Ahihi

kieso
weygandt
warfield
INTERMEDIATE
Intermediat
Intermediat
team for success
F I F T E E N T H E D I T I O N
ACCOUNTING
e e
Accounting
Accounting
Prepared by
Coby Harmon
Prepared by
University of California,
CobySanta BarbaraPrepared by
Harmon
Westmont
University College SantaCoby
of California, Harmon
Barbara
University of California, Santa Barbara
10-1 Westmont College
PREVIEW OF CHAPTER 10
Intermediate Accounting
15th Edition
Kieso Weygandt Warfield
10-2
Acquisition and Disposition
of Property, Plant, and
Equipment
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Describe property, plant, and equipment. 5. Understand accounting issues related to

acquiring and valuing plant assets.
2. Identify the costs to include in initial
valuation of property, plant, and 6. Describe the accounting treatment for
equipment. costs subsequent to acquisition.
3. Describe the accounting problems 7. Describe the accounting treatment for the
associated with self-constructed assets. disposal of property, plant, and
equipment.
4. Describe the accounting problems
associated with interest capitalization.
10-3
Property, Plant, and Equipment
Property, plant, and equipment are assets of a durable

nature. Other terms commonly used are plant assets and
fixed assets.
Includes:
Used in operations and not
Land,
for resale.
Building structures
Long-term in nature and (offices, factories,
warehouses), and
usually depreciated.
Equipment
Possess physical substance. (machinery, furniture,
tools).
10-4 LO 1 Describe property, plant, and equipment.

Equipment
LEARNING OBJECTIVES

equipment.
10-5
Property, Plant, and Equipment
Acquisition of Property, Plant, and Equipment

Historical cost measures the cash or cash equivalent price of
obtaining the asset and bringing it to the location and condition
necessary for its intended use.
Main reasons for historical cost valuation:
Historical cost is reliable.

Companies should not anticipate gains
and losses but should recognize gains
and losses only when the asset is sold.
LO 2 Identify the costs to include in initial valuation of

10-6
property, plant, and equipment.
Acquisition of PP&E
Cost of Land
Includes all expenditures to acquire land and ready it for use.
Costs typically include:
(1) purchase price;
(2) closing costs, such as title to the land, attorneys fees, and
recording fees;
(3) costs of grading, filling, draining, and clearing;
(4) assumption of any liens, mortgages, or encumbrances on the
property; and
(5) additional land improvements that have an indefinite life.
10-7 LO 2
Acquisition of PP&E
Cost of Land
Improvements with limited lives, such as private driveways,
walks, fences, and parking lots, are recorded as Land
Improvements and depreciated.
Land acquired and held for speculation is classified as an

investment.
Land held by a real estate concern for resale should be

classified as inventory.

10-8
Acquisition of PP&E
Cost of Buildings
Includes all expenditures related directly to acquisition or
construction. Costs include:
materials, labor, and overhead costs incurred during

construction and
professional fees and building permits.

10-9
Acquisition of PP&E
Cost of Equipment
Include all expenditures incurred in acquiring the equipment
and preparing it for use. Costs include:
purchase price,
freight and handling charges,
insurance on the equipment while in transit,
cost of special foundations if required,
assembling and installation costs, and
costs of conducting trial runs.

10-10
Acquisition of PP&E
Illustration: The expenditures and receipts below are related to land, land
improvements, and buildings acquired for use in a business enterprise.
Determine how the following should be classified:
(a) Money borrowed to pay building contractor Notes Payable

(b) Payment for construction from note proceeds Building
(c) Cost of land fill and clearing Land
(d) Delinquent real estate taxes on property
Land
assumed
(e) Premium on 6-month insurance policy during Building
construction
(f) Refund of 1-month insurance premium because (Building)
construction completed early
10-11 LO 2
Acquisition of PP&E
Illustration: The expenditures and receipts below are related to land, land
improvements, and buildings acquired for use in a business enterprise.
Determine how the following should be classified:
(g) Architects fee on building Building

(h) Cost of real estate purchased as a plant site
Land
(land $200,000 and building $50,000)
(i) Commission fee paid to real estate agency Land
(j) Installation of fences around property Land Improvements
(k) Cost of razing and removing building Land
(l) Proceeds from salvage of demolished building (Land)
(m) Cost of parking lots and driveways Land Improvements
(n) Cost of trees and shrubbery (permanent) Land
10-12 LO 2
Equipment
LEARNING OBJECTIVES

equipment.
10-13
Acquisition of PP&E
Self-Constructed Assets
Costs include:
1) Materials and direct labor
2) Overhead can be handled in two ways:

1. Assign no fixed overhead.
2. Assign a portion of all overhead to the construction

process.
Companies use the second method extensively.
10-14 LO 3 Describe the accounting problems associated with self-constructed assets.

Equipment
LEARNING OBJECTIVES

equipment.
10-15
Acquisition of PP&E
Interest Costs During Construction

Three approaches have been suggested to account for the
interest incurred in financing the construction.
Illustration 10-1
Increase to Cost of Asset

$0 $?
Capitalize no Capitalize
interest during Capitalize actual all costs of
construction costs incurred during funds
construction
GAAP
10-16 LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E
Interest Costs During Construction

GAAP requires capitalizing actual interest (with
modification).
Consistent with historical cost.
Capitalization considers three items:
1. Qualifying assets.
2. Capitalization period.
3. Amount to capitalize.

Interest Capitalization
Qualifying Assets
Require a period of time to get them ready for their intended
use.
Two types of assets:
Assets under construction for a companys own use.
Assets intended for sale or lease that are constructed or

produced as discrete projects.

Capitalization Period
Begins when:
1. Expenditures for the asset have been made.
2. Activities for readying the asset are in progress .
3. Interest costs are being incurred.
Ends when:
The asset is substantially complete
and ready for use.

Amount to Capitalize
Capitalize the lesser of:
1. Actual interest costs.
2. Avoidable interest - the amount of interest cost during

the period that a company could theoretically avoid if it
had not made expenditures for the asset.

