MSE608C – Engineering and Financial Cost Analysis

Refinements of Accounting Transactions

Prepaids (also called Deferrals)

Cash flows occur BEFORE the revenue or expense is recognized

Revenues Down PaymentsUnearned rentDeposits

Expenses

Prepaid Insurance

Prepaid rent

Prepaid taxes

AccrualsCash flows occur AFTER the revenue or

expense is recognized

Revenues ExpensesSales Purchases on accountNotes receivable Accrued salariesInterest on loans Warranty costs

Pensions and benefitsDepreciation of assets

• Warranty costs and Pensions are also know as Contingency Obligations

Contra Accounts

• These are special accounts that are established to decrease the balance in another account indirectly.– They preserve the identity of the primary account.– Provides an account to debit or credit when one does not exist.

• Examples:Primary Account Contra AccountAccounts Receivable Allowance for Doubtful

AccountsFixed Assets Accumulated DepreciationIntangible Assets Accumulated AmortizationSales Revenue Sales Returns and Allowance

Sales DiscountsLoans Receivable Allowance for Doubtful Loans

Accounting for Allowance Accounts

• Allowance accounts ensure the amount report in the primary account is as accurate as possible.

• These require estimates• Example: Allowance for Bad Debt

– This contra-account to Accounts Receivable acknowledges that, with every credit sale, a portion will not be collected.

• With a credit sale of $1000 and an estimate of 6.5% bad debt and COGS = $420

• When it is clear that a customer will never pay $30 that is owed the Company will record the following entries.

• Now the Expense (Bad Debt) has offset the Sales Revenue in the same period they were earned.

Allowance forBad Debt

$30

AccountsReceivable

$30

Allowance forBad Debt

$65

Bad DebtExpense

$65

COGS

$420

Inventory

$420

Sales Revenue

$1000

AccountsReceivable

$1000

Prompt Payment Discounts

• It is common for a billing invoice to have the follow type of verbiage added:

2 percent, 10 days/net, 30 days– A 2 percent discount may be taken off the bill if

paid within 10 days– The full amount is expected to be paid within

30 days.– The 2 percent savings is forfeit if the bill is paid

after day 10.

Calculating the Interest

• Accounts Payable is considered non-interest borrowing but in reality this is only true if the Prompt Payment Discount is taken.

• By not paying within the first 10 days, the customer is essentially borrowing money (the discounted amount) and paying 2 percent interest.

• Calculating the Interest:– The interest rate is based on 2 percent interest for 20 days of borrowing.– There are 18 1/4 of these 20 day periods in a year (365/20 = 18 1/4).– Therefore, the yearly Interest Rate is 36.5% (2% x 18 1/4).

• At this interest rate it would benefit of the company to use the discount.

Accounting for Prompt Payment Discounts

• There are two methods of accounting for Prompt Payment Discounts:– Net Method:

• Used when the Discount is attractive and most customers are expected to take advantage.

– Gross Method• Used when the Discount is not attractive or neutral

and most customers are not expected to take advantage.

Net Method of Accounting for Prompt Payment Discounts

It is expected that customers will take the discount!• The sale is recorded at the discounted amount.

Sale = $1000 with terms of 2 percent, 10 days/net, 30 days.

• When the receipt of cash if the discount is taken.

• Recording the receipt of cash if the discount is not taken.

Sales

$980

AccountsReceivable

$980

AccountsReceivable

$980

Cash

$980

AccountsReceivable

$980

Cash

$1000

Other Income

$20

Gross Method of Accounting for Prompt Payment Discounts

It is expected that customers will not take the discount!

• The sale is recorded at the full, billed amount.

Sale = $1000 with terms of 1/2 percent, 10 days/net, 30 days.

• Recording the receipt of cash if the discount is not taken.

• When the receipt of cash if the discount is taken.

AccountsReceivable

$1000

Sales

$1000

AccountsReceivable

$1000

Cash

$1000

AccountsReceivable

$1000

Cash

$995

DiscountsAllowed

$5

Accounting for Inventory

• Inventory– Purchased goods on hand to be sold.

• Two systems for valuing inventory that is sold– Perpetual Inventory System

• Accounts for the cost of goods sold with each sale• Most precise and highest investment

– Periodic Inventory System• Tracks inventory purchase but not inventory sold• Physical inventory count at end-of-period• Can only estimates the Cost of Goods.

