CHAPTER 7
Different types of Long-Term Assets:
Fixed, Intangible, and Natural Resources
Fixed as often called plant assets
“Physical” assets
Include assets such as land, building, vehicles, desks, and equipment
Sometimes referred to as tangible assets
EX: Truck
Intangible
oAssets that cannot be seen, touched, or held
oInclude patents, trademarks, and goodwill
oEX: Nike
Natural resources
Assets that come from the earth and can ultimately be used up
Include timber, oil, minerals, and coal
Ex: oil rig
Acquiring Assets
Recorded at: The original cost of the asset + All expenditures necessary to get the asset ready
for use
We use the term capitalize (taking a cost and putting into asset account) (debit it) to describe
recording an expenditure as an asset
oNot just initial cost, its also includes all the costs you need to get it ready
Example of Olive Garden buying land and property to create a new restaurant
Land includes the initial purchase as well as all expenditures (net of salvaged materials)
necessary to get the land ready for use.
Lump- Sum (basket) purchase
Is a purchase of multiple assets for one price
Total cost is allocated to the different assets based on their relative market values
1. Find total market value
2. Take each individual asset market value divide by total market value
3. Use % to allocate purchase price
4. Take total cost and allocate
TEST QUESTION: Assume a company purchases a lump-sum of assets for
$500,000 which included a tractor, equipment, and machinery.
Assume the fair values are $150,000, $200,000, and $450,000,
respectively. What amount will the equipment be recorded at?
a. $200,000 (don’t report at fair value)
b. $500,000
c. $800,000 (don’t report at total fair value)
d. $125,000
1. Find total fair value(market value) 150,000+200,000+450,000=800,000
2. Find percentage of total fair value that the equipment is worth= 200,000/800,000=0.25
3. Allocate costs 500,000 cost x 0.25= $125,000
4. Debit equipment
Intangible assets
Lack physical substance but can be very valuable
Existence often based on legal contract
Acquired in two ways:
Purchased
Developed internally
oPurchased intangible assets are recorded at their original cost plus all
other costs, such as legal fees, necessary to get the asset ready for use
oSubjective
oCant record as asset
Expenditures after acquisition- repairs & maintenance, additions,
improvements, litigation costs
Capitalize: including a particular cost in an asset account
Capital expenditures VS. Immediate expenses
Capital expenditures:
Costs incurred to increase an asset’s capacity or extend its useful life
Those costs should be capitalized
This means they should be added to an asset account, not expensed
immediately
Immediate Expenses:
oCosts that do not extend the asset’s capacity or its useful life
oThey are costs that merely maintain the asset or restore it to working order
oThese costs should be expensed immediately (if you expense something
right away your costs are going up and profits go down)
oIf you take a cost and put it into your asset account right away it does not
hit your income statement right away (easy way to manipulate their
numbers)
Depreciation
DEF: the process of allocating a fixed asset’s cost to expense over its useful
life
Has nothing to do with cash
You NEED cost, salvage value, and estimated useful life
Ex: you have a truck and think it will last 10 years
Depreciable cost= cost- residual value
Find using 3 different methods
oStraight-line
oUnits of production(UOP)
oDouble declining balance method
Ex:
Assume that Mackay Manufacturing purchased and placed in service
a new delivery truck on January 1.
• Purchase price.....................................$67,000
• Estimated residual (salvage) value.....$6,000
• Estimated useful life........................... 5 years
Straight-line method: Dr. Depreciation Expense, Truck
Cr. Accumulated Depreciation, Truck
Cost- Accumulated depreciation is how you calculate book value
Book value= salvage value at the end of its useful life (ALWAYS MOVING
TOWARD SALVAGE VALUE)
Units-of-production (UOP) method:
UOP depreciation method allocates a fixed amount of depreciation to each
unit of output.
Units-of-production depreciation= (cost- residual value)/ estimated useful
life in units= depreciated expense per unit
Dr. Depreciation Expense, Truck
Cr. Accumulated Depreciation, Truck
Double declining-balance method: (AKA accelerated depreciation method)
Formula: 1/estimated useful life in years x 2 x book value at the beginning of
the year
Dr. Depreciation Expense, Truck
Cr. Accumulated Depreciation, Truck
*Write all 3 methods on notecard*
Which method is best?
oStraight-line is the most common among companies
oIf the data varies a lot UOP might be better
oDouble declining is best for technology because it advances
A company purchased a truck on January 1, 2020 for $50,000.
The estimated useful life is 10 years and the salvage value is
$5,000. Assume the company uses straight-line method.
Calculate accumulated depreciation and book value at the end
of 2021
SL= (Cost-SV)/UL (useful life)
Cost-Acc Dep= BV (book value)
SOLVE
(50,000-5,000)/10 years= 4,500
4,500 x 2= 9,000 for Acc. dep.
