Learning MBA Master Degree

TEACHER: Hi, Student. In this Module we first discuss accounting for fixed assets and intangible assets, and later on we will describe the treatment of other expenses and net income.

Fixed Assets And Depreciation

First things being first, let’s begin by discussing accounting for fixed assets and intangible assets and the related charges for depreciation, depletion and amortization.

Acquisition Of Fixed Assets

STUDENT: Good, but why don’t you give me a specific definition of "fixed" assets to begin with?

TEACHER: A fixed asset is an asset that is expected to provide service for more than one year, usually for several years. A tangible asset is one that has physical substance, such as a building or a machine, as contrasted with stocks, bonds, patent rights or other intangibles. Although long-lived assets can actually be either tangible or intangible, when the term "fixed assets" is used without qualification, the reference usually is to tangible assets, and more specifically to property, plant, and equipment.

When an expenditure is recorded as a fixed asset, rather than as an expense, it is said to be capitalized. Student, I urge to remember the term "capitalize", because it is used a lot in finance and accounting. The question of whether an expenditure should be "expensed" or "capitalized" is a very common matter of discussion.

Items Included in Cost

STUDENT: How is the cost of a fixed asset determined?

TEACHER: As is the case with any productive asset, the cost of a fixed asset is the amount expended to make the asset ready to use. In many cases this amount can be determined easily; for example, the cost of an office desk purchased for cash is simply the amount of cash paid.

But other cases, the problem is more complicated. The cost of a parcel of land includes the purchase price, broker's commission, legal fees, making the land ready for its intended use; the cost of some of these items may be difficult to ascertain.

The cost of machinery includes the purchase price, sales tax, transportation costs to where the machinery is to be used, and installation costs.

STUDENT: You mean that all these extra expenses MUST be capitalized?

TEACHER: No. Many companies do not capitalize the costs incurred to make the asset ready to provide service.

STUDENT: You mean they capitalize only the purchase price. Why?

TEACHER: Depends. They may do this both because it is simpler or for tax reasons: to show less profit in the current period or to minimize property taxes.

STUDENT: And what if a fixed asset is not purchased but "home made" by the company?

TEACHER: When a company constructs a machine or a building with its own personnel, the amount to be capitalized includes all the costs incurred in construction, including the material, the labor, and a fair share of the indirect costs incurred in the company. This concept is somewhat elastic. In the case of software, some years ago the custom was to capitalize acquired software "packages" and expense in-house made software. Lately most companies capitalize the full development costs.

Maintenance and Improvements. Repair and maintenance costs are ordinarily expenses of the accounting period in which the work is done; they are not added to the cost of the asset.

On the other hand, improvements are usually capitalized.

Replacements. Replacements may be either assets or expenses, depending on how the asset unit is defined. The replacement of an entire asset results in the writing off of the old asset and the booking of the new. The replacement of a component part of an asset is maintenance expense.

STUDENT: A bit confusing, if I may say. Can you give me an example?

TEACHER: Sure. Let’s assume that one company treats a complete airplane as a single asset unit and another company treats the airframe as one unit and the engine as another.

In the first company the replacement of an engine results in a maintenance charge of the airplane while in the second company it will result in the writing off of an old asset (the replaced engine) and the inclusion of a new asset, the new engine.

In general, the broader the definition of the asset unit, the greater will be the amount of costs charged as maintenance and hence expensed in the year the replacement parts are installed.

Leased Assets. Ordinarily, when a company leases or rents an item of property or equipment, it has the right to use the item for a stated period of time, such as a month, a year, or a period of years, but it does not have any other rights with respect to the item itself. Such leases are called operating leases. Items used under such lease agreements are not assets of the lessee; rather, they are fixed assets on the accounts of the lessor.

STUDENT: However, I know of some cases where leased goods are capitalized in a way similar to goods purchased in installments.

TEACHER: True. Some lease agreements cover a relatively long periods of time and provide to the lessee almost as many rights in the property or equipment as if he owned the asset outright, including the option to purchase the asset at a specific residual price after a time. Such leases are called financial leases. Assets acquired under financial leases are capitalized, just as if they were owned.

