Fixed Asset Accounting

Fixed Assets: Reporting and Analyzing

Publication Date: September 2019

Fixed Assets: Reporting and Analyzing

Copyright 2019

DeltaCPE LLC

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Table of Contents

Course Introduction .......................................................................................................................... 1

Learning Objectives ........................................................................................................................... 2

Chapter 1: Accounting for Fixed Assets ........................................................................................... 3

Learning Objectives ....................................................................................................................................3

Role of the Accountant ...............................................................................................................................3

Classification of Assets ...............................................................................................................................4

Definition of Assets .............................................................................................................................................4

Chapter 1 Section 1 - Review Questions ......................................................................................................8

The Concept of Fixed Assets........................................................................................................................9

The Nature of Fixed Assets .................................................................................................................................9

Recording Fixed Assets .................................................................................................................................... 10

Depreciation of Property, Plant, and Equipment ............................................................................................ 14

Depletion of Natural Resources ................................................................................................................ 22

Definition of Natural Resources ...................................................................................................................... 22

Units of Production Method ............................................................................................................................ 22

Nonmonetary Transactions ....................................................................................................................... 25

Chapter 1 Section 2 - Review Questions .................................................................................................... 31

Intangible Assets ...................................................................................................................................... 33

The Nature of Intangible Assets ...................................................................................................................... 33

General Rules and Concepts ............................................................................................................................ 34

Business Combination under the Acquisition Method .................................................................................... 35

Treatment of Goodwill ............................................................................................................................. 36

Impairment Test .............................................................................................................................................. 37

Simplifying the Impairment Test ..................................................................................................................... 41

Private Company Goodwill Alternative ........................................................................................................... 43

Capitalization of Interest .......................................................................................................................... 46

General Rules ................................................................................................................................................... 46

The Amount Capitalized .................................................................................................................................. 47

Asset Retirement Obligations ................................................................................................................... 50

Applicability ..................................................................................................................................................... 50

Requirements .................................................................................................................................................. 50

Present Value Method ..................................................................................................................................... 51

Contract Costs .......................................................................................................................................... 54

Costs to Obtain a Contract .............................................................................................................................. 54

Costs to Fulfill a Contract ................................................................................................................................ 55

Accounting Change in Estimated Useful Lives ............................................................................................ 58

Disclosures ............................................................................................................................................... 60

General Requirements..................................................................................................................................... 60

Intangible Assets .............................................................................................................................................. 61

Goodwill and Other Intangible Assets ............................................................................................................. 62

Asset Retirement Obligations .......................................................................................................................... 62

Change in Estimate .......................................................................................................................................... 64


U.S. GAAP vs. IFRS .................................................................................................................................... 67

Property, Plant and Equipment ....................................................................................................................... 67

Intangible Assets and Goodwill ....................................................................................................................... 71

Not-for-Profit Organization: Non-Cash Gifts .............................................................................................. 73

General Rules ................................................................................................................................................... 73

Recognition of In-Kind Contributions .............................................................................................................. 73

Expiration of Donor-Imposed Restrictions ...................................................................................................... 74

Government Fixed Assets ......................................................................................................................... 74

General Rules for Fixed Assets ........................................................................................................................ 75

Works of Art and Historical Treasures ............................................................................................................. 76

Treatment for Leased Assets ........................................................................................................................... 77


Chapter 2: Fixed Assets - Controls ................................................................................................. 80

Learning Objectives .................................................................................................................................. 80

Top Fixed Assets Issues ............................................................................................................................. 80

Vulnerability of Fixed Assets ........................................................................................................................... 80

The Risks of Spreadsheets ............................................................................................................................... 81

Overpayment of Property Taxes and Insurance .............................................................................................. 82

Implementation of Strong Controls ........................................................................................................... 83

Control Design Principles ................................................................................................................................. 83

Basic Control Techniques ................................................................................................................................ 84

Leveraging Technology .................................................................................................................................... 88

Audit Readiness ....................................................................................................................................... 90

Audit Focus for the Fixed Asset Process .......................................................................................................... 90

The Typical Audit Approach ............................................................................................................................. 91

Internal Controls Self-Assessment ................................................................................................................... 93

Chapter 2 - Review Questions ................................................................................................................... 98

Chapter 3: Planning and Analyzing ................................................................................................. 99

Learning Objectives .................................................................................................................................. 99

The Concept of Capital Budgeting ............................................................................................................. 99

Significance of Capital Budgeting Decisions .................................................................................................... 99

The Definition of Capital Budgeting .............................................................................................................. 100

Types of Long-Term Investment Decisions .................................................................................................... 100

Features of Investment Projects ................................................................................................................... 101

The Uses of Capital Budgeting ....................................................................................................................... 101

Techniques for Evaluating Investment Proposals ..................................................................................... 102

Discount Rate ................................................................................................................................................ 102

Payback Period Method ................................................................................................................................ 105

Discounted Payback Period ........................................................................................................................... 106

Accounting Rate of Return ............................................................................................................................ 107

Net Present Value .......................................................................................................................................... 108

Internal Rate of Return .................................................................................................................................. 109

Profitability Index .......................................................................................................................................... 110

Chapter 3 Section 1 – Review Questions ................................................................................................. 111

Income Taxes and Investment Decisions ................................................................................................. 112

MACRS and Investment Decisions ........................................................................................................... 114

Working with Ratios ............................................................................................................................... 118

Rate of Return on Total Assets (ROA) ............................................................................................................ 118

Fixed Asset Turnover ..................................................................................................................................... 118

The Lease vs. Purchase Decision .............................................................................................................. 119

Implications for the Lessee ............................................................................................................................ 119

Loan Benefits ................................................................................................................................................. 123

Chapter 3 Section 2 - Review Questions .................................................................................................. 126

Glossary ........................................................................................................................................ 127

Index ............................................................................................................................................ 130

Solutions to Review Questions ...................................................................................................... 131





Chapter 2 - Review Questions ................................................................................................................. 137

Chapter 3 Section 1 – Review Questions ................................................................................................. 139


1

Course Introduction

Fixed assets can compose a significant amount of the total assets in many companies. For example, fixed assets

usually account for 35-50% of Fortune 500 companies’ total assets and represent the majority of capital

investments for most of the companies. These assets are necessary for companies to operate and, in many cases,

the efficient use of these assets determines the amount of profit that companies will earn. Fixed Assets: Reporting

and Analyzing is designed to address the key accounting principles and concepts of fixed assets and share

meaningful insights and techniques that help accounting professionals build a solid foundation to achieve greater

efficiency. To maximize efficiency, accountants must answer the following questions:

• What are the basic accounting rules and requirements for recording, reporting and disclosing fixed assets?

• How do I properly account for intangible assets and assess goodwill?

• What are the key differences between IFRS and GAAP affecting the reporting of fixed assets?

• What are the top fixed asset issues and how do I address them?

• What are the internal controls for safeguarding valuable assets?

• How can I be “audit-ready” for fixed assets? What are the targeted audit areas and common audit findings?

• How do I make optimal long-term investment decisions regarding fixed assets?

• What are the various aspects of the lease/buy decisions and considerations of new lease accounting

standards?

The content of this course includes the following chapters, which will provide guidance related to these questions

and many more integral questions connected with this topic:

1. Accounting for Fixed Assets: This chapter discusses the concept of fixed assets and accounting rules for major

activities such as acquisition of assets, nonmonetary transactions, depreciation of plant assets, depletion of

natural resources, intangible assets requirements, treatment of goodwill, capitalized interest, asset

retirement obligations, accounting changes in estimated useful life, and disclosure requirements. It also

discusses key differences between IFRS and GAAP affecting fixed assets.

2. Fixed Assets - Controls: This chapter covers the top fixed assets issues including their vulnerable nature, the

risks of spreadsheets, and the impact of ghost assets. It also identifies controls to address these issues. Key

high-risk audit areas and typical audit approach are discussed to help accountants prepare for audits. It

includes an “Audit Checklist” and “Internal Controls Self-Assessment” checklist, which assist companies to be

audit-ready.

3. Planning and Analyzing: This chapter introduces the general concepts behind capital budgeting. It discusses

and illustrates six methods for selecting the best alternatives among capital projects. The risk-return trade-off

method shown in this chapter is one way to help us come to grips with uncertainty. It also describes various

aspects of the lease/buy decisions, lease analysis, and the impact of new lease accounting standards.

This course can be used by accounting professionals as a roadmap to build a well-structured process; from

reporting and controlling to optimizing valuable assets.

2

Learning Objectives

Upon completion of this course, you will be able to:

1. Identify the characteristics of fixed assets

2. Recognize the impact of fixed assets and depreciation on financial statements

3. Identify the various types of depreciation methods

4. Identify the procedures for amortizing intangible assets

5. Recognize the concept of capitalized interest

6. Recognize how to account for asset retirement obligations

7. Identify the impact of accounting changes in depreciation method

8. Identify the disclosures required in the financial statements regarding fixed assets

9. Recognize key differences between IFRS and GAAP fixed asset reporting requirements

10. Identify the top issues and control activities related to fixed assets

11. Recognize common testing procedures for fixed asset audits

12. Identify the different techniques used to evaluate business investments and their applications

13. Recognize various aspects of lease vs. buy decisions

14. Identify the primary types of leases

3

Chapter 1: Accounting for Fixed Assets

Learning Objectives

Upon completion of this chapter, you will be able to:

• Identify the characteristics of fixed assets

• Recognize the impact of fixed assets and depreciation on financial statements

• Identify the various types of depreciation methods

• Identify the procedures for amortizing intangible assets

• Recognize the concept of capitalized interest

• Recognize how to account for asset retirement obligations

• Identify the impact of accounting changes in depreciation method

• Identify the disclosures required in the financial statements regarding fixed assets

• Recognize key differences between IFRS and GAAP fixed asset reporting requirements

Role of the Accountant

Fixed assets, such as plant, and manufacturing equipment, can compose a significant amount of the total assets

of most companies. The accounting department (AD) is involved in almost all decisions regarding the company's

fixed assets, from pre-acquisition planning to the ultimate disposal or sale of those assets. For example, the

accountant investigates all the benefits, both financial and intangible, and compares these benefits to the costs.

By determining whether or not the assets, such as equipment or plant, will be a good investment for the company,

the AD assists the company in making sound strategic business decisions. In addition, to operate a profitable

business, management must have information regarding the current location, use, condition, and future

usefulness of its assets. The AD is responsible for ensuring that a system is in place to provide the information.

Examples of fixed assets tasks performed by the AD include:

• Making decisions regarding the purchase, use, and disposal of assets

• Developing a fixed assets tracking process

• Protecting the fixed assets through internal control and assuring proper insurance coverage

• Determining the value of the asset and the period over which it will extend benefits to the company

• Recording the acquisition of, changes to, and disposal of fixed assets

4

• Providing necessary reports to both management and custodians

Classification of Assets

A clear and correct understanding of the basic divisions of the assets, what they represent and the amounts at

which they should be recorded is essential for a proper perspective of financial position of a business.

Definition of Assets

An asset is a resource controlled by an entity as a result of past events and from which future economic benefits

are expected to flow to the entity. ‘Future economic benefits’ refers to the capacity of an asset to benefit the

entity by being:

• Exchanged for something else of value to the enterprise;

• Used to produce something of value to the enterprise, or

• Used to settle its liabilities

The future economic benefits of assets usually result in net cash inflows to the enterprise. Assets are recognized

in the financial statements when:

1. The item meets the definition of an asset;

2. It can be measured with sufficient reliability;

3. The information about the item is reliable

Assets may have definite physical forms such as buildings, machinery, or supplies. On the other hand, some assets

exist not in physical or tangible form, but in the form of valuable legal claims or rights, such as accounts receivables

from customers and notes receivables from debtors.

The concept of the historical cost principle, also known as the cost principle, applies to most assets. This principle

states that assets should be recorded in the accounting system at the original acquisition cost when acquired by

the company. The carrying value of these assets is adjusted for subsequent improvements, depreciation and

impairments.

Current Assets

Assets which will likely be converted into cash or realized within one year or one operating cycle, whichever is

longer, are classified as current. An operating cycle is the average time taken by a company to convert the funds

used to purchase inventory or raw materials into cash proceeds from sales to customers. Current assets include

cash and cash equivalents, short-term investments, accounts receivable, inventories, accrued revenues (assets),

and prepaid expenses.

5

Cash and Cash Equivalents

Cash and cash equivalents represents money on hand and in bank accounts as well as highly liquid securities that

generally mature in less than 90 days. Cash includes coins, checks, money orders, bank drafts, and any item

acceptable to a bank for deposit. A compensating balance arises when a bank lends funds to a customer and

requires that a minimum balance be retained at all times in the customer’s checking account. If compensating

balances are not disclosed, misleading inferences about the company’s liquidity and interest costs might be made.

Short-Term Investments

Short-term investments may include investments in marketable debt and equity securities. These investments

are short-term, low risk, highly liquid, low yield. Examples are treasury bills and commercial paper. Investments

in debt securities are classified as trading debt, available-for-sale debt, or held-to-maturity debt securities. Equity

securities represent an ownership interest in an entity (for example, common, preferred, or other capital stock)

or the right to acquire (e.g. warrants, rights, forward purchase contracts, call options) or dispose of (e.g. put

options, forward sale contracts) an ownership interest in an entity at fixed or determinable prices.

Accounts Receivable

Accounts receivable represent amounts due from customers arising from sales of goods or services. The allowance

for doubtful accounts shown on most balance sheets is a contra asset account. The allowance represents a

reduction of the accounts receivable that is established to adjust this item to an estimate of the amount realizable.

Notes receivable are unconditional promises in writing to pay definite sums of money at certain or determinable

dates, usually with a specified interest rate.

Inventories

Inventories represent merchandise, work in process, and raw materials that a business normally uses in its

manufacturing and selling operations. Inventories are usually reported at cost or at the lower of cost or market

value. Accountants determine cost by using one of many methods, each based on a different assumption of cost

flows. Typical cost flow assumptions include the following:

1. First-in, first-out (FIFO). The costs of the first items purchased are assigned to the first items sold and the

costs of the last items purchased are assigned to the items remaining in inventory.

2. Last-in, first-out (LIFO). The costs of the last items purchased are assigned to the first items sold; the cost

of the inventory on hand consists of the cost of items from the earliest purchases. Note: IFRS does not

allow LIFO.

3. Average-cost method. Each item carries an equal cost, which is determined by dividing the total of the

goods available for sale by the number of units to arrive at an average unit cost.

4. Specific identification method. The actual cost of a particular inventory item is assigned to the item.

Major impacts of FIFO and LIFO inventory costing methods on financial statements in times of rising prices and

stable or rising inventory levels are shown here:

6

FIFO LIFO

Ending inventory Higher Lower

Current assets Higher Lower

Cost of goods sold Lower Higher

Gross profit Higher Lower

Net income Higher Lower

Taxable income Higher Lower

Income taxes Higher Lower

The major accounting objective in selecting an inventory method should be to choose the one which, under the

conditions and circumstances in practice, most clearly reflects periodic income.

Prepaid Expenses

Prepaid expenses are expenses that have been paid prior to the company’s receipt of the benefits (i.e. goods or

services). The benefits will usually be received within the next year and therefore they are classified as current

assets. Examples of prepaid expenses include prepaid rent, prepaid insurance, or prepaid advertising

Accrued Revenue

An accrued asset or accrued revenue is revenue that has been earned (i.e. the service has been performed or the

goods have been delivered) for which payment has not been received and/or that has not been recorded in the

accounts. For example, a company performs a service for a customer but has not yet billed the customer. Since

the company has earned the revenue, the company must make an entry in the accounting records to increase

accounts receivable and revenue to properly reflect this transaction.

Noncurrent Assets

Assets having a useful life of more than one year and expected to provide benefits for several years are classified

as noncurrent. Examples are long-term investments, property, plant, and equipment.

Long-Term Investments (Financial Assets)

Long-term investments in stocks, bonds, and other investments owned by a company that are to be held for a

period of time exceeding the normal operating cycle of the business or one year, whichever is longer, are classified

as investments on the balance sheet. Investments in common stock in which an investor is able to exercise

significant influence over the operating and financial policies of an investee require the use of the equity method

of accounting. An investment of between 20% and 50% in the outstanding common stock of the investee is a

presumption of significant influence. When the equity method is used, income from the investment is recorded

by the investor when it is reported by the investee. The amount of the income recognized is based on the

investor’s percentage of ownership in the investee. Dividends are recorded as reductions in the carrying value of

the investment account when they are paid by the investee. When ownership is less than 20%, the cost method

is used - the investment is recorded at cost.

7

Property, Plant, and Equipment

Property, plant, and equipment are often called plant assets or fixed assets. They represent tangible, long-lived

assets such as land, buildings, machinery, and tools acquired for use in normal business operations (and not

primarily for sale) during a period of time greater than the normal operating cycle or one year, whichever is longer.

Depreciation is recorded each year of an asset’s useful life to reduce the asset’s carrying value for the deterioration

in value (e.g. wear and tear). Depreciation methods are discussed in the “Depreciation of Property, Plant, and

Equipment” section.

Wasting Assets

Natural resources or wasting assets represent inventories of raw materials that can be consumed (exhausted)

through extraction or removal from their natural location. Natural resources include ore deposits, mineral

deposits, oil reserves, gas deposits, and timber tracts. Natural resources are classified as a separate category

within the property, plant, and equipment section. Natural resources are typically recorded at their acquisition

cost plus exploration and development cost. Natural resources are subject to depletion. Depletion is the

exhaustion of a natural resource that results from the physical removal of a part of the resource. On the balance

sheet, natural resources are reported at total cost less accumulated depletion.

Intangible Assets

Intangible assets are long-lived assets representing nonphysical rights, values, privileges, and so on - exclusive of

receivables and investments. Goodwill, patents, trademarks, trade names, copyrights, and franchise licenses are

examples of intangible assets. Goodwill is the excess of the cost of an acquired business over the value assigned

to the tangible and other identifiable intangible assets of the firm. Goodwill is recorded and reported only when

it is acquired in the purchase of a business. A franchise license is the right (acquired by paying a fee) to use another

firm’s brand name, business model, etc. to conduct business. One well known example of a business that operates

through a franchise arrangement is McDonald's.

Other Assets

Other assets are assets that cannot be classified elsewhere on the balance sheet, including prepayments for

services or benefits that will not be received within 12 months, are reported as other assets or deferred charges

and are classified as noncurrent (or long term) assets. Deferred charges include long- term bond issue costs.

Deferred charges are similar to prepaid expenses in that they both arise from advance payments. The primary

difference between these two types of assets is that the benefits from such deferred charges will be obtained

over several years whereas the benefits of prepaid expenses will generally be obtained in less than one year.

This course focuses on property, plant, equipment, natural resources, and intangible assets. It also discusses

depreciation and amortization, and techniques to allocate the cost of long-lived assets over their estimated useful

lives.

8

Chapter 1 Section 1 - Review Questions

1. What is an asset?

A. A resource with economic value that a corporation controls with the expectation that it will provide a

future benefit

B. Fees earned from selling goods or providing services

C. An obligation that may occur in the future depending on the outcome of a specific event

D. Funds from the equity holders that are made available to the company as capital contributions and

retained profits

2. Which of the following accounting principles dictates that purchased assets are initially recorded at historical cost?

A. Revenue recognition principle

B. Full disclosure principle

C. Matching principle

D. Cost principle

3. Which of the following accounts captures anything of value owned by a company?

A. Revenue

B. Owner’s equity

C. Asset

D. Liability

4. Which of the following assets is easily liquidated into cash?

A. Trademark

B. Accrued revenue

C. Building

D. Franchise license

9

The Concept of Fixed Assets

The Nature of Fixed Assets

Fixed assets are also known as Property, Plant, and Equipment. U.S. Generally Accepted Accounting Principles

(GAAP) for the accounting, reporting, and disclosures associated with fixed assets are included in ASC 360-10-50

Property, Plant and Equipment - Disclosure and ASC 360-10-35, Subsequent Measurement. Fixed assets range from

tangible equipment and vehicles to intangible copyrights or trademarks and compose more than one-half of total

assets in many corporations. These resources are expected to provide benefits over current and future accounting

periods because they are used by a company for the production or supply of goods and services, for rentals to

others, or for administrative purposes. In many cases, the efficient use of these resources determines the amount

of profit corporations will earn.

Examples of common types of fixed assets include:

Fixed Tangible Assets Fixed Intangible Assets

Assets have physical characteristics such as:

− Land

− Buildings

− Motor Vehicles

− Furniture

− Office Equipment

− Computers

− Plant and Machinery

Assets have no physical characteristics such as:

− Goodwill

− Patents

− Copyrights

− Software

− Trademarks/Trade Names

− Franchises

− Licenses

Companies buy fixed assets for long-term use in their routine business activities and do not typically intend to

resell them. Therefore, fixed assets are considered to be less liquid than current assets. For example, inventories

are not considered fixed assets because they are not long-lived and are held for sale rather than for use. What

represents a fixed asset to one company may be inventory to another. For example, a business such as a retail

store may classify a truck as a fixed asset because the truck is used to deliver merchandise whereas a business

such as a truck dealership classifies the same truck as inventory because the truck is held for sale. Land held for

speculation or not yet put into service is a long-term investment rather than a plant asset because the land is not

being used by the business.

The fixed asset life cycle begins with acquisition, continues with depreciation and maintenance and ends with

disposal. The accounting treatment of each phase is discussed in the following sections.

Acquisition DepreciationRepair &

MaintenanceDisposal

10

Recording Fixed Assets

Initial Recording

The Cost of Fixed Assets

The original cost of a depreciable asset includes more than the asset's purchase price. It takes into consideration

all of the items that can be attributed to its purchase and preparing the asset for its intended use. Therefore, cost

includes all normal, reasonable, and necessary expenditures to obtain the asset and get it ready for use, such as:

• Transportation

• Installation

• Testing, breaking in, and setup

• Assembling

• Trial runs

• Warehousing

• Sales taxes

• Title fees

• Insurance

• Commission

• Warranties

Cost of a depreciable asset = Purchase cost + Costs attributable to preparing the asset for its intended use

Generally, for purchased depreciable assets, the initial tax basis will be the same as the original cost of the asset

as defined above.

Abnormal costs are not charged to the asset but are expensed, such as for repairs of a fixed asset that was

damaged during shipment because of mishandling. If two or more assets are purchased at a lump-sum price, cost

is allocated to the assets based on their fair market values as follows:

Specific asset’s fair market value ÷ Total fair market value of all assets acquired = rate x total acquisition cost =

specific asset’s acquisition cost

EXAMPLE 1-1

AMC Inc. purchases a piece of equipment with a price tag of $30,000. The purchase also involves:

• Sales tax: $1,500

• Shipping and delivery: $450

• Set-up by contractor: $300

• Warranty: $1,000

11

For depreciation purposes, the cost of the equipment is $33,250, computed as follows:

Invoice price $30,000

Sales tax 1,500

Shipping and delivery 450

Set-up 300

Warranty 1,000

Total cost $33,250

Equipment $33,250

Cash $33,250

EXAMPLE 1-2

Beta Inc. purchased a computer, copier, and printer with a total acquisition cost of $8,000. However, the invoice

does not break down the cost of each item. How is the acquisition cost of each asset calculated?

Beta Inc. estimates the fair market value of each asset as:

Computer $ 5,000

Copier 4,000

Printer 1,000

Total fair market value $10,000

Beta Inc. computes each asset’s portion of the total $8,000 acquisition cost, as follows:

Computer: $5,000 (computer fair market value) ÷ $10,000 (total fair market value) = 0.5 x $8,000 (total acquisition

cost) = $4,000 (acquisition cost for the computer)

Copier: $4,000 (copier fair market value) ÷ $10,000 (total fair market value) = 0.4 x $8,000 (total acquisition cost)

= $3,200 (acquisition cost for the copier)

Printer: $1,000 (printer fair market value) ÷ $10,000 (total fair market value) = 0.1 x $8,000 (total acquisition cost)

= $800 (acquisition cost for the computer)

The acquisition cost of each asset, individually:

Computer $4,000

Copier 3,200

Printer 800

Total acquisition cost $8,000

12

Self-Constructed Assets

Self-constructed assets are recorded at the incremental or direct costs to build (material, labor, and variable

overhead) assuming idle capacity. Fixed overhead is excluded unless it increases because of the construction

effort. However, self-constructed assets should not be recorded at an amount in excess of the outside cost.

EXAMPLE 1-3

Incremental costs to self-construct equipment are $80,000. The equipment could be bought from an

unaffiliated third party for $76,000. The journal entry is:

Equipment $76,000

Loss 4,000

Cash $80,000

EXAMPLE 1-4

Mavis Company uses its excess capacity to build its own machinery. The associated costs are direct material

of $80,000, direct labor of $20,000, variable overhead of $10,000, and fixed overhead of $5,000. The cost

of the self-constructed machine is $110,000. The fixed overhead is excluded because it is not affected by

the construction effort.

Donation of Fixed Assets

As per ASC 958-605, a company receiving a fixed asset from a donor should record the asset at its fair value by

debiting fixed assets and crediting contribution revenue. ASC 958 states that the company donating a

nonmonetary asset recognizes an expense for the fair value of the donated asset. The difference between the

book value and fair value of the donated asset represents a gain or loss.

EXAMPLE 1-5

Harris Company donates land costing $50,000 with a fair value of $70,000. The journal entry is:

Contribution expense $70,000

Land $50,000

Gain on disposal of land 20,000

If a company pledges unconditionally to give an asset in the future, contribution expense and payable are accrued.

This includes a conditional promise where all conditions have been satisfied which, in effect, has now made the

promise unconditional. However, if the pledge is conditional, an entry is not made until the asset is, in fact,

transferred. If it is unclear whether the promise is conditional or unconditional, the former is presumed.

13

Subsequent Measurement

Expenditures incurred that increase the capacity, life, or operating efficiency of a fixed asset are capitalized.

However, insignificant expenditures are usually expensed as incurred. Additions to an existing asset are capitalized

and depreciated over the shorter of the life of the addition or the life of the original asset. Rearrangement and

reinstallation costs should be capitalized if future benefits exist. Otherwise, they should be expensed. If fixed

assets are obsolete, they should be written down to salvage value, recognizing a loss, and reclassified from

property, plant, and equipment to other assets.

Ordinary repairs such as a tune-up for a delivery truck are expensed because they only benefit less than one year.

Extraordinary repairs are capitalized to the fixed asset if they benefit more than one year. An example is a new

motor for a salesperson's automobile. Extraordinary repairs either increase the asset's life or make the asset more

useful. Capital expenditures enhance the quality or quantity of services to be obtained from the asset.

If a fixed asset is to be disposed of, it should not be depreciated. Further, it should be recorded at the lower of its

book value or net realizable value. Net realizable value equals fair value less costs to sell. Expected costs to sell

beyond one year should be discounted. Idle or obsolete fixed assets should be written down and reclassified as

other assets. The loss on the write-down is presented in the income statement.

As per ASC 410-30-25-16, Asset Retirement and Environmental Obligations: Environmental Obligations, the costs

to prevent, contain, or remove environmental contamination should be expensed. Exception: These costs can be

capitalized to the fixed asset in the following cases:

• The costs increase the asset's life or capacity or improve its efficiency or safety.

• The costs are incurred to prepare the property for sale.

According to ASC 410-30-45-6, Asset Retirement and Environmental Obligations: Environmental Obligations, the

cost to treat property bought having an asbestos problem should be deferred to the asset. Disclosure should be

made of the asbestos problem and related costs to correct.

The following table summarizes the accounting treatment for various costs incurred subsequent to the

acquisition of capitalized assets.

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The Accounting Treatment for Costs Incurred Subsequent to the Acquisition of Capitalized Assets

Type of Expenditure Normal Accounting Treatment

Additions Capitalize cost of addition to asset account.

Improvements & Replacements

• Carrying value known: Remove cost of and accumulated depreciation on old asset, recognizing any gain or loss. Capitalize cost of improvement/replacement.

• Carrying value unknown:

1. If the existing asset's useful life is extended, debit accumulated depreciation for cost of improvement/replacement.

2. If the quantity or quality of the asset's productivity is increased, capitalize cost of improvement/replacement to existing asset account.

Rearrangement & Reinstallation

• If original installation cost is known, account for cost of rearrangement/ reinstallation as a replacement (carrying value known).

• If original installation cost is unknown and rearrangement/reinstallation cost is material in amount and benefits future periods, capitalize as an asset.

• If original installation cost is unknown and rearrangement/reinstallation cost is not material or future benefit is questionable, expense the cost when incurred.

Repairs • Ordinary: Expense cost of repairs when incurred.

• Major/material: As appropriate, treat as an addition, improvement, or replacement.

Depreciation of Property, Plant, and Equipment

General Rules

The carrying value of these assets should be systematically and gradually decreased by charging “depreciation”.

Depreciation is the decline in economic potential of fixed assets due to physical deterioration (e.g. wear, tear),

inadequacy for future needs, and normal obsolescence. When a specific asset is determined to be obsolete it is

written down or off. Land is not depreciated because its benefits do not decrease over time. However,

improvements to land, such as paving or fences, are capitalized as separate assets (i.e. not as land) and

depreciated since these improvements decrease in value and wear out over time.

The main accounting purpose of depreciation is to allocate the cost of an asset over its useful life. The use of a

plant asset in operations transforms the asset cost into an operating expense. Thus, depreciation is an operating

expense resulting from the consumption of a depreciable asset even though it does not involve cash or credit

payment. The reason for the expense is to comply with the matching principle required by accrual accounting.

According to the principle, revenue and related expenses should be recorded in the same accounting period. In

this way, sacrifices (expenses) are matched against benefits or accomplishments (revenues). This matching of

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expenses and revenues is necessary for the income statement to present an accurate picture of the profitability

of a business.

Depreciation expense not only reduces an accounting period’s earnings but also reduces the book value of an

asset. The book value of an asset is its recorded cost less accumulated depreciation. Accumulated depreciation is

a contra asset account which represents the accumulation of depreciation charges resulting from allocating the

cost of an asset over its useful life.

Acquisition cost – Accumulated depreciation = Book value

Depreciation for each asset is usually computed separately based on the following factors:

1. The cost of an asset

2. The estimated useful life of an asset

3. The salvage value of an asset

4. The method of depreciation used

Although companies are free to choose from several methods to calculate depreciation expense, companies

should apply depreciation methods that closely reflect the operations’ economic circumstances in accordance

with accounting theory. Therefore, companies should select methods that systematically and rationally allocate

asset cost to accounting periods according to benefits received from the use of the assets. Some companies select

one method for certain assets and other methods for other assets. It should also be noted that companies may

use a different depreciation method (or basis or life/recovery period) for tax purposes than they use for book

purposes. When this occurs, deferred tax assets or liabilities must be calculated, recorded and reflected in the

financial statements. A detailed discussion of deferred taxes is beyond the scope of this course.

The Asset’s Estimated Useful Life and Salvage Value

An asset’s useful life is the estimated number of years that the company expects the asset to last or the amount

of production it expects from the machine measured in operating hours, units produced, miles, or other standards.

For instance, a machine’s life may be measured in years, units produced, or hours operated. A vehicle is usually

measured in miles driven or years of use. Although there is no predetermined useful life under U.S. GAAP, general

guidelines that are frequently used include:

• Land – Not a depreciable asset

• Land improvements – 15 years

• Buildings – 30-40 years

• Computer equipment – 5 years

• Furniture and equipment – 10 years

• Software – 3 years

For tax purposes, the Internal Revenue Service (IRS) dictates the allowable depreciation methods and the recovery

period/depreciable life for each asset category.

16

The salvage value (residual value) is an estimated amount that a company expects the asset to be worth at the

end of its useful life. This amount cannot be depreciated. The depreciable base equals the acquisition cost minus

the salvage value.

Acquisition cost – Salvage value = Depreciable base

Methods of Depreciation

Among the commonly used depreciation methods are straight-line and accelerated methods. The two major

accelerated methods are sum-of-the-years'-digits (SYD) and double-declining-balance (DDB). Each of these

methods is explained below.

Straight-Line Method

Most companies use the straight-line method for financial statement purposes because this method is the

simplest to compute, results in fewer errors, and the amount is consistent each year. This method is most

appropriate when an asset's usage is uniform from period to period, as is the case with furniture. The annual

depreciation expense is calculated by using the following formula:

Depreciation Expense = Cost - Salvage Value

Number of Years of Useful Life

EXAMPLE 1-6

An auto is purchased for $20,000 in Year 1 and has an expected salvage value of $2,000. The auto's estimated life

is 8 years. Its annual depreciation is calculated as follows:

Depreciation Expense = $20,000 - $2,000

= $2,250/year 8 Years

An alternative means of computation is to multiply the depreciable cost ($18,000) by the annual depreciation rate,

which is 12.5 percent in this example. The annual rate is calculated by dividing the number of years of useful life

into one (1/8 = 12.5%). The result is the same: $18,000 x 12.5% = $2,250.

