Chapter 5Learning Objectives

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Chapter 5--Learning Objectives

• 1. Explain the relationship between expense
  recognition and revenue recognition

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Expenses

• Outflows or other using up of assets or
  incurrences of liabilities from delivering or
  producing goods, rendering services, or carrying
  out other activities that constitute the entitys
  ongoing major or central operations

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The matching principle

• Expenses are recognized in the same period in
  which the benefits derived from those costs are
  recognized

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Recognition of expensesis dictated by revenue
recognition
JET FUEL

• The task of expense recognition is to establish
  associations between revenues and costs

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Joint Costs

• Benefit multiple accounting periods
• Incurred in the production of multiple outputs

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Chapter 5--Learning Objectives

• 2. Allocate costs of long-lived tangible assets
  to periods benefited

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DEPRECIATION

• A process of allocating the cost of assets to the
  accounting periods which will benefit from their
  use
• Allocation, not valuation
• Not an attempt to approximate market value
• Method must be systematic and rational

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Units of production depreciation

• Asset cost - salvage value
• Total units to be produced
• equals
• Depreciation per unit of production
• (Also used for Depletion)

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Units of production assumptions

• Asset cost 100,000
• Salvage value -0-
• Projected capacity 50,000 units
• Depreciation rate
• 100,000 - 0
• 50,000 units 2.00 per unit

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Units of production assumptions

• Year 1 production 12,500
• Year 2 production 20,000
• Year 3 production 7,500
• Year 4 production 10,000

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Units of production depreciation calculations

• Year Production Depreciation
• 1 12,500 units 25,000
• 2 20,000 units 40,000
• 3 7,500 units 15,000
• 4 10,000 units 20,000
• Totals 50,000 units 100,000

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Accelerated Depr. assumptions

• Acquisition on January 1, 20X1
• Cost 100,000
• Life estimated at 5 years
• Zero salvage value

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Sum-of-the-years digits (SYD)

• A fraction game
• For denominator, use life, count backward, add
  numbers
• A five-year life is 5 4 3 2 1 15
• For numerator, start at the top and work down
• First year of five-year life would be 5/15
• Apply fraction to depreciation base

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Depreciation schedule forsum-of-the-years digits

• Depr. Accum. Book
• Year expense deprec. value
• 1 33,333 33,333 66,667
• 2 26,667 60,000 40,000
• 3 20,000 80,000 20,000
• 4 13,333 93,333 6,667
• 5 6,667 100,000 -0-

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Double-declining balance (DDB)

• Think of life as a percentage
• If total life is 5 years, that is 100
• Each year will be 20 percent
• Use twice the straight line rate (40 for 5
  years)
• In first year, apply rate to total cost (ignore
  salvage value at the start)

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More double-declining balance (DDB)

• In second and later years, apply rate to
  remaining book value
• Heads up in later years--Dont go below estimated
  salvage value or beyond original estimated life
• DDB almost never comes out even !

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Depreciation schedule fordouble declining balance

• Depr. Accum. Book
• Year expense deprec. value
• 1 40,000 40,000 60,000
• 2 24,000 64,000 36,000
• 3 14,400 78,400 21,600
• 4 8,640 87,040 12,960
• 5 12,960 100,000 -0-

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Effective Interest Depr. assumptions

• Acquisition on January 1, 20X1
• Cost 100,000
• Life estimated at 5 years
• Zero salvage value
• Projected annual benefit 26,379
• Benefits produce a return of 10 percent
  compounded annually

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Effective interest depreciation

• Annual cash flow
• Less (Book value x rate of return)
• Equals Annual depreciation charge

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Effective interest depreciation calculations

• Cash Book value x Deprec.
• Year flow rate of return expense
• 1 26,379 (100,000 x .10) 16,379
• 2 26,379 (83,621 x .10) 18,017
• 3 26,379 (65,604 x .10) 19,819
• 4 26,379 (45,785 x .10) 21,801
• 5 26,379 (23,984 x .10) 23,984

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Depreciation schedule foreffective interest
depreciation

• Depr. Accum. Book
• Year expense deprec. value
• 1 16,379 16,379 83,621
• 2 18,017 34,396 65,604
• 3 19,819 54,215 45,785
• 4 21,801 76,016 23,984
• 5 23,984 100,000 -0-

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Straight line depreciation

• Cost - Estimated residual value
• Estimated life
• 100,000 - -0-
• 5 years
• 20,000 per year

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Disposal of Assets

• Calculate Depreciation for year
• Reduce Assets (Cr.)
• Eliminate Depreciation (Dr.)
• Balance to Gain or Loss

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Product and period costs

• Product costs are production costs that become
  part of inventory cost and include materials,
  labor and factory overhead
• Period costs are costs that are expensed
  immediately in the period incurred

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Depreciation on the factory and the factory
equipment

• Is a component of factory overhead
• Thus, this depreciation is a product cost

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Chapter 5--Learning Objectives