Interest Capitalization Illustration: Assume a company borrowed

$200,000 at 12% interest from State Bank on Jan. 1, 2014, for specific
purposes of constructing special-purpose equipment to be used in its
operations. Construction on the equipment began on Jan. 1, 2014, and
the following expenditures were made prior to the projects completion on
Dec. 31, 2014:
Other general debt existing on
Actual Expenditures during 2014: Jan. 1, 2014:
January 1 $100,000
$500,000, 14%, 10-year
April 30 150,000 bonds payable
November 1 300,000
December 31 100,000 $300,000, 10%, 5-year
Total expenditures $650,000 note payable
10-21 LO 4
Step 1 - Determine which assets qualify for capitalization of

interest.
Special purpose equipment qualifies because it requires a period of
time to get ready and it will be used in the companys operations.
Step 2 - Determine the capitalization period.

The capitalization period is from Jan. 1, 2014 through Dec. 31, 2014,
because expenditures are being made and interest costs are being
incurred during this period while construction is taking place.

Step 3 - Compute weighted-average accumulated

expenditures. Weighted
Average
Actual Capitalization Accumulated
Date Expenditures Period Expenditures
Jan. 1 $ 100,000 12/12 $ 100,000
Apr. 30 150,000 8/12 100,000
Nov. 1 300,000 2/12 50,000
Dec. 31 100,000 0/12 -
$ 650,000 $ 250,000
A company weights the construction expenditures by the amount of time

(fraction of a year or accounting period) that it can incur interest cost on the
expenditure.

Step 4 - Compute the Actual and Avoidable Interest.
Selecting Appropriate Interest Rate:

1. For the portion of weighted-average accumulated expenditures
that is less than or equal to any amounts borrowed specifically to
finance construction of the assets, use the interest rate incurred
on the specific borrowings.
2. For the portion of weighted-average accumulated expenditures

that is greater than any debt incurred specifically to finance
construction of the assets, use a weighted average of interest
rates incurred on all other outstanding debt during the
period.

Step 4 - Compute the Actual and Avoidable Interest.
Actual Interest
Interest Actual
Debt Rate Interest Weighted-average
Specific Debt $ 200,000 12% $ 24,000 interest rate on
general debt
General Debt 500,000 14% 70,000 $100,000
= 12.5%
300,000 10% 30,000 $800,000
$ 1,000,000 $ 124,000
Accumulated Interest Avoidable

Avoidable Interest Expenditures Rate Interest
$ 200,000 12% $ 24,000
50,000 12.5% 6,250
$ 250,000 $ 30,250

Step 5 Capitalize the lesser of Avoidable interest or Actual

interest.
Avoidable interest $ 30,250

Actual interest 124,000
Journal entry to Capitalize Interest:
Equipment 30,250
Interest Expense 30,250

Comprehensive Illustration: On November 1, 2013, Shalla

Company contracted Pfeifer Construction Co. to construct a building
for $1,400,000 on land costing $100,000 (purchased from the
contractor and included in the first payment). Shalla made the
following payments to the construction company during 2014.

Pfeifer Construction completed the building, ready for occupancy, on

December 31, 2014. Shalla had the following debt outstanding at
December 31, 2014.
Specific Construction Debt
1. 15%, 3-year note to finance purchase of land and
construction of the building, dated December 31, 2013, with
interest payable annually on December 31 $750,000
Other Debt
2. 10%, 5-year note payable, dated December 31, 2010, with
3. 12%, 10-year bonds issued December 31, 2009, with
Compute weighted-average accumulated expenditures for 2014.

Compute weighted-average accumulated expenditures for 2014.
Illustration 10-4
Advance slide in
presentation mode
10-29 to reveal answers. LO 4
Compute the avoidable interest.

Illustration 10-5
Advance slide in
presentation mode
Compute the actual interest cost, which represents the maximum

amount of interest that it may capitalize during 2014.
Illustration 10-6
The interest cost that Shalla capitalizes is the lesser of $120,228

(avoidable interest) and $239,500 (actual interest), or $120,228.

Shalla records the following journal entries during 2014:
January 1 Land 100,000

Buildings (or CIP) 110,000
Cash 210,000
March 1 Buildings 300,000
Cash 300,000
May 1 Buildings 540,000
Cash 540,000
December 31 Buildings 450,000
Cash 450,000
Buildings (Capitalized Interest) 120,228
Cash 239,500
10-32 LO 4
At December 31, 2014, Shalla discloses the amount of interest

capitalized either as part of the income statement or in the notes
accompanying the financial statements.
Illustration 10-7
Illustration 10-8

WHATS YOUR
WHAT S IN YOUR PRINCIPLE
INTEREST?
The requirement to capitalize interest can Anadarko Petroleum Corporation

significantly impact financial statements. capitalized nearly 30 percent of its total
For example, when earnings of building interest costs in a recent year and provided
manufacturer Jim Walters Corporation the following footnote related to capitalized
dropped from $1.51 to $1.17 per share, the interest.
company offset 11 cents per share of the
decline by capitalizing the interest on coal Financial Footnotes
mining projects and several plants under Total interest costs Incurred during the year
construction. were $82,415,000. Of this amount, the
How do statement users determine the Company capitalized $24,716,000.
impact of interest capitalization on a Capitalized interest is included as part of the
cost of oil and gas properties. The
companys bottom line? They examine the
capitalization rates are based on the
notes to the financial statements. Companys weighted-average cost of
Companies with material interest borrowings used to finance the expenditures.
capitalization must disclose the amounts of
capitalized interest relative to total interest
costs. For example,

Special Issues Related to Interest Capitalization

1. Expenditures for Land
Interest costs capitalized are part of the cost of the
plant, not the land.
2. Interest Revenue
In general, companies
should not net or offset
interest revenue against
interest cost.