Sum-of-the-Years'-Digits (SYD) Method

Under this method, depreciation charges are highest in the initial years and decrease over the useful life of the

asset. To calculate the percentage to be taken each year, use the number of years of life expectancy in reverse

order as the numerator, and sum of the digits as the denominator. For example, if the life expectancy of a machine

is 8 years, write the numbers in reverse order: 8, 7, 6, 5, 4, 3, 2, 1. The sum of these digits is 36, or (8 + 7 + 6 + 5 +

4 + 3 + 2 + 1). Thus, the fraction for the first year is 8/36, while the fraction for the last year is 1/36. The sum of

17

the eight fractions equals 36/36, or 1. Therefore, at the end of 8 years, the machine is completely written down

to its salvage value. The following formula may be used to quickly find the sum-of-the-years' digits (S):

S = (N)(N+1)

2 N represents the number of years of expected useful life

EXAMPLE 1-7

Using the information from Example 1-6, the depreciable cost is $18,000 ($20,000 - $2,000). Using the SYD

method, the computation for each year's depreciation expense is:

S = (N)(N+1)

= 8(9)

= 36 2 2

Year Fraction x Depreciable Cost = Depreciation Expense

1 8/36 $18,000 $4,000

2 7/36 18,000 3,500

3 6/36 18,000 3,000

4 5/36 18,000 2,500

5 4/36 18,000 2,000

6 3/36 18,000 1,500

7 2/36 18,000 1,000

8 1/36 18,000 500

Total $18,000

Double-Declining-Balance (DDB) Method

Under this method, depreciation expense is highest in the earlier years and lower in later years. First, a

depreciation rate is determined by doubling the straight-line rate. For example, if an asset has a useful life of 10

years, the straight-line rate is 1/10 or 10 percent, and the double-declining rate is 20 percent. Second,

depreciation expense is computed by multiplying the rate by the book value of the asset at the beginning of each

year. Since book value declines over time, the depreciation expense decreases each successive period. This

method ignores salvage value in the computation. However, the book value of the fixed asset at the end of its

useful life cannot be below its salvage value.

EXAMPLE 1-8

Assume the data in Example 1-6. Since the straight-line rate is 12.5 percent (1/8), the double-declining-balance

rate is 25% (2 x 12.5%). The depreciation expense is computed as follows:

18

Year

Book Value at Beginning of Year x Rate (%) = Depreciation Expense Year-end Book Value

1 $20,000* 25% $5,000 $15,000

2 15,000 25% 3,750 11,250

3 11,250 25% 2,813 8,437

4 8,437 25% 2,109 6,328

5 6,328 25% 1,582 4,746

6 4,746 25% 1,187 3,559

7 3,559 25% 890 2,669

8 2,669 25% 667 2,002

*Note: The Book Value at the Beginning of Year 1 is equal to cost which is $20,000 in this example.

If the original estimated salvage value had been $2,100 instead of $2,000, the depreciation expense for the eighth

year would have been $569 ($2,669 - $2,100) rather than $667, since the asset cannot be depreciated below its

salvage value.

Units of Production Method

The units-of-production depreciation method allocates asset cost based on the level of production. As production

varies, so will the depreciation expense. Each unit is charged with a constant amount of depreciation equal to the

cost of the asset minus salvage value, divided by the total units expected to be produced.

Depreciation per unit = Cost - Salvage Value

Estimated total units that can be produced in the asset's lifetime

Depreciation = Units of output for year x Depreciation per unit

EXAMPLE 1-9

The cost of a machine is $11,000 with a salvage value of $1,000. The estimated total units are 5,000. The units

produced in the first year are 400.

Depreciation per unit = $11,000 - $1,000

= $2 per unit

5,000

Depreciation in year 1 = 400 units x $2 = $800

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Journal Entries

The following table lists typical fixed asset journal entries.

Fixed Assets xxx

Cash/Accounts Payable xxx

Purchase of fixed assets

Depreciation Expense xxx

Accumulated Depreciation xxx

Record Depreciation

Cash xxx


Fixed Assets xxx

Gain on Disposal xxx

Gain on sale of asset

Cash xxx


Loss on Disposal xxx

Fixed Assets xxx

Loss on sale of asset


Fixed Asset xxx

To remove a fully depreciated asset with no salvage value

If a company fails to capitalize a fixed asset at the correct amount, this error will affect the company’s income

statement and balance sheet. If a company does not capitalize the full purchase amount, or capitalizes too much,

the balance sheet will be under or over stated as a result of the error. Since depreciation expense is calculated

based on the asset’s recorded value and directly effects the calculation of net income, the valuation error will

impact the income statement as well.

Other Considerations

Purchase during the Year

If a fixed asset is bought during the year, the annual depreciation amount will need to be prorated to reflect the

number of months the asset was in service.

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EXAMPLE 1-10

On April 1, 20X2, a fixed asset costing $30,000 with a salvage value of $2,000 and a life of 10 years is bought.

Depreciation for 20X2 using the sum-of-the-years'-digits method is:

4/1/20X2 - 12/31/20X2: 10/55 × $ 28,000 × 9/12 = $ 3,818

Depreciation for 20X3 using the sum-of-the-years'-digits method is:

1/1/20X3 - 3/31/20X3: 10/55 × $28,000 × 3/12 $1,273

4/1/20X3 - 12/31/20X3: 9/55 × $28,000 × 9/12 3,436

$4,709

Depreciation expense for 20X3 under the double declining balance method is:

Year Computation Depreciation Book Value

0 $30,000

4/1/20X2-12/31/20X2 9/12 × $30,000 × 20% $4,500 25,500

20X3 $25,500 × 20% 5,100 20,400

It is also generally acceptable under GAAP to calculate depreciation using the group and composite methods. The

group method is used for similar assets and the composite method is used for dissimilar assets. These methods

calculate and record depreciation on an entire group of assets as one entity rather than calculating and recording

depreciation on each individual asset. No gain or loss is recognized when individual assets within the group are

sold. The difference between the proceeds and the cost of the asset are recorded in the accumulated depreciation

account.

The steps needed to calculate depreciation under the composite method are as follows:

• Identify each asset to be included in the group and calculate each asset’s straight line depreciation

• Calculate the composite depreciation rate by dividing the total straight line depreciation by the total

historical cost:

Composite Depreciation rate = Straight line depreciation/Historical cost

• Calculate the composite life by dividing the total depreciable cost by the total straight line depreciation:

Composite life = Depreciable cost/Straight line depreciation

• Calculate and record composite depreciation expense for the accounting period:

Depreciation expense = Composite depreciation rate × Historical cost

Changes to the initial assets included in the group may require modifications to the calculations.

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EXAMPLE 1-11

Computations under the composite depreciation method follow:

Asset Historical Cost Salvage

Depreciable

Cost /Life =

Straight Line

Depreciation

X $ 50,000 $10,000 $ 40,000 10 $ 4,000

Y 80,000 4,000 76,000 5 15,200

Z 104,000 8,000 96,000 6 16,000

$234,000 $22,000 $212,000 $35,200

Composite depreciation rate = Straight Line Depreciation/Historical Cost = $35,200/$234,000 = 15%

Composite life = Depreciable cost/Straight Line Depreciation

= $212,000/$35,200 = 6 years

Composite annual depreciation = Composite rate x historical cost = .15 x $234,000 = $35,100

The entry to record depreciation is:

Depreciation expense $35,100

Accumulated depreciation $35,100

The journal entry to record the sale of asset X for $43,000 is:

Cash $43,000

Accumulated depreciation 7,000

Fixed asset $50,000

Which Method to Use

• At the end of the useful life of the fixed asset, the total depreciation charges will be the same regardless of

whether straight-line or accelerated depreciation is used for both book and tax purposes; only the timing of

the tax savings will differ. If assets are disposed of before the end of their useful life, the gain or loss on the

disposition will differ depending on the depreciation method used.

• The depreciation method used for financial reporting purposes should be realistic for that type of fixed asset.

For example, depreciation on an automobile may be based on mileage.

• For IRS reporting, companies generally must use MACRS (Modified Accelerated Cost Recovery System). It is

the primary depreciation method for claiming a tax deduction. The depreciation rate used varies depending

on the type of asset being depreciated. Consult the IRS depreciation tables and literature for more

information. Details of MACRS are discussed in chapter 2 “MACRS and Investment Decisions” section.

22

Depletion of Natural Resources

Definition of Natural Resources

Natural resources are wasting assets, such as petroleum, timber, and minerals. They are characterized as being

subject to complete removal and being replaced only by an act of nature. Natural resources are subject to

depletion. Depletion is the physical exhaustion of a natural resource from usage. It is a process of allocating the

cost of the natural resource over its anticipated life and is similar to depreciation except that it relates to a natural

resource instead of a fixed asset.

Units of Production Method

The most common method of recording depletion for accounting purposes is the units of production method. An

estimate of how much of the natural resource will be extracted in terms of tons, barrels, units, or other measures

is required to calculate depletion. The cost of the natural resource is divided by the total recoverable units to

arrive at the depletion per unit. Depletion expense equals the units extracted for the year multiplied by the

depletion per unit. A change in estimate requires the use of a new depletion rate per unit. Depletion expense is

presented in the income statement; accumulated depletion reduces the carrying value of the natural resource in

the noncurrent asset section of the balance sheet. In some cases, depletion is charged to inventory (or cost of

sales). For example, if depletion on a coal mine equals $20,000, the entry would be to debit coal inventory (or cost

of sales) for $20,000 and credit accumulated depletion (or land rights) for $20,000.

The basis on which depletion is computed is called the depletion base. The depletion base is generally made up

of three components, consisting of the following:

1. Acquisition cost of the depletable property: Property may be acquired in hope of finding natural resources

or may already have been determined to have proved resources on it. Alternatively, the property may

also be leased, with subsequent royalties being paid to the owner if resources are found on it.

2. Exploration costs: When the rights to explore the property are secured (through acquisition or lease),

exploration costs are incurred to determine the existence of natural resources. For most natural

resources, the costs of exploration are expensed in the period in which they are incurred. However, for

certain industries, such as oil-and gas-producing enterprises, certain specialized guidelines prevail. For

example, oil and gas entities may choose between the successful efforts method and the full cost method

of accounting for exploration costs. In the successful efforts approach, only those exploratory costs

related to successful wells are capitalized. Exploratory costs related to unsuccessful wells are expensed.

In the full cost method, exploratory costs related to both successful wells and unsuccessful wells are

capitalized as part of the depletion base.

3. Development costs: These are the costs incurred in extracting the natural resource from the ground,

making it ready for production or sale. Costs incurred on machinery and equipment that can be used for

different wells or mines are generally not considered part of the depletable base and should be separately

depreciated as they are utilized. On the other hand, intangible costs incurred on specific wells or mines

which cannot benefit to any other well or mine should be considered part of that resource's depletion

23

base. Such costs primarily include the costs incurred to dig, physically secure, and utilize the wells, mines,

tunnels, shafts.

In general, the components of the depletion base of a natural resource upon which depletion should be computed

include:

• Acquisition costs

• Capitalized exploratory costs, and

• Development costs

After a depletable asset has been fully consumed, local, state, and federal laws may require that the company pay

for any restoration costs that may be required so that the residual property that remains does not represent a

detriment to the local area in which it is situated. Estimated restoration costs represent a negative salvage value

that should be added to the components of the depletion base of the natural resource. The property's estimated

salvage value should, of course, be subtracted from the depletion base in computing depletion expense.

EXAMPLE 1-12

In January 20X7, LevSe Company incurred costs of $3,500,000 in connection with the acquisition of a mineral mine.

In addition, $200,000 of development costs were incurred in preparing the mine for production. It is estimated

that 1,200,000 tons of ore will be removed from the mine over its useful life, at which point it is estimated that

the company can sell the property for $250,000. After all the ore has been extracted, it is estimated that it will

cost the company $100,000 to restore it to an acceptable level as required by law. During 20X7, 30,000 tons of

ore were extracted and sold. On its 20X7 income statement, what amount should LevSe report as depletion?

DEPLETION BASE

Acquisition cost $3,500,000

Development costs 200,000

Restoration costs—negative salvage value 100,000

Estimated salvage value (250,000)

Depletion base $3,550,000

20X7 production 30,000 tons

Depletion rate: $3,550,000/1,200,000 tons $ 2.96/ton

Depletion—20X7 $2.96 × 30,000 tons $ 88,800

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The annual report of International Paper Company in Exhibit 1-1 shows an acceptable disclosure. It uses

condensed balance sheet data supplemented with details and policies in notes to the financial statements.

EXHIBIT 1-1: Disclosures for Property, Plant, Equipment, and Natural Resources International Paper Company

Consolidated Balance Sheet In millions at December 31 20X7 20X6 Assets Total current assets $ 6,735 $ 8,637 Plants, properties and equipment, net 10,141 8,993 Forestlands 770 259 Investments 1,276 641 Goodwill 3,650 2,929 Assets held for exchange 1,324

Deferred charges and other assets 1,587 1,251

Total assets $24,159 $24,034

Note 1 (partial)

Plants, Properties and Equipment - Plants, properties and equipment are stated at cost, less accumulated depreciation. Expenditures for betterments are capitalized, whereas normal repairs and maintenance are expensed as incurred. The units-of-production method of depreciation is used for major pulp and paper mills, and the straight-line method is used for other plants and equipment. Annual straight-line depreciation rates are, for buildings-2 1/2% to 8 1/2%, and for machinery and equipment-5% to 33%.

Forestlands. At December 31, 20X7, International Paper and its subsidiaries owned or managed about 300,000 acres of forestlands in the United States, approximately 250,000 acres in Brazil, and through licenses and forest management agreements, had harvesting rights on government-owned forestlands in Russia. Costs attributable to timber are charged against income as trees are cut. The rate charged is determined annually based on the relationship of incurred costs to estimated current merchantable volume.

Note 11 (partial)

Plants, properties and equipment by major classification were:

In millions at December 31 20X7 20X6

Pulp, paper and packaging facilities Mills $18,579 $16,665 Packaging plants 5,205 5,093 Other plants, properties and equipment 1,262 1,285

Gross cost 25,046 23,043 Less: Accumulated depreciation 14,905 14,050

Plants, properties and equipment, net $10,141 $ 8,993

25

Nonmonetary Transactions

General Requirements

Nonmonetary transactions involve the exchange of nonmonetary assets, such as inventories, plant and

equipment, or property. In general, in a nonmonetary exchange, the asset received is recorded at the amount

given up for it. Typically, this would include the fair value of the asset given up plus any cash paid. If cash is

received, the amount of fair value given up is reduced. In addition, a gain or loss may be recognized on the transfer

or disposal. The gain or loss is the difference between the fair value and book value of the asset given up.

Nonmonetary transactions may or may not have commercial substance. If a transaction has commercial

substance, a gain or loss on the disposal is fully recognized. However, if the transaction lacks commercial

substance, then a loss is always recognized but a gain may or may not be recognized based on the circumstances.

The latter situation is more complicated and is discussed further below.

In general, in exchanges of nonmonetary assets, if the fair value of the asset given up is not reliably measurable,

then the fair value of the asset received should be used. Also in this case, if a transaction has commercial

substance, fair value is used to measure the value of the asset acquired. ASC 845-10-50-1 requires note disclosure

for a period in which an entity engages in one or more nonmonetary exchanges that includes a description of the

nature of the transaction(s), the method used to account for transferred assets, and the gain or loss on the

exchanges. ASC 845-10-05-6 addresses nonmonetary transactions and covers the accounting for exchanges or

distributions of fixed assets.

Determining Commercial Substance

Commercial substance occurs when future cash flows change as a result of an exchange of nonmonetary assets

resulting in the modification of the economic positions of the two parties involved.

EXAMPLE 1-13

X Company exchanges machinery for Y Company's land. It is probable that the timing and dollar amount of cash

flows from the land received will be materially different from the equipment's cash flows. Hence, both companies

now have different economic positions indicating an exchange with commercial substance.

Even in the case of an exchange of similar assets (machine for a machine), a change in economic position may

occur. Assuming that the life of the machine received is much longer than that of the machine given up, the cash

flows for the machines can be materially different. Consequently, there is commercial substance to the transaction

and fair value should be used as the measurement basis for the machine received in the exchange. On the other

hand, if the difference in cash flows is not significant, the company is still in the same economic position as before

and a loss is recognized immediately and the measurement basis of the asset received will be equal to the basis

in the asset given up plus or minus cash received or paid. However, as noted above, a gain is recognized in only

certain circumstances.

26

Business entities must analyze the cash flow features of the assets exchanged to ascertain whether there is

commercial substance to the transaction. In determining whether future cash flows change:

1. Analyze cash flows before and after the exchange and compare them or

2. Determine whether the timing, amount, and risk of cash flows resulting from the asset received are

different from the cash flows of the asset given up.

Another consideration is whether the value of the asset received differs from that transferred, and whether the

difference is significant relative to the fair values of the assets exchanged.

Commercial Substance Exists

Following is an example of the calculations and entries related to a nonmonetary exchange when commercial

substance exists..

EXAMPLE 1-14

XYZ Company exchanged autos plus cash for land. The autos have a fair value of $100,000. They cost $130,000

with accumulated depreciation of $50,000 so the book value is $80,000. Cash paid is $35,000. The cost of the land

to XYZ equals:

Fair value of autos exchanged $100,000

Cash paid 35,000

Cost of land $135,000

The journal entry to record the exchange transaction is:

Land $135,000

Accumulated depreciation—autos 50,000

Autos $130,000

Cash 35,000

Gain on disposal of autos 20,000

The gain equals the fair value of the autos less their book value as computed below:

Fair value of autos—given up $100,000

Book value

Cost of autos $130,000

Less: accumulated depreciation 50,000 80,000

Gain $ 20,000

However, if the autos had a fair value of $78,000 rather than $100,000, there would be a loss recognized of $2,000

($80,000 less $78,000). In either situation, the company is in a different economic position and thus the

transaction has commercial substance. Hence, a gain or loss is recognized.

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EXAMPLE 1-15

ABC Company exchanges its old equipment for new. The used equipment has a book value of $40,000 (cost

$60,000 less accumulated depreciation of $20,000) with a fair value of $30,000. The list price of the new

equipment is $80,000. The trade-in allowance is $45,000. Assuming that commercial substance exists, cash to be

paid equals:

List price of new equipment $80,000

Less: trade-in allowance 45,000

Cash to be paid $35,000

The cost of the new equipment equals:

Fair value of old equipment—given up $30,000

Cash due 35,000

Cost of new equipment $65,000

The journal entry to record this exchange transaction is:

Equipment $65,000


Loss on disposal of equipment 10,000

Equipment—old $60,000

Cash 35,000

The loss is computed as follows:

Fair value of old equipment $30,000

Book value of old equipment 40,000

Loss $10,000

Commercial Substance Does Not Exist

Because assets should not be valued in excess of their fair value, a loss is recognized immediately when the fair

value of the asset given up in an exchange is greater than its book value instead of being added to the cost of the

newly acquired asset. Exchanges lacking commercial substance may occur in the real estate industry for example,

when there is a “swap” of real estate properties.

When a transaction lacks commercial substance, and a loss occurs, it is fully recognized. However, ASC 845-10-25-

6 indicates a gain may be recognized in the following situations:

28

1. If cash is received or paid, and the amount is significant, that is, 25% or more of the fair value of the

exchange, then the entire transaction is considered to be monetized and is recorded at fair value (cash

equivalent value). Thus, a gain would be fully recognized.

2. If the cash is less than 25%, then recognition of the gain (ASC 845-30-6) would be applied by the receiver

of the cash (boot) only and the payer would not recognize any gain at all.

For tax purposes, when investors make a like-kind exchange of real property (a 1031 exchange), they can defer a

gain or loss under Internal Revenue Code Section 1031. Like-kind exchanges mean that when you exchange real

property used for business or held as an investment solely for other business or investment real property that is

of the same nature or character.

EXAMPLE 1-16

A Company and B Company both have undeveloped land they want to exchange. The cash flows from these

properties are not materially different. Because of this, commercial substance does not exist. Both companies are

in the same economic position after the swap as before.

Caution: The asset given up may be impaired. If the book value is more than fair value and the impairment criteria

are met, an impairment should be recorded prior to the exchange.

EXAMPLE 1-17

Avis Car Rental has mostly Chrysler automobiles. Avis contracts with Hertz Car Rental to exchange a group of

Chrysler cars that are basically similar to Hertz's General Motors models. The Chrysler autos to be exchanged have

a fair value of $320,000 and a book value of $270,000 (cost $300,000 less accumulated depreciation of $30,000).

The General Motors cars have a fair value of $340,000. Avis also pays $20,000 cash as part of the exchange. Avis

has a total unrecognized gain of $50,000 – see calculations and journal entries below.

If the cash paid or received was 25% or more of the fair value of the exchange, the entire gain would have been

recognized. If the cash amount received was less than 25% of the total, a pro rata amount of the gain would have

been recognized.

Since the cash Avis paid ($20,000) is less than 25% of the fair value of the exchange ($320,000 x 25% = $80,000),

the gain is completely deferred by Avis, the payer. The calculations are shown below:

Fair value of Chrysler autos exchanged $320,000

Book value of Chrysler autos exchanged 270,000

Total unrecognized gain $ 50,000

In this situation, Avis still has an auto fleet generating essentially the same cash flows as the autos given up even

though they are different models. Thus, the transaction does not have commercial substance. As indicated above,

the total gain is deferred, and the basis for the GM cars is decreased. The computation of the basis of the GM

automobiles follows:

$270,000

29

Book value of Chrysler cars

Cash paid 20,000

Basis of GM cars $290,000

An alternative calculation is:

Fair value of GM cars $340,000

Less: unrecognized gain 50,000

Basis of GM cars $290,000

Avis prepares the following journal entry to record this transaction:

Autos (GM) $290,000


Autos (Chrysler) $300,000

Cash 20,000

The basis of the new autos, which was reduced by the unrecognized gain, will be used to determine the gain or

loss when they autos are sold to an external party or otherwise disposed of. The reduced basis means higher net

income since depreciation expense on the autos will be lower while the autos are held.

If fair values for either the asset received or the asset given up are not reliably measurable, the book value of the

asset received is recorded at the cost of the asset given up (plus cash paid). Another exception to the fair value

rule is for an exchange that facilitates customer sales. An example is when a business exchanges its inventory for

that of another business because its inventory has the same features as the other business (e.g., size, color), which

makes the inventory items easier to sell to an outside customer. In this situation, the earnings process for the

inventory is not deemed complete, and there will be no recognition of gain on the exchange.

EXAMPLE 1-18

Due to a change in product processing, X Company trades its outdated machinery for new machinery that can be

used in the new product processing. Because of the specialized nature of the machinery being exchanged, the fair

values of the assets being exchanged are not reliably measurable. The old machinery has a book value of $19,000

(cost $32,000 less accumulated depreciation $13,000). The new machinery has a list price of $32,000. The trade-

in allowance on the old machinery is $25,000. The cash to be paid equals:

List price of new machinery $32,000

Less: trade-in allowance for used machinery 25,000

Cash to be paid $ 7,000

The cost of the new machinery equals:

Cash to be paid $ 7,000

Book value of old machinery—given up 19,000

Cost of new machinery $26,000

The journal entry to record the exchange follows:

30

Machinery—new $26,000


Machinery—old $32,000

Cash 7,000

As previously noted, if the fair values for either the asset obtained or relinquished are not reliably measurable,

the business uses the book value of the old asset plus the cash paid as the cost basis for the new asset. The

following table summarizes asset exchange situations and the related accounting.

Type of Exchange Accounting Guidance

Exchange has commercial substance Recognize gains and losses immediately.

Exchange lacks commercial substance -no cash received/paid.

Defer gains; recognize losses immediately.

Exchange lacks commercial substance -cash received/paid.

Recognize partial gain if cash is less than 25%; recognize losses immediately.*

*Receiver of cash recognizes gain and the payer does not. If cash is 25% or more of the fair value of the exchange, recognize entire gain because earnings process is complete.

Involuntary Conversion

An involuntary conversion of nonmonetary assets to monetary assets may arise because of fire, flood, theft, or

condemnation. The destruction is followed by replacement of the damaged assets. An example is a building

destroyed by a fire and the insurance proceeds received used to buy a similar building. A contingency arises if the

old fixed asset is damaged in one year, but the insurance recovery is not received until a later year. A contingent

gain or loss is recognized in the period the old fixed asset was damaged. The gain or loss may be reflected for book

and tax reporting in different years, resulting in a temporary difference mandating inter-period income tax

allocation.

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5. An accumulated depreciation account is an example of which of the following contra accounts?

A. Contra liability account

B. Contra asset account

C. Contra equity account

D. Expense account

6. What is acquisition cost minus the salvage value equal to?

A. Book value

B. Market value

C. Depreciable base

D. Depreciation expense

7. A company changes from depreciating its vehicles at 25% on a straight line basis to 10%. How does this change

affect its profit each year?

A. Increase profits

B. Decrease profits

C. Unable to quantify

D. No effect

8. A machine with a 5-year estimated useful life and an estimated 10% salvage value was acquired on January 1,

20X0. On December 31, 20X3, how is accumulated depreciation using the sum-of-the-years' digits method

computed?

A. (Original cost minus salvage value) multiplied by 1/15

B. (Original cost minus salvage value) multiplied by 14/15

C. Original cost multiplied by 14/15

D. Original cost multiplied by 1/15

9. What factor must be present to use the units-of-production method of depreciation for a machine?

A. Total units to be produced can be estimated

B. Production is constant over the life of the asset

C. Repair costs increase with use

D. Obsolescence is expected

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10. In January, Vorst Co. purchased a mineral mine for $2,640,000 with removable ore estimated at 1.2 million tons.

After it has extracted all the ore, Vorst will be required by law to restore the land to its original condition at an

estimated cost of $180,000. Vorst believes it will be able to sell the property afterwards for $300,000. During the

year, Vorst incurred $360,000 of development costs preparing the mine for production and removed and sold

60,000 tons of ore. In its income statement for the year, what amount should Vorst report as depletion?

A. $135,000

B. $144,000

C. $150,000

D. $159,000

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Intangible Assets

The Nature of Intangible Assets

Intangible assets have a life of one year or more and lack physical substance (e.g., goodwill) or reflect a right

granted by the government (e.g., trademarks, copyrights) or by another company (e.g., license fee, franchise).

Intangibles generally have a high degree of uncertainty concerning future benefits. Intangibles should be recorded

at cost. Intangibles may be internally generated or they may be purchased. Intangibles acquired from others

should be separately reported.

Patents are limited life intangibles which give the holder exclusive rights for a period of 20 years. It would,

therefore, be inappropriate to amortize a patent for a period greater than 20 years. Internally generated costs to

derive a patented product are expensed (e.g., research and development). The patent account is charged for

registration fees, and legal fees in successfully defending the patent in court. The patent account is amortized over

its useful life not exceeding 20 years.

Copyrights are granted for the life of the creator plus 70 years. The useful life of copyrights is typically much

shorter. Franchises and licenses are also limited life intangibles although it is possible for them to have indefinite

lives. In general, limited life intangibles should be amortized over the shorter of their useful lives or legal lives.

Trademarks and trade names have legal protection for a period of 10 years and may be renewed for an indefinite

number of times. They are, therefore, considered to be indefinite life intangibles. Assets assumed to have

indefinite lives should not be amortized. Organization costs, which include initial incorporation, legal, and

accounting fees that are incurred in connection with establishing an entity, are required to be expensed as

incurred. The description and acquisition costs related to goodwill and other intangible assets are listed in Exhibit

1-2.

EXHIBIT 1-2: Acquisition Costs of Goodwill and Other Intangible Assets

Type Description Acquisition Cost

Patent

An exclusive right granted by a national

government that enables an inventor to control

the manufacture, sale, or use of an invention. In

the U.S., legal life is 20 years from patent

application date.

Purchase price, filing and registry fees, and

cost of subsequent litigation to protect

right. Does NOT include internal R&D costs.

Trademark

An exclusive right granted by a national

government that permits the use of distinctive

symbols, labels, and designs (e.g. McDonald’s

Golden Arches, Nike’s Swoosh, Apple Computer’s

name and logo). Legal life is virtually unlimited.

Same as patent.

Copyright An exclusive right granted by a national

government that permits an author to sell, license, Same as patent.

34

or control his or her work. In the U.S., copyrights

expire 70 years after the death of the author.

Franchise

Agreement

An exclusive right or privilege to use another firm’s

brand name, business model, etc. to conduct

business.

Expenditures made to purchase the

franchise. Legal fees and other costs

incurred in obtaining the franchise.

Acquired

Customer

List

A list or database containing customer

information such as name, address, past

purchases, and so forth. Companies that originally

develop such a list often sell or lease it to other

companies unless prohibited by customer

confidentiality agreements.

Purchase price when acquired from

another company. Costs to internally

develop a customer list are expensed as

incurred.

Goodwill

Goodwill represents the excess of the fair value of

the consideration given (generally the purchase

price) to acquire an entity over the fair value of the

net assets acquired (i.e. the future economic

benefits of unidentifiable assets) in a purchase

transaction. (Negative goodwill can also occur if

the purchase price is less than the book value of

the acquired company.)

Portion of purchase price that exceeds the

sum of the current market value for all

identifiable net assets, both tangible and

intangible.

Research and development (R&D) costs are those costs related to developing new products, processes, services,

or techniques, or modifying existing ones. Most R&D costs are not capitalized but are expensed as incurred. This

practice suggests that the future expected valued of these costs do not merit recognition as an asset because of

the risks, uncertainties, and estimates involved. The costs of materials, equipment, and facilities that are acquired

or constructed for R&D activities and that have alternative future uses should be capitalized when acquired or

constructed. When such equipment and facilities are used, the depreciation of the items and materials consumed

should be included as R&D costs.

General Rules and Concepts

The cost at which intangibles are recorded depends on whether the intangible was developed internally or

acquired from others. In general, expenses internally incurred to develop an identifiable intangible asset (e.g.,

patents, trademarks, and copyrights) should be expensed except for the direct costs of securing the intangible

asset such as registration fees, attorney fees, design fees, etc. These are capitalized. R&D costs should be expensed

when incurred except when arising from a business combination or asset purchase. Unidentifiable internally

developed intangibles should not be recorded. Such an asset is recognized only if it is purchased from another

entity.

When an intangible asset is acquired externally, it should be recorded at its cost at the date of acquisition. In an

exchange transaction, cost is measured by the cash paid. Otherwise, most reliable value (i.e. the fair value of the

35

consideration given or the asset acquired) is the basis for measurement. The present value of payments on the

liability incurred or the fair value of the stock issued (as these represent consideration given) may also be used to

value externally acquired intangibles if applicable. When a group of assets consisting of both tangible and

intangible assets is acquired, the identifiable intangible assets are allocated a part of the total cost based on the

fair values of the individual assets in the group. The unidentifiable intangible assets, acquired as part of a group

of assets, are valued at the excess of costs assigned to identifiable tangible and intangible assets, net of liabilities

assumed.

EXAMPLE 1-19

Purchase price $150,000

Fair value of assets acquired:

Tangible assets

Equipment $20,000

Land 80,000

Identifiable intangible assets

Copyrights 35,000

Patents 40,000

Total assets 175,000

Less: liabilities assumed (65,000) 110,000

Unidentifiable intangible assets $ 40,000

As previously noted, any costs incurred to develop and maintain intangibles should generally be charged against

earnings. For example, the costs incurred to develop a name (e.g., McDonald's) are expensed. Costs, such as legal

costs associated with registering or successfully defending a patent, are capitalized. The costs of purchasing an

externally developed patent should also be capitalized.

Business Combination under the Acquisition Method

In a business combination accounted for under the acquisition method ASC 805-20-30-1, the acquirer recognizes

at fair value, the identifiable intangible assets acquired if they meet either the separability or contractual legal

criterion. The separability criterion is met when the items are exchangeable and can be traded by the acquirer

company. Examples include unpatented technology, customer lists, databases and trade secrets, including secret

formulas. The contractual legal criterion relates to whether the holder obtains legal rights associated with the

intangible. Examples meeting this criterion include trademarks, patents, construction permits, and licensing

agreements.

