreciation = Cost – SV
§  Plug when needed
Depreciation
expense
=
Life
Ignore salvage value
175
176
Double-declining balance depreciation
Double-declining balance depreciation schedule
Depreciation variables
Depreciation Variables
Cost
Salvage value
Depreciable cost
$41,000 Life (time)
5 years
1,000 Life (units)
100,000 units
Salvage value
Depreciable cost
$40,000
DDB rate =
Cost
1
=
1
5 years
×2
= 20% × 2
= 40%
5 years
1,000 Life (units)
100,000 units
$40,000
Beg. NBV DDB Rate Dep. Exp. Acc. Dep.
×2
Life in years
$41,000 Life (time)
End NBV
1
41,000
40%
16,400
16,400
24,600
2
24,600
40%
9,840
26,240
14,760
3
14,760
40%
5,904
32,144
8,856
4
8,856
40%
3,542
35,686
5,314
5
−
(Plug)
4,314
40,000
1,000
Ending balance in acc dep must equal depreciable cost.
Ending balance in net book value must equal salvage value.
Plug as needed.
177
178
Double-declining balance depreciation schedule
Depreciation variables
Double-declining Balance
Cost
Salvage value
§  Higher salvage value: Plug earlier
§  Lower salvage value: Plug later
Depreciable cost
$41,000 Life (time)
5 years
9,000 Life (units)
100,000 units
$32,000
Beg. NBV DDB Rate Dep. Exp. Acc. Dep.
Change salvage value from $1,000 to $9,000
179
End NBV
1
2
41,000
24,600
40%
40%
16,400
9,840
16,400
26,240
24,600
14,760
3
14,760
(Plug)
5,760
32,000
9,000
4
−
−
−
32,000
9,000
5
−
−
−
32,000
9,000
Accumulated depreciation cannot exceed total depreciation
(cost – salvage value) and ending NBV cannot go below
salvage value. When DDB exceeds limits you must plug.
180
30
Convert from DDB to straight-line after two years
Depreciation variables
Double-declining Balance
Cost
$41,000 Life (time)
5 years
9,000 Life (units)
100,000 units
Salvage value
Depreciable cost
§  Can covert from DDB to SL after a
specified number of years
Beg. NBV
Convert from DDB to SL at beginning of Year 3
$32,000
DDB Rate Dep. Exp. Acc. Dep. End NBV
1
41,000
40%
16,400
16,400
24,600
2
24,600
40%
9,840
26,240
14,760
Convert to straight-line dep at beginning of year 3
Remaining depreciation = NBV − salvage value
5,760 = 14,760 − 9,000
181
Rem. Dep.
SL Rate
3
5,760
33%
Dep. Exp. Acc. Dep.
1,920
28,160
12,840
NBV
4
5,760
33%
1,920
30,080
10,920
5
5,760
33%
1,920
32,000
9,000
182
Units-of-production depreciation
Activity-Based Depreciation
Depreciation variables
Cost
$41,000 Life (time)
5 years
1,000 Life (units)
100,000 units
Salvage value
§  Depreciation can also be based on
measures of input or output
Depreciable cost
§  Service hours
§  Units-of-Production
$40,000
Depreciation per unit
=
Cost − Salvage value
Unit produced
= $41,000 − $1,000
§  Depreciation is not taken for idle assets
100,000 units
= $0.40 per unit
Date
Description
Dep. exp. (30,000 × 0.40)
183
Units-of-production depreciation schedule
Salvage value
Depreciable cost
Credit
Accumulated depreciation
12,000
184
Group and Composite Methods
Depreciation variables
Cost
Debit
12,000
$41,000 Life (time)
5 years
1,000 Life (units)
100,000 units
§  Group method
§  Assets sorted in many different groups
$40,000
Dep. / unit
Units
Dep. Exp. Acc. Dep.