Equipment
LEARNING OBJECTIVES

equipment.
10-36
Valuation of PP&E
Companies should record property, plant, and equipment:
at the fair value of what they give up or
at the fair value of the asset received,
whichever is more clearly evident.
10-37 LO 5 Understand accounting issues related to acquiring and valuing plant assets.
Valuation of PP&E
Cash Discounts Discount for prompt payment.
Deferred-Payment Contracts Assets purchased on

long-term credit contracts at the present value of the
consideration exchanged.
Lump-Sum Purchases Allocate the total cost among the

various assets on the basis of their relative fair market values.
Issuance of Stock The market price of the stock issued is

a fair indication of the cost of the property acquired.
Valuation of PP&E
Exchanges of Nonmonetary Assets

Ordinarily accounted for on the basis of:
the fair value of the asset given up or
the fair value of the asset received,
whichever is clearly more evident.
Companies should recognize immediately any gains or losses on

the exchange when the transaction has commercial substance.
Valuation of PP&E
Meaning of Commercial Substance

Exchange has commercial substance if the future cash flows
change as a result of the transaction. That is, if the two parties
economic positions change, the transaction has commercial
substance.
Illustration 10-10
* If cash is 25%
or more of the
fair value of the
exchange,
recognize entire
gain because
earnings
process is
complete.
Valuation of PP&E
ExchangesLoss Situation
Companies recognize a loss immediately whether the exchange
has commercial substance or not.
Rationale: Companies should not value assets at more than their

cash equivalent price; if the loss were deferred, assets would be
overstated.
Valuation of PP&E
Illustration: Information Processing, Inc. trades its used machine for a

new model at Jerrod Business Solutions Inc. The exchange has
commercial substance. The used machine has a book value of $8,000
(original cost $12,000 less $4,000 accumulated depreciation) and a fair
value of $6,000. The new model lists for $16,000. Jerrod gives
Information Processing a trade-in allowance of $9,000 for the used
machine. Information Processing computes the cost of the new asset
as follows.
Illustration 10-11
10-42 LO 5
Valuation of PP&E
Illustration: Information Processing records this transaction as

follows:
Equipment 13,000
Accumulated DepreciationEquipment 4,000
Loss on Disposal of Equipment 2,000
Equipment 12,000
Cash 7,000
Illustration 10-12
Loss on
Disposal
Valuation of PP&E
ExchangesGain Situation
Has Commercial Substance. Company usually records the
cost of a nonmonetary asset acquired in exchange for
another nonmonetary asset at the fair value of the asset
given up, and immediately recognizes a gain.
Valuation of PP&E
Illustration: Interstate Transportation Company exchanged a number

of used trucks plus cash for a semi-truck. The used trucks have a
combined book value of $42,000 (cost $64,000 less $22,000
accumulated depreciation). Interstates purchasing agent,
experienced in the secondhand market, indicates that the used trucks
have a fair market value of $49,000. In addition to the trucks,
Interstate must pay $11,000 cash for the semi-truck. Interstate
computes the cost of the semi-truck as follows.
Illustration 10-13
Valuation of PP&E
Illustration: Interstate records the exchange transaction as follows:
Truck (semi) 60,000

Accumulated DepreciationTrucks 22,000
Trucks (used) 64,000
Gain on Disposal of Trucks 7,000
Cash 11,000
Illustration 10-14
Gain on
Disposal
Valuation of PP&E
Lacks Commercial SubstanceNo Cash Received. Now
assume that Interstate Transportation Company exchange
lacks commercial substance.
Interstate defers the gain of $7,000 and reduces the basis of

the semi-truck.
Valuation of PP&E
Illustration: Interstate records the exchange transaction as

follows:
Trucks (semi) 53,000

Accumulated DepreciationTrucks 22,000
Trucks (used) 64,000
Cash 11,000
Illustration 10-15
Valuation of PP&E
Lacks Commercial SubstanceSome Cash Received.
When a company receives cash (sometimes referred to as
boot) in an exchange that lacks commercial substance, it
may immediately recognize a portion of the gain. The
general formula for gain recognition when an exchange
includes some cash is as follows:
Illustration 10-16
Valuation of PP&E
Illustration: Queenan Corporation traded in used machinery

with a book value of $60,000 (cost $110,000 less accumulated
depreciation $50,000) and a fair value of $100,000. It receives in
exchange a machine with a fair value of $90,000 plus cash of
$10,000.
Illustration 10-17
Valuation of PP&E
The portion of the gain a company recognizes is the ratio of

monetary assets (cash in this case) to the total consideration
received.
Illustration 10-18
Advance slide in
presentation mode
Valuation of PP&E
Queenan would record the following entry.

Illustration 10-19
Cash 10,000
Machine (new) 54,000
Accumulated DepreciationMachinery 50,000
Machine 110,000
Gain on Disposal of Machinery 4,000
Valuation of PP&E
Summary of Gain and Loss Recognition

on Exchanges of Non-Monetary Assets
Illustration 10-20
Valuation of PP&E
Illustration: Santana Company exchanged equipment used in its

manufacturing operations plus $2,000 in cash for similar equipment
used in the operations of Delaware Company. The following
information pertains to the exchange.
Santana Delaware
Equipment (cost) $28,000 $28,000
Accumulated depreciation 19,000 10,000
Fair value of equipment 13,500 15,500
Cash given up 2,000
Instructions: Prepare the journal entries to record the exchange on

the books of both companies.
Valuation of PP&E
Calculation of Gain or Loss

Santana Delaware
Fair value of equipment received $15,500 $13,500
Cash received / paid (2,000) 2,000
Less: Book value of equipment
($28,000-19,000) (9,000)
($28,000-10,000) (18,000)
Gain or (Loss) on Exchange $4,500 ($2,500)
Valuation of PP&E
Has Commercial Substance
Santana:
Equipment 15,500
Accumulated Depreciation 19,000
Cash 2,000
Equipment 28,000
Gain on Exchange 4,500
Delaware:
Cash 2,000
Equipment 13,500
Loss on Exchange 2,500
Equipment 28,000
10-56 LO 5
Valuation of PP&E
Santana (Has Commercial Substance):

