Chapter 5

1. Chapter 5 Special Topics in Accounting

2. Changes in the Equity Account • Two most common changes in equity account are the result of: • Owners’ contributions of additional equity capital • Owners’ capital withdrawals or profit distributions • Recall other changes in equity account that are the result of: • Earning Revenue • Incurring expenses

3. Changes in the Equity Account • For sole proprietorships, partnerships, or LLCs, contributions of additional equity capital normally take the form of direct cash contributions. • For corporations, contributions of additional equity capital take the form of stock sales, and the associated cash inflow is treated in a comparable manner.

4. Changes in the Equity Account • Sole proprietorships, partnerships, and some LLCs maintain drawing accounts to account for owners’ withdrawals of equity capital from the business. • Drawing account: accounting mechanism through which owner withdraws his/her share of company’s profits • At end of year, drawing account is closed to capital account. Total drawings are deducted from capital.

5. Changes in the Equity Account • Corporations distribute profits as dividends to stockholders so withdrawals of equity capital take the form of: • Dividend payment • Stock splits • Stock dividends

6. Depreciation Accounting • Contra account: entitled “accumulated depreciation” and maintained to offset its associated asset account • Capital asset: asset with expected useful life of more than one year • Depreciation accounting: technique used to allocate cost of capital asset over its expected useful life

7. Depreciation Accounting • 4-Step Process • Determine value of asset • “Delivered and installed” price: cost of acquiring asset and preparing it for use • Estimate expected useful life of asset • Estimate asset’s salvage value • Salvage value: asset’s estimated value at end of its expected useful life • Select a method to allocate dollar value of asset expected to be used up (depreciable balance = cost – salvage value) to its expected useful life

8. Depreciation Accounting • Most common methods: • Straight line • Units of production • Sum of years’ digits • Double declining balance

9. Depreciation Accounting • Straight line depreciation • Write off depreciation expense at an even rate (“straight line”) • Units-of-production depreciation • Allocate depreciable balance according to number of units the capital asset is expected to produce

10. Depreciation Accounting • Sum-of-years’-digit (SYD) depreciation • Sum the digits of number of years over which asset is to be depreciated • Establish series of depreciation fractions that have the sum of years’ digits as their denominator • Each year’s depreciation expense is determined by multiplying appropriate depreciation fraction times depreciable balance • (Type of accelerated method)

11. Depreciation Accounting • Double-declining-balance (DDB) • Firm may write off up to double the straight-line depreciation rate • Apply DDB depreciation rate to declining balance of cost of asset, rather than to depreciable balance • Firm may not write off more total depreciation than amount of depreciable balance • (Type of accelerated method)

12. Choice of Depreciation Method • How do you select the appropriate depreciation method? • Use the depreciation method that most closely matches rate at which asset actually depreciates!

13. Depreciation for Tax Purposes • Tax Reform Act of 1986 (TRA 86) • MACRS depreciation: number of years over which asset is depreciated is not tied to expected life of asset, and salvage value of asset is disregarded • Entire cost of asset is depreciated over its MACRS life • Modified accelerated cost recovery system • Most asset categories must be depreciated under MACRS • Allows up to $250,000 of cost of asset to be expensed in year of acquisition

14. Depreciation for Tax Purposes • MACRS cannot be used for financial accounting purposes since this it is not an acceptable depreciation method under GAAP. • Companies use a depreciation method for financial accounting purposes different from the one they use for tax purposes.

15. Depreciation for Tax Purposes • Many firms use straight-line depreciation for financial accounting purposes • Recognizes general erosion in value of asset that is expected to be used over its entire useful life • Minimizes impact of depreciation on firm’s reported earnings per share (see next slide)

16. Depreciation for Tax Purposes • Tax timing difference: results in creation of liability account entitled “deferred income taxes” • If firm uses straight-line depreciation for financial accounting purposes and MACRS depreciation for tax purposes, the later will exceed the former • Taxable earnings will be less than earnings reported on firm’s financial statements

17. Inventory Accounting • Most common methods: • Specific identification • Weighted average • First-in, first-out (FIFO) • Last-in, first-out (LIFO)

