BCOR3010 QUIZ 5
On July 1, 2021, Entertainment 720, Inc., purchased equipment for $90,000. The equipment is estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. How much Depreciation Expense will E720 report on its 2021 and 2022 income statements? What amount of Equipment will E720 report on its 2021 and 2022 balance sheets?
2021 The equipment will be depreciated for two quarters during 2021 Depreciation Expense = $4,000 ($8,000 per year x ½ year) Equipment = $86,000 [$90,000 cost less $4,000 depreciation] 2022 The equipment will be depreciated for four quarters during 2022 Depreciation Expense = $8,000 ($8,000 per year x 1 year) Equipment = $78,000 [$90,000 cost less $12,000 depreciation] $12,000 cumulative depreciation reflects $4,000 in 2021 and $8,000 in 2022
Days Inventory Outstanding (DIO)
365 × Average Inventory / Cost of Goods Sold
Two ways to think about depreciation:
Balance sheet and income statements.
Rent A Swag Corp. owns a fleet of delivery trucks. Rent A Swag spent the following during 2021: Oil changes$20,000 Routine maintenance$30,000 Repainting rusted exteriors as needed$12,000 New tires needed on some trucks$4,000 Adding built-in GPS units $25,000 Installing new hybrid engines in some trucks$80,000 Misc. repairs related to accidents$6,000 Insurance premiums$80,000 TOTAL $257,000 How much should Rent A Swag capitalize into PP&E during 2021?
Adding builtin GPS units $25,000 Installing new hybrid engines in some trucks$80,000 TOTAL 105,000
Finished goods
Completed cars ready to be sold
After delivery (e.g., consignment)
Consignment: item is delivered without a contract to buy
Inventory manufactured by the company:
Cost includes the expenditures made to manufacture the inventory—direct costs (e.g., raw materials and direct labor) and indirect costs (e.g., an allocation of rent, utilities, and depreciation of equipment)
Inventory purchased from a wholesaler:
Cost includes the expenditures made to purchase the inventory and transport it to its current location—the purchase price, taxes, fees, shipping, etc.
Inventory Turnover Ratio
Cost of Goods Sold / Average Inventory
Useful life is the period of time over which the asset is
Useful life is the period of time over which the asset is expected to be used
Average Cost
Uses the average cost of all inventory on hand
Fixed assets are initially recognized at cost, which is,__________________________________________________________________
adjusted over time for capital expenditures, depreciation, and impairments
Inventory is usually presented on the balance sheet
as a current asset ❑ However, excess inventory not expected to be sold within a year should be classified as a non-current asset
Current value is measured
as the net realizable value, i.e., the net proceeds expected from selling the inventory
Fixed assets are initially recognized
at "cost" Purchased fixed assets: Cost includes the expenditures made to purchase the asset, transport it to its current location, and prepare it for use the purchase price, taxes, fees, shipping, installation, etc. Manufactured fixed assets: Cost includes the expenditures made to manufacture the asset direct costs (e.g., raw materials and direct labor) and indirect costs (e.g., an allocation of rent, utilities, and depreciation of equipment) The interest expense may also be capitalized and included in the cost of manufactured fixed assets, if certain conditions are met
The net cost of an asset is recognized on the income statement not at the time of acquisition
but rather over time as the asset generates revenues
On Jan. 1, 2021, Very Good Building Co. (VGB) purchased equipment for $520,000. The equipment is estimated to have a useful life of 5 years with a salvage value of $20,000 at the end of that time. How much Depreciation Expense will VGB report on its first quarter income statement? What amount of Equipment will VGB report on the balance sheet?