50,000-9,000= 41,000= book value
Changing the useful life of a depreciable asset
Start with what your left with over the New estimated useful life- the years
that have already been depreciated
Disposing fixed assets
Usually discarded/ junked or sold
1. Record “what you got”
2. Record “what you gave up”
3. Record any gain or loss
Gains and losses result from a difference between selling price and book
value
Always start with selling price
Selling Price- book value= Gain/(Loss)
(if it comes out to 0, neither gain nor loss)
Book Value:
Cost- Accumulated Depreciation= Book value
Examples: (assuming its been fully depreciation)
Truck cost: $67,000
Accumulated depreciation: $61,000
Book Value: $6,000
1. Truck is thrown out/junked: $0 selling point - $6,000= ($-6,000) Losses are
always debited (like expenses) and gains are always credited (like revenue)
Dr. Acc. Depreciation, truck $61,000
Dr. Loss on disposal of truck $6,000
Cr. Truck $67,000
2. Truck is sold for $8,000. Selling price is 8,000- book value of 6,000= $2,000
gain
Dr. Cash $8,000
Dr. Acc. Depreciation $61,000
Cr. Truck $67,000
Cr. Gain of sale of truck $2,000
3. Truck is sold for book value of $6,000. Selling price is 6,000- book value of
6,000= $0 no gain or loss
Dr. Cash $6,000
Dr. Acc. Depreciation $61,000
Cr. Truck $67,000
4. Truck is sold for $4,000. Selling price of 4,000-book value of 6,000=($-2,000)
Dr. Cash $4,000
Dr. Acc. Depreciation $61,000
Dr. Loss on sale of truck $2,000
Cr. Truck $67,000
EXAM QUESTION: write example on note card
Purchased truck for $50,000 on Jan. 1, 2020. Estimated useful life is 10
years and the salvage value is $5,000. Assume the company uses
straight-line method. On Jan 1. 2022, the company sells the truck for
$39,000. The journal entry to record the sale would be?
Hint: we eliminate credit to loss because we credit gains
SL= ((cost)- SV)/ UL
50,000-5,000/10 years = 4,500 x 2 years=$9,000
Cost- Acc. Dep. = BV
50,000-9,000= 41,000
S/P – BV = Gain/loss
39,000-41,000= -2,000 loss
DEBIT LOSS for $2,000
Analyze long-term assets
Return on assets (profitability) vs asset turnover (efficiency)
ROA
Measures the overall profitability of total assets
oCalculated as: Net income/ average total assets = ROA (want to be high)
oTotal assets: add the beginning and ending values of total assets and divide
by 2
oNet income is from the income statement and total assets is from the
balance sheet
oThe higher the ROA the more profitable a company is
oNet profit margin and asset turnover can be used to analyze ROA in more
detail
oProfit margin x Asset turnover= ROA
Profit margin can be increased by increasing the margin it generates from
each dollar of goods that it sells
oIncreasing selling price of goods or services
oDeceasing costs
Asset turnover can be increased by increasing the volume of goods it sells
(generating more sales) or decreasing assets
Net profit margin (net income %) is the final return of each sales dollar
Net income/ Net sales= Profit Margin
Helps tell the user how profitable each sales dollar is or how effective a
company is in turning its sales into net income
Asset Turnover
Measures how efficiently a company uses its assets to generate sales
In other words, how many dollars of sales a company generates for each
dollar invested in assets
Calculated as: Net sales/ average total assets= asset turnover
Net sales is from the income statement and total assets is from the balance
sheet
The higher the asset turnover, the more efficient the company is in using
their assets
If a company can increase sales, and/pr reduce total assets, asset turnover
will increase
oEx: airline could get rid of the amount of planes they have and routes
and pack more travelers onto the planes to use the plane more
efficiently.
Chapter 8 & 4 Current and Contingent Liabilities
Liabilities:
Known liabilities: majority of a company’s liabilities fall into this category
Can be defined as known obligations of known amounts
The business knows that it owes something and it knows how much it owes
Ex: accounts payable, notes payable, unearned revenues, and accrued
liabilities, such as interest or taxes payable
Estimated liabilities: a known obligation of an unknown amount
A business will sometimes encounter a situation where it knows that a
liability exists but does not know the exact amount of the liability
The amount of the liability must be estimated
Ex: estimated warranties payable or sales refunds payable
Contingent liabilities: unique liability
Arises because of a past event, but it is dependent upon the outcome of a
future event
Whether or not a company has an obligation depends on the result of an
event that has not yet occurred
Amount of a contingent liability may be either known or unknown
Ex: pending litigation
Current vs. Long term liabilities
Current: Debts payable in cash within one year of the balance sheet date
Most current liabilities are usually associated with various day-to-day
operating activities
Ex: Accounts payable
Notes payable
Accrued liabilities
Current portion of long term debt
Unearned revenue
Short-term notes payable
Due within one year
Opposite side of notes receivable
Interest expense (not revenue) is incurred
When a notes payable is due, the company will pay cash
Notes payable is a liability is now interest expense
Notes receivable an asset is now interest revenue
Current portion of long-term debt
oPrinciple portion of a long-term liability that is payable within one year
oAssume that on June 1, 2019, Colbert Auto Parts signs a $45,000, 7% note
payable
oThe note requires that annual installments of $9,000, plus interest, be paid
on June 1 of each of the next five years.
oOn the December 31, 2019, balance sheet, the $9,000 payment that is due
on June 1, 2020, is classified as current portion of long-term debt (current
liability).
oThe remaining $36,000 will be classified as a long-term liability.