Now, let’s consider....

Measurement of Acquisition Cost

STUDENT: I guess this is no problem in the great majority of cases, when assets are acquired for cash, or for a note or other obligation whose cash equivalent is easily determined. But what about cases when assets are acquired by exchange?

TEACHER: If possible, the fair market value of the goods or services given in exchange for the fixed asset should be determined, and, second, if it is not feasible to determine this fair market value, the fair market value of the fixed asset itself should be estimated.

"Basket" (Lot) Purchases. If a company acquires in one transaction different fixed assets which are to appear in more than one balance sheet category, it must divide the cost of the acquisition between the categories on some reasonable basis. Usually this requires an appraisal of the relative value of each asset included in the "basket purchase."

Acquisitions Recorded at Other than Cost

There are a few, exceptions to the basic rule that acquisitions are recorded in the accounts at cost. If the company acquires an asset by donation or pays substantially less than the market value of the asset, the asset is recorded at its fair market value. This happens, for example, when a community donates land or a building in order to induce a company to locate there.

STUDENT: I guess sometimes it may be difficult to determine the "fair market value".

TEACHER: Yes. If the cost of an asset cannot be measured, then the asset is recorded at an amount determined by appraisal, usually performed by licensed professional appraisers.

In this context it is important to note that changes in market value do not affect the accounting records for fixed assets. Some investors acquire or build apartment houses or shopping centers with the expectation that part of the profit from this investment will be derived from the appreciation of the property. This appreciation may in fact occur, year after year, but it is not recorded in the accounts. The FASB states that "property, plant and equipment should not be written up by an entity to reflect appraisal, market or current values which are above cost to the entity."

Depreciation Of Fixed Assets

With the exception of land, most fixed assets have a limited useful life; that is, they may be of use to the company over a limited number of future accounting periods. A fraction of the cost of a fixed asset is properly chargeable as an expense in each of the accounting periods in which the asset is used by the company. The accounting process for this gradual conversion of fixed assets into expense is called depreciation.

Judgments Required

In order to determine the depreciation expense for an accounting period, judgments or estimates must be made for each fixed asset:

1. The service life of the asset, that is, over how many accounting periods will it be useful to the company?
2. The method of depreciation, that is, the method that will be used to allocate a fraction of the net cost to each of the accounting periods in which the asset is expected to be used.

The amount of depreciation expense that results from these judgments is therefore an estimate, and often it is only a rough estimate.

Service Life

The service life of an asset is the period of time over which it is expected to provide service to the company that owns it. Service life may be shorter than the period of time that the asset will last physically for either of two reasons: (1) The asset may not provide service over its full physical life because it has become obsolete (a good example being computers) or (2) the company may plan to dispose of the asset before its physical life ends. For example, although cars have an average physical life of about ten years, many companies trade in new automobiles every three years; in these companies, the service life is three years. However, tax authorities normally issue guidelines of allowed depreciation periods.

Depreciation Methods

Consider a machine purchased for $1,000 with an estimated life of 10 years and estimated residual value of zero. The problem of depreciation accounting is to charge this $1,000 as an expense over the 10-year period. How much should be charged as an expense each year?

The FASB (and tax authorities in different situations) permit any method that is "systematic and rational," and the methods described here meet those criteria.

Straight-Line Method. The company charges an equal fraction of the net cost of the asset each year. For a machine whose, net cost is $1,000 with an estimated service life of 10 years, one tenth of $1,000 is the depreciation expense of the first year, another one tenth is the depreciation expense of the second year, and so on.

Accelerated Method. This is a method which charges a larger fraction of the cost as an expense of the early years than of the later years. This is called an accelerated method.

