Acc Unit 2 Notes (2) PDF

1 Unit 2: Inventory systems, capital asset accounting, and amortization 2. 1 - Inventory Systems Inventory Supply Chain and Product Flow: ○ Manufacturers create products → Wholesalers get the goods → Distrubute to retailers, or directly customers ○ Manufactur...

1 Unit 2: Inventory systems, capital asset accounting, and amortization 2. 1 - Inventory Systems Inventory Supply Chain and Product Flow: ○ Manufacturers create products → Wholesalers get the goods → Distrubute to retailers, or directly customers ○ Manufacturers create products and distribute them through wholesalers, retailers, or direct consumer sales. Inventory Across Business Types: ○ Service businesses maintain inventory. ○ Retailers, wholesalers, and manufacturing companies are known for inventory management because they deal with physical goods. ○ All businesses will have inventory of some kind Definition & Components of Inventory Ex. Raw materials, work-in-process goods, and finished goods that are ready or will be ready for sale. Represents items for sale expected to convert to cash within a year. Types Of Inventory In Manufacturing ○ Raw materials or supplies: Items used in the production process Direct: Directly converted into finished producted Indirect: Participate in the manufacturing product ○ Work in process (WIP): Items currently being manufactured but not yet finished. ○ Finished goods: Items completed and ready to be sold to consumers. On Balance Sheet Inventory is listed on the balance sheet immediately after accounts receivable. It signifies assets that are close to being converted into cas  2 Merchandising Vs. Manufacturing Merchandising ○ Inventory = merchandise Represents goods purchased and sold directly to consumers Manufacturing ○ Inventory includes raw materials, work in process, and finished goods, Periodic Inventory System Relies on physical counts to determine inventory levels and calculate COGS, ○ Suitable for businesses with less expensive goods where continuous tracking is not cost-effective. Inventory counts are conducted periodically (e.g., monthly or quarterly). Cost of Goods Sold (COGS): ○ Calculated at the end of the period ○ The direct costs caused by the production of the goods sold by a company. Nature of System ○ Updates occur only at the end of a period. ○ Reflects the quantity and cost of goods on hand and goods sold periodically. Businesses Utilizing Periodic System: ○ Ones that sell large quantities of relatively low-priced merchandise ○ Ex. Stores selling bulk candy, Hardware stores selling individual small items like nails. Accounting Procedures in Periodic System: ○ New items purchased are recorded in a temporary expense account called "purchases." ○ Revenue from sales is recorded, but the cost of goods sold (COGS) is not recorded immediately Journal entry of sale without recording the COGS yet  3 Inventory Count at Period End: ○ Companies do a physical count of inventory at the end of the period. ○ Counts the actual quantities of merchandise in stock. Determining Cost of Merchandise: ○ The cost of merchandise in stock is determined by referencing records that detail each item's original cost. ○ This helps in accurately valuing the inventory on hand. Historical Use of Periodic Systems: ○ Tracking these items in real-time was impractical Contemporary Inventory Practices: ○ Periodic physical inventory counts are still necessary. ○ Recorded inventory aligns with the physical stock on hand. ○ Adjustments may be made due to spoilage (food goes bad), theft, obsolescence (outdated), or miscalculation. Perpetual System: Offers ongoing tracking of inventory ○ Provides real-time data on inventory levels and costs. Constantly updated Detailed records are kept to continuously track the quantity and cost of inventory available, purchased, and sold. Provides real-time visibility into inventory levels and costs. Companies should still take a physical inventory count ○ To check whether their records agree with the physical stock on hand, and to adjust Continuous Inventory Tracking: ○ Maintains a real-time record of merchandise inventory. ○ Utilizes technology like bar codes to track purchases, availability, and sales daily. ○ Tracks the net cost of merchandise purchased and updates the inventory account accordingly. COGS Management: ○ Sold item = COG in inventory → COG accounts ○ Ensures accurate calculation of COGS based on actual sales. Inventory Status and Reporting: ○ Provides instant visibility into the cost of merchandise on hand at any time. ○ COGS account reflects the current value of goods sold over a period.  4 COGS Equation: Merchandise Inventory Recording: 1. Recording the purchase of merchandise 2. Recording the sale of merchandise Purchase of merchandise. If a local hardware store purchases $50,000 of Dewalt power tools to sell to customers When the merchandise is sold, two journal entries are made. 1. Sales revenue is recorded (debit cash, accounts receivable and credit sales). 