1
$0.40
30,000
12,000
12,000
29,000
2
$0.40
20,000
8,000
20,000
21,000
3
$0.40
25,000
10,000
30,000
11,000
4
5
$0.40
$0.40
15,000
10,000
6,000
4,000
36,000
40,000
5,000
1,000
§  Trucks in one group
§  Computers in a different group
NBV
Ending check figures
Acc Dep = Dep Cost
NBV = Salvage value
§  Composite method
§  All assets in one group
§  Trucks and computers in same group
Calculations same for both methods
185
Accumulated depreciation records
not maintained for individual assets
186
31
Group and Composite Methods
Group and Composite Methods
Asset
Cost
Salvage
Tot Dep
Life
SL Dep
Asset
Cost
Salvage
Tot Dep
Life
SL Dep
Autos
$150,000
$30,000
$120,000
6
$20,000
Autos
$150,000
$30,000
$120,000
6
$20,000
Trucks
120,000
16,000
104,000
5
20,800
Trucks
120,000
16,000
104,000
5
20,800
Copiers
60,000
12,000
48,000
4
12,000
Copiers
60,000
12,000
48,000
4
$330,000
$58,000
$272,000
$330,000
$58,000
$272,000
Total
$52,800
Total
Group depreciation rate
Group depreciation rate
Total straight-line dep per year
$52,800
Total cost of assets
$330,000
= 16%
Average service life (in years)
Total straight-line dep per year
$52,800
Total cost of assets
$330,000
$272,000
Total straight-line dep per year
$52,800
= 5.15
$52,800 = 16% × $330,000
187
Change in Variables
Original
Revised
$400,000
$900,000
Salvage
$100,000
$250,000
Acc dep.
$0
$50,000
$300,000
$600,000
Life
30
45
Remaining life
30
40
$10,000
$15,000
Cost
New estimated life
Cost
− Life consumed
Remaining life
Date
− Salvage value 250,000
− Acc. dep.
Depreciation expense
Accumulated depreciation
5
− Acc. dep.
Remaining life
40
50,000
Remaining dep. 600,000
=
$600,000
40
= $15,000
189
50,000
Remaining dep. 600,000
Debit
− Life consumed
Remaining life
900,000
5
Description
− Salvage value 250,000
190
Amortization and Impairment
45
40
900,000
45
Remaining depreciation
Change in Variables
New estimated life
188
Change in Variables
Cost
Depreciation exp.
= 16%
Depreciation expense = Rate × total cost
Total depreciation
Remaining dep.
12,000
$52,800
Type
Amortization
Limited-life
Over useful life Recoverability, fair value
Impairment test
Indefinite-life None
Fair value
Goodwill
Fair value (different)
None
Old GAAP: Amortize Goodwill up to 40 years
Credit
15,000
15,000
191
192
32
Definitions: Impairment
Impairment: Limited-Life
§  Carrying amount not recoverable
§  WHEN
§  Book value > expected future cash inflows
§  Test for impairment when new information
indicates impairment
§  Write down value of intangible asset
§  HOW
Write-up not allowed
1.  Recoverability test first, then
2.  Fair value test
Same procedure as used for plant and equipment
193
Impairment: Indefinite-life
194
Impairment: Goodwill
§  WHEN
§  WHEN
§  Test for impairment annually, or when new
information indicates impairment
§  Test for impairment annually, or when new
information indicates impairment
§  HOW
§  HOW
§  Fair value test only
§  Test fair value reporting unit, then test fair
value of implied goodwill
Never fails recoverability test because of no end to life
195
Impairment: Three Cases
Intangible asset
Impairment
Limited-life
Recoverability test
then fair value test
Indefinite-life
Fair value test only
Goodwill
Test fair value reporting unit, then
test fair value of implied goodwill
196
Impairment of Value
Accounting treatment differs
Operational assets
to be held and used
Impairment loss reported in continuing operations as
“Other expenses and losses”
197
Tangible and
intangible
with finite
useful lives
Intangible
with
indefinite
useful lives
Operational assets
held to be sold
Goodwill
198
33
Tangibles and
Finite-Life Intangibles
Test for impairment of value
Test for
when it is suspected that
impairment of
book value may not be
value at least
Accounting treatment differs.annually.
recoverable
Operational assets
to be held and used
Tangible and
intangible
with finite
useful lives
Intangible
with
indefinite
useful lives
§  Two step process
§  Has impairment occurred
§  Determine amount of impairment
Operational assets
held to be sold
Same as impairment of buildings and equipment
Goodwill
Test for impairment
of value when
considered for sale.199
200
Tangibles and
Finite-Life Intangibles
Tangibles and
Finite-Life Intangibles
Measurement – Step 2
Measurement – Step 1
Impairment
=
loss
Asset impaired if
Recoverable cost < Book value
Reported as
part of
income from
continuing
operations.