Accelerated methods are used, whenever they are permitted, for income tax purposes. If an accelerated method is used, depreciation expense is greater in the early years and less in the later years as compared with the straight-line method and in practice income tax payment are deferred. In general permission from the government to use this system is intended to induce companies to invest in any or in specific types of capital goods

Units-Of-Production Method. A third concept of depreciation views the asset as consisting of a bundle of service units, the cost of each unit being the total cost of the asset divided by the number of such units, and the depreciation charge for a period therefore being related to the number of units consumed in the period. This leads to the units-of-production method. If a machine has a net cost of $12,000 and is expected to be able to produce 300,000 units of final product, depreciation would he charged at a rate of $0.04 per unit of final product. In a year in which the machine produced 50,000 units the depreciation would be $2,000. When this type of method is used it is common to add the depreciation charge directly to the cost of the final product.

Choice of a Method

In deciding on the best depreciation method, tax considerations should be kept completely separate from financial accounting considerations. For tax purposes, the best method is that which minimizes the effect of taxes. Unless tax rates applicable to the business are expected to increase, this is usually one of the accelerated methods.

With respect to financial accounting, each of the concepts described above has its advocates. An essential requirement is that there be a consistent method.

The Investment Credit

In order to encourage purchases of machinery and equipment, the income tax statutes sometimes permit a credit against income tax of a stated percentage of the cost of such assets, provided they are long lived and meet certain other criteria.

STUDENT: Yes, like the lobbing capacity of the trade associations of the manufacturer’s of those goods, right?

TEACHER: Don’t be so cynical! Are you suggesting that legislators and bureaucrats can be influenced by lobbying?

Well, anyway this is called the investment credit. The investment credit is a direct reduction in taxes; that is, if a company acquired $100,000 of equipment when the investment credit was 10 percent, it could deduct $10,000 from the income tax it would otherwise pay in that year.

STUDENT: What happens if an asset is sold for more or for less than its book value?

TEACHER: In the first case it is usually classified as nonoperating revenue on the income statement. In the second case, the difference is "written-off", that is, classified as an expense.

STUDENT: And what about trade-ins?

TEACHER: A trade-in involves the disposal of an asset, and the asset traded in is treated in the accounting records exactly as if had been sold; that is, both its cost and its accumulated depreciation are removed from the books.

Debits to Accumulated Depreciation

If a machine is given an unusual major overhaul which makes it "as good as new," the cost of this overhaul is sometimes debited to Accumulated Depreciation rather than to Maintenance Expense on the ground that the overhaul has actually canceled or offset some of the accumulated depreciation.

Group And Composite Depreciation

An alternative procedure is to treat several assets together rather than making the calculation for each one separately. If similar assets with approximately the same useful life, such as all personal computers or all office desks are treated together, the process is called group depreciation.

If dissimilar assets are treated together, the process is called composite depreciation.

STUDENT: In the latter case it may be difficult to establish the depreciation rate!

TEACHER: The depreciation rate in composite depreciation is a weighted-average rate, the weights being the dollar amounts of assets in each of the useful-life categories. All the production equipment in a plant, for example, might be included in a single composite account, even though the useful lives of the various items of equipment were not the same.

If a group or composite method is used, no gain or loss is recognized when an individual asset is sold or otherwise disposed of. The asset account is credited for the cost, and the difference between cost and the sales proceeds is simply debited to Accumulated Depreciation. This procedure assumes that gains on some sales are offset by losses on others.

STUDENT: Does the amount shown as accumulated depreciation on the balance sheet represent the "accumulation" of any tangible thing, such as a money reserve to replace the good?

TEACHER: No. It is merely that portion of the assets' original cost that has been already charged off against revenue. Now, if a company does set aside money for the specific purpose of purchasing new assets, this process is sometimes called "funding depreciation." This transaction is completely separate from the depreciation mechanism described above. If depreciation is funded, cash or securities are physically segregated; that is, they are set aside in such a way that they cannot be used in the regular operation of the business (for example, a special bank account may be created). This fact is reflected on the balance sheet by an asset titled "New Building Fund," or some similar name, the offsetting entry being a credit to Cash. However, this practice is not common.

STUDENT: I have heard high-level executives publicly say that "depreciation builds up cash". Does this make sense?

TEACHER: Not al all. There is a widespread belief that, in some mysterious way, depreciation does represent money, specifically, money that can he used to purchase new assets. Depreciation is not money; the money that the business has is shown by the balance in its Cash account. And speaking of widespread erroneous beliefs, there is also a widespread false belief that the book value of assets is related to their real value.