• 3. Differentiate between cost allocations for
  intangible assets and tangible assets

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Research and development

• Non-capital expenditures for research and
  development costs must be expensed in the year
  the cost is incurred per FASB SFAS No. 2

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Goodwill

• Internally generated goodwill is expensed as
  costs are incurred
• In the purchase of one company by another,
  goodwill is the excess of the purchase price over
  the net fair market value of the assets
• Goodwill is amortized over a period not greater
  than 40 years

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Chapter 5--Learning Objectives

• 4. Apply the principles of allocation of the
  cost-of-debt funds

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Two possibilities for interest cost allocation

• The straight-line method
• (produces equal charges each period)
• The effective interest rate method
• (produces different charges against income, but
  results in a constant interest rate)
• (GAAP requires the effective interest
• method when the amounts are material)

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Interest allocation assumptions

• Bond face amount is 1,000,000
• Stated interest rate is 8 percent
• Bonds sold January 1, 2001
• Interest paid annually on December 31
• Bonds sold for 877,068
• The effective rate is 10 percent

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Present value calculations

• Investors will receive 1,000,000 in ten years.
  The present value factor for 1 to be received in
  10 years at 10 is .3855, so the present value of
  the face amount is 385,500
• Investors will also receive ten annual payments
  of 80,000 each on December 31. The present
  value factor at 10 is 6.1446, so the present
  value of the payments is 491,568

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More interest calculations...

• PV of face amount 385,500
• PV of interest payments 491,568
• Total present value 877,068
• The total payments to be made are
• Face amount 1,000,000
• Interest payments 800,000
• Total future payments 1,800,000
• The difference is 922,932
• (total interest cost to be allocated)

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The sale of the bonds will be recorded

• Cash 877,068
• Discount on BP 122,932
• Bonds Payable 1,000,000
• The Discount on Bonds Payable account will be
  amortized over the life of the bond issue

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Note that...

• The total interest payments 800,000
• and the discount 122,932
• Equal the total effective
• interest calculated earlier 922,932

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Straight-line amortization

• Would allocate an equal amount of the 122,932
  Discount to each of the ten interest payments
• Interest Expense 92,293
• Cash 80,000
• Discount on BP 12,293

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But

• Straight-line amortization is not an acceptable
  procedure when the amounts are material
• GAAP calls for effective interest amortization of
  bond premium or discount

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In effective interest amortization

• Interest expense is calculated by multiplying the
  effective interest rate times the book or
  carrying value of the liability
• This is true for premium or discount situations

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The first calculation is

• Bond carrying value 877,068
• Effective interest rate .10
• Interest expense 87,707
• The interest payment is 80,000
• The difference is 7,707
• This is the amount of amortization for the first
  interest payment

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The first half of the amortization schedule is

• Interest Amort. Disc. Book
• Date expense amount balance value
• 1-1-X1 122,932 877,068
• 12-31-X1 87,707 7,707 115,225 884,775
• 12-31-X2 88,477 8,477 106,748 893,252
• 12-31-X3 89,325 9,325 97,423 902,577
• 12-31-X4 90,258 10,258 87,165 912,835
• 12-31-X5 91,283 11,283 75,882 924,118

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The second half of the amortization schedule is

• Interest Amort. Disc. Book
• Date expense amount balance value
• 12-31-X5 75,882 924,118
• 12-31-X6 92,412 12,412 63,470 936,530
• 12-31-X7 93,653 13,653 49,817 950,183
• 12-31-X8 95,018 15,018 34,799 965,201
• 12-31-X9 96,520 16,520 18,279 981,721
• 12-31-Y0 98,279 18,279 -0- 1,000,000

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Notes on effective interest amortization

• Except for minor rounding errors, the effective
  interest method exactly amortizes the discount
• The book value of the bond issue equals the
  present value of the payments
• Procedure works the same for premium as for
  discount

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Residual allocation

• Differences between the book value and the actual
  value of assets or liabilities must be dealt with
  when the item is liquidated
• This will result in a gain or loss in the year of
  liquidation
• The economic developments involved are not
  necessarily associated with the year of
  liquidation

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Residual allocation

• For this reason, gains and losses on the
  retirement of debt are classified as
  extraordinary items on the income statement

XYZ Company Income Statement
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Opportunity costs

• Not normally reflected in accounting records
• But need to be considered in managing the
  enterprise
• Allocation based accounting systems do not
  necessarily provide accurate performance measures
  for management

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Allocating costs of labor

• Labor costs include pension costs and
  post-retirement health benefits
• These costs are difficult to estimate and often
  far in the future
• Nevertheless, all personnel costs should be
  matched against the years in which the benefits
  of labor are recognized

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Chapter Five Objectives

• Explain the relationship between expense
  recognition and revenue recognition
• Allocate costs of long-lived tangible assets to
  periods benefited
• Differentiate between cost allocations for
  intangible assets and tangible assets
• Apply the principles of allocation to the
  cost-of-debt funds.