Goodwill may be recorded in a business combination accounted for under the acquisition method (ASC 805-30-

30). Goodwill is calculated as the excess of the fair consideration transferred (generally the purchase price) over

the fair value of net assets acquired. When the fair value of net assets acquired exceeds the fair value of

36

consideration transferred, a bargain purchase occurs. A gain on a bargain purchase is reported in the consolidated

income statement. Under the acquisition method, goodwill is defined as:

(Fair Value of Consideration Transferred + Fair Value of Any Noncontrolling Interest in the Acquiree + Fair Value

of Any Previously Held Equity Interest in the Acquiree) - Fair Value of the Net Assets Acquired

EXAMPLE 1-28

On July 1, 20X6, Jeffries Incorporated issues 40,000 shares of its common stock in exchange for an initial

acquisition of 80% of Bromard's outstanding shares. The aggregate fair value of the shares issued is $4,000,000

($100 per share). It is determined by independent appraisal that the remaining 20% of Bromard has a fair value of

$800,000. It is also determined that the fair value of 100% of the Bromard's net assets at date of acquisition is

$4,200,000. What is the goodwill?

Solution

Goodwill = [Fair Value of Consideration Transferred ($4,000,000) + Fair value of Noncontrolling Interest ($800,000)

+ Fair Value of Previously Held Equity Interest (0)] - Fair Value of Net Assets Acquired ($4,200,000) = $600,000

EXAMPLE 1-29

Same facts as above, but the fair value of Bromard's net assets at date of acquisition is $5,000,000.

Solution

In this example, there is a $200,000 excess of fair value of net assets acquired over fair value of consideration

transferred + the fair value of the noncontrolling interest. The result is a $200,000 gain on the bargain purchase

that is recognized in the consolidated income statement in the period of acquisition.

Treatment of Goodwill

The existing guidance in ASC 350, Intangibles: Goodwill and Other, offers two accounting treatments for goodwill:

1. The general model (all companies):

• Goodwill is not amortized

• An annual impairment test is performed through a two-step approach

2. Private company alternative (Election available to private companies only):

• Goodwill is amortized over a maximum of 10 years on a straight-line basis

• An annual impairment test is not performed unless there is a triggering event

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The following table summarizes the existing rules for impairment of goodwill.

GAAP Rule Accounting Treatment Impairment Test Approval

ASC 350 Cannot amortize goodwill Tested annually for impairment

with two-step approach

ASU 2014-02 Amortized over maximum of 10

years straight line

Upon occurrence of a triggering

event

The FASB issued ASU 2017-04 to simplify how an entity is required to test goodwill for impairment by eliminating

Step 2 from the goodwill impairment test. The standard has tiered effective dates, starting in 2020 for calendar-

year public business entities that meet the definition of an SEC filer.

Impairment Test

As per ASC 350-30-35-21, Intangibles - Goodwill and Other: General Intangibles Other than Goodwill, acquired or

internally developed intangible assets having indefinite lives that have been separately recognized and are

inseparable from each other owing to being operated as a single unit should be combined in one accounting unit

when the impairment test is applied.

Goodwill and intangible assets with indefinite lives are not amortized but instead are tested for impairment at

least once a year. If there is no factor (e.g., legal, economic, regulatory, competition) that limits an intangible's

useful life, such intangible is considered to have an indefinite life. Intangible assets having finite useful lives are

amortized over their useful lives. However, the arbitrary limitation of 40 years no longer applies.

Goodwill for each reporting unit must be tested each year for impairment. A reporting unit is defined as an

operating segment or one level below an operating segment. If certain events occur, more frequent impairment

testing is required. An impairment test can be performed at any date, as long as it is consistently used each year.

However, different reporting units may be tested for impairment at different dates.

There are two steps in applying the impairment test. The initial step is to determine whether there is a potential

impairment. The book value of the reporting unit (including goodwill) is compared to its fair value. No impairment

exists if fair value exceeds book value. If this is the case, the second step is not undertaken. However, if the

reporting unit's fair value is below its book value a potential impairment exists and step 2 must be performed.

EXAMPLE 1-20

Step 1

Book value $150

Fair value 190

No impairment exists. Do NOT proceed to step 2.

38

EXAMPLE 1-21

Step 1

Book value $190

Fair value 150

An impairment exists. Proceed to step 2.

In the second step, the amount of impairment, if any, is measured. A comparison is made between book value of

goodwill to the implied fair value of goodwill. Implied fair value of goodwill may be obtained by comparing the

fair value of the reporting unit to the book value of its net identifiable assets excluding goodwill. If the implied fair

value of goodwill is more than book value, no impairment loss exists and no entry is made. However, if the implied

fair value of goodwill is below book value of the entity's goodwill, an impairment loss must be recognized for the

difference. After an impairment loss for goodwill is recorded, the downwardly adjusted book value becomes the

intangible's new cost basis, which means the new accounting basis cannot be written up for a recovery in fair

value for GAAP purposes.

EXAMPLE 1-22

Step 1

The fair value of the reporting entity's net assets is $6,100, and the carrying value is $6,300 (shown in the

following figures). Because the fair value is below the carrying value, step 2 must be performed:

Current assets $2,000

Fixed assets (net) 1,600

Goodwill 3,000

Current liabilities 100

Noncurrent liabilities 200

Carrying Value of Net Assets = $2,000 + 1,600 + 3,000 - 100 - 200 = $6,300

Net identifiable assets less goodwill = $6,300 - 3,000 = $3,300

If the fair value of the reporting unit is $6,100, the implied value of goodwill is $2,800, derived as follows:

Fair value of reporting unit $6,100

Less: fair value of net identifiable assets less goodwill 3,300

Implied value of goodwill $2,800

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EXAMPLE 1-23

Step 2

Book value of goodwill $3,000

Implied fair value of goodwill 2,800

An impairment loss of $200 must be recognized. The new adjusted cost basis is $2,800. If there is a recovery

in fair value in a subsequent period above $2,800, it cannot be recorded.

EXAMPLE 1-24

Step 2

Book value of goodwill $2,800

Implied fair value of goodwill 3,000

No impairment loss should be recorded.

EXAMPLE 1-25

Adams Company has $70,000,000 in goodwill associated with its acquisition one year ago of Baker Company.

Adams is required to test for impairment using the following steps:

1. At date of acquisition, goodwill is assigned to each of Adam's business segments; in this example, Adams

has three divisions comprising its business segments, with book values excluding goodwill of: Division A—

$60 million, Division B—$220 million, Division C—$180 million. The goodwill assigned to the three divisions

is $20 million, $30 million and $20 million, respectively.

2. The book value (net assets) of each division inclusive of the allocated goodwill (from step 1) is compared to

the fair value of each division; that is, the theoretical price at which the division could be sold. The fair

values of the three divisions are $90 million, $200 million, and $300 million, respectively. (Note that these

amounts may be determined by consultation with an expert in the field of mergers and acquisitions.)

3. If the fair value of each division is greater than the book value inclusive of goodwill, no further testing is

required and there is no goodwill impairment. If the fair value of any division is less than the book value

inclusive of goodwill, proceed to step 4 for that division. In this problem, the fair value of the individual net

assets of Division B is given at $180 million.

4. Compute the implied value of goodwill. This is equal to the fair value of the division (price at which it could

be sold) minus the fair value of the specific net assets of the division. If the implied value of goodwill is less

than the book value of goodwill, the difference must be written off as an impairment loss on goodwill. If

the implied value of goodwill is greater than the book value of goodwill, no impairment has taken place.

40

Solution

($ millions)

Book Value

(without Goodwill) Goodwill

Book Value (with

Goodwill) Fair Value

Further

Testing

Division A $ 60 $20 $ 80 $ 90 No

Division B 220 30 250 200 Yes

Division C 180 20 200 300 No

Total $460 $70 $530 $590

Following the above rules, Division B requires further testing, as its fair value is less than the book value of

net assets inclusive of goodwill.

Fair value of Division B (per above) $200

Fair value of individual net assets of Division B 180

Implied value of goodwill 20

Book value of goodwill 30

Write down of goodwill 10

Journal entry: Dr. Impairment Loss on Goodwill $10 million

Cr. Goodwill $10 million

When a previously acquired subsidiary is sold, any remaining goodwill must be reduced to zero as part of

the calculation of the gain or loss on sale.

The cost of developing, maintaining, or restoring intangible assets that (1) are not specifically identifiable, (2) have

indeterminate lives, or (3) are inherent in a continuing business and related to an enterprise as a whole should be

expensed as incurred.

Goodwill should be tested for impairment at least annually. For example, ASC 350-20-35-30 notes that if an event,

circumstance, or occurrence results in a probability that would make it more likely than not that a reporting unit's

fair value is below its book value, then the reporting unit should be tested for impairment between annual tests.

Examples of such events follow:

• Unexpected actions by competitors.

• Serious lawsuits filed against the company or an adverse change in the business climate.

• Key senior executives quit.

• Anticipation that a reporting unit will be sold or disposed of.

• Recently issued government regulations or laws having a negative effect on the company.

• Applying the recoverability test of a major asset group within a reporting unit.

• Accounting for a goodwill impairment loss by a subsidiary that is part of a reporting unit. (Subsidiary

goodwill is tested for impairment at the subsidiary level using the subsidiary's reporting unit.)

41

If only a portion of goodwill is assigned to a business to be sold or disposed of, the remainder of the goodwill in

the reporting unit must be tested for impairment using the adjusted carrying value. Goodwill impairment losses

are presented as a separate line item in the income statement.

The Financial Accounting Standards Board (FASB) issued ASU 2012-02, Intangibles−Goodwill and Other (Topic

350): Testing Indefinite-Lived Intangible Assets for Impairment. The Update gives an entity the option in its annual

impairment test of an indefinite-lived intangible asset to first assess qualitative factors to determine whether it is

necessary to perform the quantitative impairment test. An entity electing to perform a qualitative assessment is

no longer required to calculate the fair value of an indefinite-lived intangible asset (and perform the quantitative

impairment test) unless the entity determines, based on the qualitative assessment, that it is more likely than not

that the asset is impaired. The Update does not change how an entity measures an impairment loss.

Simplifying the Impairment Test

In January 2017, the FASB issued ASU 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test

for Goodwill Impairment, which eliminates Step 2 from the goodwill impairment test. Instead, under the

amendments in this Update, an entity should perform its annual, or interim, goodwill impairment test by

comparing the fair value of a reporting unit with its carrying amount (e.g. measure the charge based on today’s

Step 1). The amendments also eliminate the requirements for any reporting unit with a zero or negative carrying

amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill

impairment test. Therefore, the same impairment assessment applies to all reporting units.

The amendments are required for public business entities and other entities that have goodwill reported in their

financial statements and have not elected the private company alternative for the subsequent measurement of

goodwill. Under this guidance, an entity should recognize an impairment charge for the amount by which the

carrying amount exceeds the reporting unit’s fair value. However, the loss recognized should not exceed the total

amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects

from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill

impairment loss, if applicable.

The following table summarizes ASU 2017-04 modifications for goodwill for those entities that do not elect the

private-company alternative.

Overall Accounting for Goodwill

1. Goodwill should not be amortized

2. Goodwill should be tested at least annually for impairment at a level of reporting referred to as a

reporting unit (or stockholders’ equity if only one reporting unit)

3. An entity should perform the annual goodwill impairment test using a one-step model:

• Impairment of goodwill is the condition that exists when the carrying amount of a reporting

unit (stockholders’ equity) that includes goodwill exceeds its implied fair value

• A goodwill impairment loss is recognized for the amount that the carrying amount of a

reporting unit, including goodwill, exceeds its fair value

42

• The amount of the impairment loss is limited to the total amount of goodwill allocated to that

reporting unit (stockholders’ equity)

EXAMPLE 1-26

Sun Corp., one reporting unit, performs its annual test of goodwill impairment at December 31, 20X8:

Fair value of Sun Corp.’s stockholders’ equity $800,000

Carrying amount of Sun Corp.’s stockholders’ equity 860,000

Carrying amount (book value) of goodwill 100,000

To apply the one-step model, Sun Corp. compares its fair value and carrying value of stockholders’ equity:

Fair value of Sun Corp.’s stockholders’ equity $800,000

Less Carrying amount of Sun Corp.’s stockholders’ equity (860,000)

Impairment $(60,000)

According to ASU 2017-04, entities that have one or more reporting units with zero or negative carrying amounts

of net assets should disclose those reporting units with allocated goodwill, the amount of goodwill allocated to

each, and in which reportable segment the reporting unit is included. For each goodwill impairment loss

recognized, all of the following information must be disclosed in the notes to the financial statements that include

the period in which the impairment loss is recognized:

1. A description of the facts and circumstances leading to the impairment

2. The amount of the impairment loss and the method of determining the fair value of the associated

reporting unit (whether based on quoted market prices, prices of comparable businesses or nonprofit

activities, a present value or other valuation technique, or a combination thereof)

EXAMPLE 1-27

Tech Inc. has three reporting units with goodwill; Software, Electronics, and Communications. It also has two

reportable segments including Technology and Communications. The Electronics reporting unit has a negative

carrying amount. The changes in the carrying amount of goodwill for the year ended December 31, 20X8, are as

follows.

($000s) Technology

Segment Communications

Segment Total

Balance as of January 1, 20X8

Goodwill $1,413 $1,104 $2,517

Accumulated impairment losses - (100) (100)

1,413 1,004 2,417

Goodwill acquired during year 189 115 304

Impairment losses - (64) (64)

Goodwill written off related to sale of business unit

(484) - (484)

Balance as of December 31, 20X8

43

Goodwill 1,118 1,219 2,337

Accumulated impairment losses - (280) (280)

$ 1,118 $ 939 $ 2,057

The Communications segment is tested for impairment in the third quarter. Because of increasing competition in

the cable industry, operating profits and cash flows were lower than expected in the fourth quarter of 20X7 and

the first and second quarters of 20X8. Based on that trend, the earnings forecast for the next five years was

revised. In September 20X8, a goodwill impairment loss of $64 was recognized in the Communications reporting

unit. The fair value of that reporting unit was estimated using the expected present value of future cash flows.

The Electronics reporting unit to which $504 of goodwill is allocated had a negative carrying amount on December

31, 20X8, and 20X7. This reporting unit is part of the Technology segment.

Note that a private company that previously adopted the private company alternative for goodwill is also subject

to the one-step impairment test, even though it is only required to perform impairment testing upon a triggering

event. Details of the private company alternative for goodwill are discussed in the following section.

The standard will be applied prospectively and is effective for annual and interim impairment tests performed in

periods beginning after:

• December 15, 2019 for public business entities as SEC filers

• December 15, 2020 for entities that are not SEC filers

• December 15, 2021 for all other entities, including not-for-profit entities

Private Company Goodwill Alternative

In January 2014, the FASB and the Private Company Council (PCC) issued ASU 2014-02, Intangibles—Goodwill and

Other (Topic 350): Accounting for Goodwill. For private companies, the goodwill alternative represents a

fundamental overhaul of the existing accounting model for goodwill. Application of the goodwill alternative is

optional, and a private company can continue to follow existing goodwill accounting guidance. If the goodwill

alternative is adopted, a private company must apply all provisions of ASU 2014-02 prospectively to all of its

existing and future goodwill. Therefore, if a company elects to adopt the goodwill alternative for impairment

testing, it must apply the standard’s amortization guidance. In 2019, the FASB extended private company

accounting alternatives to not-for-profit entities.

Only private companies are eligible to elect the goodwill alternative. Companies considering adoption should

carefully review the definition of a public business entity, as defined in ASU 2013-12, Definition of a Public Business

Entity. A company that meets the definition of a public business entity is not eligible to apply any of the PCC’s

accounting alternatives in its financial statements.

ASU 2013-12 defines a public business entity as a business entity meeting any one of the following criteria:

44

1. It is required by the Security and Exchange Commission (SEC) to file or furnish financial statements, or does

file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose

financial statements or financial information are required to be or are included in the filing).

2. It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated

under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.

3. It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation

for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.

4. It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or

an over-the-counter market.

5. It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by

law, contract, or regulation to prepare U.S. GAAP financial statements (including footnotes) and make them

publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of

these conditions to meet this criterion.

An eligible company that elects the goodwill alternative is able to apply a simplified impairment test but also is

required to amortize goodwill using a straight-line basis over a 10-year period. Key differences between the

goodwill alternative and the existing goodwill impairment guidance are summarized below:

Treatment Goodwill Alternative Existing Goodwill Guidance

Amortization Requires goodwill to be amortized on a straight-line basis over a period of ten years, or less in certain circumstances

Does not allow goodwill to be amortized

Level of testing for impairment assessment

Either entity-wide or reporting unit (policy election upon adoption of the accounting alternative)

Reporting unit

Frequency of impairment assessment

Upon occurrence of a triggering event At least annually, and between annual tests whenever a triggering event occurs

Measurement of impairment

Single step test, which compares the fair value of the entity (or reporting unit) to its carrying amount

Two-step test:

In the first step, the fair value of each reporting unit is compared to its carrying amount. If the fair value of the reporting unit is less than its carrying amount, a second step is used to measure any impairment.

The second step requires the preparation of a hypothetical purchase price allocation to determine the implied fair value of goodwill. The impairment, if any, is the amount by which the carrying amount of the reporting unit’s goodwill exceeds its implied fair value.

45

Allocation of impairment

Impairment charge allocated to separate amortizable units of goodwill using either a pro rata allocation based on relative carrying amounts of goodwill or another reasonable and rational basis

Impairment charge allocated at the reporting unit level

Disposal of business that constitutes a

portion of an entity (or reporting unit)

Goodwill allocated to disposed business using a reasonable and rational approach

Goodwill allocated based on the relative fair value of the business disposed of to the portion of the reporting unit being retained

Source: PwC CFOdirect Network - Goodwill Accounting Alternative, 2014

Goodwill should be tested for impairment only if there is a triggering event. That is, an event occurs or

circumstances change that indicate that the fair value of the entity may be below its carrying amount. Examples

of such events and circumstances include the following:

1. Macroeconomic conditions such as:

• A deterioration in general economic conditions

• Limitations on accessing capital

• Fluctuations in foreign exchange rates

• Other developments in equity and credit markets

2. Industry and market considerations such as:

• A deterioration in the environment in which an entity operates

• An increased competitive environment

• A decline in market-dependent multiples or metrics (consider in both absolute terms and relative to

peers)

• A change in the market for an entity’s products or services

• A regulatory or political development

3. Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings

and cash flows

4. Overall financial performance such as:

• Negative or declining cash flows

• A decline in actual or planned revenue or earnings compared with actual and projected results of

relevant prior periods

5. Other relevant entity-specific events such as:

• Changes in management, key personnel, strategy, or customers

• Contemplation of bankruptcy

• Litigation

6. Events affecting a reporting unit such as:

• A change in the composition or carrying amount of its net assets

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• A more-likely-than-not expectation of selling or disposing of all, or a portion, of a reporting unit

• The testing for recoverability of a significant asset group within a reporting unit,

• Recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a

component of a reporting unit

7. If applicable, a sustained decrease in share price (consider in both absolute terms and relative to peers).

If an entity determines that there are no triggering events, then further impairment testing is unnecessary.

Capitalization of Interest

General Rules

Some assets require a period of time to get them ready for their intended use (e.g. the construction of a long-

term asset). Interest capitalization is required for those assets if its effect, compared with the effect of expensing

interest, is material. If the net effect is not material, interest capitalization is not required.

ASC 835-20, Interest: Capitalization of Interest, specifies that interest should be capitalized for the following types

of assets (qualifying assets):

1. Assets constructed for an entity's own use (e.g. facilities)

2. Assets constructed for the entity by others for which deposits or progress payments have been made

3. Assets intended for sale or lease that are constructed as discrete projects (e.g. cruise ships, real estate

developments)

4. Investments (e.g. loans, advances) accounted for by the equity method while the investee has activities

in progress necessary to commence its principal operations, and is using funds to acquire assets for those

operations. (The investor's investment in the investee, not the individual assets or projects of the investee,

is the qualifying asset for purposes of interest capitalization.)

The interest cost associated with land can be capitalized only if it is undergoing those activities necessary to

prepare it for its intended use. The interest cost capitalized on those expenditures is a cost of acquiring the asset

that results from those activities.

• If the resulting asset is a structure, such as a plant or a shopping center, interest capitalized on the land

expenditures is part of the acquisition cost of the structure.

• If the resulting asset is developed land, such as land that is to be sold as developed lots, interest capitalized

on the land expenditures is part of the acquisition cost of the developed land.

Interest should NOT be capitalized for the following types of assets:

1. Assets that are in use or ready for use in the earning activities of the entity

2. Assets that are not being used in the earning activities of the entity and that are not undergoing the

activities necessary to get them ready for use

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3. Inventories that are routinely manufactured or produced in large quantities on a repetitive basis

4. Assets that are not included in the consolidated balance sheet of the parent entity and consolidated

subsidiaries

5. Investments in regulated investees that are capitalizing both the cost of debt and equity capital

6. Investments accounted for by the equity method after the planned principal operations of the investee

begin

7. Assets received from a gift or grant in which donor restrictions exist

The interest capitalization begins when:

• Expenditures for the asset have been made;

• Activities that are necessary to get the asset ready for its intended use are in progress; and

• Interest cost is being incurred.

The capitalization period ends when the asset is substantially finished and ready for use. When an asset has

individual components, such as cooperative units, the capitalization period of interest costs related to one of the

separate units ends when the particular unit is significantly complete and usable. Interest capitalization ceases

when construction ends, except for temporary and unexpected delays. When the total asset must be completed

to be useful, interest capitalization continues until the total asset is substantially complete. An example is a

production facility where sequential manufacturing activities must occur.

The Amount Capitalized

The amount capitalized is to be an allocation of the interest cost incurred during the period required to complete

the asset. The interest rate for capitalization purposes is to be based on the rates on the entity's outstanding

borrowings. If the entity associates a specific new borrowing with the asset, it may apply the rate on that

borrowing to the appropriate portion of the expenditures for the asset. A weighted average of the rates on other

borrowings is to be applied to expenditures not covered by specific new borrowings.

1. The following are tips in solving interest capitalization problems under ASC 835-20-30; they are fully

demonstrated in a comprehensive problem following the enumerated items below:

2. The amount of interest that is required to be capitalized under ASC 835-20-30 is the amount of interest

that could have been avoided if the qualifying assets on which the interest is based had not been

constructed. This amount of interest is sometimes referred to as avoidable interest. However, the amount

of interest that is actually capitalized may never exceed the actual interest cost incurred by the entity for

the period.

3. To calculate the amount of interest cost that should be capitalized for a given accounting period, the

average accumulated expenditures (AAE) for the period must be computed. These expenditures are

weighted based on the time that they were incurred.

4. In computing the amount of interest that should be capitalized, the following interest rates should be

utilized in weighting the AAE:

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• For the portion of the AAE represented by the specific borrowings incurred to acquire qualifying

assets, the interest rates on those borrowings should be used to determine the amount of interest to

be capitalized.

• For the remaining portion of the AAE of the period (excess of AAE over the amount of specific

borrowings), computation should be based on the average interest rate incurred on other borrowings

of the entity that are outstanding during the period.

The average rate incurred on the other borrowings of the period are weighted based on the magnitude of the

specific debt outstanding and their respective interest rates.

EXAMPLE 1-30

Assume X Company begins construction on a new building on January 1, 20X3. In addition, X obtained a $100,000

loan to finance the construction of the building on January 1, 20X3 at an annual interest rate of 10%. The

company's other outstanding debt during 20X3 consists of two notes of $600,000 and $800,000 with interest rates

of 11% and 14.5%, respectively. Expenditures that were made on the building project follow:

Expenditures

January 1 $200,000

April 1 300,000

July 1 400,000

December 1 120,000

Step 1

The AAE is computed:

$ 200,000 × 12/12 (January-December) = $200,000

300,000 × 9/12 (April-December) = 225,000

400,000 × 6/12 (July-December) = 200,000

120,000 × 1/12 (December) = 10,000

$1,020,000 AAE = $635,000

Step 2

The average interest rate is computed based on the other outstanding debt of the entity other than specific

borrowings:

$ 600,000 × 11% = $ 66,000

800,000 × 14.5% = 116,000

$1,400,000 $182,000

Average interest rate: = $182,000/$1,400,000 = 13%

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Step 3

The interest that could be avoided is computed based on the AAE:

AAE

Interest That Should

Be Capitalized

(Based on AAE)

$100,000 (specific borrowing) × 10% = $10,000

535,000 ($635,000 - 100,000) × 13% = 69,550

$635,000 $79,550

Step 4

Actual interest costs incurred during the year are computed:

$100,000 × 10% = $ 10,000

600,000 × 11% = 66,000

800,000 × 14.5% = 116,000

Total $192,000

The total interest expense incurred during the year is $192,000 which represents the maximum amount of interest

that can be capitalized. Avoidable interest of $79,550 (Step 3) is less than actual interest of $192,000 (Step 4);

therefore, $79,550 can be capitalized.

Interest Expense Journal

Interest Expense $192,000

Interest Payable $192,000

Next the capitalized interest of $79,550 is transferred from the interest expense account to the asset account:

Capitalized Interest Journal

Building $79,550

Interest Expense $79,550

The capitalized interest is now part of the total cost of the building and will be depreciated in the normal manner

over the useful life of the building. At year end, the balances in the asset (prior to recording depreciation if

applicable) and interest expense accounts are as follows:

Building ($1,020,000 + $79,550) $1,099,550

Interest Expense 112,450

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Asset Retirement Obligations

Asset Retirement Obligations (AROs) are obligations associated with the cost of retiring tangible long-lived assets.

The accounting guidance in ASC 410-20 applies to legal obligations associated with the retirement of long lived

assets resulting from the acquisition, construction, development and/or normal operation of such assets. Legal

obligations are obligations that a party is required to settle as a result of an existing or enacted law, statute,

ordinance or written or oral contract or that is based on a promise and an expectation of performance (e.g. under

the doctrine of promissory estoppel).

Applicability

ASC 410-20-15-2, Asset Retirement and Environmental Obligations: Asset Retirement Obligations, requires

companies to record a liability when a retirement obligation is incurred, provided fair value can be reasonably

estimated even though it may be years before the asset's planned retirement. ASC 410-20-15-2 applies to tangible

long-term assets, including individual ones, similar asset groups, and major parts of assets. AROs are only

recognized if an obligating event that leaves little or no discretion to avoid the future transfer of assets has

occurred.

AROs must be measured and recorded along with its associated asset retirement cost. However, the

pronouncement's requirements do not apply to an environmental remediation liability arising from an asset's

improper operation or functioning. An example is the obligation to clean up after a catastrophic accident resulting

from a failure to follow the entity’s safety procedures which is an improper use of the facility. Asset retirements

may be from sale, recycling, abandonment, or disposal. Obligations that arise solely from the entity’s intent or

plan to sell or dispose of a long-lived asset covered by Subtopic 360-10 do not require recognition.

Requirements

A company must record the fair value of a liability for an asset retirement obligation as incurred. When the initial

obligation arises, the company books a liability and capitalizes the cost to the long-term asset for the same

amount. After the initial recognition, the liability will change over time so the obligation must be accreted to its

present value each year. The long-term asset's capitalized cost is depreciated over its useful life. When the liability

is settled, the company either settles the liability for the amount recorded or will have a settlement gain or loss.

In determining the fair value, the first valuation (provided it is ascertainable) is the amount by which the obligation

could be settled in a current transaction in an active market between willing parties (not in a forced or liquidating

transaction). Quoted market prices are the best basis for fair value measurement. If quoted market prices are

unavailable, fair value can be estimated based on the best data available. Examples are the prices of similar

liabilities and the use of present value techniques.

Fair value also can be estimated based on an alternative market value valuation, such as the discounted (present)

value of projected future cash flows needed to pay the obligation. Projected cash flows are based on various

assumptions, such as technology and the inflation rate. The present value technique is typically the best method

to use when quoted market prices are unavailable.

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The carrying value of the long-lived asset is increased by the amount of the calculated asset retirement costs.

Thus, the entry consists of debiting the long- asset and crediting the asset retirement obligation. The asset,

including the deferred (capitalized) retirement costs, is depreciated over the asset’s useful life.

Any incremental liability incurred in a later year is an additional layer of the original obligation and will increase

both the carrying value of the obligation and the related long-lived asset. Each layer is initially measured at fair

value. For example, the contamination-related costs each year of a nuclear plant represent a separate layer for

measurement and recognition.

The entity may experience retirement obligations at the beginning of the asset's life or during its operating life.

An example of the former is a production facility that experiences a removal obligation when it starts operations

(e.g., oil production facility). An example of the latter is a mine that experiences a reclamation obligation gradually

over its life as digging in the mine takes place over the years. Further, an asset retirement obligation may arise

because of new governmental regulations or laws affecting the asset, such as newly enacted environmental

restrictions.

Entities measure changes in the asset retirement liability due solely to the passage of time (i.e. accretion of the

discounted liability) by applying an interest method of allocation to the liability balance at the beginning of the

year. The interest rate used is the one existing when the liability, or part thereof, was initially measured. The

accretion expense is presented in the income statement as an operating item and also increases the carrying value

of the liability each year.

Changes in the timing or initial estimated undiscounted cash flows should be recognized as an addition or

reduction of the asset retirement obligation and the associated long-lived asset in the year(s) affected. Upward

adjustments to the undiscounted estimated cash flows are discounted based on the current credit-adjusted risk-

free rate. However, downward revisions are discounted using the rate existing when the initial liability was

recognized.

If an asset has an indeterminate service life, sufficient data to estimate a range of potential settlement dates for

the obligation might not be available. In such cases, the liability is initially recognized in the year in which adequate

information exists to estimate a range of potential settlement dates required to use a present value approach to

estimate fair value.

Uncertainty of whether performance will be required does not defer recognizing a retirement obligation. Instead,

that uncertainty is considered in the measurement of the fair value of the liability through assignment of

probabilities to cash flows.

Any difference between the actual retirement costs and the asset retirement obligation is a gain or loss on

retirement presented in the income statement.

Present Value Method

ASC 410-20-25-4 through 25-6, Asset Retirement and Environmental Obligations: Asset Retirement Obligations, is

an interpretation of ASC 410-20-25, Asset Retirement and Environmental Obligations: Asset Retirement

52

Obligations. It provides that a company should identify its asset retirement obligations. If the business has

adequate data to reasonably estimate the fair value of an asset retirement obligation, it must record the liability

as incurred. The following represent reasonable estimation bases for valuing an asset retirement obligation:

1. The fair value of the obligation is embodied in the asset's purchase price,

2. There is an active market for the obligation's transfer, or

3. Adequate data is present to use an expected present value method.

An expected present value method incorporates uncertainty regarding the timing and method of settlement into

the fair value measurement. However, in some instances, adequate information about the timing and settlement

method may not be available to reasonably approximate fair value.

A company would have sufficient information to use an expected present value method and, thus, an asset

retirement obligation would be reasonably estimable when either of the following two conditions is present:

1. Data exists to reasonably estimate the settlement method, settlement date, and the probabilities of

potential settlement methods and dates. The following may be considered in making these

determinations: estimated life of asset, intent of management, prior practice, and industry policy.

2. The settlement method and date for the obligation has been stated by others, such as by contract,

regulation, or law. In this case, the settlement method and date are known so the only uncertainty is

whether performance will be required. Uncertainty concerning whether performance will be required

does not defer asset retirement obligation recognition, because:

• There is a legal duty to conduct retirement activities and

• It does not prevent reasonable estimation of fair value (this is because the only uncertainty is whether

performance will be mandated).

In using the present value method, the company must discount future estimated cash flows based on a credit-

adjusted risk-free rate (e.g., rate on a zero-coupon U.S. Treasury Security) increased for the company's actual

credit risk. After the final rate is decided on, the present value of cash flow calculation must reflect any relevant

probabilities, uncertainties, and assumptions. Multiple cash flow and probability scenarios are used based on a

range of possible outcomes.

EXAMPLE 1-31

A long-lived asset's carrying cost includes a $250,000 original cost plus the capitalized retirement cost of $53,426,

which equals the initial liability amount. The business entity incurs an obligation to retire the asset upon

installation. The asset retirement obligation is based on the following data:

Original cost $250,000

Credit-adjusted risk-free rate at date of installation 8%

Depreciation is based on the straight-line method for a five-year period.