Intangible Assets - Intangible long-lived assets, such as goodwill, organization cost (i.e., cost incurred to get a business started), trademarks, and patents are usually converted to expenses over a number of accounting periods. The amortization of intangible assets is essentially the same process as the depreciation of tangible assets.

Deferred Charges

In a broad sense, deferred charges are assets which will be charged against revenue in future accounting periods. In this sense, any asset subject to depreciation, depletion, or amortization is a deferred charge. By custom, however, the term deferred charge is usually restricted to long-lived, intangible assets. Goodwill is literally a deferred charge but is usually reported separately from other deferred charges if material in amount.

Intangible assets that will be charged against revenue in the next accounting period are called prepaid expenses and, if material in amount, are reported as current assets. The line between prepaid expenses and deferred charges is usually not drawn precisely. Some companies report "deferred charges and prepaid expenses" as a single item, which is a noncurrent asset.

Research and Development Costs

Research and development costs are costs incurred for the purpose of developing new or improved goods, processes, or services. The fruits of research and development efforts are increased revenues or lower costs. Since these fruits will not be picked until future periods, often five years or more after a research project is started, a good case can be made for capitalizing research and development costs and amortizing them over the periods benefited. But most tax authorities require that research and development costs be charged off as an expense of the current period, based on the argument that benefits to be derived in the future from research and development efforts are high1y uncertain.

Investments

The stocks and bonds that a company owns are regarded as being in a separate category from the intangibles described above. They are initially recorded at cost. They are not amortized by charging a fraction of the cost as an expense of future periods, because their service potential presumably does not expire with the passage of time. Instead, they are held as an asset until they are sold.

STUDENT: I know there is more ahead of us in this Module, but can we summarize what we have already discussed?

TEACHER: Good idea. Tangible fixed assets are recorded at their acquisition cost, which includes all elements of cost involved in making them ready to provide service. A portion of this cost (less residual value, if any) is charged as depreciation expense to each of the accounting periods in which the asset is expected to provide service. Any systematic and rational method may be used for this purpose. The straight-line or units-of-production method is ordinarily used for financial accounting purposes, but an accelerated method is ordinarily used for income tax purposes. A corresponding reduction is made each year in the net book value of the asset account.

When an asset is disposed of, its cost and accumulated depreciation are removed from the accounts, and any gain or loss appears on the income statement.

That said, let’s go on with the rest of the Module.

Other Expenses And Net Income

We have discussed the accounting treatment of most of the items that affect net income; let’s discuss the remaining items. Topics include personnel costs, income tax allocations, foreign currency adjustments, extraordinary items, and discontinued operations.

STUDENT: I know this is not the case in the US, but in some places during periods of high inflation, there is a procedure of price level adjustments.

TEACHER: Yes, we will describe price level adjustments and the method called direct costing. Although neither of these practices is currently used in the measurement of net income in the US, an understanding of them is interesting.

Personnel Costs

Personnel costs include wages and salaries earned by employees, and other costs that are related to the services furnished by employees.

As a matter of custom, the word "wages" usually refers to the compensation of employees who are on a piece-rate, hourly, daily, or weekly basis; while the word "salaries" usually refers to compensation expressed in monthly, or longer, terms.

Payroll Transactions

The effect on the accounting records of earning and paying wages and salaries is more complicated than merely debiting expenses and crediting cash, for when wages and salaries are earned or paid, certain other transactions occur almost automatically.

An employee is almost never paid the gross amount of wages or salary he earns, since from his gross earnings there must be deducted:

1. His contribution to Social Security (called FICA in the US)
2. The income tax withholding deduction.
3. Deductions for company pension contributions, savings plans, health insurance, union dues, and a variety of other items.

None of these deductions represents a cost to the business. In the case of the tax deductions, the business is acting as a collection agent for the government; the withholding of these amounts and their subsequent transfer to the government does not affect net income or owners' equity. Rather, the withholding creates a liability, and the subsequent transfer to the government pays off this liability. Similarly, the business is acting as a collection agent in the case of the other deductions. The employee is paid the net amount after these deductions have been taken.