Depreciation Expense = $25,000...... [($520,000 --$20,000) / 20 Equipment = $495,000..... [$520,000 cost less $25,000 depreciation]
Required disclosures include:
Depreciation expense for the period (if not reported separately on the income statement) Amounts of depreciable assets by major category Accumulated depreciation Description of depreciation methods and assumption If an impairment loss has occurred during the period: Description of the asset impaired Information on what led to the impairment The amount of the impairment loss The method for determining the asset's fair value Which segment the impaired asset belongs to
when prices are rising:
FIFO puts the lower, older costs into COGS on the income statement, and the higher, more current costs in Inventory on the balance sheet FIFO leads to higher net income and higher ending inventory balances LIFO lowers net income and hence companies pay less in income taxes
Upon delivery (e.g., FOB destination) Most common point of recognition for sales to individuals
FOB destination: legal title transfers upon arrival
Examples of Fixed Assets
Facilities Manufacturing and assembly facilities Warehouses and distribution centers Sales offices and administrative offices Engineering centers Land on which the above-listed facilities are situated The equipment contained in any of the above facilities Manufacturing equipment, delivery trucks, shelving, desks, computers, etc. Software developed for internal use
Companies can choose from several different cost flow assumptions. These include:
First-In, First-Out (FIFO) Last-In, First-Out (LIFO) Average Cost Note: these are cost flow assumptions and can be different from the actual physical flow of inventory
Definition of Fixed Assets
Fixed assets are long term tangible assets that are used by a company to produce income Also known as property, plant, and equipment (PP&E) Includes software developed for internal use
Income statement: depreciation
Income statement: depreciation allocates the net cost of the asset (i.e., initial cost less salvage value) into income over its useful life For example, if an asset will generate revenues over 20 years, the net cost of that asset will be recorded as an expense over those 20 years aligning the costs and revenues of the investment in the income statement
when prices are decreasing
LIFO now leads to higher income and higher ending inventory balances
Ordinary repairs and maintenance are expensed when
Ordinary repairs and maintenance are expensed when incurred
The initial cost of a fixed asset is adjusted over time for
subsequent expenditures depreciation (except for land) impairments
This allocation of net cost ensures
that net income captures the company's return on investment in fixed assets
impairment A fixed asset can be reduced on the balance sheet if the value of the asset has decreased below what is reported
value of the asset has decreased below what is reported on the balance sheet as a future economic benefit
Fixed assets are recognized when the company controls
when the company controls the asset Review: indicators of control are physical possession, legal title, risk of loss, and an obligation to pay Fixed assets include both assets owned by the company and assets that are controlled and used by the company through a long-term lease
The accounting for inventory recognizes the expense
when the inventory is sold, not when it is purchased or paid for.
Before delivery (e.g., bill & hold sale, FOB shipping point)
◼ Bill & hold sale: legal title transfers prior to shipment ◼ FOB shipping point: legal title transfers upon shipment
Examples of Inventory
◼ Ford's inventory: ❑ Raw materials ◼ Metal, glass, tires, batteries, wires, hinges, cameras, radios, seat cushions, lights, etc. ❑ Work in process ◼ Partially completed cars still on the assembly line at the end of the quarter/year ❑ Finished goods ◼ Completed cars ready to be sold
Analysis of Inventory
◼ Inventory Turnover Ratio ❑ Cost of Goods Sold / Average Inventory ◼ Days Inventory Outstanding (DIO) ❑ 365 × Average Inventory / Cost of Goods Sold ◼ High levels of inventory or DIO could indicate: ❑ Buildup of inventory due to sales being less than expected ❑ Risk of having excess inventory than won't be sold ◼ Low levels of inventory or DIO could indicate: ❑ Risk of stockouts—not having enough inventory on hand to fulfill orders
On Nov. 20, 2020, Malone's Cones purchased a shipment of goods from its supplier. The goods were sold on Jan. 28, 2021. The costs associated with this order are as follows: ◼ What Inventory amount will Malone report on its Dec. 31 balance sheet? What will Malone's Cost of Goods Sold be on Jan. 28? 11/20 Cost of items purchased $ 4,500 11/20 Cost of shipping $ 250 12/2 Cost of labor to unload shipment $ 60 12/2-12/31 Cost of rent and utilities for inventory storage $ 40 1/1 Cost of labor to move inventory from storage to store shelves $ 80 1/28 Cost of labor for store cashier $ 100
