Business & Finance Case Study: IFRS Adoption in the U.S. Assignment

Read: Revsine: Chapters 9, 11
Read: Chapter 9 – Receivables
Read: Chapter 11 – Long-Lived Assets
Watch: Module 4 Presentation https://canvas.liberty.edu/courses/950718/pages/watch-module-4-presentation?module_item_id=90922760

Case Study: IFRS Adoption in the U.S. Assignment

Receivables

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 9

Learning Objectives 1 After studying this chapter, you will understand:

How to account for accounts receivable using net realizable value.

How to analyze accounts receivable under net realizable value accounting.

How to evaluate whether or not reported receivables arose from real sales and how to spot danger signals.

How to impute and record interest when notes receivable have either no explicit interest or an unrealistically low interest rate.

How to account for accounts and notes receivable using the fair value option.

How companies use receivables to accelerate cash inflows and how the accounting treatment affects financial statement ratios.

Why receivables are securitized and how the accounting treatment affects financial statement ratios.

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Learning Objectives 2 After studying this chapter, you will understand:

Why receivables are restructured when a customer experiences financial difficulty and how to account for the troubled-debt restructuring.

The key differences between current G A A P and I F R S requirements for receivable accounting.

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Assessing the Net Realizable Value of Accounts Receivable

Accounts receivable are generally reflected in the balance sheet at net realizable value.

Two things must be estimated to determine the net realizable value of receivables:

Credit losses—the amount that will not be collected because customers are unable to pay.

Returns and allowances—the amount that will not be collected because customers return the merchandise for credit or are allowed a reduction in the amount owed.

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Accounting for Credit Losses 1

Most companies establish credit policies by weighing the expected cost of credit sales against the benefit of increased sales.

Expected cost:

Customer collection and billing costs plus potential bad debts.

This tradeoff illustrates that bad debts are often unavoidable.

Accrual accounting requires that some estimate of uncollectible accounts be offset against current period sales.

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Treatment of Bad Debt Losses

Traditionally, firms referred to losses from uncollectible accounts as bad debt expense and treated them as operating expenses.

However, the final F A S B revenue recognition standard, effective for fiscal years beginning after December 15, 2017, requires that bad debt losses be treated as expenses and include them with other impairment losses.

The impairment losses must be disclosed separately if material.

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Recording and Reporting the Allowance for Credit Losses

Bristol Corporation estimates that bad debt losses arising from first quarter sales are expected to be $30,000.

D R Credit loss expense	$30,000
C R Allowance for credit losses		$30,000

A contra-asset account subtracted from gross accounts receivable.

If Bristol’s gross accounts receivable and allowance for credit losses before recording this entry were $1,500,000 and $15,000, respectively, then after the entry the balance sheet would show:

Accounts receivable (gross)	$1,500,000
Less: Allowance for credit losses	(45,000)
Accounts receivable (net)	$1,455,000

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Approaches to Estimating Uncollectible Accounts: Sales Revenue Approach

Bristol Corporation prepares quarterly financial statements and must estimate the bad debt provision at the end of each quarter. Analyzing past customer payment patterns, Bristol determined that bad debt losses average about 1% of sales. First quarter sales total $3,000,000.

Sales Revenue Approach

Estimate the current period bad debt provision as a percentage of current period sales. For Bristol Corporation, the estimate is:

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Approaches to Estimating Uncollectible Accounts: Gross Receivables Approach

Gross Receivables Approach

Estimate the required allowance account balance as a percentage of gross receivables and then adjust the allowance upward or downward to this figure. For Bristol Corporation, the required allowance account balance is:

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Writing Off Credit Losses

When a specific account receivable is known to be definitely uncollectible, the amount must be removed from the books.

Assume that Bristol later determines that a $750 receivable from Ralph Company cannot be collected.

D R Allowance for credit losses	$750
C R Accounts receivable – Ralph Company		$750

Notice that the entry has no effect on income.

The specific account receivable (Ralph Company) is eliminated from the books and the allowance contra-account is reduced, but no credit loss expense is recorded.

This is consistent with the accrual accounting philosophy of recording estimated uncollectibles when the sales is made rather than at a later date when the nonpayment is identified.

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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 1

No matter which method is used to estimate bad debts, management must periodically assess the reasonableness of the allowance for uncollectibles balance.

The F A S B approach uses a current expected credit loss (C E C L) model.

F A S B A S C Topic 326 does not require a specific method, but provides an aging of accounts receivable example.

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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 2

Exhibit 9.1 Bristol Corporation: Allowance for Credit Losses Based on Aging of Receivables

On December 31, 20X1, Bristol Corporation’s gross accounts receivable are $1,600,000, and the balance of the Allowance for uncollectibles is $39,000. Bristol’s normal sales terms require payment within 30 days after the sale is made and the goods are received by the buyer. Bristol determines that the receivables have the following age distribution:

	Current	31 to 90 days old	91 to 180 days old	Over 180 days old	Total
Amount	$1,450,000	$125,000	$15,000	$10,000	$1,600,000

Once the receivables have been grouped by age category, a separate estimate of credit losses by category is developed. Based on past experience, Bristol determines the following estimate of expected credit losses by category:

	Current	31 to 90 days old	91 to 180 days old	Over 180 days old
Historical % of credit losses	2.3%	5.5%	18.4%	36.8%

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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 3

Exhibit 9.1

Numerous government forecasts predict that economic growth will slow in 20X2. In addition, unemployment rates have increased. Consequently, Bristol estimates that the 20X2 credit loss rates will be approximately 8% higher. Consequently, it uses the following loss percentages to estimate its allowance at December 31, 20X1.

	Current	31 to 90 days old	91 to 180 days old	Over 180 days old
Forecasted % of credit losses	2.5%	6.0%	20.0%	40.0%

The required balance in the Allowance for credit losses account would then be as follows:

	Current	31 to 90 days old	91 to 180 days old	Over 180 days old	Total
Amount	$1,450,000	$125,000	$15,000	$10,000	$1,600,000
Estimated % of credit losses	2.5%	6%	20%	40%
= Allowance for credit losses	$ 36,250	$ 7,500	$ 3,000	$ 4,000	$ 50,750

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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 4

Exhibit 9.1

Because the balance of the Allowance for credit losses is only $39,000 on December 31, 20X1, the account must be increased by $11,750. This is the difference between the $50,750 required balance (as computed) and the existing $39,000 balance. To bring the balance up to the $50,750 figure indicated by the aging, Bristol makes the following adjusting entry:

D R Credit loss expense	$11,750
C R Allowance for credit losses		$11,750

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Analysis of Uncollectible Accounts Receivable 1

Exhibit 9.2 Mattel, Inc.: Analysis of Accounts Receivable Credit Losses

($ in millions)	Dec. 31, 2018	Dec. 31, 2017	Dec. 31, 2016
A. Select Reported Amounts
Revenues	$ 4,510.9	$ 4,882.0	$ 5,456.7
Pre-tax income	(419.3)	(505.0)	409.7
Ending gross accounts receivables	992.1	1,154.0	1,136.6
B. Change in Allowance for doubtful accounts
Balance at beginning of year	$ 25.4	$ 21.4	$ 24.4
Provision for doubtful accounts	40.9	17.6	9.2
Write-offs	(44.3)	(13.6)	(12.2)
Balance at end of year	$ 22.0	$ 25.4	$ 21.4
C. Analysis
Provision for doubtful accounts as a % of sales	0.91%	0.36%	0.17%
Provision for doubtful accounts as a % of ending gross receivables	4.12%	1.53%	0.81%
Provision for doubtful accounts as a % of ending allowance	185.91%	69.29%	42.99%
Allowance as a % of ending gross receivables	2.22%	2.20%	1.88%

Source: Mattel, Inc. Form 10-Ks.

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Analysis of Uncollectible Accounts Receivable 2

Sales declined over the three-year period.

The provision for doubtful accounts increased substantially over the three year period.

The percentage of, gross receivables, and ending allowance increased substantially over the period as Mattel’s collection experience worsened.

Firms must continually adjust their allowance account as collection experience changes.

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Estimating Sales Returns and Allowances

When goods are returned or a price allowance granted, the customer’s account receivable must be reduced and an income statement charge made.

Assume that Bristol agrees to reduce by $8,000 the price of goods that arrived damaged at Bath Company:

Companies must estimate the expected amount of future returns and allowances arising from receivables currently on the books at the end of each reporting period. If significant, an adjusting entry must be recorded.

D R Sales returns and allowances	$$$
C R Allowance for sales returns and allowances		$$$

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Analytical Insight: Do Existing Receivables Represent Real Sales?

