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
Chapter 1 Section 3 - Review Questions .................................................................................................... 65
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 1 Section 4 - Review Questions .................................................................................................... 79
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 1 Section 1 - Review Questions .................................................................................................. 131
Chapter 1 Section 2 - Review Questions .................................................................................................. 132
Chapter 1 Section 3 - Review Questions .................................................................................................. 134
Chapter 1 Section 4 - Review Questions .................................................................................................. 136
Chapter 2 - Review Questions ................................................................................................................. 137
Chapter 3 Section 1 – Review Questions ................................................................................................. 139
Chapter 3 Section 2 - Review Questions .................................................................................................. 141
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.
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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
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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.
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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
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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:
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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
Accumulated Depreciation xxx
Fixed Assets xxx
Gain on Disposal xxx
Gain on sale of asset
Cash xxx
Accumulated Depreciation xxx
Loss on Disposal xxx
Fixed Assets xxx
Loss on sale of asset
Accumulated Depreciation xxx
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.
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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
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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
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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
Accumulated depreciation 20,000
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
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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
Accumulated depreciation 30,000
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:
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Machinery—new $26,000
Accumulated depreciation 13,000
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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Chapter 1 Section 2 - Review Questions
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.
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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
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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
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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.
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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 $180 million.
4. Compute the implied value of goodwill. This is equal to the fair value of the division (price at which it could
be sold) minus the fair value of the specific net assets of the division. If the implied value of goodwill is less
than the book value of goodwill, the difference must be written off as an impairment loss on goodwill. If
the implied value of goodwill is greater than the book value of goodwill, no impairment has taken place.
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Solution
($ 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
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• 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.
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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
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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:
Accumulated depreciation $303,426
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)
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______________________________
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
Accumulated depreciation $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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Chapter 1 Section 3 - Review Questions
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:
Revaluation surplus—Land $50,000
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
Revaluation surplus—Land $10,000
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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Chapter 1 Section 4 - Review Questions
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
Upon completion of this chapter, you will be able to:
• 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.
• Only the fixed asset accountant/authorized
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.
• Only the fixed asset accountant/authorized
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
Upon completion of this chapter, you will be able to:
• 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
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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.
5-year property 200%
declining balance
Autos, trucks, computers and their
peripheral equipment, office machinery such
as typewriters, copiers, duplicating
equipment, and property used in research
and experimentation.
7-year property 200%
declining balance
Office furniture and fixtures, and most items
of machinery and equipment used in
production.
10-year property 200%
declining balance
Various machinery and equipment, such as
that used in petroleum distilling and refining
and in the milling of grain.
15-year property 150%
declining balance
Sewage treatment plants, telephone and
electrical distribution facilities, and land
improvements such as shrubbery, fences
and sidewalks.
20-year property 150%
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
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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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Chapter 3 Section 2 - Review Questions
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
Chapter 1 Section 1 - 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.
Chapter 1 Section 2 - Review Questions
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.
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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.
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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. 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.
Chapter 1 Section 3 - Review Questions
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.
Chapter 1 Section 4 - Review Questions
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.
Chapter 3 Section 2 - Review Questions
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.
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