18. Inventory Accounting • Perpetual inventory: inventory records are updated whenever new items are received and old items are used up or sold • Specific identification

19. Inventory Accounting • Periodic inventory: inventory is counted periodically (i.e. monthly, quarterly) and quantity used up or sold is determined by subtracting current quantity on hand from prior inventory on hand plus purchases since then • Weighted average, FIFO, LIFO • Practical for large quantities of inventory, high inventory turnover, or large numbers of very similar items in inventory

20. Inventory Accounting • Specific identification • Commonly used for “big ticket” items (i.e. automobiles, jewelry, heavy equipment) • Each item is specifically identified by serial number and carried in inventory at its actual cost

21. Inventory Accounting • Weighted average • Commonly used for fungible goods (i.e. wheat, physically indistinguishable products) • Each unit is priced as a weighted average of cost prices of items at time of purchase

22. Inventory Accounting • FIFO • Corresponds closely to actual physical flows of inventory • Assume that oldest inventory is used up first, so that ending inventory is priced at newest (and higher) prices • Ending inventory is valued on balance sheet at prices that are closest to current prices, but inventory that is used in production is charged against income at older (and lower) prices that are less than replacement costs

23. Inventory Accounting • LIFO • Assume that newest (and higher-priced) items are used first and that oldest (and lower-priced) items remain in inventory • Realistic method of measuring cost flows on income statement

24. Inventory Accounting • FIFO vs. LIFO • FIFO: balance sheet is “accurate” (inventory is priced closest to replacement value), but income statement is “distorted” (“phantom profits” occur) • LIFO: balance sheet is “distorted,” but income statement is “more accurate” • LIFO more closely matched current costs with current revenues than does FIFO * LIFO results in lower reported earnings after tax than FIFO but a higher cash flow due to lower tax burden

25. Accounting for Leases • Operating lease: any lease agreement that does not meet criteria for a capital lease • Capital lease: lease that can be capitalized and recorded as asset with associated liability • Title is transferred to lesseeat end of lease term. • Lease contains bargain purchase option. • Term of lease is greater than or equal to 75% of estimated economic life of asset • Present value of minimum lease payments is greater than or equal to 90% of fair value of leased property

26. Accounting for Leases • Capital lease is recorded on lessee firm’s balance sheet as an asset entitled “capital-lease asset” and an associated liability entitled “obligation under capital lease” • Amount of asset and liability entitled “obligation under capital lease” is equal to present value of minimum lease payments • Asset is accounted for like any other asset that is amortized • Liability is accounted for like interest-bearing debt that is reduced over its term • Lease payments are treated partially as interest expense and partially as amortization of capital-lease liability

27. Intercorporate Investments • Accounting methods to account for ownership of voting stock in another corporation: • Consolidated financial statements • Equity method • Cost method • Choice of method is function of voting control exercised by parent corporation over subsidiary

28. Intercorporate Investments • Consolidated financial statements • Use when one corporation (parent) owns 50% or more of voting stock of another corporation (subsidiary) or, pursuant to FIN 46 has controlling financial interest other than equity or voting rights • Wholly owned subsidiary: parent owns 100% of voting stock of subsidiary

29. Intercorporate Investment • Consolidated financial statements (continued) • Present operations of parent and subsidiary as one consolidated entity • Combine accounts of subsidiary with accounts of parents and eliminate intercompany accounts • Show minority interest if subsidiary is not wholly owned • Minority interest: subsidiary ownership held by stockholders other than parent

30. Intercorporate Investment • Equity method (One-line consolidation) • Used when from 20-50% of subsidiary is owned by parent, and when parent owns more than 50% of subsidiary but consolidation would be considered inappropriate • Takes parent’s share of subsidiary’s earnings as single line item on parent’s income statement • Shows investment in common stock of subsidiary as single asset item on parent’s balance sheet

31. Intercorporate Investment • Cost method • Use when corporation owns less than 20% of voting stock of another corporation and when it is unlikely that equity of subsidiary is effectively accruing to benefit of parent • Records investment in subsidiary at cost on parent’s balance sheet • Records income on parent’s income statement only when received in form of dividends