Generally, the growth rates in sales and in accounts receivable should be roughly equal.

Receivables might grow faster than sales for the following reasons:

Deliberate change in (that is, loosening of) sales terms to attract new customers.

Deteriorating credit worthiness among existing customers.

Firm has changed its financial reporting procedures, which determine when sales are recognized (that is, accelerated revenue recognition.)

Large increases in accounts receivable relative to sales frequently represent a danger signal.

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Notes Receivable 1

When a note bears an interest rate that approximates prevailing borrowing and lending rates, the accounting is straightforward.

Michele Corporation sells a machine to Texas Products Company for $5 million. Michele accepts a three-year, $5 million interest-bearing note signed with 10% interest per annum to be paid in quarterly installments each year.

D R Note receivable—Texas Products Company	$5,000,000
C R Sales revenue		$5,000,000

Interest income accrues each quarter.

D R Accrued interest receivable	$125,000
C R Interest income		$125,000

To accrue three months’ interest = [$5,000,000 × 0.10]/4.

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Notes Receivable 2

Upon receipt of the cash payment, the accrued interest receivable is reduced.

D R Cash	$125,000
C R Accrued interest receivable		$125,000

To record receipt of the interest payment.

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Accounting for Credit Losses 2

Firms use the Current Expected Credit Loss (C E C L) model to assess the collectability of notes receivable and an appropriate allowance.

Methods may include a discounted cash flow method, a loss-rate method, or a probability-of-default method.

Significant credit quality information must be disclosed by type of receivable including:

Credit quality indicator.

Amortized cost for prior five years and in total.

How expected loss estimates are determined.

Changes in risk factors, policies, or methodologies.

Amount of significant sale of receivables.

Roll-forward of the allowance for credit losses.

Aging analysis of amortized cost by receivable type for past due receivables.

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Imputing Interest on Notes Receivable: Interest Rate not Stated 1

A complication arises for a note that does not state an interest rate.

Monson Corporation sells equipment it manufactured to Davenport Products in exchange for a $5 million non-interest-bearing note due in three years. The note bears no explicit interest. It says only that the entire $5 million is to be paid at the end of three years. Monson’s published cash selling price for the equipment is $3,756,600.

The difference between the $5 million note and the $3,756,600 cash price is the imputed interest.

The implied interest rate equates the present value of the $5 million payment to the cash price of $3,756,600.

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Imputing Interest on Notes Receivable: Interest Rate not Stated 2

Although the $5 million note itself does not contain any mention of interest, Monson will earn a return of 10% per year for financing Davenport’s long-term credit purchase.

Exhibit 9.3 Monson Corporation Effective Interest Table

	(a) Interest Income—10% of Column (d) Balance for Prior Year	(b) Cash Interest Received	(c) Increase in Present Value of Note: (a) Minus (b)	(d) End-of-Year Present Value of Note
1/1/20X1	—	—	—	$ 3,756,600
12/31/20X1	$ 375,660	$ 0	$ 375,660	4,132,260
12/31/20X2	413,226	0	413,226	4,545,486
12/31/20X3	454,514*	0	454,514	5,000,000
Total	$1,243,400

* Rounded.

Interest accumulates at 10% on the unpaid balance.

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Imputing Interest on Notes Receivable: Interest Rate not Stated 3

Monson Corporation records the sale and note receivable as:

D R Note receivable—Davenport	$3,756,600
C R Sales revenue		$3,756,600

Over the next three years, the note receivable is increased and interest income recognized.

At the end of Year 1, the entry is:

D R Note receivable—Davenport	$375,660
C R Interest income		$375,660

At the end of Year 3, Monson receives a $5 million payment, which consists of the cash sales price ($3,756,600) plus interest ($1,243,400 = $375,660 + $413,226 + $454,514).

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Imputing Interest on Notes Receivable: Interest Rate not Stated 4

D R Cash	$5,000,000
C R Note receivable—Davenport..		$5,000,000

This process of allocating the proceeds of the note between sales revenue and interest income is called imputed interest.

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Imputing Interest: Stated Rate Is Less than Prevailing Rate 1

Another complication arises when the stated interest rate is lower than prevailing rates for loans of similar risk.

Quinones Corp. sells a machine to Linda Manufacturing in exchange for a $4 million, three-year, 2.5% (Stated rate) note. At the time, the interest rate normally charged to companies with Linda’s credit rating is 10% (Prevailing rate).

The implied (cash) selling price of the machine is $3,253,966, as computed on the following slide’s exhibit.

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Imputing Interest: Stated Rate Is Less than Prevailing Rate 2

Exhibit 9.4 Quinones Corporation: Computation of Implied Sales Price for a Note with a Below-Market Interest Rate

Calculation of Present Value at 10% Effective Interest Rate

Present value of $4,000,000 principal repayment on 12/31/20X3 at 10%:

$4,000,000

0.75132

$3,005,280

Present value of three interest payments of $1,000,000 (that is, $4,000,000 × 0.025), each at 10%:

12/31/20X1	$ 100,000	×	0.90909	=	90,909
12/31/20X2	$ 100,000	×	0.82645	=	82,645
12/31/20X3	$ 100,000	×	0.75132	=	75,132
Implied sales price of machine					$3,253,966

Note: All present value factors are from the book’s Appendix A, Table 1, 10% column.

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Imputing Interest: Stated Rate is Less than Prevailing Rate 3

Exhibit 9.5 Quinones Corporation: Computation of Interest on Note Receivable

*Rounded	(a) Interest Income 10% of Column (d) Balance for Prior Year	(b) Cash Interest Received	(c) Increase in Present Value of Note (a) Minus (b)	(d) End-of-Year Present Value of Note
Inception	–	–	–	$3,253,966
Year 1	$ 325,397	$100,000	$225,397	3,479,363
Year 2	347,936	100,000	247,936	3,727,299
Year 3	372,701*	100,000	272,701	4,000,000
Total	$1,046,034

Notice that the present value of the note, and thus its carrying value increases each year.

Entry for Year 1 (similar entries are made in Years 2 and 3):

D R Note receivable—Linda Mfg.	$225,397
D R Cash	100,000
C R Interest income		$325,397

Entry when the note is paid at maturity:

D R Cash	$4,000,000
C R Note receivable—Linda Mfg.		$4,000,000

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The Fair Value Option

Although most firms record accounts and notes receivable at net realizable value, they have the option to record them at fair value.

Bristol Corporation reports a net realizable value of $1,455,000 (gross receivables of $1,500,000 – allowance for uncollectibles of $45,000).

There is an active market for these types of receivables; the price is 95% of face value, or $1,425,000.

To adjust the receivable’s carrying value to fair value, the difference between the fair value and the face amount of the receivable is recorded as an unrealized loss as follows:

D R Unrealized loss on receivables	$75,000
C R Fair value adjustment—Accounts receivable		$75,000

An asset valuation account that is adjusted upward or downward as the fair value changes.

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The Fair Value Option: Calculating Interest Income for Quinones 1

Quinones will continue to compute interest income using the original 10% rate. However, the balance sheet will reflect the fair value based on the 9% rate (shown in column e below).

Exhibit 9.6 Quinones Corporation: Note Receivable Recorded at Fair Value

	(a) Interest income	(b) Cash interest received	(c) Increase in present value of note	(d) Present value at 10%	(e) End of year fair value of note at 9%	(f) Fair value adjustment –Note receivable: (e) Minus (d)	(g) Unrealized gain (loss) on note receivable: (f) Minus prior (f)
Inception				$3,253,966
20X1	$ 325,397	$100,000	$225,397	3,479,363	$3,542,631*	$63,268†	$ 63,268
20X2	347,936	100,000	247,936	3,727,299	3,761,468	34,169	(29,099)
20X3	372,701	100,000	272,701	4,000,000	4,000,000	–	(34,169)
Total	$1,046,034						$ –

The fair value option changes the pattern of income recognition but not the total amount recognized.

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The Fair Value Option: Calculating Interest Income for Quinones 2

* Present value at market rate of 9%:

$4,000,000 × 0.84168 (pv 2, 9%)	=	$3,366,720
100,000 × 1.75911 (pvoa 2, 9%)	=	175,911
	=	$3,542,631

† Fair value of $3,542,631 minus $3,479,363 carrying value using 10%.

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The Fair Value Option: Calculating Interest Income for Quinones 3

At the end of Year 2, the fair value (column e) represents the present value of the interest payment and principal to be received in one year.

At the end of Year 3, the fair value equals the principal amount because no interest payments are remaining.

To reflect the Year 2 and Year 3 changes in the fair value, Quinones debits Unrealized gain (loss) on note receivable (column g) and credits Fair value adjustment—note receivable (column f).