When wages and salaries are earned, costs other than the wages and salaries themselves are automatically created. The employer must pay his own contribution added to the employee's FICA tax, and other amounts like the unemployment insurance. The employer's share of these taxes is an element of cost.
Thus, let’s assume that an employee earns $1500 for his work in a given period, and that $87,80 are deducted from his pay as Social Security (FICA in the US) tax contribution and $156 for withholding tax; he or she would receive the balance, $1,256.20. This is his or her "take-home pay." (The percentages are arbitrary and not material in this example and other possible deductions are omitted for purposes of simplification.)

We assume that the business would incur an expense of $87,80 for FICA and an additional expense of, say, $60.00 for federal and state unemployment insurance taxes, or a total of $147.80 for the two social security taxes.

The journal entries for these transactions are as follows:

1. When wages are earned, wages expense:

Wages Expense 1,500.00

Wages Payable ...........1,500.00

2. When wages are earned; business tax expense:

Social Security Tax Expense 147.80

FICA Taxes Payable............... 87.80

Unemployment Taxes Payable....... 60.00

3. When the employee is paid:

Wages Payable 1,500.00

Cash ......................... 1,256.20

FICA. Taxes Payable ..............87.80

Withholding Taxes Payable....... 156.00

4. When the government is paid:

FICA Taxes Payable....... 175.60

Unempl. Taxes Payable..... 60.00

Withholding Taxes Payable.156.00

Cash .............................391.60

In practice, the above entries would be made for all employees as a group rather than separately for each person. Governments generally require, however, that a record be kept of the amount of FICA or equivalent taxes and withholding tax accumulated for each employee, and that the employee be furnished a copy of this record.

The costs of employees involved in the manufacturing process are product costs and are first charged to Goods in Process Inventory. The costs of other employees are period costs and are an expense on the period in which the employees work.

Pensions

The above transactions, although complicated, involve no new problem in the application of accounting principles. One matter related to wages does involve a very difficult problem. This is the liability and related expense for pensions.

Many Americans work for companies that agree to pay them pensions when they retire. All or part of the cost of these pensions is borne by the company; the remainder, if any, comes from contributions made by employees. Accounting for the company's cost for pensions is a particularly difficult matter because the expense is incurred during the years in which the employee works for the company, but the payments to him are made at some distant future time, and the total amount of the payment is uncertain, depending on how long he lives, on his final wage or salary, and possibly on other considerations.

The pension plans of many companies are funded; that is, an estimate is made of the amount that will be necessary to meet the future pension payments arising out of the employees’ earnings in the current year, and this amount is either set aside in a trust fund or paid to an outside agency that guarantees to make the future pension payments. The amount paid into such a fund is a deductible expense for income tax purposes, provided certain other conditions are met, and is usually treated as an expense of the current year for financial accounting purposes.

This is a quote from Forbes.com of February 4, 2003: "Pensions have been a great honey pot of earnings manipulations for years. If a plan's rise in assets in any given year exceeds the future cost of benefits, the difference can be tossed into a company's earnings, never mind that it's just a paper gain. And companies can easily manipulate that gain. How? Companies must make a series of assumptions about future portfolio returns and retiree benefits in order to calculate their current cost of funding pensions. A key assumption is the return the pension portfolio will earn in the years ahead. Some pension sponsors are in the habit of assuming long-term returns based, not on market realities, but on their wildest dreams."

Make your own conclusions!

INCOME TAX ALLOCATIONS

Permanent Differences and Timing Differences

For most revenue and expense transactions, the amount used in calculating taxable income for income tax purposes is the same as the amount reported on the income statement in accordance with generally accepted accounting principles. Thus, there is a likelihood that if a company reports an income of $1 million before taxes, and if the tax rate is approximately 51 percent the Provision for Income Taxes (an expense) should be approximately $510,000.

There are two important classes of exceptions, however.