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The four possible alternative estimated market-based cash flows in year 5 to settle the obligation, along with their

related probabilities are:

Scenario Projected Cash Outflow (Year 5) Probability

1 $100,000 30%

2 80,000 35%

3 70,000 15%

4 50,000 20%

Total probability 100%

The computation of the capitalized retirement cost of $53,426 follows:

Scenario

Projected Cash

Outflow (Year 5) Probability Weighting

1 $100,000 30% $30,000

2 80,000 35% 28,000

3 70,000 15% 10,500

4 50,000 20% 10,000

Expected cash outflow $78,500

Present value for year 0 at 8% $53,426*

* $78,500 × present value of $1 factor for n = 5, i = 8% $78,500 × .68058 = $53,426

The retirement entry for the long-term asset, based on the assumption that actual cash flows to settle the

retirement liability are the same as those projected follows:


Asset retirement liability 78,500

Long-term asset $303,426

Cash 78,500

The annual accounting for the long-lived asset and the asset retirement obligation follows:

Computation of the Long-Term Asset and Obligation

Installment Asset

Accumulated

Depreciation Book Value Liability Net Balance Sheet

Install $303,426 - $303,426 $53,426 $250,000

1 303,426 $60,685a 242,741 57,700b 185,041

2 303,426 121,370 182,056 62,316 119,740

3 303,426 182,055 121,371 67,301 54,070

4 303,426 242,740 60,686 72,685 (11,999)

5 303,426 303,426 0 78,500 (78,500)

Retirement (303,426) (303,426)

54

______________________________

a $303,426 divided by 5 years = $60,685

b $53,426 × 1.08 = $57,700

The depreciation expense and interest expense (accretion) follow:

Computation of Depreciation and Interest Expense

Year Depreciation Interest Expense Net Income Statement

1 $60,685 $ 4,274c $ 64,959

2 60,685 4,616 65,301

3 60,685 4,985 65,670

4 60,685 5,384 66,069

5 60,686 5,815 66,501

Total $303,426 $25,074 $328,500

________________________

c $53,426 × 8% = $4,274

Contract Costs

Certain costs to obtain and fulfill a contract are recognized as assets under ASC 606, Revenue from Contracts with

Customers.

Costs to Obtain a Contract

Incremental costs are those costs that the entity would not have incurred if the contract had not been obtained.

For example, sales commissions that are directly related to sales achieved during a time period would likely

represent incremental costs that require capitalization. An entity should assess recoverability of the incremental

costs of obtaining a contract. Such costs will be recognized as an asset if the entity expects to recover them

through:

1. Direct recovery (e.g. through reimbursement under the contract); or

2. Indirect recovery (e.g. through the margin inherent in the contract)

Facilities costs, sales force salaries, bid, proposal, and selling and marketing costs are not incremental since the

entity would have incurred those costs even if it did not obtain the contract. Costs of obtaining a contract that are

not incremental should be expensed as incurred unless those costs are explicitly chargeable to the customer, even

if the contract is not obtained.

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EXAMPLE 1-32

Progress Inc. wins a contract to provide consulting services to a new customer. Progress Inc. incurred the following

costs to obtain the contract:

External legal fees for due diligence $25,000

Travel costs to deliver proposal 20,000

Commissions to sales employees 15,000

Total costs incurred $60,000

Progress Inc. recognizes an asset for the $15,000 incremental costs of obtaining the contract arising from the

commissions to sales employees, subject to recoverability. This means that Progress Inc. expects to recover those

costs through future fees for the services provided.

The legal fees and travel costs are recognized as expenses when incurred because they would have been incurred

regardless of whether the contract was obtained.

The following flowchart illustrates how to determine whether the costs of obtaining a contract are recognized as

an asset.

Illustration 1-1: Accounting for Incremental Costs

Costs to Fulfill a Contract

When determining the appropriate accounting treatment for contract fulfilment costs, the entity needs to

consider if other standards are applicable such as:

Does the entity incur these costs regardless of whether

the contract is obtained?

Does the entity expect to recover those costs either

directly or indirectly?

Is the amortization period of the asset one year or

less?

The entity can either expense as incurred or recognize as an asset

Recognize as an asset

Expense those costs as incurred

Are those costs explicitly chargeable to the customer regardless of whether the

contract is obtained?

Recognize as an asset

Expense those costs as incurred

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• Topic 330 on inventory; paragraphs 340-10-25-1 through 25-4 on preproduction costs related to long-

term supply arrangements

• Subtopic 350-40 on internal-use software

• Topic 360 on property, plant, and equipment; or

• Subtopic 985-20 on costs of software to be sold, leased, or otherwise marketed

Costs that are required to be expensed in accordance with other standards cannot be recognized as an asset under

the revenue standard. If these costs are not within the scope of another Topic, an entity should recognize an asset

from the costs to fulfill a contract if those costs meet all of the following capitalization criteria in ASC 340:

1. Relate directly to a contract (or a specific anticipated contract)

2. Generate or enhance resources of the entity that will be used in satisfying performance obligations in

the future

3. Are expected to be recovered (either explicitly reimbursable under the contract or reflected through

the margin inherent in the contract)

Costs to obtain and fulfill a contract are only recognized as an asset if they are recoverable.

EXAMPLE 1-33

Beta Corp enters a 3-year contract to provide IT services to a new customer. Beta Corp builds a technology

platform to migrate the customer’s data before providing the services. The initial costs incurred to set up the

technology platform including:

Design services $ 20,000

Hardware and software 180,000

Migration and testing 40,000

Total costs incurred $240,000

The initial setup costs relate primarily to activities to fulfill the contract but do not transfer goods or services to

the customer. Beta Corp accounts for these setup costs by applying the following standards:

• Hardware: Topic 360 on property, plant, and equipment

• Software: Subtopic 350-40 on internal-use software

• Migration and testing: Capitalized under the revenue standard because they meet all the following

criteria:

1. Relate directly to a contract

2. Generate or enhance resources of the entity that will be used in satisfying performance obligations in

the future

3. Are expected to be recovered through the three-year contract period

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ASC 606 provides examples of costs that relate directly to a contract should be capitalized vs. costs required to be

expensed when they are incurred:

Accounting Treatment Examples

Capitalization

• Direct labor (e.g. salaries of employees)

• Direct materials (e.g. supplies used)

• Allocations of costs that relate directly to the contract or to

contract activities (e.g. costs of contract management, insurance,

and depreciation of tools and equipment)

• Costs that are explicitly chargeable to the customer under the

contract

• Other costs that are incurred only because an entity entered into

the contract (e.g. payments to subcontractors)

Expense Costs

• General and administrative costs (unless those costs are explicitly

chargeable to the customer under the contract)

• Costs of wasted materials, labor, or other resources to fulfill the

contract that were not reflected in the price of the contract

• Costs that relate to satisfied performance obligations (or partially

satisfied performance obligations) in the contract

• Costs for which an entity cannot distinguish whether the costs

relate to unsatisfied performance obligations or to satisfied

performance obligations (or partially satisfied performance

obligations).

The following flowchart summarizes the accounting for costs to fulfill a contract.

Illustration 1-2: Accounting for Contract Fulfill Costs

Are the costs incurred in fulfilling the contract in the scope of other guidance?

Apply other guidance

Do the costs meet the criteria in ASC 340-5 to be captialized

as fulfillment costs?

Recognize the fulfillment costs as an asset

Expense costs as incurred

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Accounting Change in Estimated Useful Lives

ASC 250-10-05, Accounting Changes and Error Corrections: Overall, has standardized the manner in which

accounting changes are reported and classifies accounting changes as follows:

Types of Accounting Changes Summary

Change in Accounting Principle (Method)

• A change from one generally accepted accounting principle (GAAP) to another GAAP.

• ASC 250 requires retrospective application of the new accounting principle to prior accounting periods, unless it is impractical to do so.

Change in Accounting Estimate

• A change that occurs as the result of new information or as additional experience is acquired.

• Examples include changes in the:

− Estimates of the useful lives of depreciable assets

− Estimates for uncollectible receivables, inventory obsolescence or warranty obligations.

Change in Reporting Entity

• A change in reporting entity refers to preparing financial statements for an entity different from the ones reported in previous years. Examples of a change in reporting entity are:

− A change in the subsidiaries making up consolidated financial statements.

− Presentation of consolidated or combined statements rather than individual company statements.

• A change in reporting entity requires the restatement of previous years' financial statements as if both of the previously separate companies were always combined. No more than five years are restated.

This course focuses on the change in accounting estimate related to the useful lives of depreciable assets.

Accounting estimates will change as a result of new events, new information, or as the company acquires more

experience. They occur because companies must initially make estimates of future conditions and events, and

revise them as new information becomes available. Changes in estimates require adjustments to the carrying

amounts of assets and liabilities. Examples of areas for which changes in accounting estimates often are needed

include the following:

• Useful lives of depreciable or intangible assets

• Residual values for depreciable assets

• Uncollectible receivables

• Warranty obligations

• Quantities of mineral reserves to be depleted

• Actuarial assumptions for pensions or other postemployment benefits

• Number of periods benefited by deferred costs

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A change in accounting estimate is accounted for on a prospective basis (only over current and future years.) Prior

years are not adjusted. Distinguishing between a change in an accounting principle and a change in accounting

estimate can be difficult. In some cases, a change in accounting estimate may be required as a result of a change

in accounting principle. For example, a change in depreciation, depletion, or amortization method is a change in

estimate resulting from a change in a principle.

When the effect of a change in accounting principle is inseparable from the effect of a change in estimate, ASC

250 requires that it be accounted for in the same manner as a change in estimate only. An example of such a

change is the change in depreciation method because future benefits of the asset have changed, or the

consumption of those benefits has changed, or new information is available to the company about those benefits.

Because the new method (accounting principle) is adopted to recognize a change in estimated future benefits,

the effect of the change in accounting principle is inseparable from the change in estimate. In this case, it is

accounted for as a change in accounting estimate.

EXAMPLE 1-34

On January 1, 20X4, a fixed asset was purchased for $50,000 and had an estimated life of 20 years with a salvage

value of $2,000. On January 1, 20X7, the estimated life was revised to 14 remaining years with a new salvage value

of $2,200. Assuming that the straight-line depreciation method was, and will continue to be, used, the journal

entry on December 31, 20X7, for depreciation expense follows:

Depreciation expense $2,900


Computation:

Book value on 1/1/20X7:

Initial cost $50,000

Less: accumulated depreciation

($50,000 - $2,000)/20 years = $2,400 $2,400 ×3 years depreciated = $7,200 (7,200)

Book value $42,800

Depreciation for 20X7:

Book value $42,800

Less: new salvage value 2,200

Balance $40,600

Depreciable cost =

$40,600 = $2,900

New life 14 years

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Disclosures

General Requirements

The following should be footnoted in connection with fixed assets:

• Fixed assets by major category. Category may be in terms of nature or function.

• A description of depreciation methods and estimates used, including changes in estimates.

• Fixed assets subject to pledges, liens, leases or other commitments.

• Fixed assets held to be disposed of and any anticipated losses. The reasons why such assets are to be

disposed of should be provided. Disclosure includes expected disposal dates, carrying amounts of such

assets, and business segments affected.

• Contracts to buy new fixed assets.

• Fixed assets that are fully depreciated but still in use.

• Idle fixed assets.

• Amount of capitalized interest.

Exhibit 1-3, from the annual report of the Boeing Company, provides sample disclosures related to property, plant

and equipment.

EXHIBIT 1-3: Disclosure of Property, Plant and Equipment

The Boeing Company

Note 1: Summary of Significant Accounting Policies - Property, Plant and Equipment

Property, plant and equipment are recorded at cost, including applicable construction-period interest, less

accumulated depreciation and are depreciated principally over the following estimated useful lives: new buildings

and land improvements, from 10 to 40 years; and new machinery and equipment, from 4 to 20 years. The principal

methods of depreciation are as follows: buildings and land improvements, 150% declining balance; and machinery

and equipment, sum-of-the-years’ digits. Capitalized internal use software is included in Other Assets and

amortized using the straight-line method over 5 years. We periodically evaluate the appropriateness of remaining

depreciable lives assigned to long-lived assets, including assets that may be subject to a management plan for

disposition.

Long-lived assets held for sale are stated at the lower of cost or fair value less cost to sell. Long-lived assets held

for use are subject to an impairment assessment whenever events or changes in circumstances indicate that the

carrying amount may not be recoverable. If the carrying value is no longer recoverable based upon the

undiscounted future cash flows of the asset, the amount of the impairment is the difference between the carrying

amount and the fair value of the asset.

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Note 8: Property, Plant and Equipment

Property, plant and equipment at December 31 consisted of the following:

(Dollars in Millions) 2015 2014

Land $536 $560

Building and land improvements 12,397 11,767

Machinery and equipment 13,187 12,867

Construction in progress 2,242 1,502

Gross property, plant and equipment 28,362 26,696

Less accumulated depreciation (16,286) (15,689)

Total $ 12,076 $ 11,007

Depreciation expense was $1,357, $1,414 and $1,338 for the years ended December 31, 2015, 2014 and 2013,

respectively. Interest capitalized during the years ended December 31, 2015, 2014 and 2013 totaled $158, $102

and $87, respectively. Rental expense for leased properties was $267, $277 and $287, for the years ended

December 31, 2015, 2014 and 2013, respectively. At December 31, 2015, minimum rental payments under capital

leases aggregated $157. Minimum rental payments under operating leases with initial or remaining terms of one

year or more aggregated $1,515, net of sublease payments of $13 at December 31, 2015. Payments due under

operating and capital leases net of sublease amounts and non-cancellable future rentals during the next five years

are as follows:

(Dollars in Millions) 2016 2017 2018 2019 2020

Minimum operating lease payments, net of sublease amounts $240 $217 $182 $157 $117

Minimum capital lease payments 55 47 29 12 4

Accounts payable related to purchases of property, plant and equipment were $502 and $299 for the years ended

December 31, 2015 and 2014.

Intangible Assets

Companies must disclose information about how recognized intangible assets would aid financial statement users

to determine how a company's ability to renew or extend an arrangement impacts the company's anticipated

cash flows associated with the asset. Disclosure should be made of the:

1. Weighted-average period at acquisition or renewal before the next renewal or extension.

2. Accounting policy for costs incurred to renew or extend an intangible asset's term.

3. In the event renewal or extension costs are capitalized, the total cost incurred to renew or extend the

term of a recognized intangible asset.

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Goodwill and Other Intangible Assets

Goodwill of a reporting unit must be examined for impairment between annual tests if there is an occurrence or

circumstance that would more likely than not reduce the fair market value of a reporting unit below its carrying

value. The following are footnote disclosures for goodwill and other intangible assets:

1. The gross amount and accumulated impairment losses at the beginning of the period.

2. Impairment losses recognized during the period and a description of the facts and circumstances leading

to the impairment.

3. Total amount of impairment losses and where presented in the income statement.

4. Amortization period and expected amortization expense for the next five years.

5. Amount of any significant residual value.

6. Amount of goodwill included in the gain or loss on disposal of all or a part of a reporting unit.

7. Method in deriving fair value.

8. The book values of intangible assets by major class for intangibles subject to amortization and separately

for those not subject to amortization. An intangible asset class is a group of similar intangibles either based

on their use in the company's operations or by their nature.

9. Information relating to the changes in the carrying values of goodwill over the year in total and by

reporting unit.

Asset Retirement Obligations

An entity should disclose all of the following information about its AROs:

1. A description and valuation of legally restricted assets to settle the obligation.

2. A description of both the asset retirement liability and the associated long-lived asset.

3. If the fair value of an asset retirement liability cannot be reasonably estimated, that fact and the reasons

why shall be disclosed.

4. Reconciliation of the beginning and ending carrying amount of asset retirement obligations including the

separate presentation of liabilities incurred as well as settled in the current year, accretion expense, and

adjustments made to projected cash flows when there has been a significant change in these components

in the reporting period.

Note: Additional disclosures are required for oil and gas producing entities.

The fair value of a conditional asset retirement obligation must be recognized before the event that either

mandates or waives performance occurs. Further, a clear requirement that gives rise to an asset retirement debt

coupled with a low likelihood of required performance still requires liability recognition.

The following exhibit, from the annual report of PSE&G and Power, provides a sample disclosure of AROs.

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EXHIBIT 1-4: Disclosure of Asset Retirement Obligations

PSE&G and Power

Note 10: Asset Retirement Obligations (AROs)

PSEG, PSE&G and Power have recorded various AROs which represent legal obligations to remove or dispose of

an asset or some component of an asset at retirement.

PSE&G has conditional AROs primarily for legal obligations related to the removal of treated wood poles and the

requirement to seal natural gas pipelines at all sources of gas when the pipelines are no longer in service. PSE&G

does not record an ARO for its protected steel and poly-based natural gas lines, as management believes that

these categories of gas lines have an indeterminable life.

Power’s ARO liability primarily relates to the decommissioning of its nuclear power plants in accordance with NRC

requirements. Power has an independent external trust that is intended to fund decommissioning of its nuclear

facilities upon termination of operation. For additional information, see Note 8 - Available-for-Sale Securities.

Power also identified conditional AROs primarily related to Power’s fossil generation units and solar facilities,

including liabilities for removal of asbestos, stored hazardous liquid material and underground storage tanks from

industrial power sites, and demolition of certain plants, and the restoration of the sites at which they reside, when

the plants are no longer in service. To estimate the fair value of its AROs, Power uses a probability weighted,

discounted cash flow model which, on a unit by unit basis, considers multiple outcome scenarios that include

significant estimates and assumptions, and are based on third party decommissioning cost estimates, cost

escalation rates, inflation rates and discount rates.

Updated cost studies are obtained triennially unless new information necessitates more frequent updates. The

most recent cost study was done in 2015. When assumptions are revised to calculate fair values of existing AROs,

the ARO balance and corresponding long-lived asset are adjusted which impact the amount of accretion and

depreciation expense recognized in future periods. For PSE&G, Regulatory Assets and Regulatory Liabilities result

when accretion and amortization are adjusted to match rates established by regulators resulting in the regulatory

deferral of any gain or loss.

The changes to the ARO liabilities for PSEG, PSE&G and Power during 2014 and 2015 are presented in the following

table:

(Millions) PSEG PSE&G Power Other

ARO Liability as of January 1, 2014 $677 $274 $400 $3

Liabilities Settled (2) (2) - -

Liabilities Incurred 23 3 20 -

Accretion Expense 30 - 30 -

Accretion Expense Deferred and Recovered in Rate Base (A) 15 15 - -

ARO Liability as of December 31, 2014 $743 $290 $450 $3

Liabilities Settled (5) (4) (1) -

Liabilities Incurred 14 1 12 1

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Accretion Expense 26 - 26 -

Accretion Expense Deferred and Recovered in Rate Base (A) 16 16 - -

Revision to Present Values of Estimated Cash Flows (115) (85) (30) -

ARO Liability as of December 31, 2015 $679 $218 $457 $4

(A) Not reflected as expense in Consolidated Statements of Operations

During 2015, PSE&G recorded a reduction to its ARO liabilities primarily due to the impact of lower inflation rates.

These changes had no impact in PSE&G’s Consolidated Statement of Operations.

Change in Estimate

Footnote disclosure should be made of the nature and reasons for the change unless it involves changes in the

ordinary course of business (e.g., modifying a bad debt percentage). Disclosures are only required if the change

is material. The impact of the change in estimate on net income and per share earnings should be disclosed if the

change will affect future-year results.

The following exhibit, from the annual report of Ampco-Pittsburgh Corporation, provides a sample disclosure of a

change in estimated useful lives.

EXHIBIT 1-5: Disclosure of Change in Estimated Useful Lives

Ampco- Pittsburgh Corporation

Note 11: Change in Accounting Estimate

The Corporation revised its estimate of the useful lives of certain machinery and equipment. Previously, all

machinery and equipment, whether new when placed in use or not, were in one class and depreciated over 15

years. The change principally applies to assets purchased new when placed in use. Those lives are now extended

to 20 years. These changes were made to better reflect the estimated periods during which such assets will remain

in service. The change had the effect of reducing depreciation expense and increasing net income by

approximately $991,000 ($.10 per share).

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11. Dire Co., in a business combination initiated and completed in October 2014, purchased Wall Co. at a cost that

resulted in recognition of goodwill having an expected 10-year benefit period. However, Dire plans to make

additional expenditures to maintain goodwill for a total of 40 years. What costs should be capitalized and over

how many years should they be amortized?

A. Capitalize acquisition costs only, amortize over 0 years

B. Capitalize acquisition costs only, amortize over 40 years

C. Capitalize acquisition and maintenance costs, amortize over 10 years

D. Capitalize acquisition and maintenance costs, amortize over 40 years

12. Which of the following asset groups qualify for interest cost capitalization?

A. Assets that are being used in the earning activities of the company

B. Assets that are ready for their intended use in the activities of the company

C. Assets that are constructed for the company's own use

D. Inventories that are manufactured in large quantities on a continuing basis

13. Which of the following is TRUE about asset retirement obligations requirements?

A. Quoted market price is the only permitted option to determine the fair value

B. An asset retirement obligation can only be recorded in the year of the asset's planned retirement

C. Changes in the timing should be recognized as a gain or loss on retirement in the income statement

D. The reconciliation of the asset retirement obligation balance for the year should be disclosed

14. Sunny Inc. received a $20,000 contract to provide products to A&E Corp for two years. To win the contract,

they incurred the following costs: Legal expenses = $2,000; Travel expenses = $1,000; and Commissions =

$5,000. How should Sunny Inc. account for the expenses?

A. $3,000 as normal expenses and $5,000 as an amortizable asset

B. $8,000 in normal expenses

C. $8,000 in amortizable assets

D. $2,000 in normal expenses and $6,000 in amortizable assets

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15. Which of the following changes will result in a prospective change in the current year and years going forward?

A. A change from the cash basis of accounting for vacation pay to the accrual basis

B. A change from the straight-line method of depreciation to the double-declining-balance method because

the estimated future benefits of the assets have changed

C. A change from the presentation of statements of individual companies to their inclusion in consolidated

statements

D. A change from the completed-contract method of accounting for long-term construction-type contracts

to the percentage-of-completion method

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U.S. GAAP vs. IFRS

Property, Plant and Equipment

In general, U.S. GAAP and IFRS treat the accounting for property, plant and equipment (PP&E) similarly. Both

standards define PP&E as tangible assets that are held and used for more than one reporting period. Other

concepts that are similar include the following:

• The initial recognition is at cost; cost includes all expenditures directly attributable to bringing the asset

to the location and working condition for its intended use

• Start-up costs, general administrative and overhead costs or regular maintenance are not included in the

cost

• The estimated cost of dismantling and removing the asset and restoring the site is recognized as an asset

retirement obligation

• Subsequent to initial recognition, PP&E is depreciated over its expected useful life

• Changes in residual value and useful economic life are considered as a change in accounting estimate

requiring prospective treatment

Differences exist primarily in the following areas:

Borrowing Costs. According to IFRS, borrowing costs include interest and other costs that an entity incurs in

connection with the borrowing of funds. That is, they may be interpreted more broadly than U.S. GAAP’s definition

of interest costs. Specifically, under IFRS, eligible borrowing costs include exchange differences from foreign

currency borrowings to the extent that they are regarded as an adjustment to interest costs. However, U.S. GAAP

does not considered exchange rate differences as borrowing costs. Moreover, interest incurred is capitalized

under U.S. GAAP only during construction of a qualifying asset. Under IFRS, interest costs of borrowing may either

be capitalized for the acquisition, construction, or production of a qualifying asset or expensed in the period

incurred. Whichever method selected must be consistently applied.

The Components Approach for Depreciation. IAS 16 requires that upon initial recognition of a depreciable asset,

costs are allocated to significant components of the assets (including non-physical components). Each component

is then separately depreciated based on the component’s lives and patterns of benefits. For example, a roof would

be one component and the remainder of the structure would be a separate component—each having different

useful lives and depreciated separately. In addition, subsequent expenditures must be capitalized to the asset as

long as probable future economic benefits will flow to the entity and the costs can be reliably measured. Under

U.S. GAAP, component depreciation is permitted, but is not required. However, if component accounting is used,

its application may be different from IFRs.

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The Revaluation. Under the revaluation model the carrying value of PP&E is reported at its fair value (if it can be

measured reliably) less accumulated depreciation and subsequent impairment charges (if any). U.S. GAAP

requires PP&E be accounted for using the cost method thereby prohibiting the revaluation model. IFRS allows

companies to use either the revaluation model or the cost model to account for and report PP&E. Accumulated

depreciation is one of the accounts used to revalue depreciable plant and equipment and the amount of the

adjustment is determined by applying one of two alternatives, both of which use a revaluation surplus account.

When a depreciable asset is revalued, depreciation is also revalued over the remaining useful life of the asset.

Details are discussed below.

IAS 16 allows for two revaluation alternatives; revaluation of:

1. Specific assets regularly or

2. Assets of the same class

When revaluation occurs under IFRS, and the revaluation requires a write-up (increase) to the carrying value of

the asset (assuming no previous downward revaluation), the asset is debited (and accumulated depreciation is

adjusted if it is a depreciable asset) and the incremental increase is credited to a surplus account (revaluation

surplus account), which is an equity account. If there is a write-down (decrease) to the asset (assuming no previous

upward revaluation), such downward revaluation is debited to an expense and the asset's book value is credited.

If there had been a previous upward revaluation (causing surplus recognition) and a current downward

revaluation occurs, the write-down would first reduce the revaluation surplus to the extent of previously

recognized gain; any decrease in value beyond the reversal amount would be recognized as a loss. Examples of

land revaluations are provided below.

EXAMPLE 1-35

Assume in Year 1, QRS Corp. owns land costing $500,000 with a current fair value of $550,000. The journal entry

to adjust the book value of the land to reflect its fair value is:

Land $50,000

Revaluation surplus—Land $50,000

Any subsequent decreases in the fair value of the land would be offset against the revaluation surplus account,

with any excess charged to an expense.

EXAMPLE 1-36

Assume in the following year (Year 2), the fair value of QRS Corp.'s land has decreased to $480,000. The journal

entry to adjust the book value of the land to reflect its fair value (with previous upward revaluation) is:


Loss on Revaluation—Land* 20,000

Land $70,000

* The loss on revaluation is treated as an expense of the period.

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For previous revaluations that resulted in the recognition of an expense, any subsequent revaluations resulting in

an increase to the fair value of the asset should be recognized as income to the extent of the previously recognized

expense with any excess revaluation increase credited to the revaluation surplus account.

EXAMPLE 1-37

Assume in Year 3, the fair value of QRS Corp.'s land is $510,000. Given that there was a recent downward

revaluation in Year 2, the journal entry to adjust the book value of the land to reflect its fair value is:

Land $30,000


Gain on revaluation—Land* 20,000

* The gain on revaluation is recognized as income in Year 3 to the extent of expense recognition in the previous

year(s).

When an item of property, plant and equipment is revalued, the carrying amount of that asset is adjusted to the

revalued amount. At the date of the revaluation, any accumulated depreciation revaluation is treated in one of

the following ways:

1. The accumulated depreciation is eliminated against the gross carrying amount of the asset as

demonstrated in Example 1-38.

2. Restated proportionately with the change in the gross carrying amount of the asset so that the carrying

amount of the asset after revaluation equals its revalued amount as demonstrated in Example 1-39.

EXAMPLE 1-38

Option 1

Assume KRF Corp. owns a building that cost $2,000,000 and has accumulated depreciation of $400,000, with a

book value of $1,600,000. Assume KRF Corp. revalues the building to reflect its fair value of $1,800,000. Under

this alternative, KRF Corp. would first remove its accumulated depreciation of $400,000, reducing the building by

that amount of expired cost. Then, in the second entry, the building would be debited for $200,000 and the

revaluation surplus credited, reflecting the net amount that is being restated. The entries are:

Accumulated depreciation—Building $400,000

Building $400,000

Building $200,000

Revaluation surplus—Building $200,000

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EXAMPLE 1-39

Option 2

Assume KRF Corp. owns a building that cost $2,000,000 and has accumulated depreciation of $400,000, with a

book value of $1,600,000. Assume KRF Corp. revalues the building to reflect its fair value of $1,800,000. Under

this alternative KRF Corp. would restate the building account and accumulated depreciation based on the change

($1,600,000) in the gross carrying amount ($2,000,000) of the asset, which is 80% ($1,600,000/$2,000,000), and

the entry is:

Building $250,000*

Accumulated depreciation—Building $ 50,000

Revaluation surplus—Building 200,000

* $200,000 ÷ 80% = $250,000

The result of the above entry will provide a book value that equals the revalued amount of the building.

Additionally if property, plant, and equipment is stated at revalued amounts, IFRS requires certain disclosures

including: the effective date of the revaluation, whether an independent valuer was involved , for each revalued

class of property, the carrying amount that would have been recognized had the assets been carried under the

cost model, the revaluation surplus (including changes during the period and any restrictions on the distribution

of the balance to shareholders) and details of fair value determination.

Impairment. According to U.S. GAAP and IFRS, a company must record an asset impairment when the book value

of an asset is not recoverable. U.S. GAAP relies on a recoverability test to determine whether impairment has

occurred. If the sum of expected future cash flows (undiscounted) is less than the carrying amount of the asset,

the asset is considered impaired. Such an impairment loss is measured as the difference between the carrying

amount of the asset and its estimated fair value. U.S. GAAP prohibits subsequent impairment reversals.

EXAMPLE 1-40

The following information is provided for an asset group:

Carrying value $100,000,000

Fair value 80,000,000

Sum of the undiscounted cash flows 95,000,000

Because the carrying value is greater than the sum of the undiscounted cash flows, a non-recoverability situation

is evident. (The recoverability test is failed.) The impairment loss to be recognized equals $20,000,000

($100,000,000 - $80,000,000).

Under IAS 36, an asset is impaired when its recoverable amount is less than its carrying amount. The recoverable

amount is the greater of fair value less costs to sell and its value in use. “Value in use” is the present value of

expected future net cash flows over the remaining useful life of the asset. The impairment loss is the difference

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between the asset's book value and its recoverable amount, which is recognized in income. IFRS permits asset

write-ups for subsequent recoveries of impairments.

Intangible Assets and Goodwill

Both U.S. GAAP and IFRS define intangible assets as nonmonetary assets without physical substance. The

recognition criteria for both accounting models require that probable future economic benefits and costs can be

reliably measured. In addition, U.S. GAAP and IFRS consider intangibles as identifiable assets if they are separable

or as a result of contractual or legal rights.

Like IFRS, intangible assets acquired in a business combination are recognized at fair value under U.S. GAAP.

Intangible assets with finite useful lives are amortized over their expected useful lives, with one minor exception

in ASC 985-20, Software — Costs of Software to be Sold, Leased or Marketed, related to the amortization of

computer software sold to others. The exception and differences are discussed below.

With regard to in-process R&D costs that are acquired as part of a business combination, U.S. GAAP and IFRS

standards have converged, requiring these costs to be capitalized and amortized, with annual testing for

impairment. Subsequent expenditure on an intangible asset is not capitalized unless it can be demonstrated that

the expenditure increases the utility of the asset, which is broadly like IFRS. Finally, under both standards, the

following expenditures are expensed as they are incurred:

• Research costs

• Start-up costs

• Customer lists

• Training costs

• Relocating or re-organizing part or all of an entity

• Internally generated goodwill

Some significant differences exist:

Revaluation. Under IFRS, intangible assets (other than goodwill) may be revalued to fair value as an accounting

policy election. Since revaluation requires reference to an active market for the specific type of intangible, this is

relatively uncommon in practice. Unlike IFRS, companies are not permitted to use the revaluation model under

U.S. GAAP.

Software developed for sale. U.S. GAAP has special requirements for software developed to be sold. That is,

development costs related to computer software developed for external use are capitalized once technological

feasibility is established in accordance with specific criteria (ASC 985-20). Technological feasibility is recognized

upon completion of a detailed program and product design or, in the absence of the former, completion of a

working model whose consistency with the product design has been confirmed through testing. Thus, all software

development costs incurred up to the point of general release of the product to customers are capitalized and

recorded subsequently at the lower of amortized cost and net realizable value. Although application of these

principles may be largely consistent with ASC 985-20, IFRS does not have software-specific guidance. As such, the

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general criteria (IAS 38.57) are applied to software development costs to determine whether they should be

capitalized or expensed.

Internal-use software. Separate guidelines are provided for internal-use software (ASC 350-40) under U.S. GAAP.