The Year 2 and Year 3 losses offset the initial gain recognized in Year 1.

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Accelerating Cash Collections: Sale of Receivables and Collateralized Borrowings

Companies might want to accelerate cash collection for the following reasons:

Competitive conditions require credit sales but the company is unwilling to bear the cost of processing and collecting receivables.

There may be an imbalance between the credit terms of the company’s suppliers and the time required to collect customer receivables.

The company may have an immediate need for cash but be short of it.

There are two ways to accelerate cash collections:

Sale of receivables (factoring)

Collateralized borrowings

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Ambiguities Abound: Is It a Sale or a Borrowing?

Sometimes, it is not obvious whether the receivables have been sold or are instead being used as collateral for a loan. The ambiguity arises when certain obligations, duties, or rights regarding the transferred receivables are retained by the firm undertaking the transfer (the transferor).

Sale of Receivables:

Receivables removed from balance sheet.

Gain or loss recognized in earnings.

Collateralized Borrowing:

Receivables stay on balance sheet.

Loan shown as balance sheet liability.

No gain or loss recognized in earnings.

The F A S B has provided guidelines in the Accounting Standards Codification:

Assets are isolated and beyond reach of transferor’s creditors.

Transferee has right to pledge or exchange the assets.

Transferor has no obligation to repurchase or redeem assets in future.

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A Closer Look at Securitizations

Customers with “low” to “moderately high” risk take out 7% home mortgages with bank.

Bank forms a bundled portfolio of the 7% home mortgages; risk in the aggregate is “moderate.”

Investors are willing to buy the portfolio at a price that yields a 6% return.

A bank may reduce risk further by paying a guarantor to bear some of the default risk.

Because the selling price of the bundled portfolio is higher than the carrying value of the mortgages, the bank records a gain on the sale of receivables.

Both the investors and the bank benefit from the transaction.

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Securitization Entities

Figure 9.3 Structure of a Securitization

The transferor (for example, the bank) forms a securitization entity (S E) that is legally distinct from the transferor.

The transferor sells the receivables to the S E; receivables are beyond the reach of the transferor and its creditors.

The S E creates and issues debt securities.

The S E sells the securities to investors.

The S E remits the cash that it receives from the investors to the transferor.

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Financial Statement Effects of Securitizations 1

On December 31, 20X1, Doyle securitized $1,000,000 of mortgages using a securitization entity (S E). The cash received from the S E was exactly $1,000,000, so it recognized no gain or loss on the transaction. If the transaction meets the criteria for sale accounting, it will make the following entry:

D R Cash	$1,000,000
C R Mortgages receivable		$1,000,000

The effects of this entry on Doyle’s balance sheet are as follows:

	Balances Prior to Securitization	Change in Balances If Transaction Is Treated as a Sale	Balances after Securitization
Assets
Mortgages receivable	$ 2,200,000	$ (1,000,000)	$ 1,200,000
All other assets	800,000	1,000,000	1,800,000
Total assets	$ 3,000,000		$ 3,000,000
Liabilities and equity
Liabilities	$ 2,700,000		$ 2,700,000
Equity	300,000		300,000
Total liabilities and equity	$ 3,000,000		$ 3,000,000

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Financial Statement Effects of Securitizations 2

If the transaction does not meet the criteria for sale accounting, Doyle would treat the transaction as a collateralized borrowing and make the following entry:

D R Cash	$1,000,000
C R Loan Payable		$1,000,000

The effects of this entry on Doyle’s balance sheet are as follows:

	Balances Prior to Securitization	Change in Balances If Transaction Is Treated as a Sale	Balances after Securitization
Assets
Mortgages receivable	$ 2,200,000		$ 1,200,000
All other assets	800,000	$1,000,000	1,800,000
Total assets	$ 3,000,000		$ 4,000,000
Liabilities and equity
Liabilities	$ 2,700,000	$1,000,000	$ 3,700,000
Equity	300,000		300,000
Total liabilities and equity	$ 3,000,000		$ 4,000,000

Doyle’s net income for the year ended December 31, 20X1, is $40,000.

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Financial Statement Effects of Securitizations 3

Assuming that the net income of Doyle National Bank is $40,000 for the year, its return-on-assets ratio and debt-to-equity ratio would be computed as follows:

The left column reflects the ratio under sales treatment.

The right column shows the ratio balances that would have been reflected if the transaction had been treated as a borrowing with the mortgages serving as collateral.

Treating the transaction as a sale improves the return-on-assets ratio from 1% to 1.3%—a 30% increase.

Similarly, the sale treatment improves (reduces) the debt-to-equity ratio from 12.33 to 9—a 27% reduction.

If a gain had been recognized on the securitization, both ratios would have been improved even further.

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Troubled Debt Restructuring

When a customer is financially unable to make required interest and principal payments, rather than force the customer into bankruptcy, lenders frequently agree to restructure the loan receivable.

The restructured loan can differ from the original loan in several ways:

Scheduled interest and principal payments may be reduced or eliminated.

The repayment schedule may be extended over a longer time period.

The debtor and lender can settle the loan for cash, other assets, or equity interests.

Restructured loans benefit both the customer and the lender.

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Definition of Troubled Debt Restructuring

A restructuring of debt constitutes a troubled debt restructuring … if the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.

In other words, for the restructuring to be troubled, the borrower must be unable to pay off the original debt and the lender must grant a concession to the borrower.

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Criteria for Troubled Debt Restructuring

F A S B A S C 310-40-15-13 states that a creditor (lender) has granted a concession when it no longer expects to collect everything owed, including interest.

The creditor would consider collateral in determining the amount expected to be collected.

When assessing whether the debtor (borrower) is experiencing financial difficulties, the creditor should consider all of the following indicators:

The debtor is currently in default on any of its debt or default is probable.

The debtor is in the process of declaring bankruptcy.

The debtor is unlikely to remain a going concern.

The debtor has securities that are being delisted from an exchange.

The creditor forecasts that the debtor’s cash flows are insufficient to pay interest and principal on its debt.

Without the current modification, the debtor cannot obtain funds at nontroubled rates.

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Accomplishing a Troubled Debt Restructuring

Troubled debt restructurings can be accomplished in two different ways:

Settlement, which cancels the original loan by a transfer of cash, other assets, or equity interests (borrower’s stock) to the lender.

Continuation with modification of debt term by canceling the original loan and signing a new loan agreement.

Some troubled debt restructurings contain elements of both settlement and modification.

The accounting issues related to troubled debt restructuring encompass both the measurement of the new (modified) loan and the recognition of any gain or loss.

Example

Harper Companies purchased $75,000 of corn milling equipment from Farmers State Cooperative on January 1, 20X1. Harper paid $25,000 cash and signed a five-year, 10% installment note for the remaining $50,000 of the purchase price. The note calls for annual payments of $10,000 plus interest on December 31 of each year. Harper made the first two installment payments on time but was unable to make the third annual payment on December 31, 20X3. After much negotiation, Farmers State agreed to restructure the note receivable. At that time, Harper owed $30,000 in unpaid principal plus $3,000 in accrued interest. The restructuring was agreed to on January 1, 20X4, and both companies have recorded interest up to that date.

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Settlement: Entries Recorded by the Borrower 1

Suppose Farmers State agrees to cancel the loan if Harper pays $5,000 cash and turns over the company car. The car has a current fair value of $18,000 and is carried on Harper’s books at $16,000.

Harper Companies (Borrower)

D R Automobile	$ 2,000
C R Gain on disposal of asset		$ 2,000

To increase the net carrying amount of the automobile ($16,000) to its fair value ($18,000).

D R Note payable	$30,000
D R Interest payable	3,000
D R Accumulated depreciation	5,000
C R Cash		$5,000
C R Automobile		23,000
C R Gain on debt restructuring		10,000

To record the settlement.

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Settlement: Entries Recorded by the Borrower 2

Does Harper benefit from the restructuring?

Yes ~ The combined economic value of the cash ($5,000) and automobile ($18,000) is $23,000—or $10,000 less than the $33,000 Harper owes Farmers State.

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Settlement: Entries Recorded by the Lender

Recall that Farmers State agrees to cancel the loan if Harper pays $5,000 cash and turns over the company car.

Farmers State Cooperative (Lender)

D R Cash	$ 5,000
D R Automobile	18,000
D R Loss on receivable restructuring	10,000
C R Note receivable		$30,000
C R Interest receivable		3,000

To record the settlement.

Included in income from continuing operations (not extraordinary)

Does Farmers State benefit from the restructuring?