2. The inventory account is reduced and the cost of goods sold is recorded (debit the cost of goods sold account, and credit inventory).  5 Perpetual Inventory System Calculation: The inventory account is updated continually for purchases and goods sold. Balances in the inventory and COGS are always up to date. Periodic vs Perpetual Perpetual Periodic Inventory and COGS are immediately Inventory and COGS are updated at the end updated with each sale. of each accounting period. Sale transactions were recorded via 2 journal Sale transactions are recorded with 1 journal entries. One for sale one for COGS entry. Purchases and returns are immediately Purchases, returns and allowances accounts debited and credited into the inventory are used continuously. account. System does not require closing entry Closing entries used to update inventory and COGS More expensive to maintain Costs less as it requires physical counts Provides more accurate, up-to-date Being used less and less as it is impractical information and business are computerizing their inventory.  6 Inventory Valuations Importance: ○ The value of ending inventory is essential for accurate financial reporting. ○ Important for stakeholders, investors and analysts, ○ Inventory valuation has an impact on reported net income. Calculation of Unit Costs: ○ Physical inventory requires applying unit costs to the quantities of inventory on hand. Variation in Unit Costs: ○ Inventory items are typically purchased at varying costs ○ Complicating the calculation of unit costs. Additional expenditures can include the cost of: customs and excise duties/ freight charged by factories or wholesalers/ storing goods/ensuring shipped or stored goods/ receiving and inspecting goods  7 Four Costing Methods - WILL BE ON TEST 1. First in, first out (FIFO) a. Used in Canada 2. Last in, first out (LIFO) a. Not allowed in IFRS, GAAPS, or ASPE 3. Specific item identification method 4. Average cost (AVCO) method Selecting Inventory Valuation Method: ○ Companies must choose an inventory valuation method to determine the worth of their inventory. Impact on Financial Statements: ○ The chosen method affects how inventory is priced at the start and end of each accounting period. ○ It influences a company’s balance sheet and income statement. Guidance from CPA Canada: ○ CPA Canada emphasizes selecting an inventory flow method that aligns inventory costs with sales revenue ○ This ensures that income accurately reflects the costs associated with goods sold during the period. FIFO Inventory Valuation Method: First items that are purchased are the first items are sold Order of Cost Attribution: ○ The cost of the first item purchased is matched with the first item sold (or used in production). ○ Newer or more recent purchases are considered to be in inventory. Impact on Inventory Cost: ○ FIFO assumes that the cost of goods remaining in inventory reflects the most recent purchases. ○ This approach affects how the cost of goods sold (COGS) and ending inventory values are calculated in financial statements.  8 FIFO PERPETUAL INVENTORY CARD ○ Companies maintain a separate perpetual inventory card for each item in stock. ○ Each card tracks real-time updates of quantity and dollar value for purchases, sales, and remaining inventory. ○ Information on purchases, cost of sales, and current inventory balance is readily available and updated after each transaction. LIFO(Last in First Out) Inventory Valuation Method: The most recently acquired or produced items are considered the first to be sold or used. Used more the US This results in assigning the cost of newer inventory to the cost of goods sold (COGS) and older inventory to the ending inventory. Suitability and Examples: ○ LIFO is effective for goods stored in piles or large bins where the physical order of sale mirrors the LIFO cost flow. Ex. Sand or Hay ○ It focuses on the flow of costs rather than the physical movement of goods, Specific Item Identification Method: Each individual item sold and remaining in inventory is identified and tracked. The cost of each specific item sold during a period is directly added to the cost of goods sold (COGS) for that period. The cost of specific items still on hand at the end of the period is included in the ending inventory valuation. This method is ideal in situations where a small number of easily distinguishable items ○ Ex. Jewellery, automobiles, handicrafts, and furniture Practical Application: ○ Suitable when items with distinct costs can be physically separated or identified ○ Provides accurate matching of costs to revenue, reflecting the actual flow of inventory costs.  