Equipment 15,500
Cash 2,000
Equipment 28,000
Gain on Disposal of Equipment 4,500
Santana (LACKS Commercial Substance):

Equipment (15,500 4,500) 11,000
Cash 2,000
Equipment 28,000
10-57 LO 5
Valuation of PP&E
Delaware (Has Commercial Substance):

Cash 2,000
Equipment 13,500
Equipment 28,000
Delaware (LACKS Commercial Substance):

Cash 2,000
Equipment 13,500
Equipment 28,000
WHATS YOUR
ABOUT THOSE PRINCIPLE
SWAPS
In a press release, Roy Olofson, former vice But Global Crossing and Qwest, among
president of finance for Global Crossing, others, counted as revenue the money
accused company executives of improperly received from the other company in the swap.
describing the companys revenue to the (In general, in transactions involving leased
public. He said the company had improperly capacity, the companies booked the revenue
recorded long-term sales immediately rather over the life of the contract.) Some of these
than over the term of the contract, had companies then treated their own purchases
improperly booked as cash transactions as capital expenditures, which were not run
swaps of capacity with other carriers, and had through the income statement. Instead, the
fi red him when he blew the whistle. spending led to the addition of assets on the
The accounting for the swaps involves balance sheet (and an inflted bottom line).
exchanges of similar network capacity. The SEC questioned some of these
Companies have said they engage in such capacity exchanges, because it appeared they
deals because swapping is quicker and less were a device to pad revenue. This reaction
costly than building segments of their own was not surprising, since revenue growth was
networks, or because such pacts provide a key factor in the valuation of companies
redundancies to make their own networks such as Global Crossing and Qwest during
more reliable. In one experts view, an the craze for tech stocks in the late 1990s and
exchange of similar network capacity is the 2000.
equivalent of trading a blue truck for a red Source: Adapted from Henny Sender, Telecoms Draw
truck-it shouldnt boost a companys Revenue. Focus for Moves in Accounting, Wall Street Journal
(March 26, 2002), p. C7.
10-59
Valuation of PP&E
Accounting for Contributions

Companies should use:
the fair value of the asset to establish its value on the

books and
should recognize contributions received as revenues in the

period received.
Valuation of PP&E
Contributions
Illustration: Max Wayer Meat Packing, Inc. has recently accepted
a donation of land with a fair value of $150,000 from the Memphis
Industrial Development Corp. In return Max Wayer Meat Packing
promises to build a packing plant in Memphis. Max Wayers entry is:
Land 150,000
Contribution Revenue 150,000
Valuation of PP&E
Contributions
When a company contributes a non-monetary asset, it should
record the amount of the donation as an expense at the fair value
of the donated asset.
Illustration: Kline Industries donates land to the city of Los

Angeles for a city park. The land cost $80,000 and has a fair value
of $110,000. Kline Industries records this donation as follows.
Contribution Expense 110,000

Land 80,000
Gain on Disposal of Land 30,000
Equipment
LEARNING OBJECTIVES

equipment.
10-63
Costs Subsequent to Acquisition
In general, costs incurred to achieve greater future benefits

should be capitalized, whereas expenditures that simply
maintain a given level of services should be expensed.
In order to capitalize costs, one of three conditions

must be present:
1. useful life must be increased,
2. quantity of units produced must be increased, and
3. quality of units produced must be enhanced.
10-64 LO 6 Describe the accounting treatment for costs subsequent to acquisition.

10-65 LO 6 Describe the accounting treatment for costs subsequent to acquisition.

Summary Illustration 10-21
10-66
Equipment
LEARNING OBJECTIVES

equipment.
10-67
Disposition of PP&E
A company may retire plant assets voluntarily or dispose of

them by
Sale,
Exchange,
Involuntary conversion, or
Abandonment.
Depreciation must be taken up to the date of disposition.
LO 7 Describe the accounting treatment for the

10-68
disposal of property, plant, and equipment.
Disposition of PP&E
Sale of Plant Assets

Illustration: Barret Company recorded depreciation on a machine
costing $18,000 for 9 years at the rate of $1,200 per year. If it sells
the machine in the middle of the tenth year for $7,000, Barret
records depreciation to the date of sale as:
Depreciation Expense ($1,200 x 1/2) 600

Accumulated Depreciation 600

10-69
Disposition of PP&E
Illustration: Barret Company recorded depreciation on a machine

costing $18,000 for 9 years at the rate of $1,200 per year. If it sells
the machine in the middle of the tenth year for $7,000, Barret
records depreciation to the date of sale. Record the entry to record
the sale of the asset:
Cash 7,000
Machinery 18,000
Gain on Disposal of Machinery 400

10-70
Disposition of PP&E
Involuntary Conversion
Sometimes an assets service is terminated through some type of
involuntary conversion such as fire, flood, theft, or
condemnation.
Companies report the difference between the amount recovered

(e.g., from a condemnation award or insurance recovery), if any,
and the assets book value as a gain or loss.
They treat these gains or losses like any other type of disposition.