Most likely ~ Lenders often receive more through restructuring than they would from foreclosure or bankruptcy.

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Continuation with Modification of Debt Terms

Instead of reaching a negotiated settlement of the note receivable, Harper and Farmers State could have resolved the troubled debt by modifying the terms of the original loan.

The possibilities are endless.

For accounting purposes, what matters is whether the undiscounted sum of future cash flows under the restructured note is:

More than the note’s carrying value (including accrued interest) at the restructuring date.

Less than the note’s carrying value (including accrued interest) at the restructuring date.

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Summary of Accounting Procedures for Troubled Debt Restructurings

Exhibit 9.10 Summary of Accounting Procedures for Troubled Debt Restructurings

Restructured Loan Cash Flows Are

	Settlement Gain or Loss	Lower Than Current Carrying Value of Loan*	Higher Than Current Carrying Value of Loan*
Borrower
New loan payable	N A†	Total of restructured cash flows	Current book value
Gain on debt restructuring	Yes	Yes	None
Gain (loss) on transfer of assets	Yes	N A	N A
Future interest expense	N A	None, all payments applied to principal	Based on rate that equates current carrying value and restructured cash flows
Lender
New loan receivable	N A	Present value of new cash flows at original effective interest rate	Present value of new cash flows at original effective interest rate
Loss on debt restructuring	Yes	Yes	Yes
Future interest income	N A	Based on original loan rate	Based on original loan rate

* Includes unpaid accrued interest.

† N A means “not applicable.”

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Global Vantage Point: Credit Losses 1

The general accounting for accounts and notes receivable under I F R S is similar to the accounting under U.S. G A A P.

The accounting is called amortized cost, which refers to the gross amount of the receivable.

An allowance is still established for credit losses and returns.

Both I F R S and U.S. G A A P use a current expected credit loss model (C E C L) but the approaches are different.

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Global Vantage Point: Credit Losses 2

The I A S B modified I F R S 9 effective for fiscal years beginning after January 1, 2018.

The I A S B approach computes loss expected values by multiplying probabilities by potential cash shortfalls and summing the products.

The approach recognizes expected credit losses, but measures the losses according to how credit quality for a financial instrument has changed.

For receivables with only small declines in credit risk, the loss is based on expected cash shortfalls associated with a possible default within the 12 months after the balance sheet date.

For receivables that have had significant declines in credit quality, the loss is based on expected losses over the life of the loan.

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Global Vantage Point: Credit Losses 3

The F A S B provided its credit loss guidance in A S U 2016-13.

Public companies do not have to comply with guidance until they issue financial statements for fiscal years beginning after December 15, 2019.

The F A S B approach uses a current expected credit loss (C E C L) model. It is similar to the approach used under I F R S 9; however, the F A S B:

Has one model that computes expected losses over the life of the receivable for all financial assets measured at amortized cost.

Guidance differs for investments carried at amortized cost and those classified as available-for-sale securities.

Allows firms to use judgment in determining relevant information and estimation methods.

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Global Vantage Point: Fair Value Option, Sale of Receivables, and Debt Restructurings 1

Fair Value Option:

G A A P

Allows the fair value option for a broader set of transactions.

I F R S

Firms may elect the fair value option only in cases where it:

Eliminates an accounting mismatch or,

Because a group of assets are managed and evaluated using fair values.

Requires firms to disclose the fair value of short-term trade receivables and loans in addition to long-term notes receivables.

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Global Vantage Point: Fair Value Option, Sale of Receivables, and Debt Restructurings 2

Guidance regarding sales of receivables is similar to the post-2009 U.S. accounting guidance. Under prior guidance, Q S P Es were off-balance-sheet. Under both I F R S and U.S. guidance, most of these entities will not stay on the balance sheet.

I F R S for debt restructurings from the lender’s perspective are similar to U.S. G A A P. I F R S does not have explicit guidance from the borrowers perspective. The F A S B provides explicit guidance related to credit losses for troubled debt restructurings, but I F R S 9 does not address this specifically.

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Summary 1

G A A P requires that accounts receivable be shown at their net realizable value.

Companies use one of two methods to estimate credit losses: (1) the sales revenue approach or (2) the gross accounts receivables approach. In either case, firms must periodically assess the reasonableness of the uncollectibles balance using a method consistent with the Current Expected Credit Loss (C E C L) model, which utilizes both historical collection experience and expectations about the future.

Analysts should scrutinize the allowance for uncollectibles balance over time. Significant increases in the allowance could indicate collection problems, while significant decreases in the allowance could be a sign of earnings management.

Receivables growth can exceed sales growth for several reasons, including a change in customer mix or credit terms. But a disparity in the growth rate of receivables and sales could also indicate that aggressive revenue recognition practices are being used.

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Summary 2

In certain long-term credit sales transactions, interest must be imputed by determining the note receivable’s present value.

Firms may elect the fair value option for accounts and notes receivable. Changes in fair value are recognized in net income.

Firms sometimes transfer or dispose of receivables before their due date to accelerate cash collection. Sales of receivables—also called factoring—can be with or without recourse.

Receivables are also used as collateral for a loan.

In analyzing receivables transactions, it is sometimes not obvious whether the transaction to accelerate cash collection represents a sale or a borrowing; however, authoritative accounting literature provides guidelines in Topic 860 Transfers and Servicing of the F A S B Accounting Standards Codification for distinguishing between sales (when the transferor surrenders control over the receivables) and borrowings (when control is not surrendered). Sales of receivables change ratios such as receivables turnover as well as potentially masking the underlying real growth in receivables.

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Summary 3

Subprime loans and securitizations were at the heart of the 2008 economic crisis. Accounting and regulatory reforms are under way to address some of the problems identified during the crisis.

Banks and other holders of receivables frequently restructure the terms of the receivable when a customer is unable to make required payments because of financial difficulties.

These troubled debt restructurings can take one of two forms: (1) settlement or (2) continuation with modification of debt terms.

When terms are modified, the precise accounting treatment depends on whether the sum of future cash flows under the restructured note is more or less than the note’s carrying value at the restructuring date. The interest rate used in troubled debt restructurings may not reflect the real economic loss suffered by the lender.

Both the F A S B and I A S B have finalized most of their rules on financial instrument reporting. There are significant differences in the requirements related to estimating credit losses.

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Accessibility Content: Text Alternatives for Images

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Approaches to Estimating Uncollectible Accounts: Gross Receivables Approach – Text Alternative 1

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The 0.03 is circled with the callout reading Management believes that 3% of existing gross receivables will ultimately be uncollectible. And the credited $30,000 has a callout that reads Notice this second step.

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Approaches to Estimating Uncollectible Accounts: Gross Receivables Approach – Text Alternative 2

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"Backing into” the $30,000 with the use of a T-account is shown as follows. All three entries are on the right side of the T account. First is a current balance of $15,000, followed by a required adjustment of 30,000, which computes to a new balance of $45,000.

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Analytical Insight: Do Existing Receivables Represent Real Sales? – Text Alternative

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Assume that before introducing more lenient credit terms, Hmong Company had annual sales of $12 million and customers, on average, paid within 30 days. Outstanding accounts receivable, therefore, represent one month's sales, or $1 million. Under the new credit program, customer receivables would represent four months' sales, or $4 million; this represents a 300% increase in receivables even if total sales remain unchanged.

The line graph shows two lines: Sales, steadily increasing, and then Receivables, also steadily increasing as Sales but then increasing more rapidly at midway point indicating faster growth

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Accelerating Cash Collections: Sale of Receivables and Collateralized Borrowings – Text Alternative

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Sales of receivables (factoring) is comprised of three parties: Company, Credit customer of company, and Bank or other financial institution. 1. Company makes sale to customer on credit.

Interaction: Company to Credit customer

2. Company sells customer receivable to factor for cash.

Interaction: Company to Bank

3. Customer payment sent to factor.

Interaction Credit customer to Bank

4. If sold “with recourse,” company buys back uncollectible accounts.

Interaction: Bank to Company

The process of collateralized borrowings is comprised of three parties: Company, Credit customer of company, and Bank or other financial institution.

1. Company makes sale to customer on credit.

Interaction: Company to Credit customer

2. Company borrows cash from lender using receivables as security. Interaction: Bank to Company

3. Customer payment sent to company. Interaction Credit customer to Company

4. Company’s loan payment sent to lender. Interaction: Company to Bank

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A Closer Look at Securitizations – Text Alternative

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Bank has an arrow leading to Investors which reads Receivables transferred in exchange for cash. Customers has an arrow pointing up to Bank that reads Home mortgage receivables.

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Securitization Entities – Text Alternative

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The diagram contains five entities:

Securitization entity (S E) is formed to facilitate the securitization.