9 Company makes the following purchases and sales in the period. The 3,000 units in the inventory on April 30 are composed of 500 units from purchases made on April 1, 1,500 units from purchases made on April 12, and 1,000 units from purchases made on April 30. Advantage of Specific Item Identification: ○ Ensures that the flow of costs directly corresponds to the physical movement of inventory. ○ Allows for accurate matching of actual costs against revenues, providing precise financial reporting. Disadvantage of Specific Item Identification: ○ Potential for manipulation of net income due to the discretion in choosing which specific items to sell. Ex. Selecting higher-cost or lower-cost items from inventory to influence reported income, impacting financial transparency. Average Cost (AVCO) Method: Commonly used in businesses with periodic inventory systems. Uses the average cost per unit to calculates both the cost of ending inventory and cost of goods sold ○ (COGS) based on the average cost per unit of inventory.  10 Application: ○ Provides a simpler method, suitable for periodic inventory management. Weighted Average Cost Method in Periodic Inventory: ○ In the periodic inventory system, the weighted average cost per unit is calculated for the entire inventory class. Calculation Application: Cost of ending inventory = Weighted average cost per unit x Number of units remaining in inventory at the end of the period. Errors In Valuing Inventory Accurate physical inventory counts are crucial for companies to avoid errors happening during financial reporting. It can impact calculations for cost of goods sold, gross profit, net income, current assets, and equity. Incorrect inventory figures at the end of one period carry forward as the starting numbers for the next period,  11 ○ Starting a downward spiral of mistakes Affects the reliability and effectiveness of financial reports Affecting decision-making and stakeholder confidence. Affect on Balance Sheet: Understating Ending Inventory: ○ Leads to understated current and total assets, as well as equity due to lower reported net income. Overstating Ending Inventory: ○ Results in overstatements impacting asset and equity values. Impact of Beginning Inventory Errors: ○ Errors in beginning inventory primarily affect the income statement rather than the balance sheet Influencing net income calculations.  12 2.2 - Internal Control Objectives Introduction to Internal Control Business managers prioritize using internal control systems to observe and regulate operations effectively. *These systems are designed to identify and assess risks, develop operational strategies, and monitor resources. 4 Purposes of Internal Control Operational Efficiency: ○ Companies need to maximize resource utilization, minimize costs, and ensure business follows policies. ○ They must report any necessary adjustments and follow regulations. ○ Efficient resource management, cost control, policy enforcement, and regulatory compliance. Detection of, and protection against, errors and fraud: ○ Detect and prevent errors and fraud to protect company resources. Uses fraud prevention measures and vigilant oversight within the organization ○ Failure to do so can lead to significant losses and potential legal consequences Ex. Widespread fraud Safeguarding assets and records: ○ Protecting records, assets Prevent resource wastage Records include financial information, customer information, etc. ○ It ensures accuracy and completeness as well as supports operational efficiency Providing accurate and reliable information: ○ Important for making informed decisions and upholding ethical standards in the business sector. ○ It supports transparency, accountability, and trustworthiness Other Purposes: ○ Ensure compliance with applicable laws and regulations ○ Align the business’s objectives ○ Encourage good management ○ Reduce exposure to risk An Adequate System of Internal Control Make sure that internal control is preventative and detective  13 ○ Preventative is more important because it notifies of things before it go wrong ○ Detective controls only go off after wrong things happen 5 Internal Control Principles - ON TEST AND EXAM Control environment ○ Influenced by management's attitude and behaviour ○ Organizational structure defines roles and responsibilities, creating clear lines of authority and accountability. ○ Policies surrounding hiring, training, evaluation, compensation, and promotion, makes sure employees are following ethical rules. Risk assessment process ○ Businesses use risk assessment to identify and evaluate various risks they encounter. Ex. Food producers assessing product safety risks. Airlines managing weather-related risks like accidents and flight disruptions. ○ All companies are exposed to risk of financial insolvency. When a business is unable to pay their debts During these times it is important for a business to make ethical decisions Control procedures ○ Guidelines that ensure that management's instructions are being implemented effectively. ○ Competent personnel are hired Duties are rotated, and mandatory vacations are taken. ○ Assigning responsibilities for a series of related transactions to more than one person. It lets people check others work an make sure everyone is being honest. ○ Addressing bias from hiring practices. ○ Developing and using documentation procedures, such as pre-numbered documents (e.g., invoices, purchase orders, receipts). ○ Using softwares with strong data encryption when data is transmitted over the Internet. ○ Enforcing the use of computer firewalls. ○ Ensuring that employees who handle large amounts of cash and assets are bonded. This is a type of insurance policy Control monitoring process ○ Auditors assess internal control systems to detect weaknesses and enhance effectiveness. ○ In smaller firms, managers and owners personally oversee control operations ○ An external auditor ensures accuracy in accounting and financial records.  