10-71
Disposition of PP&E
Illustration: Camel Transport Corp. had to sell a plant located on
company property that stood directly in the path of an interstate highway.
For a number of years, the state had sought to purchase the land on
which the plant stood, but the company resisted. The state ultimately
exercised its right of eminent domain, which the courts upheld. In
settlement, Camel received $500,000, which substantially exceeded the
$200,000 book value of the plant and land (cost of $400,000 less
accumulated depreciation of $200,000). Camel made the following entry.
Cash 500,000
Accumulated DepreciationPlant Assets 200,000
Plant Assets 400,000
Gain on Disposal of Plant Assets 300,000

10-72
Copyright
Copyright 2013 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.
10-73
kieso
weygandt
warfield
INTERMEDIATE
Intermediat
Intermediat
team for success
ACCOUNTING
e e
Accounting
Accounting
Prepared by
Coby Harmon
Prepared by
Harmon
Westmont
Barbara
15th Edition
10-75
Depreciation, Impairment,
and Depletion
LEARNING OBJECTIVES
1. Explain the concept of depreciation. 5. Explain the accounting issues related to

asset impairment.
2. Identify the factors involved in the
depreciation process. 6. Explain the accounting procedures for
depletion of natural resources.
3. Compare activity, straight-line, and
decreasing-charge methods of 7. Explain how to report and analyze
depreciation. property, plant, equipment, and natural
resources.
4. Explain special depreciation methods.
10-76
DepreciationMethod of Cost Allocation
Depreciation is the accounting process of allocating the cost

of tangible assets to expense in a systematic and rational
manner to those periods expected to benefit from the use of
the asset.
Allocating costs of long-lived assets:

Fixed assets = Depreciation expense
Intangibles = Amortization expense
Natural resources = Depletion expense
10-77 LO 1 Explain the concept of depreciation.

and Depletion
LEARNING OBJECTIVES

asset impairment.
resources.
10-78
Factors Involved in the Depreciation Process

Three basic questions:
(1) What depreciable base is to be used?
(2) What is the assets useful life?
(3) What method of cost apportionment is best?
10-79 LO 2 Identify the factors involved in the depreciation process.


Depreciable Base for the Asset
Illustration 11-1


Estimation of Service Lives
Service life often differs from physical life.

Companies retire assets for two reasons:
1. Physical factors (casualty or expiration of
physical life).
2. Economic factors (inadequacy, supersession,

and obsolescence).

WHATS YOUR
ALPHABET DUPE PRINCIPLE
Some companies try to imply that depreciation is sales start to tail off. That means analysts really
not a cost. For example, in their press releases should view depreciation associated with the
they will often make a bigger deal over earnings costs of maintaining the rides (or buying new
before interest, taxes, depreciation, and ones) as an everyday expense. It also means
amortization (often referred to as EBITDA) than investors in those companies should have strong
net income under GAAP. They like it because it stomachs. Whats the risk of trusting a fad
dresses up their earnings numbers. Some on accounting measure? Just look at one years
Wall Street buy this hype because they dont like bankruptcy numbers. Of the 147 companies
the allocations that are required to determine net tracked by Moodys that defaulted on their debt,
income. Some banks, without batting an eyelash, most borrowed money based on EBITDA
even let companies base their loan covenants on performance. The bankers in those deals
EBITDA. probably wish they had looked at a few other
For example, look at Premier Parks, which factors. On the other hand, nonfinancial
operates the Six Flags chain of amusement companies in the S&P 500 generated a
parks. Premier touts its EBITDA performance. But substantial EBITA margin of 20.9 percent in 2011.
that number masks a big part of how the company Some analysts are concerned that such a high
operatesand how it spends its money. Premier number suggests that companies are reluctant to
argues that analysts should ignore depreciation incur costs and want to stockpile cash. The
for big-ticket items like roller coasters because the lesson? Investors will do well to avoid focus on
rides have a long life. Critics, however, say that any single accounting measure.
the amusement industry has to spend as much as Source: Adapted from Herb Greenberg, Alphabet Dupe:
50 percent of its EBITDA just to keep its rides and Why EBITDA Falls Short, Fortune (July 10, 2000), p. 240;
attractions current. Those expenses are not and V. Monga, Operating Efficiency Runs High at U.S.
optionallet the rides get a little rusty, and ticket Firms, Wall Street Journal (February 28, 2012), p. B7.
10-82
and Depletion
LEARNING OBJECTIVES

asset impairment.
resources.
10-83
Methods of Depreciation
The profession requires the method employed be systematic
and rational. Methods used include:
1. Activity method (units of use or production).
2. Straight-line method.
3. Sum-of-the-years-digits.
Decreasing charge methods
4. Declining-balance method.
5. Group and composite methods.

Special methods
6. Hybrid or combination methods.
LO 3 Compare activity, straight-line, and decreasing-

10-84 charge methods of depreciation.
Activity Method
Illustration 11-2
Stanley Coal
Mines Facts
Illustration: If Stanley uses the crane for 4,000 hours the first
year, the depreciation charge is:
Illustration 11-3
10-85 LO 3
Straight-Line Method
Illustration 11-2
Stanley Coal
Mines Facts
Illustration: Stanley computes depreciation as follows:

Illustration 11-4
10-86 LO 3
Decreasing-Charge Methods
Illustration 11-2
Stanley Coal
Mines Facts
Sum-of-the-Years-Digits. Each fraction uses the sum of the

years as a denominator (5 + 4 + 3 + 2 + 1 = 15). The numerator
is the number of years of estimated life remaining as of the
beginning of the year.
Alternate sum-of-the- n(n+1) 5(5+1)

= = 15
years calculation 2 2
10-87 LO 3
Sum-of-the-Years-Digits
Illustration 11-6

Decreasing-Charge Methods
Illustration 11-2
Stanley Coal
Mines Facts
Declining-Balance Method.
Utilizes a depreciation rate (percentage) that is some multiple
of the straight-line method.
Does not deduct the salvage value in computing the

depreciation base.

Declining-Balance Method
Illustration 11-7

Illustration(Four Methods): Maserati Corporation purchased a

new machine for its assembly process on August 1, 2014. The cost
of this machine was $150,000. The company estimated that the
machine would have a salvage value of $24,000 at the end of its
service life. Its life is estimated at 5 years and its working hours are
estimated at 21,000 hours. Year-end is December 31.
Instructions: Compute the depreciation expense under the

following methods.
(a) Straight-line depreciation. (c) Sum-of-the-years-digits.
(b) Activity method (d) Double-declining balance.