Transferor (the firm undertaking the securitization).

Investors.

Guarantor.

Credit-rating agency.

The steps in a securitization proceed as follows:

Mortgage receivables are transferred to the S E (Interaction: from transferor to S E).

SE obtains default guarantees from a third party (Interactions: SE pays fees to Guarantor; Guarantor provides guarantee to S E).

SE obtains a rating for new securities (Interactions: S E pays fees to Credit-rating agency; Credit-rating agency provides rating to S E).

Mortgage receivables are collateral for newly created debt securities sold to investors (Interaction: S E sells to investors).

Cash from sale of debt securities is received by the SE (Interaction: from Investor to S E).

Proceeds from the sale of debt securities is remitted to the transferor (Interaction: from SE to transferor).

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Long-Lived Assets

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 11

Learning Objectives 1 After studying this chapter, you will understand:

Why depreciated historical cost is used to measure long-lived assets.

What specific costs can be capitalized and how joint costs are allocated.

How generally accepted accounting principles (G A A P) measurement rules can complicate both trend analysis and cross-company analysis.

Why balance sheet carrying amounts for internally developed intangibles differ from their real values.

How to address long-lived asset impairments.

How to account for asset retirement obligations and assets held for sale.

How different depreciation methods are computed.

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Learning Objectives 2 After studying this chapter, you will understand:

How analysts can adjust for different depreciation assumptions.

How to account for exchanges of long-lived assets.

The key differences between G A A P and I F R S requirements for long-lived asset accounting.

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Long-Lived Assets 1

Operating assets expected to yield their economic benefits (or service potential) over a period longer than one year are called long-lived assets.

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Long-Lived Assets 2

EXHIBIT 11.1 Exxon Mobil: Partial Consolidated Statement of Financial Position—December 31, 2017

($ in millions)		Percentage
Assets
Cash and cash equivalents	$ 3,177
Notes and accounts receivable, less estimated doubtful accounts	25,597
Inventories
Crude oil, products and merchandise	12,871
Materials and supplies	4,121
Other current assets	1,368
Total current assets	47,134	13.5%
Investments, advances and long-term receivables	39,160	11.2
Property, plant, and equipment, at cost, less accumulated depreciation and depletion	252,630	72.5
Other assets, including intangibles, net	9,767	2.8
Total assets	$348,691	100.0%

Long-lived assets comprise 72.5% of ExxonMobil’s total assets.

Source: Exxon Mobil Corporation 2017 financial statements and supplemental information.

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Measurement of the Carrying Amount of Long-Lived Assets

There are two ways that long-lived assets could be measured on balance sheets:

Expected Benefit Approach

$$	Discounted present value. Net realizable value.

Estimated value in an output market where the asset is sold

Economic Sacrifice Approach

$$	Historical cost. Replacement cost.

Estimated value in an input market where the asset is purchased

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The Approach Used by G A A P 1

Assume a truck originally costing $100,000, is two years old, has a remaining life of 8 years, is being depreciated on a straight-line basis, and is expected to have no salvage value.

The hypothetical range of long-lived asset carrying amounts as measured under each approach—expected benefit versus economic sacrifice—is shown in 11.3.

U.S. G A A P uses historical cost—an economic sacrifice approach—to measure long-lived assets in most circumstances.

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The Approach Used by G A A P 2

EXHIBIT 11.3 Hypothetical Long-Lived Asset Carrying Amounts (10-year life, 8 years remaining)

Expected Benefit Approach Examples

Discounted present value:

Expected net operating cash inflows = $16,275 per year (assumed) for eight remaining

years, discounted at a 10% (assumed) rate

Net realizable value:

Current resale price from an over-the-road equipment listing (Purple Book) for the specific vehicle model

$85,000 (assumed)

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The Approach Used by G A A P 3

Economic Sacrifice Approach Examples

Replacement cost:

Replacement cost of a two-year-old vehicle in equivalent condition

Historical cost less accumulated depreciation:

* Discount factor for an ordinary annuity for eight years at 10%. See “Present Value of an Ordinary Annuity of $1” table in end-of-book appendix.

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Long-Lived Asset Measurement Rules

The initial balance sheet carrying amount of a long-lived asset is governed by two rules:

All costs necessary to acquire the asset and make it ready for use are included in the asset account; that is, they are capitalized costs. (Expenditures excluded from asset categories are “expensed” to income.)

Capitalized

$$	Price paid for land
$$	Cost of clearing land

Expensed

$$	Monthly equipment rental
$$	Cost to repair damaged equipment

Joint costs incurred in acquiring more than one asset are apportioned among the acquired assets on a relative fair value basis or some other rational basis.

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Long-Lived Asset Measurement Rules Illustrated 1

Background information:

Canyon Corporation acquired a tract of land on 6/1/X1, by paying $6,000,000 and by assuming an existing mortgage of $1,000,000 on the land.

Canyon demolished an empty structure on the property at a cost of $650,000.

Bricks and other materials from the demolished building were sold for $10,000.

Regrading and clearing the land cost $35,000.

Architectural fees were $800,000, and the payments to contractors for building a new factory on the site totaled $12,000,000.

Canyon negotiated a bank loan for the construction. Interest payments over the construction period totaled $715,000.

Legal fees incurred in the transaction totaled $57,000:

$17,000 was attributable to both examination of title and legal issues linked to the assumption of the existing mortgage.

The remaining $40,000 of legal fees related to contracts with the architect and the construction companies.

The construction project was completed on 12/31/X1.

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Long-Lived Asset Measurement Rules Illustrated 2

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Computing Avoidable Interest

G A A P requires capitalizing what are called avoidable interest payments on self-constructed assets; this interest is defined as that “could have been avoided . . . if expenditures for the assets had not been made.”

Avoidable interest = Cumulative weighted average expenditures on the constructed asset x I interest rate

Canyon’s calculation of avoidable interest:

Date and Amount			Portion of Year		Cumulative Weighted Average Expenditures
June 1	$10,000,000	×	58.630%*	—	$5,863,000
August 22	3,558,788	×	36.164%†	—	1,287,000
					$7,150,000

Construction expenditures

Avoidable interest = $7,150,000 × 10% = 715,000

DR Construction in progress	$715,000
CR Interest expense		$715,000

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Limits on the Amount of Interest Capitalized

G A A P limits the amount of interest that can be capitalized to the lower of (1) interest actually incurred or (2) avoidable interest.

Case 1:

Case 2:

Actual interest is less in this case

Therefore only $600,000 would be capitalized

Capitalization is restricted to interest arising from actual borrowings from outsiders.

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Tax Versus Financial Reporting Incentives

How costs are allocated between land and building affects the amount of income that will be reported in future periods.

Allocation 1:

Higher depreciation

Lower net income

Lower taxes

Allocation 2:

Lower depreciation

Higher net income

Higher taxes

For tax purposes, the incentives for allocating costs between land and building asset categories are completely different because the objective of most firms is to minimize tax payments, not to “correctly” allocate costs.

The higher the costs allocated to land for tax purposes, the higher the future taxable income becomes because land cannot be depreciated.

However, U.S. income tax rules generally parallel financial reporting rules and require cost allocations between land and buildings that are similar to U.S. G A A P rules. The same is true for interest capitalization.

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Capitalization Criteria—An Extension

G A A P capitalizes expenditures that increase an assets usefulness—that is, increases the carrying amount of a long-lived asset—when the expenditure causes any of the following conditions:

The useful life of the asset is extended.

The capacity of the asset is increased.

The efficiency of the asset is increased.

There is any other type of increase in the economic benefits (or future service potential) of the asset that results as a consequence of the expenditure.

When the expenditure does not meet any of these conditions, it must be treated as a period expense and be charged to income.

Routine equipment maintenance is one example.

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Capitalization criteria: Costs incurred after initial use 1

EXHIBIT 11.6 Winger Enterprises: Determination of Capitalized Costs

On January 1, 20X1, Winger Enterprises purchased a machine that will be used in operations. Its cash purchase price was $80,000. The freight cost to transport the machine to Winger's factory was $1,200. During the month of January 20X1, Winger's employees spent considerable time calibrating the machine and making adjustments and test runs to get it ready for use. Costs incurred in doing this were:

Allocated portion of production manager's salary for coordinating machine adjustments	$2,200
Hourly wages of production workers engaged in test runs of the machine	3,600
Cost of raw materials that were used in test runs (the output was not salable)	1,500

Given these facts, on January 1, 20X1, the capitalized amount of the machine would be the total of the shaded costs ($80,000 + $1,200 + $2,200 + $3,600 + $1,500 = $88,500).