14 Involves evaluating employee conduct and the accounting system for indications of control issues. ○ Control assessments are commonly conducted during significant changes in company strategy, senior management, business structure, or operations. Information systems and technology. ○ Fewer processing errors: Effective softwares minimize the risk of intentional sabotage and calculation errors. ○ More extensive testing: Technology allows management to exert greater control over data Internal and external auditors have access and control over the system. ○ Limited evidence of processing: It has made retrieving physical document records for review or evidence challenging because all records are online. Internal Control Summary Crucial for management but requires support and understanding ○ Most effective when all stakeholders in an organization. Just as unity for the common good is emphasized, internal controls function best when every employee aligns with the organization’s objectives and ethical standards. It highlights the importance of collective commitment to maintaining effective internal controls across all levels of the organization. Internal Control For E-Commerce E-commerce has risks surrounding cybersecurity. Hackers can exploit vulnerabilities to access sensitive information ○ Ex. Account numbers and passwords. This highlight the importance of robust cybersecurity measures in online transactions. It helps build trust and encourage purchases. Ex. Stolen credit card numbers, computer viruses and Trojans, phishing expeditions and identity theft are all major issues with e-commerce Wireless networks (WiFi and cellular) is a risk when customers' financial data due to breaches in internet security systems are exposed Internal Control Limitations Internal control systems cannot guarantee achievement of business objectives due to limitations. Some events beyond management's control and no internal control system is flawless.  15 Errors in Judgement: ○ Happen from negligence, fatigue, haste, or confusion, leading to flawed business decisions Cost-benefit standard: ○ Internal controls should balance costs and benefits, and recognize morale and legal rights, Ex. Accessing emails only when essential to protect the company. Breakdown due to human error: ○ Internal controls can fail when personnel misunderstand instructions, are overloaded with tasks, or lack training on new technology, leading to inadequate performance of duties. Management overriding internal control system: ○ A manager may still engage in "management override," where they intentionally bypass established policies or procedures Collusion: ○ Involves individuals working together to manipulate or hide actions ○ Actions such as altering financial or management information outside the control system's oversight. Internal Control Over Cash Receipts & Payments Cash Control ○ Procedures to safeguard cash receipts and manage cash disbursements securely. ○ Should meet three basic guidelines: Separate handling of cash from record keeping of cash Deposit cash in bank daily or as often as possible Make cash payments by cheque Cheque has records Can only be deposited for the people it was made for Cash Receipts ○ Ex. Cash sales Cheques for accounts receivable Receipts of interest, dividends, and rent Investments by owners Bank loans  16 Over the Counter Cash Receipts ○ POS machines display transaction amounts publicly to ensure transparency for customers during purchases. ○ Modern cash registers lock in transaction records, It prevents unauthorized changes by cashiers Automatically integrating cash transactions into accounting records. ○ Cashiers are responsible for issuing receipts for debit and credit card sales to match recorded payment amounts accurately. Cash Receipts by Mail ○ Not many people use this ○ Two individuals are required to open mail and receive cheques. ○ The person opening the cheque records the details ○ Another person compares the bank's deposit record with accounting records to ensure accuracy. ○ In smaller companies, the owner typically handles these responsibilities. Electronic Funds Transfer ○ Electronic exchange or transfer of money between accounts. ○ Can occur within a single financial institution or across multiple institutions. ○ Ex. Electronic bill payments Smart cards ATM withdrawals Internal Control Over Cash Disbursements Control over cash payments is typically stronger when made via cheque or Electronic Funds Transfer (EFT) rather than physical cash Control Activities Over Cash Payments Signing Responsibility: ○ Only authorized personnel are permitted to sign cheques or approve electronic payments. Human Resources: ○ Bonded employees manage cash, oversee vacation schedules, and undergo background checks. Duty Segregation: ○ Different individuals handle approval and payment processes; those signing cheques do not record payments.  