1. First, the income tax regulations permit certain deductions from taxable income that will never be counted as expenses and they permit that certain revenue items be omitted from taxable income. These create a permanent tax difference.
2. In other situations, the income tax regulations permit revenue to be recognized in a later period, or expenses in an earlier period, than the method used in financial accounting. These create a timing tax difference.

No special accounting arises in the case of permanent tax differences. The amount reported as Provision for Income Taxes of the current period is simply lower than it would be if the preferential treatment did not exist.

Accounting for Timing Differences

In the case of timing differences, however, an adjustment in Provision for Income Taxes in the current period is required. This adjustment makes the amount of Provision for Income Taxes reported for a period match the amount of income reported on the income statement for the period and is therefore consistent with the matching concept.

Foreign Currency Adjustments

If a domestic firm engages in transactions with foreign firms, or has branch operations or subsidiaries in foreign countries, then these foreign transactions must be converted into the local currency in preparing the domestic firm's financial statements. Exchange rates fluctuate, often widely, depending on the relative strengths of the involved currencies in international trade. Most revenue and expense items of foreign branches or subsidiaries are translated at the average rate of exchange prevailing during the period.

Extraordinary Items

STUDENT: What can be defined as an "extraordinary" item?

TEACHER: The definition of an extraordinary item is extremely narrow. It has two parts:

1. The event must be unusual; that is, it should be highly abnormal and unrelated to the ordinary activities of the entity.
2. The event must occur infrequently; that is, a "rare" occurrence.

Accounting Treatment

In those rare cases in which extraordinary gains or losses can be identified, they are reported separately near the bottom of the income statement. The amount reported is the net amount after the income tax effect of the item has been taken into account.

Discontinued Operations

The other type of transaction which, if material, must be reported separately on the income statement is the gain or loss from the discontinuance of a division or other identifiable segment of the business. The transaction must involve a whole business unit, as contrasted with the disposition of an individual fixed asset or discontinuance of one product in a product line. Discontinuance may occur by abandoning the segment and selling off the remaining assets for whatever they will bring, or it may occur by selling the whole segment as a unit to some other company.

The effect of the decision to dispose of the segment is recorded on the income statement in the period in which the decision is made, which may well be earlier than the period in which the actual sales transaction is consummated. Unless a specific agreement has been implemented in the current period, the amount of gain or loss must be estimated.

Accounting Treatment

As is the case with extraordinary items, the amounts related to discontinued operations are reported after their income tax effect has been taken into account. Two items are shown:

1. The income or loss attributable to the operations of the segment

during the current year, and

2. The estimated net gain or loss after all aspects of the sale, the effect

of operations until the disposal is finished, the write-off of

assets that are not sold, and any other effects are taken into account.

Price Level Adjustments

The accountant measures the goods and services that enter into the calculation of net income essentially at their acquisition cost, that is, at the prices paid when these goods and services were originally acquired by the company.

In some countries, especially those with a high rate of inflation, changes in the purchasing power of the monetary unit are explicit1y incorporated in the basic financial statements. In the United States, however, this is not done.

The amounts reported on the conventional balance sheet and income statement are on a "units of money" basis. The effect of price level changes is reported by restating each of these amounts on a "units of general purchasing power" (GPP) basis. In making this restatement, one type of adjustment is required for monetary items and quite a different type is required for nonmonetary items.

In making price level adjustments, an index of general price level changes is used. The objective is to take account of changes in the general purchasing power of the currency, not changes in the prices of specific assets.

And now, before you ask, here is the summary!

Summary

In analyzing transactions regarding wage and salary costs, a careful distinction must be made between the amount earned by the employee, the additional cost that the company incurs for payroll taxes, and the amount collected from employees which is to be transmitted to the government. Pension costs are a cost associated with work done in the current period although the actual pension payments may not begin until many years later.

The Provision for Income Taxes is calculated as if the income tax were computed on the amount of accounting income reported for the period. The entry required to adjust actual income tax payments liability to this basis creates another liability account, deferred income taxes. This account does not represent an amount due the government.

An extraordinary gain or loss and a gain or loss from a discontinued operation are reported separately on the income statement. The amount is adjusted for the applicable income tax.

And now... good bye!

STUDENT: Bye, Teacher