The Perpetual Inventory System

• Accounts for each individual purchase or sale.– More applicable to inventory that is high cost and low volume.– Does not require end-of-period adjustments.

• Purchases of Inventory:Debit Credit

Inventory $500Cash or Accounts Payable $500

• Sale of product (two entries):Debit Credit

Cash or Accounts Receivable $800Sales Revenue $800

Debit CreditCost-of-goods-sold $500Inventory $500

The Periodic Inventory System

• Requires physical inventory counts.• Best for low cost, high volume inventory.• Purchases of inventory:

Debit CreditPurchases $500 Cash or Accounts Payable $500

• Sale of product (one entry): Debit Credit

Cash or Accounts Receivable $800 Sales Revenue $800

The Periodic Inventory System• Calculating Inventory consumed over the accounting period:

Beginning Inventory $2500 + Purchases $800 - Returns ($250) = Inventory Available $3050Ending Inventory $1500 = Inventory Sold (COGS) $1550

• End-of-period adjusting entries:Debit Credit

Inventory (ending amount) $1500Returns $250 Inventory (begin amt) $2500 Purchases $ 800Cost of Goods Sold $1550

Inventory Accounting

• Issues in valuing Inventory and Cost-of-Goods-Sold:– Different prices are paid for inventory

depending on when items were purchased.– Price level changes due to Inflation and

Deflation.– Currency fluctuations.

FIFO and LIFO• The FIFO (First-in, First-out) convention:

– The value of the oldest inventory, the First-in, is the value of the Cost-of-Goods-Sold for current sales, the First-out.

• The LIFO (Last-in, First-out) convention:– The value of the newest inventory items, the Last-in, is used to

value Cost-of-Goods-Sold for current sales, the First-out.

• In periods of high Inflation:– LIFO will have a higher COGS and better match Expenses to

Revenues;

– Profits are lower (more conservative);

– Better matches replacement costs of Inventory;

– Lower Income Taxes thus higher cash flows.

• GAAP allows FIFO or LIFO with restrictions (Riggs 147).

Price Level Changes

• Price level changes due to Inflation and Deflation are a fact of life.– Inflation:

a decrease in the purchasing power of currency; prices increase to compensate; the value of inventory decreases.

– Deflation: an increase in the purchasing power of currency; prices drop to compensate; the

value of inventory increases.

• Two approaches to price-level accounting:– Specific-price adjustments (SPA)– General-price-level adjustments (GPLA)

Specific-Price Adjustments (SPA)

Adjustments are made to specific goods and services; typically inventory and fixed assets. This identifies that only certain

items may be affected by price changes.

• Several methods can be used to estimate the current value of assets.• Time-adjusted value:

Estimates the value of revenue streams over time. This method tends to be inaccurate both in estimating the original value as well as the new value.

• Market value:Determines the replacement value of assets and requires good secondary markets to be

efficient.

• Price indices:Use of published indices for the asset being re-valued. Multiplying the current value by

the index number will establish the current value.

General-Price-Level Adjustments (GPLA)

Recomputes the value of all assets and liabilities on the financial statements. Also

called Constant-dollar Accounting.

• Uses General Price Indices– Gross National Product (GNP)– Consumer Price Index (CPI)

Currency Fluctuations

• Companies operating foreign subsidiaries must account for gains or losses due to fluctuation in currency exchange rates on their consolidated financial statements.

• The value of assets and liabilities must be adjusted to account for different rates of inflation between the foreign and home currencies.

• The accountant must determine what exchange rate to use and when should it be applied.

Fixed Asset Accounting• Fixed Assets are Non-current Assets• Revenue and Capital Expenditures

– Revenue expenditures are for Current Assets

– Capitalization expenditures are for Non-current Assets.

• Fixed Assets are also used to conduct an organization’s business, rather than inventory for resale.– A truck is a fixed asset for a delivery service but an

inventory item for a car dealership.

Elements of Fixed Asset Accounting1) Initial (capitalization) Cost

– Purchase price + freight + installation + major overhauls

– Commonly called the “basis”2) Useful life

– Productive years for the present owner– Dictated by wear, obsolescence and new

requirements.– Useful life generally shorter than the asset’s total life.– Income tax laws establish guidelines

3) Salvage Value– Estimated sale value of the asset at the end of it’s

useful life, usually $0.