17 Physical and IT Controls: ○ Cash is secured in safes, and access to blank cheques and signing machines is restricted. Electronic payments are preferred over cash for business-to-business transactions. Document Procedures: ○ Use pre-numbered cheques for business transactions, ensuring each cheque correlates with an approved invoice. Independent Checks: ○ Personnel compare cheques with invoices and reconcile bank statements monthly to verify accuracy. Cheques ○ At least two authorized employees sign them after ensuring they review supporting payment documentation. ○ The customer signs the cheque to authorize the bank to pay the specified amount to the payee. ○ This involves three parties: Customer: Issues and signs the cheque. Payee: Receives the cheque amount. Bank: Where the cheque is drawn, responsible for processing the payment. Electronic Payments ○ Direct deposit ensures instant transfer of funds from company to employee ○ Pre-authorized electronic payments are common for recurring expenses like insurance premiums. ○ Benefits of Electronic Payments: Proper authorization and segregation of duties enhance control. Reduce costs associated with cheque payments. Improve overall efficiency in financial transactions. Petty Cash Fund ○ Used by companies for small expenses without writing cheques. ○ Ensures suitable control over these expenditures. ○ Adjusting the petty cash amount based on usage patterns, either increasing or decreasing as required. ○ Steps in Operating a Petty Cash Fund: 1. Establishing the Fund: Setting up an initial amount for petty cash. 2. Making Payments: Using the fund to make small payments as needed. 3. Evaluating and Replenishing: Assessing the fund's balance and replenishing it as necessary to maintain operations.  18 2.3 - Capital Assets Accounting- Capital Vs. Revenue Expenditures Capital Expenditures Makes the life of an asset longer or improves it Helps limit depreciation Additions/Enlargements ○ Expenditures aimed at increasing the size or capacity of an existing asset. ○ Ex. Adding a new building to the school Extraordinary repairs ○ Repairing significant expenditures beyond routine maintenance and restore the asset to its original condition. ○ Ex. Putting a new engine in a car, adding heating/cooling system to the school Betterments ○ Improve the efficiency, extend the useful life, or add value to the existing asset. ○ Do not lengthen the asset’s life, Cost is debited to the asset account. ○ Ex. Replacing all the computers in a building with better models  19 Revenue or Operating Expenditure Do not increase the value or extend the life of fixed assets Treated as a revenue (operating) expense (directly contributes to revenue) Directly contributes to revenue and is used to maintain business or day-to-day operations. ○ Purchasing "floating" or current assets intended for resale, raw materials, and other supplies. ○ Maintaining assets in proper working order Ex. repairs to plant and machinery, and building furniture and fittings. ○ Covering day-to-day business operations Ex. Salaries, rent, rates, taxes, stationery, and postage. Treatment in financial statements: ○ Deducted from the firm’s earned income and used to determine net income Journal Entries: Capital Expenditures & Revenue (Operating) Expenditures Capital Expenditure Revenue Expenditure Its effect is long-term: it is not exhausted within Its effect is temporary: it is exhausted within the the current account year. Its benefit is enjoyed in current accounting year. future years, too. Its value and effect reduce Only in the current year gradually. Stretched over many years An asset is acquired or an asset's value is No assets are acquired, and none increase in increased, as a result of this expenditure. value. It does not occur repeatedly or regularly. It occurs repeatedly and regularly Generally, it has physical existence: it is a tangible it has no physical existence: it is not a tangible object (you can see it and feel it) object. This expenditure improves the company's position This expenditure helps to maintain the company A portion of this expenditure is shown in the The whole amount of this expenditure is shown in trading and profit and loss account (or income and the trading and profit and loss account (or income expense account) as depreciation and expense account), but deferred revenue expenditures and prepaid expenses are not shown.  