That is, the costs incurred for the acquisition, development or modification of software to meet the company’s

specific needs are capitalized depending on the stage of development (e.g. preliminary, application development,

and post-implementation/operation). For instance, costs incurred during the preliminary and post-

implementation stages are expensed as they are incurred. However, costs incurred during the application

development stage are capitalized including only:

1. The external direct costs of materials and services consumed in developing or obtaining internal use

software;

2. Payroll and payroll-related costs for employees who are directly associated with, and who devote time

to, the internal use software project, and

3. Interest incurred during development

Unlike U.S. GAAP, there is no separate IFRS guidance addressing the treatment of costs incurred to develop

internal-use software. Therefore, the general IFRS rules related to treatment of costs of internally developed

intangible assets, which are similar to U.S. GAAP, are applied.. It should be noted that the amounts expensed and

capitalized under IFRS and GAAP can be different depending on when the IFRS recognition criteria is met.

Advertising costs. Under U.S. GAAP, advertising and promotional costs are either expensed as incurred or

expensed when the advertising takes place for the first time (policy election). However, advertising and

promotional costs are expensed as incurred under IFRS. Moreover, direct response advertising costs may be

capitalized if both of the following criteria are met under U.S. GAAP:

1. The primary purpose is to elicit sales from customers who can be shown to have responded specifically

to that advertising; and

2. If it results in probable future economic benefits

There is no specific guidance in IFRS on the accounting for direct-response advertising. Costs are expensed as they

are incurred.

Impairment. IFRS uses a one-step process in testing for goodwill impairment, where an impairment loss is

recognized if the asset's carrying amount exceeds the greater of its fair value less costs to sell and value in use,

which is based on the net present value of future cash flows. The FASB issued ASU 2017-04 that eliminated step

2 from the goodwill impairment test. Eliminating step 2 from the goodwill impairment test under ASC 350 results

in guidance that more closely aligns with the requirements in IFRS as indicated in IAS 36.

Cloud computing. The FASB issued ASU 2015-05, Customer’s Accounting for Fees Paid in a Cloud Computing

Arrangement (Subtopic 350-40 Intangibles – Goodwill and Other – Internal-Use Software), providing guidance for

a customer’s accounting for fees paid in a cloud computing arrangement (CCA). Previously, there was no specific

U.S. GAAP guidance on accounting for such fees from the customer’s perspective. Under ASU 2015-05, customers

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apply the same criteria as vendors to determine whether a CCA contains a software license or is solely a service

contract. Fees paid by a customer in a CCA are within the scope of the internal-use software guidance if both of

the following criteria are met:

1. The customer has the contractual right to take possession of the software at any time during the CCA

period without significant penalty, and

2. It is feasible for the customer to run the software on its own hardware (or to contract with another

party to host the software).

Arrangements that do not meet both of the criteria are considered service contracts, and separate accounting for

a license will not be permitted. Arrangements that meet the criteria are considered multiple-element

arrangements to purchase both a software license and a service of hosting the software.

There is no specific guidance in IFRS on cloud computing arrangements and the general principles for intangible

assets apply.

Not-for-Profit Organization: Non-Cash Gifts

General Rules

The FASB defines not-for-profit organizations (NFPOs) as unique from for-profit organizations in that they usually

have the following characteristics:

1. They receive contributions from others who do not expect a monetary return.

2. They operate for a purpose other than to make a profit.

3. There is an absence of ownership interests, like that found in normal businesses.

NFPOs will typically follow many of the normal accounting principles that for-profit businesses follow; however,

they are dissimilar in that the focus of the reporting is not on providing information on net income.

When contributions are received by an NFPO, they must be classified as either net assets without donor

restrictions or net assets with donor restrictions:

1. Net Assets without Donor Restrictions: The part of net assets of an NFPO that is not subject to donor-

imposed restrictions (donors include other types of contributors, including makers of certain grants).

2. Net Assets with Donor Restrictions: The part of net assets of an NFPO that is subject to donor-imposed

restrictions (donors include other types of contributors, including makers of certain grants).

Recognition of In-Kind Contributions

Almost all NFPOs receive some form of non-cash gifts including tangible property (e.g. building, furniture,

equipment, supplies, and clothing) and contributed services (e.g. volunteer, accounting, and legal). These donated

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goods and services are referred to as in-kind contributions. All in-kind donations must be captured and reported

appropriately in a NFPO’s financial records. Similar principal applies to a capital asset donation such as building or

equipment; to record the revenue and capitalize the asset at fair market value on the date of donation. A common

consideration when estimating the fair value of the contributed use is whether the NFPO would otherwise be

willing to pay the market price for the same asset if its use was not contributed. In general, the entire contribution

should be recorded as revenue in the period the contribution is received or pledged. The amount recognized as a

contribution should not exceed the fair value of the long-lived asset at the time unconditional promise is made.

A restriction by a donor can impact the timing of revenue recognition because it can only be revenue if the

contribution is an unconditional transfer to the NFPO. Only after a conditional transfer becomes unconditional

can it be recognized as revenue. In this case, a NFPO should record the asset and the revenue in appropriate

classifications to reflect purpose and time restrictions.

Contributions of items such as artworks and historical treasures need not be capitalized and recognized as

revenues if they are added to collections that are: (1) subject to a policy that requires the proceeds of sales of

collection items to be used to acquire other collection items; (2) protected, kept unencumbered, cared for, and

preserved; and (3) held for public exhibition, education, or research for public service purposes rather than

financial gain.

Expiration of Donor-Imposed Restrictions

The expiration of a donor-imposed restriction on a contribution should be recognized in the period in which the

restriction expires. This occurs when (1) the purpose for which the resource was restricted has been satisfied, (2)

the time of the imposed restriction has elapsed, or (3) both of these criteria occur. For example, a donor

established a memorial fund for a loved one that requires that the money (accounted for as revenue or a gain in

the period in which it was received) be invested in a certain type of investment (i.e., Bonds) for 10 years. The

contribution must be classified as donor-restricted support in the period of receipt. After the donor-imposed

restriction is satisfied (i.e., after the 10 years have passed), the entity must report a reclassification that shows

that its net assets without donor restrictions have increased and net assets with donor restrictions of the entity

has decreased.

Government Fixed Assets

Because governments are fundamentally different from business enterprises, separate accounting, financial

reporting, and auditing standards for governments are required to meet the specific needs of stakeholders.

Mainly, these standards aim to address the need for public accountability by helping stakeholders assess how

public resources were acquired and used. Thus, the Governmental Accounting Standards Board’s (GASB) financial

reporting objectives consider accountability to be the cornerstone on which all other financial reporting objectives

should be built. GASB Statements have the highest level of authority for state and local governments.

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General Rules for Fixed Assets

Governmental entities may acquire equipment that has an economic life of more than one year. Accounting for

this acquisition depends on which fund expends the resources for the acquisition. The governmental funds are

concerned with the expendability and control over available resources and account for the acquisitions of

equipment as expenditures. In the governmental funds, the entire amount of the cost of the acquisition of

equipment and other capital assets is recognized as an expenditure in the year the asset is acquired.

No capital assets are recorded in the general fund; they are treated as expenditures of the period. Capital assets,

such as equipment, are reported in the government-wide statement of net assets and in the proprietary fund

statement of net assets. They must be depreciated over their estimated useful lives unless they are inexhaustible

or are infrastructure assets (e.g. roads, bridges, tunnels, drainage systems, water and sewer systems, dams, and

lighting systems) that meet certain requirements. Buildings, except those that are an ancillary part of a network

of infrastructure assets, should not be considered infrastructure assets for purposes of GASB Statement No. 34.

Examples of buildings that may be an ancillary part of a network or subsystem include road maintenance

structures such as shops and garages associated with a highway system and water pumping buildings associated

with water systems.

The proprietary funds are concerned with capital maintenance and account for acquisitions of capital assets in the

same manner as commercial entities. Thus, the accounting for the purchase of a capital asset differs in the five

governmental funds from the accounting used in the proprietary funds. The five types of governmental funds are

(1) general fund, (2) special revenue funds, (3) capital projects funds, (4) debt service funds, and (5) permanent

funds.

EXAMPLE 1-41

On January 1, 20X7, the first day of the new fiscal period, the city council of Bancroft City approves the operating

budget for the general fund, providing for $900,000 in revenue and $850,000 in expenditures. Approval of the

budget provides the legal authority to levy the local property taxes and to appropriate resources for the

expenditures. The term appropriation is the legal description of the authority to expend resources. The entry

made in the general fund's accounting records on this date is as follows:

January 1, 20X7

(1) ESTIMATED REVENUES CONTROL $900,000

APPROPRIATIONS CONTROL $850,000

BUDGETARY FUND BALANCE—UNASSIGNED 50,000

Record general fund budget for year.

Assume that Bancroft City acquires a truck. The acquisition is made from the resources of, and is accounted for

in, the general fund. The encumbrance is $12,000, but the actual cost is $12,500 because of minor modifications

required by the city.

The general fund makes the following entries to account for the acquisition of the truck:

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(2) ENCUMBRANCES $12,000 BUDGETARY FUND BALANCE—ASSIGNED FOR

ENCUMBRANCES $12,000

Order truck at estimated cost of $12,000. (3) BUDGETARY FUND BALANCE—ASSIGNED FOR

ENCUMBRANCES $12,000

ENCUMBRANCES $12,000 Cancel reserve for truck received.

(4) EXPENDITURES $12,500 Vouchers Payable $12,500 Receive truck at actual cost of $12,500.

The truck is not recorded as an asset in the general fund; it is an expenditure in this fund. However, the proprietary

fund will capitalize the truck as an asset as noted above.

Sales of capital assets are recorded as a debit to Cash (or receivable) and a credit to Other Financing Sources—

Sales of General Capital Assets for the amount received from the sale. If the amount from the sale is immaterial,

the government entity may elect to record the credit to other revenues. A schedule of the acquisition or sale of

capital assets by any governmental fund should be maintained, but that record is only for the government-wide

financial statements, which do report the assets of a government unit.

Works of Art and Historical Treasures

For the purposes of government-wide financial statements, governments should capitalize works of art, historical

treasures, and similar types of assets at their historical costs at acquisition or at their fair values at the date of the

contribution. For example, if the general fund expended $10,000 for a work of art, it reports an expenditure for

that amount. However, when preparing the government-wide financial statements, the cost of the work of art is

reported as an asset of the government. If the assets were received as a donation, contribution revenue would be

recognized in the government-wide financial statements.

The GASB provided practical guidance to the general rule of capitalizing works of art and historical treasures. For

example, many collections have a very large number of items collected over long periods of time, and it is virtually

impossible to determine the cost or fair value at the times of acquisition. A provision in GASB 34 states that the

government is not required, but is still encouraged, to capitalize a collection of art or historical treasures if the

government meets all three of the following provisions:

1. Holds the collection for public exhibition, education, or research;

2. Protects and preserves the collection; and

3. Has an organizational policy that requires the proceeds from sales of items in the collection to be used to

acquire other items for the collection.

If contributed items are not capitalized, the government-wide financial statements report both a program expense

and a contribution revenue for the fair market value of the item at the time of its donation.

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Capitalized collections that are exhaustible, such as displays of works whose useful lives are reduced due to the

display, or used for education or research, should be depreciated over their estimated useful lives.

Collections or individual items whose lives are inexhaustible are not depreciated. Inexhaustible collection or items

are items whose economic benefit or service potential is used up so slowly that the estimated useful lives are

extraordinarily long. Because of their cultural, aesthetic or historical value, holders of the asset protect and

preserve the asset more than that for similar assets without such value.

Treatment for Leased Assets

In 2017, the GASB issued GASB Statement No. 87, Leases, to establish a single model for lease accounting based

on the foundational principle that leases are financings of the right to use an underlying asset. The requirements

of Statement No. 87 are effective for reporting periods beginning after December 15, 2019.

The GASB treats all leases as financing—there is no distinction between operating and financing lease

classifications for financial reporting purposes. Thus, government entities will have to report operating leases on

the balance sheets (with certain exceptions discussed below). Specifically, government entities that lease

nonfinancial assets, such as vehicles, equipment, and buildings, must treat these leases as financings of the right

to use an underlying asset. In other words, an intangible right of use asset will be capitalized and amortized and

the lease liabilities will be booked and classified as long-term debt with the lease payments classified as capital

financing. The guidance affects the lessee in the following ways:

• The lessee should recognize a lease liability and a lease asset at the start of the lease term, or upon

adoption of this guidance, unless the lease is a short-term lease or it transfers ownership of the underlying

asset

• The lessee will no longer report rent expense for today’s operating-type leases, but will instead report

interest expense on the liability and amortization expense related to the asset

• In cash flow statements, lease payments will be classified as capital financing outflows

The following table summarizes general requirements by the lessee under GASB 87.

Requirements Lessee

At the

commencement of

the lease term

• Recognizing a lease liability and a lease asset

• Exception: Short-term lease, and leases that transfer ownership of the

underlying asset

Measurement of

Lease Value

• Lease Liability: Measured at the present value of payments expected to be

made during the lease term (less any lease incentives)

• Lease Asset: Measured at the amount of the initial measurement of the lease

liability, plus any payments made to the lessor at or before the commencement

of the lease term and certain direct costs.

Accounting

Treatments

• Lease Liability: Reduce the lease liability as payments are made and recognize

an outflow of resources (for example, expense) for interest on the liability

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• Lease Asset: Amortize the lease asset in a systematic and rational manner over

the shorter of the lease term or the useful life of the underlying asset.

Disclose

• A description of leasing arrangements

• The amount of lease assets recognized

• A schedule of future lease payments to be made

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16. Under IFRS, when may an entity that acquires an intangible asset use the revaluation model for subsequent

measurement?

A. Only if the useful life of the intangible asset can be reliably determined

B. Only if an active market exists for the intangible asset

C. Only if the cost of the intangible asset can be measured reliably

D. Only if the intangible asset is a monetary asset

17. How would you categorize contributions subject to donor-imposed restrictions?

A. Net Assets without donor restrictions

B. Temporarily restricted assets

C. Net assets with donor restrictions

D. Controlled assets

18. The Anderson Museum, a not-for-profit organization, received a contribution of historical artifacts. It need

NOT recognize the contribution if the artifacts are to be sold and the proceeds used for which of the following

activities?

A. Support general museum activities

B. Acquire other items for collections

C. Repair existing collections

D. Purchase buildings to house collections

19. When a snowplow purchased by a governmental unit is received, how should it be recorded in the general

fund?

A. As an encumbrance

B. As an expenditure

C. As a general capital asset

D. As an appropriation

20. All of the following are infrastructure asset EXCEPT:

A. Buildings

B. Bridges

C. Roads

D. Lighting systems

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Chapter 2: Fixed Assets - Controls

Learning Objectives


• Identify the top fixed assets issues and control activities

• Recognize common testing procedures for fixed asset audits

Top Fixed Assets Issues

Vulnerability of Fixed Assets

According to the Association of Certified Fraud Examiners (ACFE), there are three main categories of fraud that

affect organizations including asset misappropriation, fraudulent statements, and corruption. The ACFE’s recent

Report to the Nations reveals that asset misappropriation schemes are the most common and least costly

occupational (corporation) fraud. Asset misappropriation involves the theft or misuse of an organization’s assets

including theft of tangible assets (e.g., cash, inventory, and fixed assets) and intangible assets (e.g., patents,

copyrighted materials, and customer lists). In addition to misappropriation of assets, management often

exaggerates the value of assets through the manipulation of the fixed assets to falsely strengthen a company’s

financial performance. Fraudulent valuation also involves fictitious assets and manipulation of estimates (e.g.

useful lives, in-service dates, and salvage values of assets).

The ACFE report indicates that the highest percentage of schemes involved accounting department personnel.

These employees are responsible for processing and recording transactions and may also have access to the assets

increasing their opportunity to conceal the fraud. Concealment includes writing the stolen asset off as scrap,

obsolete, missing, donated, or destroyed. For example, the following normal day-to-day business activities can be

used to conceal the theft of fixed assets:

• Accept goods without documentation to support the receipt

• Write off assets as scrap, damaged, lost, shrinkage

• Create false receiving reports or documentation to alter quantity or quality

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• Alter records after the physical count to hide the discrepancies

When fixed assets are diverted before the company takes possession, management should review the receiving

procedures for improvement. If theft of assets occurs after the company’s possession, internal controls need to

be strengthened in the physical security area.

Misuse of assets is a form of abuse a company’s resources. The following are typical assets involved in misuse

fraud cases:

• Office equipment

• Equipment and tools

• Real estate, such as apartment and storage facilities

• Transportation assets, such as vehicles or air transportation

Key controls to prevent and detect fixed assets frauds are discussed in “Basic Control Techniques” section.

The Risks of Spreadsheets

Since fixed assets represent a significant portion of most organizations’ balance sheets, incomplete and out-of-

date information can have a major financial and compliance impact. Effective fixed asset management requires

an organized, consistent system to manage fixed assets that yields reliable, accurate depreciation results.

Spreadsheets, which generally require manual programming and updating, are still the most common way to

calculate depreciation. Although spreadsheets can perform complex mathematical calculations, they are not the

best tool for managing fixed assets because they can be time consuming to maintain and are prone to error.

Common issues with spreadsheets include:

• Changes in rules and regulations are not reflected

• Errors in formulas go undetected

• Inability to attach other information (such as images) to an asset

• Difficulty in changing depreciation methods for an asset

• Difficulty in integrating with other applications

• Limited internal control features such as lack of audit trails and history

Diversion of Assets

BEFORE the Company's Possession

Weakness in

RECEIVING

AFTER the Company's Possession

Weakness in

PHYSICAL SECURITY CONTROLS

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To save time and resources, management may consider replacing spreadsheets with fixed asset management

software that can control, track and record all fixed assets activity that occurs during an asset’s lifetime. “Leveraging Technology” section discusses the use of technology to enhance fixed asset management.

Overpayment of Property Taxes and Insurance

A “ghost” asset refers to property that is lost, stolen, or unusable and is still listed as an active fixed asset in the

general ledger. Statistics shows that on average 12% to 30% of fixed assets are ghost assets. As a result,

companies may be overpaying property taxes and insurance on ghost assets%. It may also mean that companies

are depreciating assets that are no longer producing benefits and that they are not recording the appropriate

disposal entries (which could include losses) which impacts both their books and tax returns. Material inaccuracies

in fixed asset records affect the overall accuracy of company financials posing a threat to executives responsible

for ensuring regulatory compliance (e.g., SOX 404). In general, ghost assets impact a company in the following

ways:

• Increased property taxes: The calculated personal/real property liability is higher than necessary as the

taxable base is overstated

• Increased insurance premiums: Insuring ghost assets may result in higher premiums as the insurable

amount may be overstated

• Workflow issues: Production estimates based on nonexistent assets may lead to the inability to meet

customer demand

• Inaccurate forecast: Incorrect fixed assets could affect the accuracy of capital budgeting

• Waste of resources: Employees could spend hours identifying and updating fixed asset records related to

ghost assets

• Legal implications: Inaccurate financial reporting resulting from ghost assets increases the risk of

noncompliance with the Sarbanes-Oxley Act

According to Sage Software, companies are, on average, overpaying taxes and insurance on approximately 12%

of the fixed assets on their books as a result of ghost assets. Following is an example of the effects of 12%

overpayment of federal and state income tax, personal property tax, and insurance:

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Example of the Effects of Overpayment of Taxes & Insurance

Number of Fixed Assets 500

Total Cost of Depreciable Fixed Assets $2,000,000

Average Cost of Each Asset $4,000

Percentage of Ghost Assets 12%

Total Cost of Ghost Assets $240,000

Tax Rate: Federal & State 21% on 40% average remaining asset life

Personal Property Tax 3.4% on 70% of assets

Insurance Rate 1 cent per $1

Potential Overpayment - Federal & State $20,160

Potential Overpayment - Personal Property Tax $5,712

Potential Overpayment - Insurance $2,400

Total Potential Annual Overpayments $42,672

Source: Sage Software, Best Practices for Fixed Asset Managers: Developing solid techniques for proper management of

fixed assets - White Paper

To eliminate ghost assets, a company must first identify and remove inaccurate records. Then, management needs

to ensure that adequate controls, asset tracking software, and required resources are in place to prevent ghost

assets recurring. Key control activities are discussed in the “Basic Control Techniques” section.

Implementation of Strong Controls

Control Design Principles

Internal controls are a coordinated set of policies and procedures that reflect a comprehensive strategy for

achieving the following management objectives:

1. Reliable and comprehensive financial and other information

2. Compliance with laws, regulations, policies, plans and procedures

3. Efficient and effective operation and use of resources

4. Safeguarding of assets

Internal controls should be designed with the risk in mind and tailored to the particular circumstances of the

company. Thus, to design an effective internal control system that reduces the risk of fraudulent activity, one must

take a systematic and risk-oriented approach in the development of internal controls. There are two main risks

usually associated with fixed assets including:

• Financial Risk: The errors in determining cost basis, useful life, and depreciation

• Physical Risk: The assets are misplaced, lost, stolen or damaged

In addition, management must take fraud risk into consideration. A fraud risk is the probability that fraud will

occur and the potential consequences to the company when it occurs. The probability of a fraudulent activity is

usually based on how easy it is to commit fraud, the motivational factors, and the company’s fraud history. Fraud

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risk factors do not always indicate the existence of fraud; however, they often are present in circumstances in

which fraud exists. A fraud risk review often considers whether errors or events could be the result of a deliberate

act designed to benefit the perpetrator. It involves asking questions such as:

• What could go wrong?

• Why would someone (internal and external) commit fraud?

• Where are we vulnerable? (opportunities already existed)

• How might a fraudster exploit weakness in the system of controls?

• How might a fraudster override or circumvent controls (e.g. transaction approval)

• What could a fraudster do to conceal the fraud? (e.g. creating fraudulent physical documents)

• What types of assets are susceptible to fraud? Where are they located?

• Which personnel have control over or access to tangible or intangible assets?

Although every company is susceptible to errors and fraud, it is not cost-effective to try to eliminate all risks. An

effective internal control system should be designed to provide management with the appropriate balance

between risk of the business practice and the level of control required to ensure business objectives are met.

Before making the decision to adopt a control, management must analyze the costs of establishing and

maintaining it, and consider:

1. The potential benefits the control will provide

2. The risk and effects of non-compliance

The level of security of the assets should be based on the vulnerability of the items being secured. In other words,

the probability of loss and the possible impact (if a loss occurs) should be taken into consideration when assets

are being secured.

Basic Control Techniques

In the current regulatory and highly competitive business environment, asset management is having a far greater

impact on a company’s financial condition than in the past, with the pressure of return on investment and full

disclosure of financial asset information. Unfortunately, many companies’ asset management is still one of the

weakest areas of internal controls resulting in the risk of misuse or theft, non-compliance with regulatory

requirements, overpayment of taxes and insurance, and higher cost of ownership. Whether it is Sarbanes-Oxley

compliance or the pressure to maximize return on assets, companies must make significant improvements to

address how fixed assets are tracked, managed, and protected. The responsibility for an internal control system

rests with management.

From an accounting perspective, sufficient financial control of fixed assets ensures that the values of assets are

properly reported on the annual financial statements. From a management perspective, internal controls are

designed to ensure the use of assets for authorized purposes and to prevent theft or misuse. The following internal

controls address concerns from both accounting and management perspectives:

Segregation of Duties: Segregation of duties is designed to reduce the opportunities for any person to be in a

position to both perpetrate and conceal errors or irregularities (fraud) in the normal course of his or her duties

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and involves assigning different people the responsibilities of authorizing transactions, recording transactions, and

maintaining custody of assets.

Custody of fixed assets should be separate from the related record keeping. For example, the person who receives

a fixed asset should not be the same person who records the transaction. The person who disposes of an asset

should not also record the sale. In addition, the person who audits fixed assets should not be involved with fixed

assets. In general, there should be segregation of duties between the following functions:

• Custodians

• Authorization

• Maintenance of records

• Verification

Physical Security: Assets (e.g. cash, equipment, and inventory) should be protected against the danger of loss,

unauthorized use, or theft. For instance, sensitive items should be kept in a locked storage area at all times when

not in use. Cash and checks should be deposited promptly. Emphasis should be placed on “walk-away” assets (e.g.

laptops, tools), which are assigned to specific employees or verified by employees as needed. Examples of controls

over physical access include locked doors, filing cabinets, drawers, and safes. The number of individuals with

access to the keys or lock combinations should be limited. Keys and combinations should be changed when

employees with access to significant assets terminate or transfer/change job responsibilities.

Verification of Physical Existence and Condition: The fixed asset physical count is essential to the prevention and

detection of asset misappropriation and fictitious asset schemes. Fixed assets at all locations should be counted

and verified to accounting records at least once a year. During the count:

• The conditions of the assets should be evaluated

• The value of damaged or deteriorated assets should be adjusted to reflect the current condition

• Discrepancies (e.g., unrecorded additions or retirements) between the count and records should be

investigated prior to posting the adjustments

The periodic inspection should be performed by staff independent in relationship to the fixed assets.

Fixed Assets Policies & Procedure: A clear fixed assets procedure should be implemented and cover the following

areas:

• Capitalization policy

• Depreciation policy/schedule

• Delegation of authority

• Roles and responsibilities

• Additions and disposals

• Relocation/transfers

• Fixed asset tagging (receipt of goods/relocation/disposal)

• Maintenance of capital assets

• Accounting and reconciliations

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• Write off

• Reporting

• Periodic inventory evaluations

• Instances of non-compliance with procedures including investigation and follow-up

A capitalization policy is a policy set by an entity to establish a threshold(s) for capitalizing a fixed asset. Different

monetary amounts are usually established in the policy for different classes of fixed assets. Management should

use reasonable and consistent rationale in establishing appropriate capitalization thresholds. In addition, a written

policy including approval limits and approval steps required to acquire, transfer, dispose and obsolete fixed assets

should be in place. The documented delegation of authority should cover authority to:

• Acquire

• Transfer

• Dispose

• Write off

The approval chain should include at least two levels of approval with additional approval required for fixed assets

with higher values.

A Sample Capitalization Policy

A capitalized fixed asset is property, such as equipment, buildings and land, with a cost or value equal to or greater

than $2,000 at the date of acquisition, effective January 1, 20x2, and an expected useful life of more than one

year.

Capitalized fixed assets are acquired for the use in normal operations and are not for resale. All capitalized fixed

assets are entered into the Fixed Assets Module for inventory and financial reporting purposes. Assets costing

below $2,000 are expensed in the fiscal year of purchase and are not capitalized nor maintained through the Fixed

Assets Module.

The only exception allowable is for the capitalization of low cost equipment for the initial outfitting of a tangible

capital asset or operational unit, or an expansion or renovation to either. Equipment for this treatment should be

budgeted and charged to the capital project as equipment.

Costs incurred to keep a fixed asset in its normal operating condition that do not extend the original useful life of

the asset or increase the asset’s future service potential are not capitalized. These costs are expensed as repairs

or maintenance.

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Identification of Assets: Each fixed asset should be promptly tagged to permit easy identification and recorded in

a fixed asset register to ensure traceability. Accuracy of the tags can be verified through periodic physical counts.

Bar coding is usually recommended for businesses with more than a few hundred assts. The bar code reader

eliminates the problems of transcription errors on the part of a human reading a number and either keying or

writing it on a document. Pre-numbered, bar coded tags including the company name, can be obtained from many

firms specializing in inventory equipment.

Up-to-Date Fixed Assets Register: The asset register should clearly identify each asset including the following

details for both book and tax purposes:

• Initial Cost

• Quantities

• Tag Number

• Serial Number

• Location

• Asset Category/Class/Group

• Description

• Date of Acquisition

• Methods and start of Depreciation/Date placed in service

• Useful Life

• Current and Accumulated Depreciation Value

• Net Book Value

• Insurance and Warranty Details

• Status (e.g. In/Not in Use)

• Department/Individual Responsible

Accuracy of the register should be verified through periodic physical counts. Adjustments to the register are

reviewed and investigated before being authorized.

Reconciliations with General Ledger: The asset register should be reconciled to the general ledger to ensure the

accuracy of the financial statements on a monthly basis by the accountant and reviewed by the supervisor. The

reconciliation process usually identifies unrecorded additions and unrecorded retirements. Discrepancies should

be investigated before adjustments are posted.

Random Audits: The supporting documentation of additions and disposals should be periodically audited for

completeness and accuracy. Conducting random checks is an effective way to communicate to employees that

management cares about the integrity of fixed assets.

Assign Assets to Employees: Employees should be held accountable for assets assigned to them. Some portion of

their annual performance appraisals could be tied to the presence and condition of those assets. This control

works best at the department level, where department managers are assigned responsibility for the assets in their

areas.

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Analytical Procedures: This method is used to detect and examine relationships of financial information (e.g.

actual vs. expected, prior time period vs. current time period) that do not appear reasonable. For example, it

allows management to compare.

• Dispositions of fixed assets to replacements

• Depreciation and amortization expenses to the cost of fixed assets

• Accumulated depreciation to the cost of fixed assets

The analysis helps management:

• Determine if assets acquired are legitimate and meet the capitalization requirements

• Identify an unusual pattern in depreciation amounts

• Analyze write offs and scrap sales transactions which may hide a fraudulent activity

Leveraging Technology

Information systems connect people and processes to provide meaningful information to decision-makers,

therefore, it is critical to develop systems that support the partnership between accounting and operations.

Improved processes with the right technology can help increase productivity, reduce the risk of error, and meet

regulations requirements. However, many companies are not fully leveraging available technology. For example,

they are still using Excel to manage vital processes. Although Excel is a very useful tool to accountants, it is not an

automated process. It cannot support collaboration workflows. Therefore, the use of spreadsheets can lead to

several issues. A recent IMA survey identified the following common problems encountered as a result of using

spreadsheets:

1. Excessive manual effort

2. Multiple “versions of truth”

3. Difficulties in maintaining and/or updating the system

4. Lack of timely reporting

Fortunately, many accounting software packages are available to automate and streamline the fixed asset process.

An effective fixed asset system should help management achieve the following objectives:

1. Maintain a complete and accurate fixed asset accounting and management system to track the value,

condition, remaining lives, and maintenance and repair schedules of those assets

2. Enable an up-to-date asset condition analysis to form a prioritized preventive maintenance schedule and

determine the amount and sources of funding available for any project

3. Develop more accurate capital and operating budgets

The following are features and key considerations of deploying an effective fixed asset system:

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Features Key Consideration

System Function

• Integration with the Accounting System (e.g. general ledger, inventory)

• Ability to facilitate exporting and importing files

• Capability of splitting an asset into sub-assets, and calculating deprecation on

sub-assets

• Providing projections of future depreciation

• E-mail functionality for exchange of reports and other information

• Security features including flexible access rights for various user groups (Read,

Write, Change/Delete)

Queries and

Reports

• A wide range of standard reports to meet the entity’s needs (e.g. by category,

classes, and groups) such as:

− Acquisition Report

− Depreciation Expense Report

− Disposal Report

− Transfer Report

− Net Book Value Report

− Period-Close Summary

− Annual Activity Report

• Ability to customize standard reports

• Reports containing sufficient details in accordance with users’ need

• Allowing for queries and ad-hoc reports

• Providing reports related to critical dates such as maintenance, warranty and

insurance

In summary, to deploy the right software, management should be aware of the following:

• For small companies: Find an affordable fixed asset system designed for the needs of small business to

optimize fixed asset management and maintain reasonable return on investment. • For midsized to large companies: Ensure that the software integrates with other modules (e.g., general

ledger, payables, purchase order, and inventory management) to provide additional functionality over the

current system. • For company expects to purchase more assets: Ensure that the software has the ability to meet the growth

and needs of an expanding database. • In general, the software package should be easily customized to meet the company’s needs.

In addition, a fixed asset software package should at least provide the ability to:

1. Manage complex depreciation methods and conventions

2. Maintain accurate physical inventory

3. Integrate with other modules (e.g., general ledger, payables, and purchase order)

4. Automatically handle disposal of both full and partial assets

5. Provide comprehensive application data security

6. Maintain sufficient audit trail to track all data changes

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Audit Readiness

Audit Focus for the Fixed Asset Process

Due to the materiality and vulnerability of fixed assets, most auditors consider them as high-risk audit areas. For

example, fixed assets usually constitute a significant item on the balance sheet in many capital-intensive industries

such as healthcare, power generation and manufacturing. Audits of fixed assets, therefore, assume considerable

importance. Both the internal and external auditors of the entity assess the effectiveness of internal control;

whether the controls are properly designed, implemented, and operated effectively. For example, the purpose of

an external audit is usually to determine if:

• The intent of the management control system has been effectively carried out, and

• The representation of fixed assets is accurately reflected in the financial statements

External auditors tend to move toward a qualified audit opinion when:

1. Fixed asset records do not materially reflect the value of fixed assets or

2. Proper internal controls are not in place to safeguard the assets

In general, fixed asset audits help identify invalid asset transactions, noncompliant asset valuation and incorrect

asset classification. Auditors usually intensify their examination of fixed asset records when they identify the

following problems (red flags) during the review:

1. Fixed assets were already disposed but still listed on the fixed assets list

2. Fixed assets recently purchased are not listed on the fixed assets list

3. Fixed assets are not valued correctly

The following examples of common audit findings provide an indication of what auditors may focus on for the

fixed asset process.