Straight-line Method
Current
Depreciable Annual Partial Year Accum.
Year Base Years Expense Year Expense Deprec.
2014 $ 126,000 / 5 = $ 25,200 x 5/12 = $ 10,500 $ 10,500
2015 126,000 / 5 = 25,200 25,200 35,700
2016 126,000 / 5 = 25,200 25,200 60,900
2017 126,000 / 5 = 25,200 25,200 86,100
2018 126,000 / 5 = 25,200 25,200 111,300
2019 126,000 / 5 = 25,200 x 7/12 = 14,700 126,000
$ 126,000
Journal entry:
2014 Depreciation expense 10,500

Accumultated depreciation 10,500
Advance slide in
presentation mode to
10-92 reveal answer. charge methods of depreciation.
Activity Method (Assume 800 hours used in 2014)

($126,000 / 21,000 hours = $6 per hour)
(Given) Current
Hours Rate per Annual Partial Year Accum.
Year Used Hours Expense Year Expense Deprec.
2014 800 x $6 = $ 4,800 $ 4,800 $ 4,800
2015 x =
2016 x =
2017 x =
2018 x =
800 $ 4,800
Journal entry:
Advance slide in presentation mode to reveal answer.

10-93 LO 3
Sum-of-the-Years-Digits Method
5/12 = .416667
7/12 = .583333
Current
Depreciable Annual Partial Year Accum.
Year Base Years Expense Year Expense Deprec.
2014 $ 126,000 x 5/15 = 42,000 x 5/12 $ 17,500 $ 17,500
2015 126,000 x 4.58/15 = 38,500 38,500 56,000
2016 126,000 x 3.58/15 = 30,100 30,100 86,100
2017 126,000 x 2.58/15 = 21,700 21,700 107,800
2018 126,000 x 1.58/15 = 13,300 13,300 121,100
2019 126,000 x .58/15 = 4,900 4,900 126,000

$ 126,000
Journal entry:
10-94 Advance slide in presentation mode to reveal answer. LO 3
Double-Declining Balance Method

Current
Depreciable Rate Annual Partial Year
Year Base per Year Expense Year Expense
2014 $ 150,000 x 40% = $ 60,000 x 5/12 = $ 25,000
2015 125,000 x 40% = 50,000 50,000
2016 75,000 x 40% = 30,000 30,000
2017 45,000 x 40% = 18,000 18,000
2018 27,000 x 40% = 10,800 Plug 3,000

$ 126,000
Journal entry:
Advance slide in presentation mode to reveal answer.
10-95 LO 3
and Depletion
LEARNING OBJECTIVES

asset impairment.
resources.
10-96
Special Depreciation Methods

Two methods of depreciating multiple-asset accounts exist:
Group method used when the assets are similar in nature
and have approximately the same useful lives.
Composite approach used when the assets are dissimilar

and have different lives.
The choice of method depends on the nature of the assets involved.
The computation for group or composite methods is essentially the

same: find an average and depreciate on that basis.
10-97 LO 4 Explain special depreciation methods.

Group and Composite Methods
Illustration: Mooney Motors establishes the composite

depreciation rate for its fleet of cars, trucks, and campers as
shown below.
Illustration 11-8

If Mooney retires an asset before or after the average service life

of the group is reached, it buries the resulting gain or loss in the
Accumulated Depreciation account.
Illustration: Suppose that Mooney Motors sold one of the

campers with a cost of $5,000 for $2,600 at the end of the third
year. The entry is:

Cash 2,600
Cars, Trucks, and Campers 5,000

If Mooney purchases a new type of asset (mopeds, for example),

it must compute a new depreciation rate and apply this rate in
subsequent periods.
Illustration 11-9
Disclosure of Group
Depreciation Method

Special Depreciation Methods
Hybrid or Combination Methods

Companies are also free to develop tailor-made depreciation
methods, provided the method results in the allocation of an
assets cost over the assets life in a systematic and rational
manner.
Illustration 11-10
Disclosure of Hybrid
Depreciation Method

WHATS YOURDEPRECIATION
DECELERATNG PRINCIPLE
Which depreciation method should managers object to traditional depreciation

management select? Many believe that the methods because in their view, real estate
method that best matches revenues with often does not decline in value. In addition,
expenses should be used. For example, if because real estate is highly debt-financed,
revenues generated by the asset are most real estate concerns report losses in
constant over its useful life, select straight- earlier years of operations when the sum of
line depreciation. On the other hand, if depreciation and interest exceeds the
revenues are higher (or lower) at the revenue from the real estate project. As a
beginning of the assets life, then use a result, real estate companies, like Kimco
decreasing (or increasing) method. Thus, if Realty, argue for some form of increasing-
a company can reliably estimate revenues charge method of depreciation (lower
from the asset, selecting a depreciation depreciation at the beginning and higher
method that best matches costs with those depreciation at the end). With such a
revenues would seem to provide the most method, companies would report higher
useful information to investors and total assets and net income in the earlier
creditors for assessing the future cash years of the project.
flows from the asset.
Managers in the real estate industry face
a different challenge when considering
depreciation choices. Real estate

Special Depreciation Issues

1. How should companies
See slides for
compute depreciation for
LO 3
partial periods?
Funds for the
2. Does depreciation provide for replacement of
the replacement of assets? assets come from
revenues.
3. How should companies
handle revisions in
depreciation rates?

Revision of Depreciation Rates

Changes in estimates are a continual and inherent
part of any estimation process.
Accounted for in the current period and prospective

periods.
No change to previously reported results.

Revision of Depreciation Rates
Arcadia HS, purchased equipment for $510,000 which was

estimated to have a useful life of 10 years with a residual value
of $10,000 at the end of that time. Depreciation has been
recorded for 7 years on a straight-line basis. In 2014 (year 8),
it is determined that the total estimated life should be 15 years
with a residual value of $5,000 at the end of that time.
Questions:
What is the journal entry to correct No Entry
the prior years depreciation? Required
Calculate the depreciation expense

for 2014.