20 It appears in the balance sheet until its benefit is Deferred revenue expenditure, outstanding fully exhausted. expenditure, outstanding expenses, and prepaid expenses, however, are temporarily shown in the balance sheet It does not reduce the company's revenue. It reduces revenue. Paying salaries to employees Purchasing fixed assets does not affect revenue. decreases revenue. Capital expenditure (CapEx) and depreciation: ○ Benefits two or more accounting periods during depreciation. ○ Expensed over future accounting periods. Recording and financial statements: ○ Expensed items appear on the expense side of the income statement. ○ Capitalized items are recorded on the balance sheet. Property, Plant & Equipment Long-lived assets owned and utilized by the company to produce goods or services over multiple years. They have physical substance (a definite size and shape). They are not intended for sale to customers. Cost of Property, Plant, and Equipment: ○ Purchase price of the asset + non-refundable taxes - discounts Capitalization of Costs: ○ When an asset retires, costs for dismantling, removal, or restoration obligations are estimated. ○ These costs are capitalized (recorded as property, plant, and equipment) Only if future economic benefits will come from the asset. Differentiating Costs: ○ Operating Expenditures: Expensed and benefit only the current period. ○ Capital Expenditures: Included in long-lived asset accounts. Benefit future periods. Property, plant, and equipment classes: - WILL BE ON TEST Land: ○ Cost is not depreciated or allocated over its useful life because land is unlimited. ○ Cost of land includes: Purchase price  21 Closing cost, surveying and legal fees Preparing the land for its intended use, Ex. Removal of old buildings, clearing, draining, filling, and grading Costs are debited to the land account. ○ Ex. Purchase real estate for $90,000 cash. Contains a warehouse that is removed at a net cost of $5,000 ($7,500 to remove it - $2,500 received for material from the warehouse). Additional expenditures include the legal fee of $3,000. The land cost is $98,000, as calculated in the following table. When recording the acquisition, land is debited for $98,000 and cash is credited for $98,000 (assuming that the cost was paid in cash). Land Improvements: ○ Structural additions to land Ex. Driveways, sprinkler systems, sidewalks, fences, and parking lots. ○ Separate from land as they deteriorate over time and require maintenance/replacement. ○ Depreciation and Maintenance: Land improvements are depreciated over their useful lives Regular maintenance or eventual replacement is necessary ○ Cost Classification: Initial one-time costs to prepare land for use are not charged to the land improvement account This ensures proper allocation of costs and accurate accounting for land and land improvements. Buildings ○ Ex. Ownership of stores, offices, factories, and warehouses. ○ Costs of purchasing or constructing building Recorded in building account  22 Purchase price + closing costs like legal fees. Expenses for preparing the building for its intended use, such as remodelling and repairs, are also included. ○ Construction of New Buildings: Costs: Contract price, architects’ fees, building permits, and excavation costs. Interest costs are added to the building's cost ○ Ex. Materials and labor ○ Only interest costs are capitalized. ○ Post-Construction Interest: Costs: Ongoing interest payments on loans expensed as interest expenses. Plant and equipment Plant and Equipment: ○ Plant: Immobile machinery, furnaces, air-conditioning systems. ○ Equipment: Broad category, delivery equipment, office equipment, computers, vehicles, furniture, fixtures, and similar assets. ○ Cost Components: Purchase Price: Initial cost of acquiring the asset. Freight Charges and Insurance: Transit cost paid by the purchaser. Assembly, Installation, Testing: Costs for setting up the equipment for use. Treated as capital expenditures because they provide benefits over future periods. Capitalizing involves recording them as part of the asset's total cost rather than expensing them immediately.  23 2.4 - Amortization & Depreciation Amortization & Depreciation Amortization and depreciation refer to the process of allocating the cost of an asset over its estimated useful life in a systematic and rational manner Both terms are acceptable. Typically, depreciation is used for tangible assets, such as buildings and machinery. Amortization is used for intangible assets with a finite life ○ e.g., pharmaceutical patents in Canada are generally for 20 years). Measuring Amortization A capital asset is amortized according to three main factors: ○ its cost ○ its estimated useful life ○ its estimated residual value Amortization recorded for an asset cannot exceed its amortizable cost. Amortizable cost = Total cost of the asset - Residual value: ○ Residual Value: The expected value of the asset at the end of its useful life. Not considered part of the asset's