• Lack of current policies and procedures

• Inaccurate reporting of fixed assets

• Inadequate asset descriptions

• Lack of segregation of duties

• Inconsistent application of the capitalization threshold

• No periodic/regular inventory counts/reconciliation

• Poor tracking of asset movement (e.g. transfers and disposals)

• Inadequate use of assets identification tags

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The Typical Audit Approach

To prepare for an audit, one may want to learn about some of the most common testing procedures performed

by auditors. A combination of controls testing and substantive testing is often adopted by auditors to obtain audit

assurance on fixed assets. Typical audit procedures include verification of account balance accuracy, test of

account transaction validation, and assessment of the appropriateness of asset valuation.

When performing financial audits, auditors are required to:

• Identify and assess the risks of material misstatement at the relevant assertion level for classes of

transactions, account balances, and disclosures in sufficient detail to assign risk ratings and develop

appropriate audit procedures to address the level of risk assigned.

• Use relevant assertions in assessing risks by relating the identified risks to what can go wrong at the

relevant assertion, taking into account the relevant controls the auditor intends to test, and designing

further audit procedures that are responsive to the assessed risks.

Assertions are representations by management that are embodied in the financial statements and are used by

the auditor to consider the different types of potential misstatements that may occur. The following table lists the

relevant assertions for fixed assets with examples of testing procedures:

Assertions Description Examples of Common Audit Procedures

Completeness All fixed assets that should have been recorded have been recorded

Trace fixed asset purchases to the subsidiary ledger to verify that the assets are recorded

Valuation & Allocation

Fixed assets are included in the financial statements at appropriate amounts, and any resulting valuation or allocation adjustments are appropriately recorded

• Review a roll-forward analysis for the cost and depreciation account balances

• Conduct reasonableness testing of current year depreciation expense calculations

• Assess the appropriateness of the depreciation such as the reasonableness of estimated economic life and the method used

• Verify the accuracy of additions in the fixed assets records

• Verify retired fixed assets were properly adjusted in the assets and depreciation accounts

Existence Recorded fixed assets exist • Trace entries in the accounting records to supporting

evidence (e.g. invoices)

• Perform the physical observation

Occurrence & Cutoff

Fixed assets occurring during the period have been recorded in the correct accounting period

Examine supporting documentation to determine if transactions were recorded in the proper period

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Classification Fixed assets have been recorded in the proper accounts

• Examine repair and maintenance expenditure accounts and supporting documentation to ascertain the accuracy of the expense and capital asset determination

• Review lease agreements to determine if assets should be capitalized

Rights & Obligations

• The entity holds or

controls the rights to the

fixed assets

• Liabilities related to fixed

assets are obligations of

the entity

Verify the ownership by examining titles of the fixed

assets.

During the review, auditors also test key controls to determine if they operate effectively. Examples of areas where

auditors will look to identify key controls to test include:

1. Asset purchase order issuance and authorization

2. Receipt of assets and vendor invoices

3. Reconciliation of the vendor invoices to receiving reports and purchase orders

4. Approval of the payment of vendor invoices

5. Approval for adjusting, adding or removing any asset subsidiary ledgers

6. Authorization for disposal or transfer of fixed assets

7. Reconciliation of the general ledger accounts to the subsidiary ledgers

8. Periodic inventory evaluations

Exhibit 2-1 provides an example of checklist that can be used on any audit engagement where fixed assets are a

significant transaction cycle.

EXHIBIT 2-1: AUDIT CHECKLIST

This checklist documents an auditor’s understanding of how internal control over property, plant, and equipment

is designed and whether it is operating effectively. It helps the auditor in planning a primarily substantive

approach. To assess control risk below the maximum, the auditor will need to develop audit procedures and test

the company’s specific controls in order to opine on their design and operational effectiveness. The auditor’s

knowledge of the property, plant, and equipment cycle should be sufficient to understand:

• How fixed asset transactions are authorized and initiated.

• How fixed assets transactions and depreciation are processed by the accounting system.

• The accounting records and supporting documents involved in the processing and reporting of fixed assets

and depreciation.

• The processes used to prepare significant accounting estimates and disclosures.

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The processes, documents, and controls listed on this questionnaire are typical for medium to large business

entities but are by no means all-inclusive. The preponderance of ‘‘No’’ or ‘‘N/A’’ responses may indicate that the

entity uses other processes, documents, or controls in their information and communication systems or that

potential internal control weaknesses exist.

Fixed Assets and Depreciation N/A No Yes

A. Authorization and Initiation

1. Fixed asset acquisitions and retirements are authorized by management. A. B. C.

B. Processing and Documentation

2. The company maintains detailed records of fixed assets and related accumulated depreciation.

D. E. F.

3. Responsibilities for maintaining fixed asset records are segregated from the custody of assets.

G. H. I.

4. The general ledger and detailed fixed asset records are updated for fixed asset transactions on a timely basis.

J. K. L.

5. A process exists for the timely calculation of depreciation expense for both book and tax purposes.

M. N. O.

6. The general ledger and detailed fixed asset records are updated for depreciation expense on a timely basis.

P. Q. R.

7. The general ledger is periodically reconciled to the detailed fixed asset records.

S. T. U.

C. Disclosure and Estimation

8. Management identifies events or changes in circumstances that may indicate fixed assets have been impaired (ASC 360).

V. W. X.

9. Management assesses and understands the risk of specialized equipment becoming subject to technological obsolescence (ASC 275).

Y. Z. AA.

Internal Controls Self-Assessment

The best way to prepare for an audit is to be audit-ready year around. For example, the company should regularly

review and update its policies and procedures and take into account how changes (e.g. technology, regulations,

operations, and growth) may affect the process.

Self-assessment is a valuable tool to help identify potential internal control deficiencies. It serves as a road map

to ensure that the internal controls are in alignment with auditors’ expectations. When internal controls are

strong, auditors may reduce the planned level of substantive tests. Therefore, it is desirable for entities to ensure

that the design and operating of controls are efficient and effective.

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Internal controls help ensure that the direction, policies, procedures, and practices designed and approved by

management are in place and are functioning as designed/desired. An effective internal control system should

be designed to achieve the following objectives:

Acquisition of Fixed Assets

• Asset acquisitions are authorized in accordance with policy and procedures

• Recorded fixed asset acquisitions represent fixed assets purchased by the entity

• All fixed assets purchased are recorded

• Fixed asset acquisitions are accurately recorded

• Fixed asset acquisitions are recorded in the proper period

• Fixed asset acquisitions are properly classified

Depreciation of Fixed Assets

• Depreciation and amortization expenses are valid

• All depreciation and amortization expenses are recorded

• Depreciation and amortization expenses are correctly calculated and recorded timely

• Depreciation and amortization expenses are recorded in the proper period

• Depreciation and amortization expenses are accurately allocated

• The depreciation or amortization method and useful life used for depreciating or amortizing individual or

classes of assets are established in accordance with company and policies and with GAAP

Disposal and Transfer of Fixed Assets

• Disposal of fixed assets is permitted only in accordance with policy

• The transfer and disposal of assets are appropriately approved by management

• Recorded fixed asset disposals are valid

• All fixed asset disposals are recorded

• Fixed asset disposals are accurately calculated and timely recorded

• Fixed asset disposals are recorded in the proper period

• Profits/losses on the disposal of assets are accurately and timely classified and reported

Management of Fixed Assets

• Fixed assets are adequately safeguarded

• Access to update the fixed asset register is limited to appropriate staff

• Only valid changes are made to the fixed asset register

• Changes to the fixed asset register are accurate and processed timely

• Fixed asset maintenance records are updated promptly

• Records of fixed asset maintenance activity are sufficiently maintained

The questions in Exhibit 2-2 are the types of questions entities are likely to be asked during an audit. The document

also identifies sample procedures that can be implemented to address internal control risks.

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EXHIBIT 2-2: INTERNAL CONTROLS SELF-ASSESSMENT

The Self-Assessment lists sample procedures that can be implemented to address internal control risks. The

recommendations are not meant to be a comprehensive guide to implementing internal control systems.

Fixed Assets Cycle Recommended Key Control N/A No Yes

1. Are there guidelines in place for acquisition, depreciation, disposal and transfer, management, safeguarding, and reporting of fixed assets?

Documented policies/procedures are implemented to

cover the following areas:

− Capitalization policy

− Depreciation and Amortization policy/schedule

− Delegation of authority

− Roles and responsibilities

− Additions and disposals

− Relocation/transfers

− Fixed asset tagging (receipt of

goods/relocation/disposal)

− Maintenance of capital assets

− Accounting and reconciliations

− Impairment and obsolescence

− Write off

− Reporting

− Fixed assets physical count

− Instances of non-compliance with the procedures

for investigation and follow-up

BB. CC. DD.

2. Are the following duties generally performed by different people?

− Custodian of fixed assets

− Reconciliation of the Fixed Asset System with the control accounts

− Recording of transactions

− Authorization of transactions

• Different people are assigned with the

responsibilities of authorizing transactions,

recording transactions, and maintaining custody of

assets.

• Compensating controls can be applied when

limited staffing makes segregation challenging. For

example, adding review and authorization steps or

assigning receipt of goods and review of packing

slips to an employee outside the accounting

function.

EE. FF. GG.

3. Are fixed assets properly protected to prevent loss or theft?

• All fixed assets are tagged upon acquisition with

unique identifying numbers.

• A physical inventory count is performed annually

against the fixed asset subsidiary ledger.

Discrepancies are investigated timely and resolved.

HH. II. JJ.

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• High-risk fixed assets are counted more frequently.

4. Are all asset acquisitions proper?

• Written requests for the purchase of capital assets

are supported by sufficient justification and are

approved based on asset cost by an appropriate

level of management.

• Fixed assets purchases are recorded at the date of

receipt.

• Periodic independent inspection of fixed assets is

performed. The results are compared to fixed asset

records. Discrepancies are investigated timely and

resolved.

• Periodic independent checks from fixed asset

records are conducted to ensure that the assets

physically exist.

• Only the fixed asset accountant/authorized

individual has access rights to change records (e.g.

add/delete items).

KK. LL. MM.

5. Are all asset disposals/transfers proper?

• Clear criteria, in writing, exist for the identification

and disposal/transfer of damaged, obsolete, or

unneeded fixed assets.

• Major asset disposals are reviewed and approved

in accordance with policies and procedures.

• Asset disposal forms are completed and approved

prior to disposal.

• All disposals are recorded in the fixed assets ledger

on a timely basis.

• Periodic review and verification of disposal and

transfers should be made by independent

supervisory personnel.


individual has access rights to change records (e.g.

add/delete items).

NN. OO. PP.

6. Are sufficient fixed asset records maintained to support the classification and identification of items?

• Detailed fixed asset records are maintained and

updated directly from source purchase

documentation.

• Each asset record is allocated to a specific asset

class in the fixed asset system.

QQ. RR. SS.

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• Fixed asset class determines the depreciation

method used.

7. Are depreciation and amortization expenses valid?

• Depreciation and amortization schedules are

reviewed and approved by the

Controller/authorized individual to ensure that

asset categories are assigned appropriate useful

lives.

• Depreciation and amortization expenses are

dictated by the fixed asset accounting policy.


individual has access rights to change the

depreciation or amortization period.

TT. UU. VV.

8. Are adjustments to fixed assets accurate and valid?

• Adjustments are authorized in accordance with the

Limits of Authority.

• Supervisory review, verification and approval of

adjusting entries are performed.

WW. XX. YY.

9. Are financial statements supported by the subsidiary fixed asset ledgers and is depreciation and amortization correctly calculated?

• Fixed asset subsidiary ledgers are reconciled to the

general ledger control accounts.

• Depreciation and amortization is calculated in

accordance with GAAP.

ZZ. AAA. BBB.

10. Are fixed asset maintenance records updated timely and accurately?

• Asset maintenance schedules are prepared,

updated, and monitored by management.

• Management periodically reviews asset

maintenance activities.

CCC. DDD. EEE.

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Chapter 2 - Review Questions

21. Which of the following best describes an act of the employee to write off a stolen asset as scrap, obsolete,

missing, donated, or destroyed?

A. Financial statement fraud

B. Concealment

C. False claims

D. Corruption

22. All of the following are impacts of ghost assets EXCEPT:

A. Higher insurance premiums

B. Inability to forecast capital expenditures accurately

C. Wasted employee resources

D. Underpaying property taxes

23. Proper segregation of functional responsibilities to achieve effective internal control calls for separation of

certain functions. Which of the following identify three functions that should be separated?

A. Authorization, execution, and payment

B. Authorization, recording, and custody

C. Custody, execution, and reporting

D. Authorization, payment, and recording

24. Which of the following control activities assures the traceability of assets?

A. Fixed assets are regularly verified for physical existence

B. Each fixed asset is tagged to permit easy identification and recorded in a fixed asset register

C. The asset register is reconciled to the general ledger

D. Employees are held accountable for assets assigned to them

25. In an audit of financial statements, what is an auditor's primary consideration regarding an internal control?

A. Whether the control reflects management's philosophy and operating style

B. Whether the control affects management's financial statement assertions

C. Whether the control provides adequate safeguards over access to assets

D. Whether the control enhances management's decision-making processes

26. During the audit, the auditor performs testing procedures to determine if assets are included in the financial

statements at accurate amounts. The auditor applies which of the following assertions?

A. Rights & Obligations

B. Completeness

C. Existence

D. Valuation & Allocation

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Chapter 3: Planning and Analyzing

Learning Objectives


• Identify the different techniques used to evaluate business investments and their applications

• Recognize various aspects of lease vs. buy decisions

• Identify the primary types of leases

The Concept of Capital Budgeting

Significance of Capital Budgeting Decisions

Capital budgeting is the process of making long-term investment decisions. The principal accounting officer (or

the controller) plays an important role in advising management on long-range decisions that will benefit the

company for many years, such as investing in new buildings and equipment. Long-term decisions have a significant

impact on the future success of a company. Incorrect long-term decisions can threaten the survival of a company.

Therefore, the controller must be very careful in his/her analysis of capital projects. Capital expenditures do not

occur as often as ordinary expenditures, such as payroll or inventory purchases, but involve substantial sums of

funds that are committed for a long period. As a result, the methods by which companies evaluate capital

expenditure decisions should be more formal and detailed than would be necessary for ordinary purchase

decisions. Understanding these techniques is important for accounting professionals in both for-profit and

nonprofit industries. For instance, the accountant should:

• Understand the general concepts behind capital budgeting

• Identify methods for selecting the best alternatives among capital projects

• Conduct post-installation reviews of capital projects

The capital expenditure budget lists capital assets to be purchased, sold, or discarded. Capital expenditures may

be made to replace obsolete machinery or to expand and improve operations such as expenditures needed for

new product lines. Capital assets must be used efficiently and productively. A company should carefully evaluate

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each alternative. These decisions should be made in light of the goals of the company. The stockholders have

entrusted the company with their money, and they expect the firm to invest their money wisely. Investments in

fixed assets should be consistent with the goal of maximizing the market value of the firm.

This chapter introduces the general concepts behind capital budgeting. It discusses and illustrates six methods for

selecting the best alternatives among capital projects. The risk-return trade-off method shown in this chapter is

one way to help us come to grips with uncertainty. It also describes various aspects of lease/buy decisions, lease

analysis, and the impact of new lease accounting standards.

The Definition of Capital Budgeting

There are many investment decisions that the company may have to make in order to grow. Examples of capital

budgeting applications are product line selection, keep-or-sell a business segment decisions, lease or buy

decisions, and determination of which asset to invest in. To make long-term investment decisions in accordance

with its goal, the company must evaluate each capital project by performing at least these three tasks:

1. Estimate cash flows

2. Estimate the cost of capital (or required rate of return)

3. Apply a decision rule to determine if a project is "good" or "bad."

Capital budgeting is the process of considering alternative capital projects and selecting those alternatives that

provide the most profitable return on available funds within the framework of company goals and objectives. A

capital project is any available alternative to purchase, build, lease, or renovate buildings, equipment, or other

long-term property. The alternative selected usually involves large sums of money and brings about a large

increase in fixed costs for a number of years in the future. Once a company builds a plant or commits to other

capital expenditure, its future plans are less flexible. Factors to consider in determining capital expenditures

include:

• Rate of return

• Budget ceiling

• Probability of success

• Competition

• Tax rate

• Dollar amounts

• Time value of money

Types of Long-Term Investment Decisions

There are typically two types of long-term investment decisions:

1. Selection decisions in terms of obtaining new facilities or expanding existing ones: Examples include:

• Investments in property, plant, and equipment as well as other types of assets

• Resource commitments in the form of new product development, market research, introduction of

information technology (IT), refunding of long-term debt, and so on

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Refunding is the process of retiring or redeeming an outstanding bond issue at maturity by using the

proceeds from a new debt issue)

• Mergers and acquisitions in the form of buying another company to add a new product line

2. Replacement decisions in terms of replacing existing facilities with new ones. Examples include replacing

an old machine with a high-tech machine.

Features of Investment Projects

In general, long-term investments have three important features:

1. They typically involve a large amount of initial cash outlay which tends to have a long-term impact on the

company’s future profitability. Therefore, this initial cash outlay needs to be justified on a cost-benefit

basis.

2. There are expected recurring cash inflows (for example, increased revenues, savings in operating

expenses, etc.) over the life of the investment project. This frequently requires considering the time value

of money. Depreciation expense is a consideration only to the extent that it affects the cash flows for

taxes. Otherwise, depreciation is excluded from the analysis because it is a noncash expense.

3. Income taxes could make a difference in the accept-or-reject decision. Therefore, income tax factors must

be considered in every capital budgeting decision.

The Uses of Capital Budgeting

Whenever the company is faced with a long-term investment decision, questions such as the following may need

to be addressed:

1. Should we replace certain equipment?

2. Should we expand facilities by renting additional space, buying an existing building, or constructing a new

building?

3. Should we purchase information technology (IT), or lease it, or rent it as a service?

4. Should we launch a new product development effort?

5. We’ve been thinking about adding a new product to our line. Will it be profitable?

Poor capital-budgeting decisions can be costly not only because of the large sums of money and relatively long

periods involved, but can create other problems as well such as:

• The company may lose all or part of the funds originally invested in the project and not able to realize the

expected benefits.

• Resources allocated to the project, such as suppliers and setting up the manufacturing site, are wasted if

the capital-budgeting decision must be revoked.

• The company's competitive position may be damaged because the company does not have the most

efficient productive assets required to compete in the markets.

• Workers hired for the project are laid off due to project failures.

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On the other hand, failure to invest enough funds in a good project can also be expensive. For example, at the

time of the original capital budgeting process for the Ford Mustang, Ford underestimated the demand for the car.

As a result, Ford under committed capital funds and found itself short of production capacity. This initially led to

postponed and/or lost sales of the automobile and ultimately increased overall expenses as it expedited capital

expenditures to catch up with sales.

Finally, the amount of funds available for investment will be limited because once a company makes a capital

investment decision, alternative investment opportunities are usually lost. The benefits or returns lost by rejecting

other alternative investments are the opportunity costs of a given project.

The following sections discuss techniques, taxes considerations, MACRS, investment decisions, and lease vs.

purchase analysis to help the AD select the best long-term investment proposals.

Techniques for Evaluating Investment Proposals

Discount Rate

Several of the following topics rely upon estimating the present value of either an annuity or a lump sum received

in the future. These are critical concepts that recognize the time value of money; that is, money received at a

later date is worth less than money received today due to inflation, interest rates and opportunity costs. Future

values must therefore be discounted. To help compute these discounts, we will use values based on Table 3-1

and Table 3-2, found on the next pages. Of course, most people will use a spreadsheet or calculator to compute

these values, but the exercises will help provide you with a basic understanding of how the concepts are applied.

• Table 3-1 is used to determine the present value of an annuity. It discounts future annual payments, such

as loan payments, using the number of periods the payment will continue and the interest rates (or

different costs of capital.)

• Table 3-2 is used to discount a lump-sum received at a future date, given different time periods and

interest rates (or different costs of capital.)

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Table 3-1 The Present Value of an Annuity of $1 = T1(i,n)

Interest Rates

Periods 4% 6% 8% 10% 12% 14% 16% 18% 20%

1 0.9615 0.9434 0.9259 0.9091 0.8929 0.8772 0.8621 0.8475 0.8333

2 1.8861 1.8334 1.7833 1.7355 1.6901 1.6467 1.6052 1.5656 1.5278

3 2.7751 2.6730 2.5771 2.4869 2.4018 2.3216 2.2459 2.1743 2.1065

4 3.6299 3.4651 3.3121 3.1699 3.0373 2.9137 2.7982 2.6901 2.5887

5 4.4518 4.2124 3.9927 3.7908 3.6048 3.4331 3.2743 3.1272 2.9906

6 5.2421 4.9173 4.6229 4.3553 4.1114 3.8887 3.6847 3.4976 3.3255

7 6.0021 5.5824 5.2064 4.8684 4.5638 4.2883 4.0386 3.8115 3.6046

8 6.7327 6.2098 5.7466 5.3349 4.9676 4.6389 4.3436 4.0776 3.8372

9 7.4353 6.8017 6.2469 5.7590 5.3282 4.9464 4.6065 4.3030 4.0310

10 8.1109 7.3601 6.7101 6.1446 5.6502 5.2161 4.8332 4.4941 4.1925

11 8.7605 7.8869 7.1390 6.4951 5.9377 5.4527 5.0286 4.6560 4.3271

12 9.3851 8.3838 7.5361 6.8137 6.1944 5.6603 5.1971 4.7932 4.4392

13 9.9856 8.8527 7.9038 7.1034 6.4235 5.8424 5.3423 4.9095 4.5327

14 10.5631 9.2950 8.2442 7.3667 6.6282 6.0021 5.4675 5.0081 4.6106

15 11.1184 9.7122 8.5595 7.6061 6.8109 6.1422 5.5755 5.0916 4.6755

16 11.6523 10.1059 8.8514 7.8237 6.9740 6.2651 5.6685 5.1624 4.7296

17 12.1657 10.4773 9.1216 8.0216 7.1196 6.3729 5.7487 5.2223 4.7746

18 12.6593 10.8276 9.3719 8.2014 7.2497 6.4674 5.8178 5.2732 4.8122

19 13.1339 11.1581 9.6036 8.3649 7.3658 6.5504 5.8775 5.3162 4.8435

20 13.5903 11.4699 9.8181 8.5136 7.4694 6.6231 5.9288 5.3527 4.8696

30 17.2920 13.7648 11.2578 9.4269 8.0552 7.0027 6.1772 5.5168 4.9789

40 19.7928 15.0463 11.9246 9.7791 8.2438 7.1050 6.2335 5.5482 4.9966

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Table 3-2 The Present Value of $1 = T2 (i,n)

Interest Rates

Periods 4% 6% 8% 10% 12% 14% 16% 18% 20%

1 0.9615 0.9434 0.9259 0.9091 0.8929 0.8772 0.8621 0.8475 0.8333

2 0.9246 0.8900 0.8573 0.8264 0.7972 0.7695 0.7432 0.7182 0.6944

3 0.8890 0.8396 0.7938 0.7513 0.7118 0.6750 0.6407 0.6086 0.5787

4 0.8548 0.7921 0.7350 0.6830 0.6355 0.5921 0.5523 0.5158 0.4823

5 0.8219 0.7473 0.6806 0.6209 0.5674 0.5194 0.4761 0.4371 0.4019

6 0.7903 0.7050 0.6302 0.5645 0.5066 0.4556 0.4104 0.3704 0.3349

7 0.7599 0.6651 0.5835 0.5132 0.4523 0.3996 0.3538 0.3139 0.2791

8 0.7307 0.6274 0.5403 0.4665 0.4039 0.3506 0.3050 0.2660 0.2326

9 0.7026 0.5919 0.5002 0.4241 0.3606 0.3075 0.2630 0.2255 0.1938

10 0.6756 0.5584 0.4632 0.3855 0.3220 0.2697 0.2267 0.1911 0.1615

11 0.6496 0.5268 0.4289 0.3505 0.2875 0.2366 0.1954 0.1619 0.1346

12 0.6246 0.4970 0.3971 0.3186 0.2567 0.2076 0.1685 0.1372 0.1122

13 0.6006 0.4688 0.3677 0.2897 0.2292 0.1821 0.1452 0.1163 0.0935

14 0.5775 0.4423 0.3405 0.2633 0.2046 0.1597 0.1252 0.0985 0.0779

15 0.5553 0.4173 0.3152 0.2394 0.1827 0.1401 0.1079 0.0835 0.0649

16 0.5339 0.3936 0.2919 0.2176 0.1631 0.1229 0.0930 0.0708 0.0541

17 0.5134 0.3714 0.2703 0.1978 0.1456 0.1078 0.0802 0.0600 0.0451

18 0.4936 0.3503 0.2502 0.1799 0.1300 0.0946 0.0691 0.0508 0.0376

19 0.4746 0.3305 0.2317 0.1635 0.1161 0.0829 0.0596 0.0431 0.0313

20 0.4564 0.3118 0.2145 0.1486 0.1037 0.0728 0.0514 0.0365 0.0261

30 0.3083 0.1741 0.0994 0.0573 0.0334 0.0196 0.0116 0.0070 0.0042

40 0.2083 0.0972 0.0460 0.0221 0.0107 0.0053 0.0026 0.0013 0.0007

105

Payback Period Method

The payback period measures the length of time required to recover the amount of initial investment. When the

annual cash flows are constant and of equal amounts, then the payback period can be calculated by dividing the

initial investment by the cash inflows generated from increased revenues or cost savings. When using payback

period analysis to evaluate investment proposals, management may choose one of these options:

1. Select the investments with the shortest payback periods.

2. Select only those investments that have a payback period of less than a specified number of years.

Both options focus on the rapid return of invested capital. If capital can be recovered quickly, a company can

invest it in other projects or investments, thereby generating more cash inflows or income. The formula for the

payback period is:

Payback Period = Initial Investment

Annual Net Cash Inflows

EXAMPLE 3-1

Consider the following data:

Cost of investment $18,000

Annual after-tax cash savings $3,000

The payback period is calculated as follows:

Payback Period = Initial Investment

= $18,000

= 6 Years Annual Net Cash Inflows $3,000

DECISION OPTION: Choose the project with the shorter payback period. The rationale behind this choice is: the

shorter the payback period, the less risky the project, and the greater the liquidity. When periodic cash flows are

not equal, then calculation of the payback period is more complex.

EXAMPLE 3-2

Consider two projects whose after-tax cash inflows are not even. Assume each project costs $1,000.

Cash Inflow

Year A B

1 $100 $500

2 200 400

3 300 300

4 400 100

5 500 0

6 600 0

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When cash inflows are not even, the payback period has to be found by trial and error. The payback period of

project A is 4 years ($1,000= $100 + $200 + $300 + $400). The payback period of project B is 2-1/3 years ($1,000

= 2 years ($500 + $400) + 1/3 year ($100/$300).)

Project B is the project of choice in this case, since it has the shorter payback period.

The advantages of using the payback period method of evaluating an investment project are that:

1. It is simple to compute and easy to understand

2. It handles investment risk effectively.

The shortcomings of this method are that:

• It does not recognize the time value of money

• It ignores the impact of cash inflows received after the payback period, and cash flows after the payback

period will determine profitability of an investment.

Discounted Payback Period

The company can take into account the time value of money by using the discounted payback period. The payback

period will be longer using the discounted method since money is worth less over time.

Discounted payback is computed by adding the present value of each year's cash inflows until they equal the initial

investment. The formula for the discounted payback is:

Discounted Payback = Initial Investment

Discounted Annual Cash Inflows

EXAMPLE 3-3

A company invests $40,000 and receives the following cash inflows. Assume a 10% discount rate. Using Table 3-2, the

discounted payback period is calculated as follows:

Accumulated

Year Cash inflows T2 factor Present value present value

1 $15,000 .9091 $13,637 $13,637

2 20,000 .8264 16,528 30,165

3 28,000 .7513 21,036 51,201

Thus, it takes 2 years to get $30,165 back plus an additional .47 years [($40,000-$30,165)/21,036], to get the

remaining $9,835 back (i.e. total paid back of $40,000) for a total of 2.47 years.

Note: the present value can also be computed using the Excel formula: =PV(Rate,Nper,Pmt)

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Accounting Rate of Return

Accounting rate of return (ARR) measures profitability from the conventional accounting standpoint by relating

the required investment or the average investment to the future annual net income. The average investment is

the (Beginning balance + Ending balance)/2. If the ending balance is zero (as we assume), the average investment

equals the original cash investment divided by 2. Under the ARR method, management would choose the project

with the higher rate of return.

The formula for the ARR is:

ARR = Net Income

Average Amount of Investment

Notice that this calculation uses annual net income rather than net cash inflow.

The advantages of this method are that it is easily understandable, simple to compute, and recognizes the

profitability factor. However, it has several limitations:

• The length of time over which the return is earned is not considered.

• The rate allows a sunk cost, depreciation, to enter into the calculation. Since depreciation can be

calculated in so many different ways, the rate of return can be manipulated by simply changing the

method of depreciation used for the project.

• The timing of cash flows is not considered. Thus, the time value of money is ignored.

EXAMPLE 3-4

Consider the following investment:

Initial investment $6,500

Estimated life 20 years

Cash inflows/revenue per year $1,000

Depreciation per year (using straight line method) $ 325

The accounting rate of return for this project is:

ARR = Net Income

= $1,000 - $325

= 10.4%

Average Amount of Investment ($6,500+$6,500)/2

If the ending balance is zero, then the average investment (usually assumed to be one-half of the original

investment) is $3,250 and the ARR is:

ARR = $1,000 - $325

= 20.8%

$3,250

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Net Present Value

Net present value (NPV) takes into account the time value of money in the analysis. NPV is the difference between

the present value (PV) of cash inflows generated by the project and the amount of the initial investment (I):

NPV = PV – I

The present value of future cash flows is computed using the so-called cost of capital (or minimum required rate

of return) as the discount rate. In the case of an annuity, the present value would be:

PV = A * T1 (i, n) A is the amount of the annuity. The value of T1 is found in Table 3-1.

If NPV is positive, management should consider accepting the project. Otherwise reject it.

In many projects, the only cash outflow is the initial investment, and since it occurs immediately, the initial

investment does not need to be discounted. Therefore, in such projects, a company may compute the net present

value of the proposed project as the present value of the annual net cash inflows minus the initial investment.

Some projects require that additional investments, such as a construction project or major repair, be made at

later dates in the life of the project. In those cases, the company must discount those cash outflows to their

present value and consolidate the present values of all cash flows of the project before comparing them to the

present value of the net cash inflows.

The advantages of the NPV method are that it obviously recognizes the time value of money and it is easy to

compute whether the cash flows are from an annuity or vary from period to period. A major issue in applying the

net present value method is determining an appropriate discount rate to use in computing the present value of

cash flows.

Management generally requires some minimum rate of return on its investments. This rate should be the

company's cost of capital, but that rate is difficult to determine. Therefore, under the net present value method,

management often selects a target rate that it believes to be at or above the company's cost of capital, and then

uses that rate as a basis for present value calculations.

EXAMPLE 3-5

Consider the following investment:

Initial investment $12,950

Estimated life 10 years

Annual cash inflows $3,000

Cost of capital (minimum required rate of return) 12%

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Present value of the cash inflows is:

PV = A * T1 (i, n)

= $3,000 * T1 (12%,10 years)

= $3,000 * (5.650) $16,950

Initial investment (I) 12,950

Net present value (NPV = PV - I) $ 4,000

Using Excel, the formula would be: =PV(Rate,Nper,Pmt)-12950 =PV(.12,10,-3000)-12950 =$16,951-12950 = $4,001.

Since the NPV of the investment is positive, the investment should be considered.

Internal Rate of Return

Internal rate of return (IRR) is defined as the rate of interest that equates I with the PV of future cash inflows. In

other words, at IRR:

I = PV

or NPV = 0

If the IRR equals or exceeds the cost of capital or target rate of return, a company should consider the investment

further. If the proposal's IRR is less than the minimum rate, the company should reject the proposal.