After 7
Revision of Depreciation Rates years
Equipment cost $510,000 First, establish NBV

Salvage value - 10,000 at date of change in
Depreciable base 500,000 estimate.
Useful life (original) 10 years
Annual depreciation $ 50,000 x 7 years = $350,000
Balance Sheet (Dec. 31, 2013)

Equipment $510,000
Accumulated depreciation 350,000
Net book value (NBV) $160,000

After 7
Revision of Depreciation Rates years
Net book value $160,000 Depreciation

Salvage value (new) 5,000 Expense calculation
Depreciable base 155,000 for 2012.
Useful life remaining 8 years
Annual depreciation $ 19,375
Journal entry for 2012
Depreciation Expense 19,375


WHATS YOUR
DEPRECIATION PRINCIPLE
CHOICES
The amount of depreciation expense

recorded depends on both the depreciation
method used and estimates of service lives
and salvage values of the assets.
Differences in these choices and estimates
can significantly impact a companys
reported results and can make it difficult to
compare the depreciation numbers of
different companies.
For example, when Willamette Industries During the year, the estimated service lives for
most machinery and equipment were
extended the estimated service lives of its
extended five years. The change was based
machinery and equipment by five years, it
upon a study performed by the companys
increased income by nearly $54 million. engineering department, comparisons to
An analyst determines the impact of typical industry practices, and the effect of the
these management choices and judgments companys extensive capital investments
on the amount of depreciation expense by which have resulted in a mix of assets with
examining the notes to financial longer productive lives due to technological
statements. For example, Willamette advances. As a result of the change, net
Industries provided the following note to its income was increased by $54,000,000.
financial statements.

and Depletion
LEARNING OBJECTIVES

asset impairment.
resources.
10-109
Impairments
When the carrying amount of an asset is not recoverable, a

company records a write-off referred to as an impairment.
Events leading to an impairment:

a. Significant decrease in the fair value of an asset.
b. Significant change in the manner in which an asset is used.
c. Adverse change in legal factors or in the business climate that
affects the value of an asset.
d. An accumulation of costs in excess of the amount originally
expected to acquire or construct an asset.
e. A projection or forecast that demonstrates continuing losses
associated with an asset.
10-110 LO 5
Impairments
Measuring Impairments
1. Review events for possible impairment.
2. If the review indicates impairment, apply the recoverability

test. If the sum of the expected future net cash flows from the
long-lived asset is less than the carrying amount of the asset,
an impairment has occurred.
3. Assuming an impairment, the impairment loss is the amount

by which the carrying amount of the asset exceeds the fair
value of the asset. The fair value is the market value or the
present value of expected future net cash flows.
10-111 LO 5 Explain the accounting issues related to asset impairment.

Impairments
Illustration 11-16
Graphic of Accounting
for Impairments
Loss reported as part of

income from continuing
operations, in the Other
expenses and losses
section.
10-112 LO 5
Recoverability
Impairments Text
Illustration 1: M. Alou Inc. has equipment that, due to changes in its

use, it reviews for possible impairment. The equipments carrying
amount is $600,000 ($800,000 cost less $200,000 accumulated
depreciation). Alou determines the expected future net cash flows
(undiscounted) from the use of the equipment and its eventual disposal
to be $650,000. Determine whether an impairment has occurred.
Expected future cash flows $ 650,000

Carrying value of asset:
Cost $ 800,000
Accumulated depreciation -200,000 600,000
50,000
No
Impairment
Advance slide in
10-113 reveal answer. LO 5
Recoverability
Impairments Text
Illustration 2: M. Alou Inc. has equipment that, due to changes in its

use, it reviews for possible impairment. The equipments carrying
amount is $600,000 ($800,000 cost less $200,000 accumulated
depreciation). Alou determines the expected future net cash flows
(undiscounted) from the use of the equipment and its eventual disposal
to be $580,000. Determine whether an impairment has occurred.
Expected future cash flows $ 580,000

Cost $ 800,000
-20,000
Advance slide in Impairment
Measurement
Impairments of Loss
Illustration 2: The recoverability test indicates that the expected

future net cash flows of $580,000 from the use of the asset are less
than its carrying amount of $600,000. Therefore, an impairment has
occurred. Assume this asset has a fair value of $525,000.
Determine the impairment loss, if any.
Fair value of equipment $ 525,000

Cost $ 800,000
-75,000
Impairment
Advance slide in Loss
Measurement
Impairments of Loss
Illustration 2:
Fair value of equipment $ 525,000

Cost $ 800,000
Impairment loss -75,000
M. Alou records the impairment loss as follows:
Loss on Impairment 75,000

10-116 LO 5
Impairments
Restoration of Impairment Loss

After recording an impairment loss,
the reduced carrying amount becomes its new cost basis.
No change in the new cost basis except for depreciation or

amortization in future periods or for additional impairments.
No restoration of impairment loss for an asset held for use.

Rationale is that the new cost basis puts the impaired
asset on an equal basis with other assets that are
unimpaired.

Impairments
Impairment of Assets to Be Disposed Of

Assets held for disposal are like inventory; companies
Should report them at the lower-of-cost-or-net realizable
value.
Can write up or down an asset held for disposal in future

periods, as long as the carrying value after the write-up never
exceeds the carrying amount of the asset before the
impairment.
Should report losses or gains related to these impaired assets

as part of income from continuing operations.

and Depletion
LEARNING OBJECTIVES

asset impairment.
resources.
10-119
Depletion
Natural resources, often called wasting assets, include

petroleum, minerals, and timber.
They have two main features:
1. complete removal (consumption) of the asset, and
2. replacement of the asset only by an act of nature.
Depletion is the process of allocating the cost of natural resources.
10-120 LO 6 Explain the accounting procedures for depletion of natural resources.

Depletion
Establishing a Depletion Base

Computation of the depletion base involves four factors:
(1) Acquisition cost.
(2) Exploration costs.
(3) Development costs.
(4) Restoration costs.