❑ Ending Inventory and COGS will both be $4,810 ◼ $4,810 = $4,500 purchase price + $250 shipping + $60 unloading ❑ Once the goods "arrive", subsequent costs are usually not capitalized into inventory; they are included with SG&A expenses on the income statement ◼ The rules are not specific, so actual practices vary across companies
Inventories are:
❑ assets held for sale in the ordinary course of business, or ❑ goods to be used in the production of assets held for sale
Required inventory disclosures include:
❑ the composition of inventory (e.g., raw materials, work in process, and finished goods, if applicable) ❑ the inventory cost flow assumption used (e.g., FIFO) ❑ significant estimates used (e.g., impairment test estimates) ❑ significant impairment losses ❑ changes in the method of accounting for inventory ❑ financing arrangements that use inventory as collateral
Inventory's net book value (NBV) and current value are used to
determine whether it is impaired
Inventory is checked for impairment________________ ❑ Impairment: significant decline in the value of an asset
every quarter
Depreciation expense, impairment losses, and gains/losses from the sale of fixed assets are included in operating income
in operating income
Impairment losses must be included
in operating income ❑ They are usually included within Cost of Goods Sold ❑ However, large or unusual losses should be either reported separately on the income statement or disclosed in the notes to the financial statements
Fixed assets are checked for impairment when
indications suggest an impairment might have occurred
Fixed assets (other than land) are depreciated from
initial cost down to salvage value in a "systematic and rational manner" over their useful life
NBV:
initial cost of the inventory less prior impairments, if any ◼ That is, the amount at which inventory is reported on the balance sheet
Depreciating assets are presented
Depreciating assets are presented as noncurrent assets in the balance sheet, net of accumulated depreciation (i.e., NBV)
First-In, First-Out (FIFO)
Assume the earliest purchased inventory is the first sold
Last-In, First-Out (LIFO)
Assume the most recently purchased inventory is the first sold Note: the rules are different for companies using LIFO
Timing of transfer of control:
Before delivery (e.g., bill & hold sale, FOB shipping point) Upon delivery (e.g., FOB destination)***most common for individuals After delivery (e.g., consignment)
High levels of inventory or DIO could indicate:
Buildup of inventory due to sales being less than expected Risk of having excess inventory than won't be sold
The cost of inventory purchased is recognized as an expense on the income statement when the inventory is sold, not when it is purchased
By recognizing the expense at the time of sale alongside the revenue from the sale, the income statement captures the company's gross profit margin Cost flow assumptions are used to determine the cost of an item sold when its specific cost is not tracked
When an item of inventory is sold, the cost of that item is removed from the
Inventory balance and included in Cost of Goods Sold on the income statement ❑ The cost of inventory is expensed on the income statement at the time of sale; not at the time of purchase Because it is not always practical or meaningful to track the cost of individual inventory items, companies must assume the cost of sold items if they are not tracked individually
De-Recognition from the Financial Statements
Inventory is removed (i.e., de-recognized) from the balance sheet when it is sold, or when it is lost, damaged, or obsolete ❑ That is, when (a) the company no longer controls the inventory or (b) the inventory no longer has value
Inventory is initially recognized at "cost"
Inventory purchased from a wholesaler or Inventory manufactured by the company
Raw materials
Metal, glass, tires, batteries, wires, hinges, cameras, radios, seat cushions, lights, etc.
Work in process
Partially completed cars still on the assembly line at the end of the quarter/year
The gain or loss = Sale Proceeds NBV
Proceeds usually equals the cash (or other assets) received NBV = original cost accumulated depreciation
Durrr Burger purchased inventory in Q1 for $2,000, which it expects to sell for $2,400. Durrr expected to sell the inventory for $2,400 at the end of Q1, $2,500 at the end of Q2, $2,100 at the end of Q3, and $1,800 at the end of Q4. What inventory cost should Durrr report on each of its quarterly balance sheets?