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Capitalization criteria: Costs incurred after initial use 2

Suppose that in January 20X4, Winger spends an additional $8,000.

$6,000 for the installation of a new component that allowed the machine to consume less raw material and operate more efficiently

Capitalized in 20X4 and added to the carrying amount of the machine

$2,000 for ordinary repairs and maintenance

Treated as a period expense

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Deferred Costs

Incremental costs related to the successful negotiation of a contract (such as sales commissions) should be capitalized.

The asset is then systematically amortized over the life of the contract, including expected renewals.

To be capitalized, the costs must meet all of the following criteria:

Relate to a specific contract.

Generate or enhance resources that will be used to satisfy performance obligations in the future.

Expected to be recovered.

Expenses that would have been incurred without the contract signing are expensed immediately.

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Intangible Assets

Intangible assets are long-lived assets that do not have physical substance.

The category includes the following types of assets.

Patents.

Copyrights.

Trademarks.

Brand names.

Customer lists.

Licenses.

Technology.

Franchises.

Employment contracts.

The accounting for acquired intangible assets is straight-forward:

The acquired intangible asset is first recorded at the arm’s length transaction price.

Most acquired intangible assets are amortized (depreciated) on a straight-line basis over their expected useful economic lives and reviewed for impairment.

Some intangible assets, known as indefinite-lived intangible assets, have indefinite lives and are not amortized. Instead, they are evaluated annually for impairment.

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Research and Development (R&D)

Difficult financial reporting issues exist when the intangible asset is developed internally instead of being purchased from another company.

These difficulties arise because it is uncertain whether current expenditures will ultimately lead to valuable patents or trademarks.

The recoverability of research and development (R&D) expenditures is highly uncertain at the start of a project.

Consequently, the G A A P requires that virtually all R&D expenditures be charged to expense immediately.

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Computer Software Products

Prior to establishing the technological feasibility of a computer software product, companies are required to expense all R&D costs incurred to develop it.

After technological feasibility is established, additional costs incurred to ready the product for general release to customers are supposed to be capitalized.

The capitalization of additional costs ceases when the final product is available for sale.

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Asset Impairment: Tangible and Amortizable Intangible Assets

Figure 11.1

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Asset Impairment Illustration 1

Solomon Corporation manufactures a variety of computer products. The growing popularity of tablets is expected to reduce the demand for Solomon’s notebook computers. The notebook computers are produced on an assembly line consisting of five special purpose assets with a carrying amount (cost of $5,300,000 less accumulated depreciation of $3,300,000) of $2,000,000.

Solomon’s management believes that this change in the business climate threatens the recoverability of these assets’ carrying amount; accordingly, their answer to the question in Stage A is yes.

Consequently, to apply Stage B, they prepare the following estimate of future undiscounted cash flows over the expected 3-year remaining life of the notebook computer assembly line:

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Asset Impairment Illustration 2

Impairment possible?

Yes

Undiscounted net

cash flows expected

$1,500,000

Are cash flows lower

than carrying amount?

Yes ($1,500,000 > $2,000,000)

Impairment loss

$2,000,000 – $750,000 = $1,250,000

Net operating cash flows
20X1	$ 800,000
20X2	400,000
20X3	200,000
Expected salvage value	100,000
Total undiscounted cash flows	$1,500,000

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Asset Impairment Illustration 3

To record the loss, Solomon would make the following entry:

DR Impairment loss	$1,250,000
CR Equipment		$1,250,000

The impairment loss decreases both assets and net income.

Though it does not affect current cash from operations, the loss has negative implications for future revenue and cash flow.

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Indefinite-Lived Intangible Assets

Indefinite-lived intangible assets must be evaluated for impairment at least annually.

A two-step evaluation process is allowed by G A A P:

Firm first assesses qualitative factors to determine whether it is necessary to perform a quantitative impairment test.

If based on this qualitative evaluation, management believes that it is more likely than not that an indefinite-lived intangible asset has been impaired, then it must go to the second step.

Perform a quantitative assessment by calculating the fair value of the intangible asset.

If the book value of the asset exceeds the fair value, then the asset is considered impaired.

The firm then reduces the book value of the asset to its estimated fair value and records a loss.

The book value of the asset cannot be increased later if the fair value recovers.

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Management Judgments and Impairments

Impairment write-downs present managers another set of potential earnings management opportunities.

Auditors and other financial statement analysts should be alert to the potential use of write-offs opportunistically by managers.

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Obligations Arising From Retiring Long-Lived Assets 1

EXAMPLE

Kalai Oil Corporation constructs an oil drilling rig off the Texas coast, which is placed into service on January 1, 20X1. The rig cost $300 million to build. Texas law requires that the rig be removed at the end of its estimated useful life of five years. Kalai estimates that the cost of dismantling the rig will be $12 million and its credit-adjusted risk-free rate is 8%. The liability’s discounted present value is $8,167,000. Assume that Kalai has already capitalized the $300 million cost of the rig in the account Drilling rig.

Kalai records the asset retirement obligation (A R O) when the asset is placed into service:

DR Drilling rig (asset retirement cost)	$8,167,000
CR A R O liability		$8,167,000

This results in additional depreciation expense:

DR Depreciation expense	$1,633,400*
CR Accumulated depreciation—drilling rig		$1,633,400

*$8,167,000/5 yrs. = $1,633,400.

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Obligations Arising from Retiring Long-Lived Assets 2

The liability is initially recorded at its present value but increases over time as retirement nears.

	(a) Present Value of the Liability at Start of Year	(b) Accretion Expense [8% × Column (a) Amount]	(c) Present Value of the Liability at Year-End [Column (a) + Column (b)]
20X1	$8,167,000	$653,360	$8,820,360
20X2	8,820,360	705,629	9,525,989
20X3	9,525,989	762,079	10,288,068
20X4	10,288,068	823,045	11,111,113
20X5	11,111,113	888,887*	12,000,000

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Obligations Arising From Retiring Long-Lived Assets 3

The entry to record the increase in the liability in 20X1:

DR Accretion expense	$653,360
CR ARO liability		$653,360

Assume that an outside contractor dismantles the rig early in January 20X5 at a cost of $11,750,000.

DR ARO liability	$12,000,000
CR Cash		$11,750,000
CR Gain on settlement of ARO liability		250,000

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Assets Held for Sale

When firms actively try to sell assets they own, the asset groups should be classified on the balance sheet as “held for sale.”

When assets are held for sale, they are reported at the lower of book value or fair market value minus costs to sell.

So, these assets would be shown on the balance sheet at $2,304,000.

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Depreciation

The costs of productive assets must be apportioned to the periods in which they provide benefits.

In financial reporting, the cost to be allocated to periods is the asset’s original historical cost minus its expected salvage value.

Computing depreciation requires the reporting entity to estimate three things:

The expected useful life (in years or units) of the asset.

The depreciation pattern that will reflect the asset’s declining service potential.

The expected salvage value that will exist at the time the asset is retired.

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Depreciation: Straight-Line Depreciation Method

The straight-line (S L) depreciation method simply allocates cost minus salvage value evenly over the asset’s expected useful life.

EXHIBIT 11.10 Depreciation Example

Facts

Cost of the asset	$ 10,500
Expected salvage value	$ 500
Expected useful life	5 years
Expected units	20,000

Straight-Line Depreciation (S L)

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Depreciation: Units of Production Method 1

The units-of-production (U P) depreciation method allocates cost minus salvage over the expected units to be produced instead of the expected useful life.

EXHIBIT 11.10 Depreciation Example

Facts

Cost of the asset	$ 10,500
Expected salvage value	$ 500
Expected useful life	5 years
Expected units	20,000

Units-of-Production (U P)

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Depreciation: Units of Production Method 2

EXHIBIT 11.10 Depreciation Example

Year	Unit Rate ($10,500 − $500)/20,000	Units Produced (Assumed)	Depreciation
1	$0.50	4,200	$ 2,100
2	0.50	3,400	1,700
3	0.50	6,000	3,000
4	0.50	3,300	1,650
5	0.50	3,100	1,550
Total		20,000	$10,000

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Depreciation: Double-Declining Balance Method 1

The depreciation rate for the double-declining balance (D D B) method is double the straight-line rate. Applying a constant D D B depreciation percentage to a declining balance will produce a book value at the end of the asset’s economic life that is above or below the salvage value.

Apply twice the S L rate to the book value of the assets without subtracting the salvage value.

Once the D D B depreciation amount falls below what it would be with S L, a firm might use the straight-line method for the remaining years.