Expected future total undiscounted net cash
inflows generated by use of asset
201
Tangibles and
Finite-Life Intangibles
$0
Fair
Value
$125
No impairment
Fair
value
–
•  Market value if sold
•  Price of similar assets
•  PV net future cash inflows
Fair value < recoverable cost
due to the time value of money
202
Tangibles and
Finite-Life Intangibles
Recoverable
Cost
$250
BV < $250
Book
value
Fair
Value
$125
$0
BV > $250
Impairment
1. Test for impairment: Compare book value to recoverable cost
203
Case 1:
$50 book value
No impairment
Recoverable
Cost
$250
BV < $250
No impairment
Case 2:
$150 book value
No impairment
BV > $250
Impairment
Case 3:
$275 book value
Impairment
204
34
Tangibles and
Finite-Life Intangibles
Tangibles and
Finite-Life Intangibles
Fair
Value
$125
$0
Data for Impairment
Recoverable
BV
Cost
$275
$250
Loss = BV − Fair value
Book value
$170,000
Undiscounted future cash flows
$150,000
Fair value
$140,000
Step 1: Test for Impairment
Case 3:
$275 book value
Recognize loss
Book value
$170,000
Undiscounted future cash flows
$150,000
Book value > undiscounted cash flow, impairment loss recognized
Step 2: Calculation of Impairment Loss
Loss of $150
205
Book value
$170,000
Fair value
$140,000
Impairment loss
$30,000
206
Tangibles and
Finite-Life Intangibles
Tangibles and
Finite-Life Intangibles
Data for Write Down
§  Debit Loss on impairment
§  Debit Accumulated amortization
§  Take old accumulated amortization off
books because revaluing asset
Cost of patent
$300,000
Accumulated amortization
$130,000
Book value
$170,000
Fair value
$140,000
Impairment loss
§  Credit asset account
Date
§  Reduce asset to FMV
§  Credit = Cost − FMV
Description
Loss on impairment
Accumulated amortization
$30,000
Debit
130,000
Patent
Calculate new amortization expense prospectively
207
Credit
30,000
160,000
After AJE, asset cost = fair value
208
Data for Write Down
Cost of patent
$300,000
Accumulated amortization
$130,000
Book value
$170,000
Fair value
$140,000
Impairment loss
Date
§  If life of intangible asset unknown
$30,000
Description
Loss on impairment
Accumulated amortization
Debit
§  Trademark or goodwill
Credit
30,000
§  Do not amortize
§  Test for impairment at least annually,
more frequently if events reduce value
130,000
Patent
160,000
Patent
Acc Amortization
300,000
130,000
160,000
140,000
Indefinite-Life Intangibles
130,000
0
209
210
35
Indefinite-Life Intangibles
Indefinite-Life Intangibles
§  Indefinite life intangibles (not goodwill)
§  If BV of asset > fair value,
recognize impairment loss for difference
Test for Impairment
Cost of trademark
$800,000
Fair value
$100,000
Impairment loss
$700,000
Date
Description
Loss on impairment
Debit
Credit
700,000
Trademark
700,000
211
Creation of Goodwill
212
Impairment of Value: Goodwill
Parent Corporation Purchases Subsidiary Corporation
Cash paid by parent
Market value of subsidiary assets
Payoff amount of subsidiary liabilities
$500,000
§  Goodwill cannot be separated
§  Compare value of business unit to BV
§  Test for goodwill impairment each year
$600,000
200,000
Market value of net assets
400,000
Book value of goodwill
$100,000
Description
Debit
Data for Goodwill Impairment Tests at end of Year 5
Credit
FMV Assets (Cash, Equip, Patents)
600,000
Book value of Sub’s net assets, including goodwill
$440,000
Goodwill (plug)
100,000
Fair value of Sub (if sold today)
$350,000
Liabilities (A/P, N/P, etc)
200,000
Fair value Sub’s identifiable net assets (ex goodwill)
$325,000
Cash
500,000
Book value of Sub’s goodwill
$100,000
213
214
Step 1: Test for Impairment
Fair value of Sub (if sold today)
$350,000
Book value of Sub’s net assets (with goodwill)
$440,000
Impairment indicated if fair value < book value
Impairment of Value: Goodwill
Impairment
Step 3: Calculation of Goodwill Impairment Loss
Step 2: Determination of Implied Goodwill
Implied value of goodwill
$25,000
Fair value of Sub (if sold today)
$350,000
Book value of goodwill
$100,000
Fair value Sub’s identifiable net assets (w/o goodwill)
$325,000
Impairment loss recognized
($75,000)
Implied value of goodwill
$25,000
Date
Step 3: Calculation of Goodwill Impairment Loss
Implied value of goodwill
Goodwill impairment
$25,000
Book value of goodwill
$100,000
Impairment loss recognized
($75,000)
Description
Goodwill
215
Debit
Credit
75,000
75,000
216
36