The advantage of using the IRR method is that it considers the time value of money and, therefore, is more exact

and realistic than the ARR method. The shortcomings of this method are that:

• It is time-consuming to compute, especially when the cash inflows are not even, although most business

calculators have a program to calculate IRR

• It fails to recognize the varying sizes of investment in competing projects

When cash inflows are not even, IRR is computed by the trial and error method, which is not discussed here.

Financial calculators frequently have a key for IRR calculations.

EXAMPLE 3-6

Assume the same data given in Example 3-5, and set the following equality (I=PV):

$12,950 = $3,000 * T1(i,10 years)

T1(i,10 years) = $12,950/$3,000 = 4.317

which is somewhere between 18 percent and 20 percent in the 10-year line of Table 3-1. The interpolation follows:

PV of an Annuity of $1 Factor T1(i,10 years)

18% 4.494 4.494

IRR 4.317

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20% _ 4.192

Difference 0.177 0.302

Therefore,

IRR = 18% + (0.177/0.302) (20% - 18%)

= 18% + 0.586(2%) = 18% + 1.17% = 19.17%

Since the IRR of the investment is greater than the cost of capital (12 percent), consider the project.

Spreadsheets can be used to calculate IRR. For example, Excel has a function IRR (values, guess), where ‘values’ is

the range of cells containing the cash outflows and inflows. Excel considers negative numbers as cash outflows

such as the initial investment, and positive numbers as cash inflows. Many financial calculators have similar

features.

Suppose you want to calculate the IRR of a $37,910 investment (the value -37910 entered in year 0 that is followed

by 5 monthly cash inflows of $10,000). Using a guess of 8% (the value of 0.08), which is in effect the cost of capital,

the formula would be =IRR(values, 0.08) and Excel would return 10%, as shown below.

Year 0 1 2 3 4 5

-37910 10000 10000 10000 10000 10000

IRR= 10%

Profitability Index

The profitability index uses the same variables as NPV but combines them differently. Profitability index (PI) is

defined as the ratio of the total PV of future cash inflows to the initial investment, that is, PV/I. This index is used

as a means of ranking projects. Management should consider only those proposals having a profitability index

greater than or equal to 1.00. Proposals with a profitability index of less than 1.00 cannot yield the minimum rate

of return because the present value of the projected cash inflows is less than the initial cost. The profitability index

has the advantage of putting all projects on the same relative basis regardless of size.

EXAMPLE 3-7

Using the data in Example 3-5, the profitability index is:

PV =

$16,950 = 1.31

I $12,950

Since this project generates $1.31 for each dollar invested (i.e., its profitability index is greater than 1), consider

the project.

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Chapter 3 Section 1 – Review Questions

27. Which of the following budgets is prepared for replacement of assets and expansion of production facilities?

A. Research and Development Budget

B. Cash Budget

C. Master Budget

D. Capital Expenditure Budget

28. Which one of the following statements about the payback method of investment analysis is correct?

A. The payback method does not consider the time value of money

B. The payback method considers cash flows after the payback has been reached

C. The payback method uses discounted cash flow techniques

D. The payback method is rarely used in practice

29. Russell Corp. is considering the purchase of a new machine for $78,000. The machine would generate an

annual cash flow of $23,214 for five years. At the end of five years, the machine would have no salvage value.

What is the payback period in years for the machine approximated to two decimal points?

A. 3.36

B. 9.48

C. 3.00

D. 4.00

30. Doro Co. is considering the purchase of a $100,000 machine that is expected to result in a decrease of $25,000

per year in cash expenses after taxes. This machine, which has no residual value, has an estimated useful life

of 10 years and will be depreciated on a straight-line basis. For this machine, what would the accounting rate

of return (ARR) based on initial investment be?

A. 10%

B. 15%

C. 25%

D. 35%

31. What is the internal rate of return (IRR)?

A. The hurdle rate

B. The rate of interest for which the net present value is greater than 1.0

C. The rate of interest for which the net present value is equal to zero

D. The accounting rate of return

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Income Taxes and Investment Decisions

Income taxes make a difference in many capital budgeting decisions. In other words, a project that is attractive on a

before-tax basis may be rejected on an after-tax basis. Income taxes typically affect both the amount and the timing

of cash flows. Since net income, not cash inflows, is subject to tax, after-tax cash inflows are not usually the same as

after-tax net income.

Let us define:

S = Sales

E = Cash operating expenses

d = Depreciation

t = Tax rate

Then, for a cash basis company where book and tax depreciation are the same,

Before-tax cash inflows (or before-tax cash savings) = S – E

Net income = S - E – d

By definition,

After-tax cash inflows = Before-tax cash inflows – Taxes

or (S - E) – [(S - E - d) (t)]

Stated another way:

After-tax cash inflows = (S - E) (1 - t) + (d)(t)

A tax shield can be described as a reduction in income tax payments that result from taking allowable deductions that

reduce taxable income. The tax shield for depreciation is calculated as follows:

Tax shield = Tax savings on depreciation = (d)(t)

EXAMPLE 3-8

Assume:

S = $12,000

E = $10,000

d = $500 per year using the straight-line method

t = 30%

Then,

After-tax cash inflow = ($12,000 - $10,000) (1 - 0.3) + ($500)(0.3)

= ($2,000)(.7) + ($500)(0.3)

= $1,400 + $150 = $1,550

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Note that the depreciation tax shield = tax savings on depreciation = (d)(t)

= ($500)(.3) = $150

Since the tax shield is (d)(t), the higher the depreciation deduction, the higher the tax savings on depreciation will

be. Therefore, an accelerated depreciation method (such as double-declining balance) produces higher tax savings

than the straight-line method. Accelerated methods produce higher present values for the tax savings that may

make a given investment more attractive.

EXAMPLE 3-9

The Shalimar Company estimates that it can save $2,500 a year in cash operating costs for the next ten years if it buys

a special-purpose machine at a cost of $10,000. No salvage value is expected. Straight-line depreciation is $10,000/10

= $1,000 per year. Before-tax cash savings = (S - E) = $2,500.

Assume that the income tax rate is 30%, and the after-tax cost of capital (minimum required rate of return) is 10%.

After-tax cash savings can be calculated as follows:

After-tax cash savings = (S - E) (1 - t) + (d)(t)

= $2,500(1 - 0.3) + $1,000(0.3)

= $1,750 + $300 = $2,050

To see if the purchase of this machine should be considered, the net present value can be calculated.

PV = $2,050* T1(10%, 10 years) = $2,050* (6.145) = $12,597.25

Thus, NPV = PV - I = $12,597.25 - $10,000 = $2,597.25

Since NPV is positive, purchase of the machine should be considered.

Note: Using Excel, the formula would be: =PV(0.1,10,-2050)-10000 = $12,596.36 – 10,000 = $2,596.36, which is a

similar outcome.

Further Consideration: Depreciation for tax purposes can differ from depreciation recorded in the books. When

this is the case, deferred tax assets or liabilities arise and must be booked in the accounting records. Deferred tax

assets and liabilities are beyond the scope of this course. The IRS specifies the allowable methods and conventions

that can be used to depreciate assets. The tax department usually selects the allowable method and convention

that maximizes the net present value of the tax depreciation deduction. Most asset accounting packages provide

tax depreciation and investment tax credit calculations. Due to the increase in the investment in fixed assets,

many companies are revisiting their fixed asset processes and may need to implement new software that meets

the needs of the accounting and tax departments.

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MACRS and Investment Decisions

In 1981 a different way of computing depreciation deductions for tax purposes was introduced. The rule is called the

Modified Accelerated Cost Recovery System (MACRS) rule, was enacted by Congress in 1981 and then modified

somewhat in 1986 under the Tax Reform Act of 1986. This rule is characterized as follows:

1. It abandoned the concept of useful life and accelerates depreciation deductions by placing all depreciable

assets into one of eight age property classes. It calculates deductions based on an allowable percentage of

the asset's original cost over a specified recovery period (See Tables 3-3 and 3-4). Since the recovery period

is generally shorter than useful life, the company would be able to deduct depreciation more quickly and save

more in income taxes in the earlier years, thereby making an investment more attractive. The rationale

behind the system is that this way the government encourages the company to invest in facilities and increase

its productive capacity and efficiency. (Remember that the higher d, the larger the tax shield (d)(t)).

2. A company may elect the straight-line method. The straight-line convention must follow what is called the

half-year convention unless the mid-quarter convention applies. This means that the company can deduct

only half of the regular straight-line depreciation amount in the first year. The reason for electing MACRS

optional straight-line method is that some firms may prefer to have lower depreciation deductions in the

early years rather than to accelerate them. Those firms are generally just starting out or have little or no

income and/or wish to show more income on their income statements in the early years.

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Table 3-3 Selected MACRS Recovery Rates (rounded) based on the Property Classification of Assets (Half-Year

Convention)

Year 3-year 5-year 7-year 10-year 15-year 20-year

1 33.3% 20.0% 14.3% 10.0% 5.0% 3.8%

2 44.5 32.0 24.5 18.0 9.5 7.2

3 14.8 19.2 17.5 14.4 8.6 6.7

4 7.4 11.5 12.5 11.5 7.7 6.2

5 11.5 8.9a 9.2 6.9 5.7

6 5.8 8.9 7.4 6.2 5.3

7 8.9 6.6 5.9 4.9

8 4.5 6.6 5.9 4.5

9 6.5 5.9 4.5

10 6.5 5.9 4.5

11 3.3 5.9 4.5

12 5.9 4.5

13 5.9 4.5

14 5.9 4.5

15 5.9 4.5

16 3.0 4.4

17 4.4

18 4.4

19 4.4

20 4.4

21 ____ ____ ____ ____ ____ 2.2

Total 100% 100% 100% 100% 100% 100%

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Table 3-4 MACRS Property Classes and Depreciation Methods under the General Depreciation System and

examples of the types of property included in each class.*

MACRS Property Class &

Depreciation Method Examples of Assets

3-year property 200%

declining balance

Most small tools and tractor units for use

over-the-road; the law specifically excludes

autos and light trucks from this property

class.


declining balance

Autos, trucks, computers and their

peripheral equipment, office machinery such

as typewriters, copiers, duplicating

equipment, and property used in research

and experimentation.


declining balance

Office furniture and fixtures, and most items

of machinery and equipment used in

production.


declining balance

Various machinery and equipment, such as

that used in petroleum distilling and refining

and in the milling of grain.


declining balance

Sewage treatment plants, telephone and

electrical distribution facilities, and land

improvements such as shrubbery, fences

and sidewalks.


declining balance

Service stations and other real property with

an ADR midpoint life of less than 27.5 years

are included.

27.5-year property straight-

line All residential rental property is included.

31.5 and 39-year property

straight-line All nonresidential real property is included.

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EXAMPLE 3-10

Assume that a machine falls under a 3-year property class and costs $3,000 initially. The straight-line option under

MACRS differs from the traditional straight-line method in that under this method the company would deduct only

$500 depreciation in the first year and the fourth year ($3,000/3 years =$1,000; $1,000/2=$500). The table below

compares the straight line with half-year convention with the regular MACRS with half-year convention deduction.

Straight Line

(half-year) MACRS

Year depreciation Cost MACRS % deduction

1 $ 500 $3,000 x 33.3% $999

2 1,000 3,000 x 44.5 1,335

3 1,000 3,000 x 14.8 444

4 500 3,000 x 7.4 222

$3,000 $3,000

EXAMPLE 3-11

A machine costs $1,000. Annual net cash inflows (S-E) are expected to be $500. The machine will be depreciated using

the MACRS rule and will fall under the 3-year property class. The cost of capital after taxes is 10%. The estimated life

of the machine is 4 years. The tax rate (t) is 30%. The formula for computation of after-tax cash inflows (S - E)(1 - t)+

(d)(t) needs to be computed separately. We will first compute the present value of the after-tax cash inflows for 4

years, and then add the present value of the depreciation benefit. The NPV analysis can be performed as follows:

After-tax cash inflow Present Value factor @10% Present value

(S-E)(1-t)=$500(.7)=$350 for 4 years 3.170(a) $1,109.5

Depreciation Benefit

Year Cost MACRS% d (d)(t)

1 $1,000 x 33.3% $333 $99.9 .909(b) 90.81

2 $1,000 x 44.5 445 133.5 .826 110.27

3 $1,000 x 14.8 148 44.4 .751 33.34

4 $1,000 x 7.4 74 22.2 .683 15.16

Net Present Value $1,359.08

Therefore, NPV = PV - I = $1,359.08 - $1,000 = $359.08, which is positive, so purchasing the machine should be

considered.

(a) T1(10%, 4 years) = 3.170 (from Table 3-1, present value of an annuity).

(b) T2 values obtained from Table 3-2.

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Working with Ratios

Rate of Return on Total Assets (ROA)

The basic ROA calculation (Net Income/Total Assets) measures the ability of the company to earn a profit on its

total assets. The problem with this calculation is that it uses only the return to equity shareholders since it uses

net income in the numerator. To address this issue, the basic ROA calculation is modified to arrive at an “Adjusted

ROA” by adding back interest expense, adjusted for the tax shield it provides, to net income, since both creditors

and investors have financed the company’s assets. The Adjusted ROA ratio is calculated as follows:

Net Income + Interest Expense (1–tax rate)

Average Total Assets

Where Average Total Assets = [total assets (beginning) + total assets (ending)] / 2

EXAMPLE 3-12

The Ogel Supply Corporation showed the following net income, interest expense and total asset figures for the

years ended December 31, 20X7, and December 31, 20X6:

20X7 20X6

Net Income $103,140 $88,970

Interest Expense $24,000 $26,000

Total Assets $945,800 $887,000

Assume the income tax rate is 30% and calculate the rate of return on total assets for 20X7.

Average Total Assets = $103,140 + $24,000 (1-.3)

= $119,940

= 13.1% (945,800 + 887,000) / 2 $916,400

Fixed Asset Turnover

Fixed asset turnover reflects the productivity and efficiency of property, plant, and equipment in generating revenue

and earnings. A higher fixed-asset turnover reflects positively on the company's ability to utilize its fixed assets in

business operations. The fixed asset turnover rate is:

Sales

Average fixed assets

The following data for Beta is given:

20X6 20X7

Sales $1,530.0 $1,450.0

Average Fixed assets 520.0 498.2

Fixed-asset turnover 2.94 times 2.91

Fixed assets are more productive in 20X6, as indicated by the higher turnover rate.

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Further Consideration

Managers and financial analysts understand that assets should not be held by an enterprise unless they contribute to sales or profitability; thus, utilization of many of these turnover ratios is critical to understanding the productivity of assets. Higher ratios of asset utilization are better because they indicate that assets are more productive in obtaining a return. A high ratio for one industry, however, may be considered a low ratio for another. In certain special situations, such as developmental companies, the meaning of asset turnover may have to be modified because most assets are committed to the development of future potential. Similarly, if abnormal supply situations exist or if strikes occur, these factors affect capital utilization and require separate evaluation and interpretation.

The Lease vs. Purchase Decision

Implications for the Lessee

Definition of a Lease

ASC 842 defines a “lease” as a contract, or part of a contract, that conveys the right to control the use of property,

plant, or equipment (an asset) for a period of time in exchange for consideration. A period of time may be

described in terms of the ‘amount of use’ of an asset. Control over the use of the asset means that the customer

has both the right to:

1. Obtain substantially all of the economic benefits from the use of the asset and

2. Direct the use of the asset (right-of-use)

In general, lease accounting guidance applies to any arrangement that conveys control over the use of an asset to

another party. An arrangement is a lease or contains a lease if an asset is explicitly or implicitly identified and the

right of use of the asset is controlled by the customer for a period of time in exchange for consideration.

EXAMPLE 3-13

Star Inc. enters into a 15-year contract with EMX Corp. (Supplier) for the right to use 3 specified, physically distinct

dark fibers within a larger cable connecting Hong Kong to Tokyo. Star Inc. makes the decisions about the use of

the fibers by connecting each end of the fibers to its electronic equipment. For example, Star Inc. “lights” the

fibers and decides what data and how much data those fibers will transport. If the fibers are damaged, EMX Corp.

is responsible for the repairs and maintenance. EMX Corp. owns extra fibers but can substitute those for Star Inc.’s

Lessor:

Transfer the control of the use of an identified

asset

Lessee:

Give consideration for the use of an identified

asset

Lease

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fibers only for reasons of repairs, maintenance, or malfunction (and is obliged to substitute the fibers in these

cases).

The contract contains a lease of dark fibers. Star Inc. has the right to use the 3 identified dark fibers for 15 years.

The fibers are explicitly specified in the contract and are physically distinct from other fibers within the cable.

Star Inc. has the right to control the use of the fibers throughout the 15-year period of use because it has:

1. The right to obtain substantially all of the economic benefits from use of the fibers over the 15-year period

of use. Star Inc. has exclusive use of the fibers throughout the period of use.

2. The right to direct the use of the fibers. Star Inc. makes the relevant decisions about how and for what

purpose the fibers are used by deciding when and whether to light the fibers and when and how much output

the fibers will produce. Star Inc. has the right to change these decisions during the 15-year period of use.

Although EMX Corp.’s decisions about repairing and maintaining the fibers are essential to their efficient use,

those decisions do not give EMX Corp. the right to direct how and for what purpose the fibers are used. Thus, EMX

Corp. does not control the use of the fibers during the period of use.

Types of Leases

In a contract, the lessor is the party who provides the right to use an asset. The lessee obtains the right to use the

asset in exchange for consideration. The following types of leases exist:

Finance lease. A lessee should classify a lease as a finance lease when the lease meets any of the following criteria

at lease commencement:

1. Ownership is transferred from the lessor to the lessee at the end of the lease term.

2. The lease provides a purchase option that is reasonably certain to be exercised. The FASB determined that “reasonably certain” is a high threshold (>75-80%).

3. The lease term is for the major part of the remaining economic life of the asset (usually 75%).

4. The present value of all lease payments equals or exceeds the fair value of the asset and any lessee-guaranteed residual value. One approach to applying this indicator is to consider payments equal to or greater than 90% of the asset’s fair value.

5. The asset is so specialized in nature that only the lessee can use it.

Operating lease. When none of the criteria listed above are met, a lessee should classify the lease as an operating

lease. Unlike a finance lease, ownership is not transferred to the lessee. The lessor may be the manufacturer of

the asset or it may be a leasing company that buys assets from the manufacturer to lease to others. Maintenance

and service are provided by the lessor. A cancellation clause that provides the lessee with the right to cancel the

contract and return the property prior to the expiration date of the agreement usually exists. The life of the

contract is less than the economic life of the property.

Sale and leaseback. A sale and leaseback transaction takes place when the lessor sells the asset (e.g. equipment)

and then leases all or some of it back. The seller is referred to as the seller-lessee, and the buyer is termed the

buyer-lessor. Possible reasons for a sale and leaseback are to raise needed funds or to achieve a tax benefit. The

121

seller-lessee transfers legal ownership of the asset to the buyer-lessor in exchange for consideration, and then

makes periodic rental payments to the buyer-lessor to retain the use of the asset. To qualify as a sale of an asset

under the revenue standard, the seller-lessee needs to ensure the customer (in this case, the buyer-lessor) obtains

control of the asset. If the sale and leaseback transaction does not qualify as a sale, both the seller-lessee and the

buyer-lessor account for the transaction as a financing arrangement. In this case, the seller-lessee recognizes a

financial liability and continues to recognize and depreciate the asset, while the buyer-lessor recognizes a financial

asset (e.g. a receivable).

ASC 842 eliminates leveraged lease accounting, although lessors can continue to account for existing leveraged

leases using ASC 840 guidance.

Advantages and Disadvantages of Leasing

Companies considering the acquisition of new assets commonly confront the lease-purchase decision. It is a hybrid

capital budgeting decision that forces a company to compare the leasing and financing (purchasing) alternatives.

Leasing is utilized by many companies because it is a means of gaining access to assets and/or of reducing a

company’s exposure to the full risks of asset ownership. Seventy-two percent of U.S. companies use some form

of financing when acquiring equipment, including loans, leases and lines of credit (excluding credit cards). Any

type of equipment can be leased, such as railcars, helicopters, bulldozers, barges, CT scanners, computers, and so

on. The largest group of leased equipment involves information technology equipment, followed by assets in the

transportation area (trucks, aircraft, rail), and then construction and agriculture.

There are many business reasons why companies lease:

• Immediate cash outlay is not required (no down payment, less up-front expense).

• Typically, a purchase option exists, allowing lessee to obtain the property at a bargain price at the

expiration of the lease. This provides the flexibility to make the purchase decision based on the value of

the property at the termination date.

• The lessor's expert service is made available.

• Asset management costs are lower for the lessor since the ownership of certain assets often increases

their maintenance and repair expenses; however, the lessee usually outsources the repair and

maintenance functions to the lessor or a specialized third party.

• Typically, fewer financing restrictions (e.g., limitations on dividends) are required by the lessor than are

imposed when obtaining a loan to purchase the asset.

• In bankruptcy or reorganization, the maximum claim of lessors is 3 years of lease payments. With debt,

creditors have a claim for the total amount of the unpaid financing.

There are several drawbacks to leasing, including the following:

• In the long run, the cost is higher than if the asset was bought.

• The interest cost of leasing is typically higher than the interest cost on debt.

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• If the property reverts to the lessor at termination of the lease, lessee must either sign a new lease or buy

the property at potentially higher current prices. Also, the salvage value of the property is realized by the

lessor.

• Lessee may have to retain property no longer needed (i.e., obsolete equipment).

• Lessee cannot make improvements to the leased property without the permission of the lessor.

The Impact on the Financial Results

Historically, lease accounting treatment had been straightforward: a capital lease vs. an operating lease. An

operating lease was treated as an “off-balance” sheet operating expense. That is, lessees were not required to

recognize assets or liabilities arising from operating leases on their balance sheet, but rather would recognize

lease payments as expense on a straight-line basis over the lease term. That is, operating leases had enabled

American firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets. This

off-balance sheet treatment created challenges for analysts and investors trying to understand a company’s

financial obligations. For example, financial statement users must estimate an operating lease’s effects on

financial metrics, such as profitability and leverage ratios due to their off-balance sheet treatment.

The FASB issued ASC 842 in response to the growing need for transparency and comparability among

organizations. The core principle of ASC 842 is that all leases give rise to liabilities for future rental payments and

assets (e.g. the right to use the underlying asset). Thus, they should be reported on the company’s balance sheet.

In other words, under ASC 842, companies must recognize all leases on the balance sheet unless they are shorter

than 12 months. For example, for finance leases, lessees recognize interest expense (from the lease liability) and

depreciation/amortization expense (from the right-of-use asset) separately in the income statement. In contrast,

for operating leases, lessees recognize a single lease expense figure equal to the lease payment in the income

statement. The following table summarizes the accounting by lessees for the different types of leases.

Financial Statement Impact Snapshot for Lessee

Lessee Balance Sheet Income Statement Cash Flow Statement

Finance Right-of-Use Asset

Lease Liability

Front Loaded:

• Depreciation /

Amortization Expense

(right-of-use asset)

• Interest Expense

(lease liability)

Interest expense: Operating activities

Principal payment: Financing activities

Operating Right-of-Use Asset

Lease Liability Lease Expense Lease expense: Operating activities

For lessees with prior material off-balance sheet leases, the most significant effect of ASC 842 can be a gross-up

in the balance sheet by increases in lease assets and financial liabilities. The result will be that an estimated $3

trillion of leases will transfer onto corporate balance sheets over the next few years as companies adopt ASC 842.

The FASB acknowledged that the additional lease liabilities recognized could cause some companies to violate

debt covenants or may affect their access to credit because of the potential effect on the GAAP-reported assets

and liabilities. To address these concerns, the FASB stated that liabilities from operating leases generally do not

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meet the definition of debt under U.S. GAAP. Specifically, the FASB noted that the following factors significantly

mitigate the potential issues of debt covenants:

1. A significant portion of loan agreements contain “frozen GAAP” or “semi-frozen GAAP” clauses.

Therefore, a change in a lessee’s financial ratios resulting solely from a GAAP accounting change either:

• Will NOT constitute a debt covenant default, or

• Will require both parties to negotiate in good faith when a technical default (breach of loan covenant)

occurs as a result of the adoption of ASC 842

2. Banks outreach reveals an ongoing commitment to customers. They are unlikely to dissolve a good

customer relationship by “calling a loan” because of a technical default arising solely from a GAAP

accounting change, even if the loan agreement did not have a frozen or semi-frozen GAAP provision.

3. Operating lease liabilities are operating obligations rather than debt. Consequently, there should be a

limited impact on certain financial ratios that often are used in debt covenants, such as:

• Current ratio

• Basic fixed-charge coverage

• Debt service coverage

In general, ASC 842 does not change the treatment of leases for income tax purposes. Companies with operating

leases will continue to get a tax deduction for actual amounts paid under the lease.

The effective date for the ASC 842 is 2019 for public companies and 2020 for all other entities.

Loan Benefits

A loan can be the best choice for a company who wishes to keep the equipment and build equity quickly. Loans

can be structured to own the equipment outright at the end of the term. If a company wants to retain the

equipment beyond the lease term and prefers to know the full cost of the financing up front, the company may

choose a Lease Purchase option. As its name implies, this option requires no additional payment to own the

equipment at the end of the lease.

Periodic Payment on a Lease

To facilitate the ultimate financing decision, you may want to determine the periodic payment required on a lease.

EXAMPLE 3-13

You enter into a lease for a $100,000 machine. You are to make 10 equal annual payments at year-end. The

interest rate on the lease is 6%. The periodic payment equals:

$100,000 = $13,587

7.3601

where T1(10, 6%) = the present value of an ordinary annuity factor for n = 10, i = 6% = 7.3601 (Table 3-1).

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The Excel payment formula would be: =PMT(Rate,Nper,PV,FV,Type) =PMT(0.06,10,-100000) = $13,586.60.

EXAMPLE 3-14

Use the same facts as those for Example 3-13, except that the annual payments are to be made at the beginning

of each year. Using the T1 table, the periodic payment is computed as follows:

Year Factor

0 1.0

1-9 6.8017

7.8017

$100,000 = $12,818

7.8017

The Excel PMT formula has an input for ‘type’, which is either 0 for a payment at the end of the period or ‘1’ for a

payment at the beginning of the period: =PMT(Rate,Nper,PV,FV,Type) =PMT(0.06,10,-100000,,1) = $12,817.73.

The interest rate associated with a lease agreement can also be computed. Divide the value of the leased property

by the annual payment to obtain the factor, which is then used to find the interest rate with the help of an annuity

table.

EXAMPLE 3-15

You leased $300,000 of property and are to make equal annual payments at year-end of $40,000 for 11 years.

The interest rate associated with the lease agreement is

$300,000 = 7.5

$40,000

Going to the present value of annuity table (Table 3-1) and looking across the 11-years entry to a factor nearest

to 7.5, we find 7.4987 at a 7% interest rate. Thus, the interest rate in the lease agreement is 7%.

To find interest rates in Excel, use the RATE formula: =RATE(Nper,Pmt,PV) =RATE(11,-40000,300000) = 6.99%.

There are tax benefits from leasing equipment rather than financing it with a term loan. Depending upon a

company’s needs and the nature of their business, the entire lease payment may be fully deductible as a business

expense, thereby reducing taxable income. With a loan, only the interest and depreciation can be used for

deductions. Another benefit a lease offers is 100 percent financing plus additional amounts on the equipment’s

costs to cover “soft costs,” such as taxes, shipping, and installation. Some term loans offer 100 percent financing

but, typically, they cover the cost of equipment only.

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A lease can help manage cash flow. The payments are usually lower than for a term loan. Since a lease often

requires no down payment or deposit, the equipment can be obtained without depleting a large amount of capital.

The types of businesses that most often lease equipment to generate revenue are manufacturing, transportation,

printing, and professional corporations, such as medical, law, or accounting firms. Leasing works well for such

companies since they can keep their equipment current without having to dip into purchase assets. Since the

business is not making a large outlay of capital to acquire the equipment, and is incurring the cost over the lease

term, they can use the retained capital for business development, investment and expansion.

Present Value Comparison

To make an intelligent financial decision on a lease-purchase, an after-tax cash outflow, present value comparison

is needed. There are special steps to take when making this comparison. When considering a lease, take the

following steps:

1. Find the annual lease payment.

2. Calculate the after-tax cash outflows.

3. Calculate the present value of the after-tax cash outflows.

When considering financing a purchase with a loan, take the following steps:

1. Find the annual loan amortization using the time-value tables, a spreadsheet, or numbers provided as part

of the loan package.

2. Calculate the interest. The interest is segregated from the principal in each of the annual loan payments

because only the interest is tax-deductible. (Note: Effective in the 2018 tax year and beyond, interest

expense deductions are limited for higher-income businesses. Smaller businesses can still take the full

interest deduction. But the interest deduction for businesses with annual average gross receipts of $25

million or more is limited at 30 percent of the company's EBITDA (earnings before interest, taxes,

depreciation, and amortization)).

3. Calculate the cash outflows by adding interest and depreciation (plus any maintenance costs), and then

compute the after-tax outflows.

4. Calculate the present value of the after-tax cash outflows.

Once you have the present value of the after-tax cash outflows for both the lease and the purchase, it will be easy

to compare the two numbers and choose the preferred approach.

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32. Flex Corporation is studying a capital acquisition proposal in which newly acquired assets will be depreciated

using the straight-line method. Which one of the following statements about the proposal would be

INCORRECT if a switch is made to the Modified Accelerated Cost Recovery System (MACRS)?

A. The net present value will increase

B. The internal rate of return will increase

C. The payback period will be shortened

D. The profitability index will decrease

33. Which of the following measurements reflects the productivity and efficiency of plant assets in generating

revenue and earnings?

A. Return on equity

B. Fixed asset turnover

C. Leverage ratios

D. Profitability

34. What is a contract that conveys the right to control the use of an identified asset (e.g. equipment) for a period

of time in exchange for consideration?

A. Inventory

B. Performance obligation

C. Financial asset

D. Lease

35. Beta Inc. (Lessee) obtains control of the leased equipment with a lease term 75% of the remaining economic

life of the equipment. How does Beta Inc. account for this agreement in accordance with ASC 842?

A. Finance lease

B. Operating lease

C. Leveraged lease

D. Sublease

36. How should the payments of interest on the lease liability arising from a finance lease be presented on the

statement of cash flows?

A. Operating activities

B. Financing activities

C. Investing activities

D. Disclosed only

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Glossary

Accrued Revenue - Revenue recognized as earned prior to the collection of cash.

Accumulated depreciation - A contra asset account to depreciable assets such as buildings, machinery, and

equipment. This account shows the total depreciation taken for the depreciable assets. On the balance sheet,

companies deduct the accumulated depreciation from its related asset.

Amortization - The process of measuring and recognizing the periodic decline in future usefulness of intangible

assets; e.g. the periodic write off of a bond premium.

Asset - Probable future economic benefit obtained or controlled by a particular entity as a result of past

transactions or events.

Balance Sheet - Shows a snapshot at a given point in time of the net worth of the business. It details the assets,

liabilities and owner’s equity.

Budgeting - A quantitative plan of activities and programs expressed in terms of assets, liabilities, revenues, and

expenses.

Capital Expenditure Budget - This budget is prepared to estimate the capital expenditure on fixed assets-

Buildings, machinery, plant, furniture, etc. It is generally a long-term budget. It is prepared for replacement of

assets, expansion of production facilities, adoption of new technologies, diversification, etc.

Current Asset - Cash and other assets expected to be used or received within 12 months (e.g. trade accounts

receivable or marketable securities).

Current Liability - Obligations to be paid within 12 months (e.g. trade accounts payable or bank overdraft).

Depreciation - The procedure of spreading out the acquisition cost of fixed assets (such as machinery and

equipment) to each of the time periods which they are utilized.

Expense - Outflows or other uses of assets or incurrence of liabilities (or a combination of both) during a period

from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s

ongoing operations.

Financial Accounting Standards Board (FASB) - A seven-member organization established by the accounting

profession to establish accounting principles which represent generally accepted reporting practices.

Financial Statements - Reports companies produce to communicate their business activities and financial

performance to users, especially investors and creditors.

Fixed Asset - Long-term tangible asset not expected to be converted to cash within 12 months (e.g. building or

vehicle).

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Generally Accepted Accounting Principles (GAAP) - The conventions, rules, and procedures that reflect a

consensus at a particular time about the correct way to report information on financial statements. Responsibility

for the development of authoritative generally accepted accounting principles is primarily the responsibility of the

Financial Accounting Standards Board (FASB).

Goodwill - Future economic benefits, obtained in a business combination, that are not attributable to separately

recognized assets and liabilities of the acquiree.