consumption over time. Importance of Accuracy: ○ It affects the amount of amortization expense recorded. ○ Amortization directly impacts the calculation of net income Amortization Definitions: ○ Known Cost: The initial cost of the asset is a definite figure. ○ Estimated Factors: Amortization involves estimating two factors: ○ Useful Life: The period over which the asset is expected to provide economic benefits. ○ Estimated useful life: The length of the service or total production expected from the asset. May be expressed in years, units of production, kilometres, etc ○ Estimated residual value: (Salvage value) is the asset’s expected cash value at the end of its useful life. ○ Scrap value: Value at the end of its physical life. After its expected lifespan Amortization Methods Three methods allocate different amounts of amortization expense to each period, but all result in the same total amortization over asset’s life.  24 Straight-line method ○ The straight-line method allocates an equal amount of amortization for each year of asset use. ○ Ex. ○ Journal: Debit: Amortization expense - Delivery Truck Credit: Accumulated amortization - Delivery Truck ○ Formula for straight-line method is restated to show the useful life as a rate or percentage If an asset is amortized each year, the formula can be restated as shown: ○ Balance Sheet: Units-of-production method ○ Produces a fixed amount of amortization for each unit of production that the asset produces.  25 ○ Activity can be measured in units of output Ex. Kilometres driven or hours in use. Double-declining-balance method ○ Multiplies the asset's book value by a constant percentage. Double the rate used in the straight-line method. ○ Higher amortization expenses in the early years of the asset's life but gradually decreases over time. ○ Expense in the final year is often a "plug" figure. It is the amount required to adjust the asset's book value to match its residual value (scrap value). ○ Calculation Method: Calculate the straight-line amortization rate per year Multiply the straight-line rate by two to get the DDB rate. Calculate the year’s DDB amortization For the final year: Subtract book value from residual value to get the exact value Intangible Assets Nature of Intangible Assets: ○ Provide economic benefits over future periods Used in manufacturing, not for immediate sale to customers. ○ No physical existence ○ Affected by amortization An operating expense on the income statement. ○ Ex. Patents, copyrights, franchises, and goodwill. ○ Help with corporate value based on customer loyalty or brand recognition. ○ Long-lived assets on the balance sheet. ○ Do not have contra-accounts associated with them. ○ Current intangible assets are things like accounts receivable or prepaid insurance.  26 Patents: ○ Granted by government ○ Give a company an exclusive right to produce/sell an invention for 20 years. Invention product or a process. ○ A Canadian patent is usually granted for 20 years, but is amortized for a shorter period. Copyrights: ○ Better for creators of artistic, literary, musical, or other creative works to publish and distribute their works. Ex. Musical compositions by renowned artists Can remain valuable investments over several decades. ○ Lasts for the creator's life plus 50 years. ○ Initial cost of acquiring a copyright is recorded as an asset. ○ Amortized over its expected useful life Expensed in an account called "Amortization Expense - Copyright." ○ Companies may purchase existing ones at the entire amount May provide future economic benefits ○ Ex. A publisher might acquire a novelist's next book copyright, expecting it to yield returns comparable to previous successes. Intangible Assets with Indefinite Lives: ○ Have an indefinite life No limit to the length of time over which the asset is expected to generate cash. ○ Ex. Trademarks and brand names, franchises and licences. ○ Intangible assets do not always fit perfectly within a specific category. Trademarks and Brand Names: ○ Trademarks and brand names are distinctive identifications of products or services. Ex. Molson Canadian, Swiss Chalet, Roots, and Toyota ○ Advertising slogans are protected for a period of 15 years (can be renewed). ○ Amortized over its useful life.  27 Franchise and Licenses: ○ Franchisor grants a franchisee the right to sell certain products, provide specific services, or use certain trademarks or brand names Within a specific geographic area. Agreed upon contract ○ Have indefinite lives and are not amortized. ○ Annual payments (royalties) are sometimes required ○ Recorded as operating expenses in the period Goodwill ○ Excess of the cost to purchase a company over the market value of its net assets (assets minus liabilities). Purolator Inc. acquired Mattawa Express Couriers at a cost of $10 million. The market value of Mattawa Express’s assets is $9 million, and its liabilities total $1 million. In this case, Purolator paid $2 million for goodwill, calculated as