Q1: $2,000 (original cost, because current value > original cost) ◼ Q2: $2,000 (original cost, because current value > original cost) ◼ Q3: $2,000 (original cost, because current value > original cost) ◼ Q4: $1,800 (write down to current value)
Low levels of inventory or DIO could indicate:
Risk of stockouts—not having enough inventory on hand to fulfill orders
Salvage value (or residual value) is the expected selling
Salvage value (or residual value) is the expected selling price of the asset at the end of the useful life Salvage value is often assumed to be $0
Match Company purchased a truck on January 1, 2019, for $30,000. The truck had an estimated life of 5 years and an estimated residual value of $5,000. Match Company uses the straight line method to depreciate the asset. On July 1, 2021, the truck was sold for $17,000 cash. Determine the gain or loss on the sale of the asset.
Step 1: Calculate accumulated depreciation till time of sale Annual depreciation: (30,000 5,000)/5 =$5,000 per year Depreciation in 2019: $5,000 Depreciation in 2020: $5,000 Depreciation in 2021: $5,000 x ½ = $2,500 Accumulated depreciation = $5,000 + $5,000 + $2,500 = $12,500 Step 2: Calculate Net Book Value (NBV) at time of sale NBV = original cost accumulated depreciation NBV = $30,000 --$12,500 = $17,500 Step 3: Calculate gain/loss at time of sale Gain/(Loss) = Sale proceeds NBV $17,000 --$17,500 = --$500, i.e., a loss
The company is free to choose how to depreciate the
The company is free to choose how to depreciate the asset over its useful life Common examples include straight line, activity based, and accelerated depreciation methods
Analysis of Fixed Assets
The fixed asset turnover ratio shows how efficiently a company uses its fixed assets to generate sales Fixed Asset Turnover ratio = sales / average net fixed assets Ford: 156,776 / [(36,178 + 36,469) / 2] = 4.32 Ford generates $4.32/year in sales for every $1.00 invested in net fixed assets
A fixed asset is removed from the balance sheet when it
is sold, or when it is disposed of (if it no longer has value) When the asset is removed, the company recognizes a gain or loss if there is a difference between the sale price (or $0 in the case of disposal) and the amount the asset was last reported on the balance sheet (more on this
Inventory is reduced (or impaired) when the company expects
it will not recover its initial cost when the inventory is sold
If current value > NBV
leave inventory value as is ❑ Companies are not allowed to increase their inventory value
When the asset is sold, the company recognizes a gain or loss
loss if there is a difference between the sale price and the asset's net book value.
High levels of inventory could indicate
lower-than-expected sales or risk the inventory will not be sold
If current value < NBV
reduce to current value ❑ The reduction of an asset's reported amount to current value is referred to as an impairment or a write-down ❑ Impairment is reported as a loss on the income statement ◼ The loss is typically included in Cost of Goods Sold
It is a loss on sale if
sales price < NBV
It is a gain on sale if
sales price > NBV
Balance sheet: through depreciation, the balance sheet
the balance sheet captures the decline in the net book value (NBV) of the asset over time
Inventory is recognized when
the company controls the item ❑ Review: indicators of control are physical possession, legal title, risk of loss, and an obligation to pay
The cost of improvements or additions that increase the value of the asset (i.e., the benefits it provides
the value of the asset (i.e., the benefits it provides beyond those originally anticipated) should be capitalized (i.e., included in the asset's For example, expenditures that increase the asset's useful life, its operating efficiency, or the quality of the goods it produces or services it provides
The asset's net book value (NBV) and estimated future net cash flows (FCF) are used
to determine whether the asset is impaired If FCF > NBV , leave asset value as is If FCF < NBV , reduce to current value