Accrued Liabilities
Result from the company needing to record expenses in the current period since
they have been incurred, but not yet paid in cash
Ex:
oUtilities payable
oInterest payable
oRent payable
oTaxes payable
oSalaries payable
Unearned revenue
On September 1, a company receives $300,000 in advance for
a 6-month subscription. Assume the company’s year-end is
December 31. How much is credited to Subscription Revenue
on September 1? How much remains in Unearned Revenue on
December 31?
Dr. Cash 300,000
Cr. Unearned revenue 600,000
1. 0
2. 100,000
Contingent Liabilities
oRepresents a potential, rather than an actual obligation
oThe outcome of the future event will determine whether a company will
incur an obligation
oEx: pending legal action, tax disputes, etc.
oThe accounting treatment of a contingent liability depends on the likelihood
of a loss or obligation occurring
L of loss A T
Remote (very unlikely) Nothing
Reasonably possible Footnote only (disclosing in the notes
to the financial statements)
Probable (more likely than not) If able to estimate amount, journal
entry to record liability and footnote. If
cannot estimate loss, footnote only
Suppose you’re being sued by a former employee for wrongful termination
The lawsuit represents a contingent liability because it’s the result of a past
event but it is dependent on the outcome of a future event (settlement of
the lawsuit)
If the lawsuit is without merit and the change of losing the suit is remote,
no action is required
If it is reasonably possible that your company will lose the lawsuit, it
should disclose the lawsuit as a contingent liability in the notes to its
financial statements (in the notes)
oIf it is probable you will lose the lawsuit, the lawsuit should be disclosed in
the financial statement notes
oThe amount that the lawsuit is expected to cost your company should be
recorded in the accounting records if it can be reasonably estimated
oThe contingent liability would be recorded by debiting a loss account and
crediting a liability account
oContingent liabilities are classified as current vs Long-term based upon
when the liability is expected to be paid
Fraud and Internal Control
Intentional misrepresentation of facts for the purpose of persuading
another party to act in a certain way
Causes injury or damage
Misappropriation of assets (most common)
oCommitted by employees
oTheft of money or inventory
oBribery and kickback schemes
oOverstate expense reimbursements (business trips and lie about how much
you spent)
Fraudulent financial reporting
Committed by managers
False and misleading journal entries
Deceive investors and creditors
Fraud Triangle
Motive: may have a lot of debt, lot of medical bills, financial
pressure. Or greed. Reason for committing fraud.
Opportunity: The chance to commit the fraud, typically from a weak internal
control system
Rationalization: (tell yourself something to make you feel better Ex: “they
won’t notice, it’s just a little bit, I deserve it”)
Internal control
Primary way to prevent, detect, and correct fraud
Def: is a plan of organization and procedures implemented to accomplish 5
objectives:
oSafeguard assets
oEncourage employees to follow company policy
oPromote operational efficiency
oEnsure accurate, reliable accounting records
oComply with legal requirements
Components of internal control
1. Control environment
Tone at the top
Code of ethics
2. Risk assessment
Identify business risks
Establish procedures to deal with risks
3. Information system
Means by which accounting into enters and exits
Accurately track assets, profits, & losses
4. Control procedures
Means by which companies gain access to the 5 objectives of
internal controls
5. Monitoring of controls
Internal and external auditors
Proper approvals
Management’s general or specific approval
oManagement may delegate approval to specific
department
Purchasing department
oOnly buy from approved vendors
oBased on competitive bids
Safeguard controls
oImportant documents in fireproof vaults
oBurglar alarms and security cameras
oLoss prevention specialists
oFidelity bonds on cashiers
oMandatory vacations and job rotation
Chapter 9
Long term liabilities
Bonds Payable: Long term, interest- bearing debt issued to lenders called
bondholders
We focus on the term “BONDS”
They all mature at the same specified time
TERMINOLOGY:
Principal/ Par Value/ Face Value: Amount borrower must pay back to
bondholders on maturity date
Maturity Date: Date at which borrower must re[au principal amount to
bondholders
Stated interest rate: rate on bonds that determines the amount of cash
interest the bond issuer pays each interest date
Market interest rate: rate of interest investors are expecting to receive for
similar bonds of equal risk at the current time
Always debit cash for selling price!!!
Always credit bonds payable at par!!
Hard to remember discount vs premium
Stated rate= market rate: bond is sold at par- investors are willing to pay full
maturity value
Stated rate< market rate: bond is sold at discount- investors are willing to
pay a lower price for the bond because they receive a lower rate of interest
Stated rate> market rate: bond is sold at premium- investors are willing to
pay a higher price for the bond because they receive a higher rate of interest
LOWER DEBT RATIO IS SAFER THAN A HIGH DEBT RATIO.
HIGHER RATIO INDICATES A COMPANY IS FINANCED WITH MORE DEBT
High debt ratio may have trouble meeting debt repayments or interest
expense, especially when sales are low and cash is low
Managers commit fraudulent financial reporting