follows: Special Features: ○ “Plug” value that balances the accounts Does not generate cash flows. ○ Goodwill is an intangible asset Acquiring company records when one business combines with another. ○ Paid by the acquiring company for intangible assets owned or developed Journal: Assume that the goodwill purchased in the preceding example is worth only $1,500,000 at the end of the first year,  28 2.5 - A Closer Analysis of Amortization Which Amortization Method to Choose? Depends on the specific asset being considered. The method must align an asset's expense with the revenue it generates. Company must disclose the chosen method in its annual reports Straight Line Method: ○ Asset that generates revenue fairly evenly over time Ex. Major appliances, office furniture and lights ○ Most popular method for small businesses to use Unit-of- production (UOP) Method: ○ Assets that wear out due to physical use, not obsolescence, or are intermittently used. Ex. Farming equipment, commercial airplanes, and factory machinery ○ Depreciation varies based on actual usage and is recorded only when the asset is used. Higher use = Higher depreciation ○ Profit fluctuates with asset usage each year The Double Declining (DDB) Method: ○ Assets that generate higher revenue and productivity in their initial years Ex. Smartphones, computer equipment. ○ Most valuable asset and generate more revenue when new. ○ Reduces profits during early years, but higher profits as the asset ages. Depreciation & Income Tax Canada Revenue Agency: Single diminishing-balance method for tax returns. Businesses can choose their preferred depreciation method for financial reporting. ○ Choose based on the assets use and the least amount of depreciation Amortizing an Intangible Asset Amortization reduces the value of intangible assets and decreases stockholders' equity on the balance sheet ○ Ex. The diminishing value of technology patents is reflected on the balance sheet due to its rapid obsolescence The cost of an intangible asset is initially recorded on the balance sheet when purchased from another party and when it has a finite life. The company spreads out the asset's cost as an expense over successive accounting periods.  29 Calculating Annual Amortization Expense Effects on Assets: ○ Ammortization reduces the value of an intangible asset on the balance sheet. Ex. An intangible asset with a five-year useful life has a $200 annual amortization expense. Its balance sheet value decreases by $200 each year. Effects on Stockholders’ Equity: ○ Decreases net income on the income statement Revenue minus expenses. ○ Decreases retained earnings on the balance sheet. Represent the accumulated net income that has been retained within the company. ○ Ex. A $200 annual amortization expense decreases net income by $200 on the income statement, and reduces retained earnings on the balance sheet by $200. Cash Flow Statement: ○ Indirect method to calculate cash flow Adding or subtracting non-cash expenses (depreciation) and gains. Because it increases net income without corresponding cash outflows. Doesn’t contribute to cash generation. Non-cash sales on credit are subtracted from net income Increase net income Do not increase cash flow, as cash is not received immediately. ○ Allows accountants to identify and explain differences by adjusting net income for non-cash items like depreciation.  30 Depreciation and Cash Flow Depreciation expense added back to net income when preparing an indirect cash flow statement. This treatment applies to depreciation of physical assets and other non-cash expenses ○ Ex. Increases in accounts payable and accumulated interest expenses. Overall, net income reflects less cash received than the actual business operations generated. To obtain an accurate cash flow figure, these non-cash expenses are added back to the net income. Direct Method & Depreciation Of The Cash Flow Statement The direct method of preparing the cash flow statement focuses solely on cash inflows and outflows. ○ Net cash flows = Sum of all cash receipts - Cash payments Depreciation is not included in the direct method calculations because it doesn’t involve actual cash transactions. Lacks the advantage of explaining discrepancies between net income and cash flow. Loan Depreciation & Cash Flow Various depreciation schedules lead to different payment amounts in each billing cycle. ○ Therefore, the business should have cash available to pay the lender Businesses must choose appropriate depreciation schedules. Adjustments in cash flow management are crucial to ensure there is enough cash on hand to meet loan payment obligations regularly. Depreciation of Property & Cash Flow Purchasing property with cash avoids interest on loans, but reduces immediate cash flow. A loan for property purchase adds future obligations ○ Which is managed within the business's cash flow. Property depreciation impacts cash flow by influencing initial purchasing decisions and further loan obligations.