Elements of Fixed Asset Accounting4) Depreciation

– The rational, equitable, and systematic allocation of the difference between an asset’s initial cost and it’s estimated salvage value over the useful life.

– It allows an organization to deduct, or expense, the incremental consumption of a fixed asset to the periods that benefit from it’s use.

– It is a non-cash transaction.– It reduces taxable income.– Journal entries at the end of each accounting period

and no source documents (an Internal accounting event).

Methods for Depreciation

• Computation uses formulas or tables• Many accepted methods for depreciation including:

– Straight line;– Sum-of-the-years-digits;– Units of production;– Declining balance;– Modified accelerated cost recovery system (MACRS)

• One method is allowed for financial statements and a different method may be used, for the same fixed asset, for income tax accounting purposes.

Disposition of a Fixed Asset• Calculating Net Gain or Loss on Sale/Salvage

Book Value = Capitalization Cost – Accumulated Depreciation

Net Gain (Loss) = Sales/Salvage Proceeds – Book Value

• If proceeds are greater than the Book Value = Gain

• If proceeds are less than the Book Value = Loss

Disposition of a Fixed AssetConsider: BV = $26,000 - $14,400 = $11,600

Sold for $12,000 (a Gain):Debit Credit

Accumulated Depreciation, Equipment ($14,400 remaining) $14,400

Fixed Asset, Equipment (Capital Cost = $26,000) $26,000Cash $12,000Gain on Disposition of Fixed Asset _______ $400

$26,400 $26,400

Sold for $8,000 (a Loss):Debit Credit

Accumulated Depreciation, Equipment ($14,400 remaining) $14,400

Fixed Asset, Equipment (Capital Cost = $26,000) $26,000Cash $8,000Loss on Disposition of Fixed Asset $3,600 ________

$26,000 $26,000

Disposition of a Fixed AssetMaking a Deal (Riggs pg 172)

Consider: BV = $13,000 - $8,000 = $5,000 Purchasing equipment for $21,000

Trade-in equipment, paid $14,000 cash:Debit Credit

Accumulated Depreciation, Equipment ($7,000 remaining) $8,000Fixed Asset, Equipment (Capital Cost = $13,000) $13,000Fixed Asset, Equipment (new Purchase of $21,000) $21,000Cash $14,000Gain on Disposition of Fixed Asset _______ $2,000

$29,000 $29,000

Would have accepted $19,500 if no trade-in:Debit Credit

Accumulated Depreciation, Equipment ($14,400 remaining) $7,000Fixed Asset, Equipment (Capital Cost = $26,000) $13,000Fixed Asset, Equipment (new Purchase of $19.500) $19,500Cash $14,000Loss on Disposition of Fixed Asset $500 ________

$27,000 $27,000

Depreciation and Income Taxes

• A company is obligated to minimize the amount of income tax it must pay.

• They are allowed to keep two sets of “books”; one for preparing financial statements and one for reporting taxable income.– For financial reporting a less aggressive method will increase a fixed

asset’s net book value.– For tax reporting a more aggressive method will increase depreciation

expense; decrease taxable income and decrease income taxes.• The lower income taxes are reported on the Income Statement and

this improves Net Income.

• Deferred Income Taxes is the difference between the two depreciation methods.

Accounting for Deferred Taxes

For Financial Reports(actual amount of taxes owed)Operating Profit

$780,000less: Depreciation

250,000Taxable Income

530,000Income Taxes (@40%) 212,000

Alternate Allowed to Reduce Paid Tax

Operating Profit $780,000less: Depreciation 360,000Taxable Income 420,000Income Taxes (@40%) 168,000

Income Tax Payable Deferred Income Taxes Income Tax Expense 168,000 44,000 212,000

Assessment

• For Prepaids, cash flow occur when?• What is the purpose of a Contra account?• What are the two methods for Prompt Payment

Discounts?• What are the two methods for valuing Inventory?• What is the impact of Inflation using FIFO?• A Gain on the sale of a fixed asset results in a

Credit or Debit entry?• Where do Deferred Income Taxes come from?