Double-Declining Balance Depreciation (D D B)

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Depreciation: Double-Declining Balance Method 2

Year	Beginning-of-Year Book Value	Depreciation (40% of Beginning-of-Year Book Value)	Year-End Book Value
1	$10,500.00	$4,200.00	$6,300.00
2	6,300.00	2,520.00	3,780.00
3	3,780.00	1,093.33*	2,686.67
4	2,686.67	1,093.33	1,593.34
5	1,593.34	1,093.34	500.00

* Year 3: Switch to straight-line method (as explained in the text).

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Depreciation: Sum=of-the-Years’ Digits Method 1

The sum-of-the-years’ digits (S Y D) method is another accelerated depreciation method. It depreciates an asset to precisely its salvage value.

Sum-of-the-Years’ Digits Depreciation (S Y D)

† The formula for determining the sum-of-the-years' digits is n(n + 1 )/2 where n equals the estimated life of the asset. In our example: 5(5 + 1)/2= 15. This, of course, is the answer we get by tediously summing the years‘ digits—that is, 5 + 4 + 3 + 2 + 1 = 15.

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Depreciation: Sum=of-the-Years’ Digits Method 2

Year	Depreciation Basis ($10,500 − $500)	Applicable Fraction	Depreciation
1	$10,000	5/15	$ 3,333.33
2	10,000	4/15	2,666.67
3	10,000	3/15	2,000.00
4	10,000	2/15	1,333.33
5	10,000	1/15	666.67
Total		15/15	$10,000.00

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Depreciation: Alternative Depreciation Methods

Figure 11.2 Alternative depreciation methods

Annual depreciation charges

Total depreciation expenses is the same under all methods

Net book value

Ending book values are the same under all methods

Access the text alternative for slide images.

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Disposition of Long-Lived Assets

When individual long-lived assets are disposed of before their useful lives are completed, any difference between the net book value of the asset and the disposition proceeds is treated as a gain or loss.

Assume the asset in Exhibit 11.10 is being depreciated using the D D B method and is sold at the end of Year 2 for $5,000 when its book value is $3,780.

The entry to record the disposition removes the asset and its accumulated deprecation from the books:

DR Cash	$5,000
DR Accumulated depreciation	6,720
CR Long-lived asset		$10,500
CR Gain on sale of asset		1,220

Gain (loss) = $5,000 − ($10,500 − $6,720) = $1,220

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Financial Analysis and Depreciation Differences

Most U.S. firms use straight-line depreciation for financial reporting purposes.

Nevertheless, making valid comparisons across firms is often hindered by other depreciation assumptions, especially differences in useful lives.

To improve comparisons of profitability of firms, an analyst could standardize the average useful life used to compute depreciation expense.

This adjustment process relies on several assumptions.

The useful life differences are artificial and do not reflect real differences in expected asset longevity.

The salvage value proportions are roughly equivalent for all firms in the industry

The dollar breakdown within the asset categories are similar across the firms being compared.

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Exchanges of Nonmonetary Assets 1

Sometimes firms exchange one nonmonetary asset like inventory or equipment for another nonmonetary asset.

Unless certain exceptions apply, the recorded cost of the acquired asset is the fair market value of the asset given up.

Rohan Department Store exchanges a delivery truck with a fair value of $70,000 for 10 checkout scanners from Electronic Giant Warehouse, Inc. The truck's book value is $60,000—original cost of $80,000 minus accumulated depreciation of $20,000. In addition to the truck, Rohan pays Electronic Giant $15,000.

DR Store equipment	$85,000
DR Accumulated depreciation—delivery truck	20,000
CR Delivery truck		$80,000
CR Cash		15,000
CR Gain on exchange		10,000

F M V of truck plus cash

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Exchanges of Nonmonetary Assets 2

Asset exchange rules were subject to manipulation. To prevent a repeat of these abuses, the F A S B issued rules that now require companies to record certain exchanges of nonmonetary assets at the existing book value of the relinquished asset if any of the following conditions apply:

The fair value of neither the asset(s) received nor the asset(s) relinquished is determinable within reasonable limits.

The transaction lacks commercial substance.

The exchange transaction is made to facilitate sales to customers. Specifically, the transaction is an exchange of inventory or property held for sale in the ordinary course of business for other inventory or property to be sold in the same line of business.

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Exchanges Recorded at Book Value: Fair Value Not Determinable

What if the fair value of neither the asset(s) received nor the asset(s) relinquished cannot be determined?

The new asset received is recorded at the sum of the at the sum of the book value of the old asset that was given up plus the cash given.

Denver Construction Corporation (a fictional company) agrees to swap with Cody Company (another fictional company) one type of crane in exchange for a slightly different model whose features are better suited for a highway bridge project it is currently engaged in. The old crane Denver is exchanging has a book value of $600,000 at the time of the transaction. Its original cost was $700,000, and accumulated depreciation is $100,000. Denver also pays Cody $40,000 to complete the transaction. It is not possible to measure the fair value of either crane within reasonable limits.

DR Construction crane (new)	$640,000
DR Accumulated depreciation—construction crane (old)	100,000
CR Construction crane (old)		$700,000
CR Cash		40,000

B V of old crane plus cash

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The Commercial Substance Criterion

Booking exchange transactions at fair value introduces the possibility of gains (or losses) on the transaction.

G A A P requires that the transaction must possess commercial substance. An exchange transaction has commercial substance when the firm’s future cash flows are expected to change significantly as a result of the exchange.

A significant cash flow change exists if either:

The configuration (risk, timing, and amount) of the future cash flows of the asset(s) received differs significantly from the configuration of the future cash flows of the asset(s) transferred.

The entity-specific value of the asset(s) received differs from the entity-specific value of the asset(s) transferred, and the difference is significant in relation to the fair values of the assets exchanged.

If both conditions are not met, the transaction must be recorded using the book value of the asset(s) relinquished.

This precludes any gain recognition.

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Exchange Transaction to Facilitate Sales to Customers

Sometimes firms exchange assets with other firms—even competitors—to balance inventories:

Lee Electronics faces a shortage of plasma television sets but has an excess of liquid crystal display (L C D) sets. It agrees to swap L C Ds with a fair value of $50,000 and a book value of $40,000 for plasma sets with a fair value of $52,000 from Bonnie Enterprises.

Because the exchange does not culminate an earnings process, the plasma sets are recorded as:

DR Inventory—plasma sets	$40,000
CR Inventory—LCDs		$40,000

Book value of asset surrendered with no gain or loss recorded

The $12,000 gain on the swap (= $52,000 fair value − $40,000 book value) will be recognized only when the plasma sets are ultimately sold to customers.

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Exchange Transaction to Facilitate Sales to Customers: Cash Received—A Special Case 1

Let’s assume instead that Lee Electronics also receives cash representing 10% of the proceeds.

DR Cash	$ 5,778
DR Inventory—plasma sets	36,000
CR Inventory—L C Ds		$40,000
CR Recognized gain on exchange		1,778

10% of ($52,000 + $5,778 − $40,000)

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Exchange Transaction to Facilitate Sales to Customers: Cash Received—A Special Case 2

Fair value of plasma sets		$52,000
Less: Portion of gain deferred:
Total gain	$17,778
Gain recognized	(1,778)
Gain deferred		(16,000)
Inventory—plasma sets		$36,000

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Global Vantage Point: Comparison of I R F S and G A A P Long-Lived Asset Accounting 1

Although there are many similarities between U.S. G A A P and I F R S, numerous important differences exist. I F R S allows more choice in valuation models and has different specific guidance for issues such as depreciation and impairments.

Tangible Long-Lived Assets:

I A S 16 allows two different models for tangible long-lived assets:

Cost Method (same as U.S. G A A P)

Revaluation Method – Asset is carried at a revalued amount reflecting fair market value at the revaluation date.

Subsequent depreciation is based on fair value, not original cost.

The amount of the write-up is credited to an owners’ equity account called Revaluation Surplus (equivalent to Accumulated other comprehensive income).

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Global Vantage Point: Comparison of I R F S and G A A P Long-Lived Asset Accounting 2

Intangible Long-Lived Assets:

The accounting under I A S 38 is similar to U.S. G A A P.

Generally, acquired assets are carried at amortized cost.

A revaluation method is allowed, but an active market must be available for the intangible.

There is a difference regarding internally developed intangibles.

Research is expensed.

Some development expenditures may be capitalized.

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Global Vantage Point: Comparison of I R F S and G A A P Long-Lived Asset Accounting 3

Impairments:

I A S 36, “Impairment of Assets,” provides the guidelines for impairments of long-lived tangible and intangible assets other than investment property measured at fair value.