IFRS - International Financial Reporting Standards. Accounting principles developed and published by the

International Accounting Standards Board. In addition to the actual IFRS, the International Accounting Standards

that are still valid and the interpretations of the International Financial Reporting Interpretations Committee and

Standard Interpretations Committee are grouped under the IFRS.

Impairment - Assets are considered impaired when their book value is greater than their fair value; however,

impairment tests are performed on the impaired assets to establish whether the carrying value of each asset is

higher than the recoverable amount for the asset prior to booking a write down. The asset is written down to the

recoverable value when it exceeds the carrying value.

Income Statement - A financial statement that shows revenues, expenses, and net income (loss) for a business

over an accounting period.

Intangible Assets - Consist of the noncurrent, nonmonetary, nonphysical assets of a business. Companies must

charge the costs of intangible assets to expense over the period benefited. Among the intangible assets are rights

granted by governmental bodies, such as patents and copyrights. Other intangible assets include leaseholds and

goodwill.

Journal Entry - Documents all of the effects of a business transaction, expressed in debit(s) and credit(s) and

should include an explanation of the transaction.

Leasehold Improvements - Physical alterations made by the lessee to the leased property when these benefits

are expected to last beyond the current accounting period. An example is when the lessee builds room partitions

in a leased building.

Ledger - The complete collection of all of the accounts of a company; often referred to as the general ledger.

Liability - Probable future sacrifices of economic benefits arising from present obligations of a particular entity to

transfer assets or provide services to other entities in the future as a result of past transactions or events.

Modified Accelerated Cost Recovery System (MACRS) - The system used in computing annual depreciation for

assets acquired in 1987 and later.

Net Income - The net increase in owners’ equity resulting from the financial operations of a company; revenues –

expenses = net income.

Prepaid Expenses - Assets that arise as a result of paying for goods or services before they are received.

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Reliability - A concept that requires that information be reasonably free from error and bias and faithfully

represent what it purports to represent.

Revenue - Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination

of both) during a period from delivering or producing goods, rendering services, or other activities that constitute

the entity’s ongoing major or central operations.

Sarbanes-Oxley (SOX) Act - Wide-ranging U.S. corporate reform legislation, coauthored by the Demo- crat in

charge of the Senate Banking Committee, Paul Sarbanes, and Republican Congressman Michael Oxley. The Act,

which became law in July 2002, lays down stringent procedures regarding the accuracy and reliability of corporate

disclosures, places restrictions on auditors providing non-audit services and obliges top executives to verify their

accounts personally. Section 409 is especially tough and requires that companies disclose information on material

changes in the financial condition or operations of the issuer on a rapid and current basis.

Security and Exchange Commission (SEC) - A federal agency created by the Securities Exchange Act of 1934 to

protect investors from dangerous or illegal financial practices or fraud by requiring full and accurate financial

disclosure by companies offering stocks, bonds, mutual funds, and other securities to the public. It is the chief

regulator of the U.S. securities market and overseer of the nation’s stock exchanges, broker-dealers, investment

advisors, and mutual funds.

Unearned Revenue - Revenue received before completion of the earnings process.

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Index

Accounting rate of return, 107

Change in Accounting Estimate, 61, 64

Commercial substance, 25

Debt Covenants, 123

Disclosures, 60

Discount rate, 102

Discounted payback period, 106

Double-Declining Balance depreciation, 17

Fair value, 36, 39, 40

False Asset Valuation, 80

Finance lease, 120

Fixed assets, 9

Goodwill, 35, 36, 37, 40

Implied value, 40

Intangible assets, 33

Internal rate of return, 109

Involuntary conversion, 30

Modified Accelerated Cost Recovery System, 114

Natural resources, 22

Net present value, 108

Payback period, 105

Physical security, 85

Present value method, 52

Profitability index, 110

Sale and Leaseback, 120

Sales-type lease, 120

Self-constructed assets, 12

Sum-of-the-years' digits depreciation, 16

Tests of controls, 92

Units-of-production depreciation, 18

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Solutions to Review Questions


1. What is an asset?

A. Correct. An asset is a resource controlled by an entity as a result of past events and from which future

economic benefits are expected to flow to the entity. Assets increase a company’s value (e.g. cash, accounts

receivable) or benefit the company’s operations (e.g. fixed assets).

B. Incorrect. Revenues refer to inflows or other enhancements of assets of an entity or settlements of its

liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities

that constitute the entity’s ongoing major or central operations (e.g. fees earned from selling goods).

C. Incorrect. A contingent liability is an existing condition involving uncertainty as to possible loss that may occur

in the future depending on the outcome of a specific event such as pending lawsuits and product warranties.

D. Incorrect. Equity (shareholders' equity) refers to the amount of capital contributed by the owners or the

difference between a company's total assets and its total liabilities. Examples of equity include common stock,

preferred stock, paid-in capital in excess of par value, and retained earnings.

2. Which of the following accounting principles dictates that purchased assets are initially recorded at historical cost?

A. Incorrect. The revenue recognition principle determines when revenue is recognized or accounted for.

According to the principle, revenues are recognized when they are realized or realizable, and are earned.

B. Incorrect. The full disclosure principle requires that information provided in financial statements be

sufficiently complete to avoid misleading users of the reports by omitting significant facts of information. The

full disclosure principle also refers to revealing information that would be useful in the decision-making

processes of informed users.

C. Incorrect. The matching principle requires that revenues generated and expenses incurred in earning those

revenues be reported in the same income statement. In this way, sacrifices (expenses) are matched against

benefits or accomplishments (revenues). It is through the matching process that net income is determined.

D. Correct. The cost principle states that the acquisition cost is the proper amount at which transactions and

events involving assets should be initially recorded in the accounting system.

3. Which of the following accounts captures anything of value owned by a company?

A. Incorrect. Revenues are actual or expected inflows of assets resulting from delivering or producing goods (as

by retail business), or rendering services (as by a lawyer).

B. Incorrect. Owner’s equity is the residual interest in the assets of an entity that remains after deducting its

liabilities. In a business enterprise, the equity or capital is the ownership interest.

C. Correct. Assets are probable economic benefits obtained or controlled by a particular entity as a result of

past transactions or events. Examples of assets include cash, accounts receivable, inventory, supplies,

buildings, equipment, and vehicles.

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D. Incorrect. Liabilities are debts owed to outsiders (creditors) and are frequently described on the balance sheet

by titles that include the word "payable." The liability arising from the purchase of goods or services on credit

(on time) is called an account payable.

4. Which of the following assets is easily liquidated into cash?

A. Incorrect. A trademark is considered a long-term asset. It is an investment that will benefit the company for

many years.

B. Correct. An accrued revenue is a revenue that has been earned but has not yet been received or recorded.

Accrued revenue items consist of asset/revenue adjustments. For example, a company performs a service

for a customer but has not yet billed the customer. Since the company has earned the revenue, the

company must make an entry in the accounting records to increase accounts receivable and revenue to

properly reflect this transaction

C. Incorrect. Plant assets represent tangible, long-lived assets such as land, buildings, machinery, and tools

acquired for use in normal business operations (and not primarily for sale) during a period of time greater

than the normal operating cycle or one year, whichever is longer.

D. Incorrect. A franchise license is an asset with a long term life that lacks physical substance and arises from a

right granted by another company.


5. An accumulated depreciation account is an example of which of the following contra accounts?

A. Incorrect. A contra liability account is a liability with a debit balance. It reduces other liabilities on the balance

sheet. A discount on bonds payable is an example of a contra liability account.

B. Correct. A contra asset account is a deduction from the asset in the balance sheet. The accumulated

depreciation account is a contra asset account indicating the total of all depreciation recorded on the asset

from the date of acquisition through the balance sheet date. A contra asset account decreases the original

cost of the asset down to its remaining undepreciated cost or book value.

C. Incorrect. A contra equity account with a debit balance that decreases an equity account. For example,

treasure stock carries a debit balance and decreases the overall stockholders’ equity.

D. Incorrect. Expenses are actual or expected outflows of assets or incurrences of liabilities resulting from

delivering or producing goods, or rendering services. Examples of expense accounts include administrative

expense, amortization expense, bad debt expense, cost of goods sold, and depreciation expense.

6. What is acquisition cost minus the salvage value equal to?

A. Incorrect. The book value is the cost of an asset net of all accumulated depreciation and other charges

(e.g. impairments) that have been recorded against it.

B. Incorrect. The market value is the estimated worth of an asset based on the supply of and demand for it

in the current market.

133

C. Correct. The salvage value (residual value) is an estimated amount that a company expects the asset to

be worth at the end of its useful life. The depreciable base equals the acquisition cost minus the salvage

value. It is the amount of an asset's cost that can be depreciated over time.

D. Incorrect. Depreciation is the allocating and expensing of the cost of an asset over its useful life.

7. A company changes from depreciation its vehicles at 25% on a straight-line basis to 10%. How does this change

affect its profit each year?

A. Correct. The annual depreciation expense is calculated using the formula: Cost - Salvage Value/Number

of Years of Useful Life. The depreciation rate change from 25% to 10% indicates that the number of years

of useful life increased from 4 years to 10 years. Since the number of years of useful life increased, the

amount of depreciation expense will be smaller which results in increased profits each year.

B. Incorrect. When the number of years of useful life is changed from 4 years to 10 years, the depreciation

expense decreases resulting in increased profits.

C. Incorrect. The change of depreciation rate can be quantified as demonstrated in answer A and B.

D. Incorrect. The change of deprecation rate affects a company’s profit calculation as demonstrated in answer

A and B.

8. A machine with a 5-year estimated useful life and an estimated 10% salvage value was acquired on January 1,

20X0. On December 31, 20X3, how is accumulated depreciation using the sum-of-the-years' digits method

computed?

A. Incorrect. (Original cost minus salvage value) multiplied by 1/15 is the depreciation expense for 20X4.

B. Correct. SYD depreciation is calculated on a constant depreciable base equal to the original cost minus the

salvage value, multiplied by the SYD fraction. The SYD fraction's numerator is the number of years of

remaining useful life of the asset. The denominator is the sum of the digits of the total years of the expected

useful life. In this case, the denominator is 15 (1 + 2 + 3 + 4 + 5). Thus, the accumulated depreciation at the

end of 20X3 is the sum of the depreciation calculated in each of the 4 years, or 14/15 (5/15 + 4/15 + 3/15 +

2/15) times the depreciable base.

C. Incorrect. Original cost multiplied by 14/15 is the depreciation at December 31, 20X3 assuming no salvage

value.

D. Incorrect. Original cost multiplied by 1/15 is the depreciation expense for 20X4 assuming no salvage value.

9. What factor must be present to use the units-of-production method of depreciation for a machine?

A. Correct. The units-of-production depreciation method allocates asset cost based on the level of

production. As production varies, so will depreciation expense. Each unit produced is charged with a

constant amount of depreciation equal to the cost of the asset minus salvage value, divided by the total

units expected to be produced.

B. Incorrect. An advantage of the units-of-production method is that depreciation can vary with production.

C. Incorrect. Repairs do not affect depreciation.

D. Incorrect. Obsolescence need not be expected. The units-of-production method treats obsolescence in

the same way as other depreciation methods.

134

10. In January, Vorst Co. purchased a mineral mine for $2,640,000 with removable ore estimated at 1.2 million

tons. After it has extracted all the ore, Vorst will be required by law to restore the land to its original condition

at an estimated cost of $180,000. Vorst believes it will be able to sell the property afterwards for $300,000.

During the year, Vorst incurred $360,000 of development costs preparing the mine for production and

removed and sold 60,000 tons of ore. In its income statement for the year, what amount should Vorst report

as depletion?

A. Incorrect. The amount of $135,000 does not include the $180,000 restoration costs.

B. Correct. Vorst's per-ton charge is calculated as follows: Purchase Price + Restoration costs – Residual value

+ Preparation Costs = Depletion base ($2,640,000 + 180,000 – 300,000 + 360,000 = $2,880,000). The

Depletion base divided by the estimated removable tons = depletion charge per ton ($2,880,000 /

1,200,000 = $2.40). Accordingly, Vorst should report $144,000 (60,000 tons sold x $2.40 per ton) as

depletion in its income statement for the year.

C. Incorrect. The amount of $150,000 does not consider the restoration costs and the residual value of the land

in the calculation of the depletion base.

D. Incorrect. The amount of $159,000 does not consider the deduction for the $300,000 residual value of the

land in the calculation of the depletion base.


11. Dire Co., in a business combination initiated and completed in October 2014, purchased Wall Co. at a cost that

resulted in recognition of goodwill having an expected 10-year benefit period. However, Dire plans to make

additional expenditures to maintain goodwill for a total of 40 years. What costs should be capitalized and over

how many years should they be amortized?

A. Correct. GAAP requires that goodwill (the excess of the cost of the acquired entity over the fair value

of the acquired net assets) from a business combination be capitalized. Subsequent accounting for

goodwill is governed by GAAP, which provides that goodwill acquired after June 30, 2001 is tested for

impairment but not amortized. In contrast, the cost of developing, maintaining, or restoring intangible

assets that (1) are not specifically identifiable, (2) have indeterminate lives, or (3) are inherent in a

continuing business and related to an enterprise as a whole should be expensed as incurred.

B. Incorrect. The goodwill acquired externally is not amortized.

C. Incorrect. The goodwill acquired externally is not amortized and the costs of maintaining goodwill should

be expensed as incurred.

D. Incorrect. The goodwill acquired externally is not amortized and the costs of maintaining goodwill should

be expensed as incurred.

12. Which of the following asset groups qualify for interest cost capitalization?

135

A. Incorrect. ASC 835 explicitly prohibits capitalization of assets that are being used in the earning activities

of the company.

B. Incorrect. GAAP 34 explicitly prohibits capitalization of assets that are ready for their intended use in the

activities of the company.

C. Correct. In accordance with ASC 850, interest should be capitalized for two types of assets: those

constructed or otherwise produced for an enterprise's own use, including those constructed or

produced by others, and those intended for sale or lease that are constructed or produced as discrete

products (e.g., ships).

D. Incorrect. ASC 835 explicitly prohibits capitalization of inventories that are manufactured in large

quantities on a continuing basis.

13. Which of the following is TRUE about asset retirement obligations requirements?

A. Incorrect. Quoted market prices are the best basis for fair value measurement. If quoted market prices

are unavailable, fair value can be estimated based on the best data available. Examples are the prices of

similar liabilities and the use of present value techniques.

B. Incorrect. Companies are required to record a liability when a retirement obligation is incurred, provided

fair value can be reasonably estimated even though it is years before the asset's planned retirement.

C. Incorrect. Changes in the timing or initial estimated undiscounted cash flows should be recognized as an

addition or reduction of the asset retirement obligation and the associated asset retirement cost deferred

to the long-lived asset.

D. Correct. An entity should disclose the reconciliation of the asset retirement obligation balance for the

year. This reconciliation shows the beginning and ending carrying values of the asset retirement

obligation including separate presentation of the changes related to the liability incurred as well as

settled in the current year, accretion expense, and adjustments made to projected cash flows.

14. Sunny Inc. received a $20,000 contract to provide products to A&E Corp for two years. To win the contract,

they incurred the following costs: Legal expenses = $2,000; Travel expenses = $1,000; and Commissions =

$5,000. How should Sunny Inc. account for the expenses?

A. Correct. The only expense that should be capitalized and amortized is the incremental expense of the

sales commissions ($5,000). The other expenses; legal and travel expenses, would have been incurred

whether or not Sunny Inc. won the contract ($3,000).

B. Incorrect. $8,000 includes all expenses as normal operating and is incorrect because it does not break out

the capitalized expenses of securing the contract.

C. Incorrect. $8,000 includes operating expenses which should not be capitalized under the revenue

guidance.

D. Incorrect. This answer incorrectly allocates the costs. Capitalized expenses are those that would not have

been incurred if the contract was not obtained.

15. Which of the following changes will result in a prospective change in the current year and years going forward?

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A. Incorrect. A change from an accounting principle that is not generally accepted to one that is, such as from

the cash basis to the accrual basis for vacation pay, is a correction of an error that should be treated as a

prior-period adjustment.

B. Correct. A change in accounting principle that is adopted to recognize a change in the estimated future

benefits of the assets becomes inseparable from the change in estimate and is therefore accounted for

as a change in estimate (i.e. prospectively).

C. Incorrect. A change to consolidated statements is a change in the reporting entity (a special change in

accounting principle) and therefore requires restatement of prior-period statements.

D. Incorrect. A change in the method of accounting for long-term construction-type contracts is a special

change in accounting principle that is reported as a restatement of prior-period statements.


16. Under IFRS, when may an entity that acquires an intangible asset use the revaluation model for subsequent

measurement?

A. Incorrect. An intangible asset may have an indefinite life.

B. Correct. An intangible asset is carried at cost minus any accumulated amortization and impairment

losses, or at a revalued amount. The revaluation model is similar to that for items of PPE (initial

recognition of an asset at cost). However, fair value must be determined based on an active market.

C. Incorrect. Initial recognition of an intangible asset is at cost. Recognition is permitted only when it is

probable that the entity will receive the expected economic benefits, and the cost is reliably measurable.

D. Incorrect. An intangible asset is nonmonetary.

17. How would you categorize contributions subject to donor-imposed restrictions?

A. Incorrect. Net assets without donor restrictions are the part of net assets of an NFPO that is not subject

to donor-imposed restrictions (donors include other types of contributors, including makers of certain

grants).

B. Incorrect. To reduce complexity, the FASB eliminates the distinction between resources with permanent

restrictions and those with temporary restrictions from the face of financial statements.

C. Correct. Net assets with donor restrictions are the part of net assets of an NFPO that is subject to donor-

imposed restrictions (donors include other types of contributors, including makers of certain grants).

D. Incorrect. Control is the ability to determine the direction of management and policy for purposes of

presenting combined financial statements.

18. The Anderson Museum, a not-for-profit organization, received a contribution of historical artifacts. It need

NOT recognize the contribution if the artifacts are to be sold and the proceeds used for which of the following

activities?

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A. Incorrect. If the proceeds are used to support general museum activities, the contribution must be

recognized.

B. Correct. Contributions of such items as art works and historical treasures need not be capitalized and

recognized as revenues if they are added to collections that are (1) subject to a policy that requires the

proceeds of sales of collection items to be used to acquire other collection items; (2) protected, kept

unencumbered, cared for, and preserved; and (3) held for public exhibition, education, or research for

public service purposes rather than financial gain (ASC 958-605-05-3).

C. Incorrect. If the proceeds are used to repair existing collections, the contribution must be recognized.

D. Incorrect. If the proceeds are used to purchase buildings to house collections, the contribution must be

recognized.

19. When a snowplow purchased by a governmental unit is received, how should it be recorded in the general

fund?

A. Incorrect. An encumbrance is recorded to account for the purchase commitment.

B. Correct. When previously ordered goods are received, the entry includes a debit to expenditures for the

actual amount to be paid.

C. Incorrect. General capital assets are reported only in the governmental activities column of the

government-wide statement of net assets.

D. Incorrect. Appropriations are accounted for when recording the budget.

20. All of the following are infrastructure asset EXCEPT:

A. Correct. Buildings, except those that are an ancillary part of a network of infrastructure assets, should

not be considered infrastructure assets for purposes of GASB Statement No. 34. Examples of buildings

that may be an ancillary part of a network or subsystem include road maintenance structures such as

shops and garages associated with a highway system and water pumping buildings associated with

water systems.

B. Incorrect. Infrastructure consists of long-lived capital assets that are normally stationary in nature and can

be preserved for a significantly greater number of years than most capital assets. Infrastructure assets are

often linear and continuous. Bridges are the considered infrastructure asset.

C. Incorrect. Infrastructure assets are “networks” of assets such as roads, drainage system, parks and

buildings.

D. Incorrect. Lighting systems should be treated as infrastructure asset.

Chapter 2 - Review Questions

21. Which of the following best describes an act of the employee to write off a stolen asset as scrap, obsolete,

missing, donated, or destroyed?

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A. Incorrect. Financial statement fraud is a scheme in which an employee intentionally causes a

misstatement or omission of material information in the entity’s financial reports, such as fictitious

revenues, understating reported expenses, or artificially inflating reported assets.

B. Correct. Concealment includes writing off a stolen asset as scrap, obsolete, missing, donated, or

destroyed. Normal day-to-day business activities can be used to conceal the theft of fixed assets such

as accepting goods without documentation to support the receipt and creating false receiving reports

or documentation to alter quantity or quality.

C. Incorrect. False claims usually pertain to Social Security, defense contractors, healthcare company fraud,

or other instances in which a company or individual attempts to be paid by the government for an invalid

reason.

D. Incorrect. Corruption is a scheme that involves an employee that misuses his or her influence in a business

transaction in a way that violates his or her duty to the employer to gain a direct or indirect benefit. Such

schemes include extortion, conflict of interest or bribery.

22. All of the following are impacts of ghost assets EXCEPT:

A. Incorrect. The company pays higher insurance premiums when ghost assets are included in the insurable

base amount.

B. Incorrect. Capital budget is incorrect because management will be unaware of critical assets needing

replacement.

C. Incorrect. Employees could spend hours identifying and updating fixed asset records related to ghost

assets.

D. Correct. Since the company has not removed ghost assets from its books, the property subject to tax

may be inflated resulting in an overpayment of property taxes.

23. Proper segregation of functional responsibilities to achieve effective internal control calls for separation of

certain functions. Which of the following identify three functions that should be separated?

A. Incorrect. Payment is a form of execution (operational responsibility).

B. Correct. One person should not be responsible for all phases of a transaction, i.e., for authorization of

transactions, recording of transactions, and custodianship of the related assets. These duties should be

performed by separate individuals to reduce the opportunities to allow any person to be in a position

both to perpetrate and conceal errors or fraud in the normal course of his/her duties.

C. Incorrect. Custody of assets and execution of related transactions are often not segregated.

D. Incorrect. Payments must be recorded when made. These two functions are not separable.

24. Which of the following control activities assure the traceability of assets?

A. Incorrect. The fixed asset physical count is essential to the prevention and detection of the asset

misappropriation and fictitious asset schemes.

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B. Correct. Each fixed asset should be promptly tagged to permit easy identification and recorded in a fixed

asset register to ensure traceability.

C. Incorrect. The reconciliation between the asset register and the general ledger assures the accuracy of

the asset records not necessarily the traceability of assets.

D. Incorrect. Holding employees accountable for assets assigned to them may protect the assets from theft

but it does not necessarily assure the traceability of assets.

25. In an audit of financial statements, what is an auditor's primary consideration regarding an internal control?

A. Incorrect. Management's philosophy and operating style is just one factor in the control environment of

internal control.

B. Correct. An auditor's primary concern is whether a specific control affects financial statement

assertions. Much of the audit work required to form an opinion consists of gathering evidence about

the assertions in the financial statements. These assertions are management representations embodied

in the components of the financial statements. Controls relevant to an audit are individually or in

combination likely to prevent or detect material misstatements in financial statement assertions.

C. Incorrect. Restricting access to assets is only one of many physical controls, which constitute the control

activities of internal control.

D. Incorrect. Many controls concerning management's decision-making process are not relevant to a

financial statement audit.

26. During the audit, the auditor performs testing procedures to determine if assets are included in the financial

statements at accurate amounts. The auditor applies which of the following assertions to consider the

potential misstatements?

A. Incorrect. Auditors use the rights & obligations assertion to determine if the entity holds or controls the

rights to assets.

B. Incorrect. Auditors apply the completeness assertion to determine if all transactions and events that

should have been recorded have been recorded.

C. Incorrect. Auditors use the existence assertion to determine if recorded assets exist.

D. Correct. Auditors apply the valuation & allocation assertion to determine if assets are included in the

financial statements at appropriate amounts, and any resulting valuation or allocation adjustments are

appropriately recorded.

Chapter 3 Section 1 – Review Questions

27. Which of the following budgets is prepared for replacement of assets and expansion of production facilities?

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A. Incorrect. A research and development budget is prepared to estimate the research and development

expenditures to be incurred during a specific period. The budget is prepared in two parts, one is for

expenses and another is to estimate the capital expenditures to be incurred.

B. Incorrect. A cash budget is used to ascertain whether company operations and other activities will provide

a sufficient amount of cash to meet projected cash requirements. If not, management must find

additional funding resources. Therefore, it is a tool for cash planning and control and for formulating

investment strategies.

C. Incorrect. Master (comprehensive) budgeting is a term applied to the whole process of planning and

control. It includes both the long- and short-range plans and encompasses the profit plan and the various

budgets prepared for the various operating segments. A comprehensive (master) budget is a formal

statement of management's expectation regarding sales, expenses, volume, and other financial

transactions of an organization for the coming period. It covers both the operating and financial budgets.

D. Correct. A capital expenditure budget is prepared to estimate the capital expenditure on fixed assets-

Buildings, machinery, plant, furniture, etc. It is generally a long-term budget. It is prepared for

replacement of assets, expansion of production facilities, adoption of new technologies, diversification,

etc.

28. Which one of the following statements about the payback method of investment analysis is correct?

A. Correct. The payback method calculates the amount of time required for a company to recoup its

original investment. Although the payback method is easy to use, it has inherent problems. The time

value of money and returns after the payback period are not considered.

B. Incorrect. The payback method ignores cash flows after payback, which means it does not take into

account returns after the payback period.

C. Incorrect. The payback method does not use discounted cash flow techniques, because it does not

consider the time value of money.

D. Incorrect. The payback method is often used, given its simplicity and effectiveness in risk management

and cash conservation.

29. Russell Corp. is considering the purchase of a new machine for $78,000. The machine would generate an

annual cash flow of $23,214 for five years. At the end of five years, the machine would have no salvage value.

What is the payback period in years for the machine approximated to two decimal points?

A. Correct. The payback period measures the length of time required to recover the amount of initial

investment. When the annual cash flows are constant and of equal amounts, then the payback period

can be calculated by dividing the initial investment by the cash inflows generated from increased

revenues or cost savings. The payback period in years for the machine equals 3.36 ($78,000/$23,214).

B. Incorrect. The annual cash flow is $23,214 yields a payback period 3.36 years. To have 9.48 years payback

period, the machine would only need to generate an annual cash flow of $8,227.85 ($78,000/$8,227.85 =

9.48).

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C. Incorrect. The annual cash flow is $23,214 yields a payback period of 3.36 years. To have 3.00 years

payback period, the machine would need to generate an annual cash flow of $26,000 ($78,000/$26,000

= 3).

D. Incorrect. The annual cash flow is $23,214 yields a payback period of 3.36 years. To have 4.00 years

payback period, the machine would only need to generate an annual cash flow of $19,500

($78,000/$19,500 = 4).

30. Doro Co. is considering the purchase of a $100,000 machine that is expected to result in a decrease of $25,000

per year in cash expenses after taxes. This machine, which has no residual value, has an estimated useful life

of 10 years and will be depreciated on a straight-line basis. For this machine, what would the accounting rate

of return (ARR) based on initial investment be?

A. Incorrect. 10% is the depreciation rate per year.

B. Correct. The ARR is based on the accrual method and does not discount future cash flows. Accordingly,

the ARR equals the decrease in annual cash expenses after taxes minus annual depreciation, divided by

the initial investment. Annual straight-line depreciation is $10,000 [($100,000 cost - $0 salvage value) ÷

10 years]. So, the ARR would be ($25,000- $10,000) / $100,000 = 15%.

C. Incorrect. Depreciation must be deducted from the $25,000 of cash expenses.

D. Incorrect. Depreciation must be deducted from, not added to, the $25,000 of cash expenses.

31. What is the internal rate of return (IRR)?

A. Incorrect. The hurdle rate is the rate used to calculate the NPV; it is determined by management prior to

the analysis.

B. Incorrect. The IRR is the rate at which the NPV is zero. Internal rate of return (IRR) is defined as the rate

of interest that equates the initial investment (I) with the PV of future cash inflows. In other words, at

IRR, I = PV (or NPV = 0).

C. Correct. The IRR is the interest rate at which the PV of the expected future cash inflows is equal to the

initial investment for a project. Thus, the IRR is the interest rate that will produce the NPV equal to

zero.

D. Incorrect. The accounting rate of return does not incorporate the time value of money.


32. Flex Corporation is studying a capital acquisition proposal in which newly acquired assets will be depreciated

using the straight-line method. Which one of the following statements about the proposal would be

INCORRECT if a switch is made to the Modified Accelerated Cost Recovery System (MACRS)?

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A. Incorrect. The NPV will increase. The present value of the net inflows will increase with no change in the

investment.

B. Incorrect. The IRR will increase. Deferring expenses to later years increases the discount rate needed to

reduce the NPV to $0.

C. Incorrect. The payback period will be shortened. Switching to MACRS defers expenses and increases cash

flows early in the project’s life.

D. Correct. MACRS is an accelerated method of depreciation under which depreciation expense will be

greater during the early years of an asset’s life. Thus, the outflows for income taxes will be less in the

early years, but greater in the later years, and the NPV (present value of net cash inflows-investment)

will be increased. The profitability index (present value of net cash inflows / the investment) must

increase if the NPV increases.

33. What is a contract that conveys the right to control the use of an identified asset (e.g. equipment) for a period

of time in exchange for consideration?

A. Incorrect. Inventory is defined as tangible property that is: 1) held for sale in the ordinary course of

business 2) in the process of production for sale, or 3) consumed in the production of goods or services to

be available for sale.

B. Incorrect. Performance obligation is a promise in a contract with a customer to transfer to the customer

either: 1) a good or service (or a bundle of goods or services) that is distinct or 2) a series of distinct goods

or services that are substantially the same and that have the same pattern of transfer to the customer

C. Incorrect. Financial asset refers to cash, evidence of ownership in an entity, or a contract that conveys

another entity the right to: 1) receive cash or another financial instrument from the first entity or 2)

exchange other financial instruments on potentially favorable terms with the first entity.

D. Correct. ASC 842 defines a lease as a contract, or part of a contract, that conveys the right to control the

use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for

consideration.

34. Which of the following measurements reflects the productivity and efficiency of plant assets in generating

revenue and earnings?

A. Incorrect. Return on stockholders’ equity (ROE) indicates management’s success or failure at maximizing

the return to stockholders based on their investment in the company. This ratio emphasizes the income

yield in relationship to the amount invested. Financial leverage can be estimated by subtracting return on

total assets from return on shareholders’ equity.

B. Correct. Fixed asset turnover reflects the productivity and efficiency of property, plant, and equipment

in generating revenue and earnings. A high fixed-asset turnover reflects positively on the company's

ability to utilize its fixed assets in business operations. The fixed asset turnover rate is Net

Income/Average fixed assets.

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C. Incorrect. Leverage ratios measure a company’s ability to pay long-term debt. Two key methods used to

measure a company’s ability to pay its legal obligations (solvency) as they become due are the debt ratio and

the times-interest-earned ratio.

D. Incorrect. Profitability ratio measure the profitability of the company by comparing various expenses to

revenues, and measure how well the assets of the company been used to generate revenue. The primary

ratios are rate of return on net sales, rate of return on total assets, and rate of return on common

stockholders' equity.

35. Beta Inc. (Lessee) obtains control of the leased equipment with a lease term 75% of the remaining economic

life of the equipment. How does Beta Inc. account for this agreement in accordance with ASC 842?

A. Correct. For lessees, a lease is a finance lease if the lessee effectively obtains control of the underlying

asset, by meeting any of the five criteria required by ASC 842. For example, the lease term is for a major

part (generally 75%) of the remaining economic life of the underlying asset.

B. Incorrect. Operating lease occurs when a lessor transfers the use of an asset to a lessee for a period of

time but does not effectively transfer control of the underlying asset.

C. Incorrect. Leveraged lease occurs when a lessor (equity participant) finances a minimal amount of the

purchase but has total equity ownership. ASC 842 eliminates leveraged lease accounting, although lessors

can continue to account for existing leveraged leases using ASC 840 guidance.

D. Incorrect. Sublease refers to an underlying asset that is re-leased by the original lessee (or intermediate

lessor) to a third party, and the lease (or head lease) between the original lessor and lessee remains in

effect.

36. How should the payments of interest on the lease liability arising from a finance lease be presented on the

statement of cash flows?

A. Correct. Payments of interest on the lease liability arising from a finance lease should be classified as

operating activities on the statement of cash flows.

B. Incorrect. Payments of the principal portion of the lease liability arising from a finance lease are classified

as financing activities on the statement of cash flows.

C. Incorrect. Payments for the interest portion of the lease liability arising from a finance lease should be

classified as operating activities (not investing activities).

D. Incorrect. ASC 842 requires the lessees to report the payments of interest on the lease liability on the

statement of cash flows.

Fixed Asset Accounting

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