For tangible assets and amortizable intangible assets:

Events that require an impairment review are similar to the U.S. G A A P events mentioned in Stage A. However, Stage C differs in that an impairment loss occurs if the carrying value exceeds the recoverable amount, defined as the higher of the asset’s fair value (less costs to sell) and its value in use, which is the discounted net cash flows identified in Stage B.

I F R S rules also permit reversals of previously recognized impairment losses when there has been a change in the estimates that were previously used to measure the loss. The reversal increases net income.

I F R S accounting for indefinite-lived intangible assets is similar to G A A P.

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Summary 1

U.S. G A A P for long-lived assets is far from perfect. The need for unbiased, accurate, cost-effective, and verifiable numbers causes these assets to be measured in terms of the economic sacrifice incurred to obtain them—their historical cost—rather than in terms of their current expected benefit—or economic worth—to the firm.

Changes in the amount of capitalized interest from one period to the next can distort earnings trends. A thorough understanding of how the G A A P measurement rules are applied allows statement readers to avoid pitfalls in trend analysis when investment in new assets is sporadic.

Incremental costs, such as sales commissions, associated with acquiring a contract may be deferred and amortized over the life of the contract.

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Summary 2

Because it is uncertain whether future benefits result from research and brand development costs, these costs are generally expensed in the period incurred. Consequently, balance sheet carrying amounts for intangible assets often differ from their real value to the firm. Analysts must scrutinize disclosures of R&D expenses to undo the overly conservative accounting.

When comparing return on assets (R O A) ratios across firms, one must remember that historical cost leads to an upward drift in reported R O A as assets age. So, analysts must determine whether the average age of the long-lived assets for firms being analyzed is stable or rising. Inflation also injects an upward bias into reported R O A.

Asset impairment write-downs depend on subjective forecasts and could be used to manage earnings.

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Summary 3

An understanding of differences in depreciation choices across firms permits better interfirm comparisons. When making interfirm comparisons, analysts should use note disclosures to overcome differences in the long-lived asset useful lives chosen by each firm and, when possible, in their depreciation patterns.

International practices for long-lived assets are sometimes very different from those in the United States. Statement users who make cross-country comparisons must exercise caution. I F R S allows much greater use of fair value than does U.S. G A A P.

Some of the key differences between I F R S and U.S. G A A P relate to the revaluation of tangible assets, investment property, capitalization of intangible development costs, and impairment losses.

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Accessibility Content: Text Alternatives for Images

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Long-Lived Asset Measurement Rules Illustrated 2 – Text Alternative 1

Return to parent-slide containing images.

Land section includes:

Cash payment of $6,000,000

Mortgage assumed of 1,000,000

Demolition of existing structure, $650,000

Less: Salvage value of material, (10,000)

These last two lines subtotal to 640,000

Regrading and clearing land, 35,000

Legal fees allocated, 17,000

Capitalized land costs, $7,692,000

Building section includes:

Architectural fees of $800,000

Building costs, 12,000,000

Interest capitalized, 715,000

Legal fees allocated, 40,000

Capitalized building costs, $13,555,000

Advance to rest of text alternative.

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Long-Lived Asset Measurement Rules Illustrated 2 – Text Alternative 2

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Callouts identify key amounts. The $6,000,000 cash and 1,000,000 mortgage are the purchase price. Preparation costs include the 640,000 demolition minus salvage and the 35,000 regrading line item. The 17,000 legal fees are joint cost. The architectural fees of 800,000, building costs of 12,000,000, and interest at 715,000 are all construction costs. The 40,000 legal fees under building are also joint cost. An additional notation is by this figure that reads Special GAAP rules apply.

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Computer Software Products – Text Alternative

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Left side lists Before Development expenditures, to be expensed as incurred. And at the right is listed After Development expenditures, to be capitalized and amortized. Midway point represents technological feasibility established.

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Asset Impairment: Tangible and Amortizable Intangible Assets – Text Alternative

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The flowchart contains five levels. Stage A: Have events or changes in circumstances raised the possibility that certain long-lived assets may be impaired?

If Yes, go to Stage B.

If No, No impairment write-down is necessary.

Stage B: Estimate the future undiscounted net cash flows expected from the use and the disposal of the asset. Stage C: Are these future undiscounted net cash flows lower than the carrying amount of the asset?

If Yes, go to Stage D.

If No, No impairment write-down is necessary.

Stage D: The impaired asset must be written down. Stage E: The impairment loss is the difference between the fair value of the asset and the carrying amount of the asset.

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Assets Held for Sale – Text Alternative

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On the left is Book value at $2,500,000. In the middle is Fair value: $2,350,000. And at the right is Expected cost to sell: $46,000.

The last two boxes are connected showing the equation of $2,350,000 minus $46,000 equals $2,304,000.

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Depreciation – Text Alternative

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Depreciation is made up of Buildings and Equipment. Amortization includes Intangibles. Depletion would apply to Mineral deposits and Wasting assets.

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Depreciation: Alternative Depreciation Methods – Text Alternative

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In the first graph, year (1 through 5) is marked on the horizontal axis, and depreciation expenses in dollars are indicated on the vertical axis. The graph has four lines: straight line; sum-of-the-years’ digits; units-of-production; and double-declining balance.

Straight line depreciation is a horizontal line that remains at $2,000 for all five years.

Sum-of-the-years’ digits is a downward-sloping line that begins at $3,333 in year 1 and ends at $667 in year 5.

Units-of-production begins at $2,100 in year 1, with varying values for the remaining four years: $1,700, $3,000, $1,650, and $1,550.

Double-declining balance begins at $4,200 in year 1, $2,520 in year 2, and remains at $1,093 for years 3, 4, and 5.

In the Net Book Value graph, end of year (1 through 5) is displayed on the x-axis and Book value in dollars (0 through 9000) is displayed on the y-axis. The Straight line method starts at about 8700 and declines in a straight line to roughly 700 in year 5. The sum of the years' digits starts at just above 7000 in year 1, declines to about 4700 in year 2, and 2700 in year 3. The drop then becomes more gradual to just above 1000 in year 4 and then finishes with the other methods in year 5. The units of production line starts near the straight line method at approximately 8600. It virtually mirrors the straight line method at about 6700 in year 2. It drops more dramatically in year 3 to about 3700, then slopes less steeply to approximately 2000 in year 4, before ending with the others at about 700. The double-declining balance method starts lower than all the others at approximately 6400 and declines sharply to about 3800 in year 2. The line then declines much less steeply to just under 3000 in year 3, around 1700 in year 4 and then ending with the other methods.

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BUSI 532

Case Study Overview

Overview

During this course, you will complete seven Case Study Assignments. The purpose of the case study is to allow you to read through real-world examples from various companies and learn more about the financial issues that they face. You will use the case study scenarios to apply the concepts that you have learned from the weekly content. Case studies are an engaging assignment that allow you to not only apply the concepts from the course, but also to use critical thinking skills when completing the analysis.

Instructions

· Length of assignment – Each case study analysis should be a minimum of 500 to 1000 words in length. The assignments should be submitted in a Word document with spreadsheets embedded in the Word document, as needed.

· A cover page is also required. A properly formatted reference page and corresponding in-text citations are also required.

· You should use APA formatting

· A minimum of two scholarly citations are required

· Acceptable sources include scholarly articles published within the last five years and your textbook.

Note: Your assignment will be checked for originality via the Turnitin plagiarism tool.

BUSI 532

Case Study: IFRS Adoption in the U.S. Assignment Instructions

Overview

During this course, you will complete seven case study assignments. The purpose of the case study is to allow you to read through real-world examples from various companies and learn more about the financial issues that they face. You will use the case study scenarios to apply the concepts that you have learned from the weekly content. Case studies are an engaging assignment that allow you to not only apply the concepts from the course, but also to use critical thinking skills when completing the analysis.

Instructions

· Read Case 11.5. Royal Dutch Shell PLC: Identifying differences and similarities between IFRS and GAAP on pages 11-58 through 11-59.

· Respond to the question prompt.

· Prepare your analysis of the company based on your response to question prompt provided.

· Length of assignment – Each case study analysis should be a minimum of two pages in length. The assignments should be submitted in a Word document with spreadsheets embedded in the Word document, as needed.

· A cover page is also required, but not part of the two pages of content. A properly formatted reference page and corresponding in-text citations are also required.

· You should use APA formatting

· A minimum of two scholarly citations are required

· Acceptable sources include scholarly articles published within the last five years and your textbook.

· Refer to Case Study Overview document for further instructions.

Note: Your assignment will be checked for originality via the Turnitin plagiarism tool.

Business & Finance Case Study: IFRS Adoption in the U.S. Assignment

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