Depletion
Write-off of Resource Cost

Normally, companies compute depletion (cost depletion) on a
units-of-production method (activity approach). Depletion is a
function of the number of units extracted during the period.
Calculation:
Total cost Salvage value

= Depletion cost per unit
Total estimated units available
Units extracted x Cost per unit = Depletion

Depletion
Illustration: MaClede Co. acquired the right to use 1,000 acres

of land in Alaska to mine for gold. The lease cost is $50,000, and
the related exploration costs on the property are $100,000.
Intangible development costs incurred in opening the mine are
$850,000. MaClede estimates that the mine will provide
approximately 100,000 ounces of gold.
Illustration 11-17
Advance slide in
10-123 reveal answer.
LO 6
Depletion
If MaClede extracts 25,000 ounces in the first year, then the

depletion for the year is $250,000 (25,000 ounces x $10).
Inventory (gold) 250,000

Gold Mine 250,000
Some companies use an Accumulated Depletion account. In that

case, MaCledes balance sheet would presented as follows:
Illustration 11-18
MaClede debits cost of goods sold when the gold is sold.

10-124 LO 6
Depletion
Estimating Recoverable Reserves

Same as accounting for changes in estimates.
Revise the depletion rate on a prospective basis.
Divide the remaining cost by the new estimate of the

recoverable reserves.

WHATS
RAH-RAH YOUR PRINCIPLE
SURPRISE
Cuts in the estimates of oil and natural gas In one case, for example, ExxonMobils
reserves at Royal Dutch Shell, El Paso estimate was 29 percent higher than an
Corporation, and other energy companies at estimate the SEC developed. Exxon-Mobil
one time highlighted the importance of reserve was more optimistic about the effects of new
disclosures. Investors appeared to believe technology that enables the industry to
that these disclosures provide useful retrieve more of the oil and gas it finds. Thus,
information for assessing the future cash flows to ensure the continued usefulness of RRA
from a companys oil and gas reserves. For disclosures, the SEC may have to work on a
example, when Shells estimates turned out to measurement methodology that keeps up with
be overly optimistic (to the tune of 3.9 billion technology changes in the oil and gas
barrels or 20 percent of reserves), Shells industry.
stock price fell.
The experience at Shell and other Source: S. Labaton and J. Gerth, At Shell, New
companies has led the SEC to look at how Accounting and Rosier Outlook, New York Times
companies are estimating their proved (nytimes.com) (March 12, 2004); and J. Ball, C.
reserves. Proved reserves are quantities of oil Cummins, and B. Bahree, Big Oil Differs with
and gas that can be shown with reasonable SEC on Methods to Calculate the Industrys
certainty to be recoverable in future years. . . Reserves, Wall Street Journal (February 24,
The phrase reasonable certainty is crucial to 2005), p. C1.
this guidance, but differences in interpretation
of what is reasonably certain can result in a
wide range of estimates.
10-126 LO 6
Depletion
Liquidating Dividends - Dividends greater than the

amount of accumulated net income.
Illustration: Callahan Mining had a retained earnings balance of

$1,650,000, accumulated depletion on mineral properties of
$2,100,000, and paid-in capital in excess of par of $5,435,493.
Callahans board declared a dividend of $3 a share on the 1,000,000
shares outstanding. It records the $3,000,000 cash dividend as
follows.
Retained Earnings 1,650,000

Paid-in Capital in Excess of Par 1,350,000
Cash 3,000,000

Depletion
Continuing Controversy
Oil and Gas Industry: Cost of drilling
a dry hole is a cost
Full cost concept needed to find the
Successful efforts concept commercially
profitable wells.
Companies should
capitalize only the
costs of successful
projects.

FULL-COST OR SUCCESSFUL EFFORTS?
The controversy in the oil and gas Indeed, failure to consider the
industry provides a number of lessons. economic consequences of
First, it demonstrates the strong accounting principles is a frequent
influence that the federal government criticism of the profession. However,
has in financial reporting matters. the neutrality concept requires that the
Second, the concern for economic statements be free from bias.
consequences places pressure on the Freedom from bias requires that the
FASB to weigh the economic effects of statements reflect economic reality,
any required standard. Third, the even if undesirable effects occur.
experience with RRA highlights the Finally, the debate over oil and gas
problems that accompany any pro- accounting reinforces the need for a
posed change from an historical cost conceptual framework with carefully
to a fair value approach. Fourth, this developed guidelines for recognition,
controversy illustrates the difficulty of measurement, and reporting, so that
establishing standards when affected interested parties can more easily
groups have differing viewpoints. resolve issues of this nature in the
future.
10-129 LO 6
and Depletion
LEARNING OBJECTIVES

asset impairment.
resources.
10-130
Presentation and Analysis
Presentation of Property, Plant, Equipment, and

Natural Resources
Because of the significant impact on the financial statements of the
depreciation method(s) used, companies should disclose the
following.
1. Depreciation expense for the period.
2. Balances of major classes of depreciable assets, by nature and
function.
3. Accumulated depreciation.
4. A general description of the method or methods used in computing
depreciation with respect to major classes of depreciable assets.
10-131 LO 7
Analysis of Property, Plant, and Equipment

Asset Turnover Ratio
Measure of a firms
ability to generate
sales from a
particular investment
in assets.
Illustration 11-20
Advance slide in
LO 7

Profit Margin on Sales
Measure of the ability to
generate operating
income from a particular
level of sales.
Illustration 11-21
Advance slide in
LO 7

Rate of Return on Assets
Measures a firms
success in using
assets to generate
earnings.
Illustration 11-22
Advance slide in
reveal answer.
10-134 LO 7
Analyst obtains further insight into the behavior of ROA by

disaggregating it into components of profit margin on sales and
asset turnover as follows:
Rate of Return Profit Margin on Asset Turnover

= x
on Assets Sales
Net Income Net Income Net Sales

= x
Average Total Assets Net Sales Average Total Assets
LO 7 Explain how to report and analyze property,

10-135
plant, equipment, and natural resources.
Analyst obtains further insight into the behavior of ROA by

disaggregating it into components of profit margin on sales and
asset turnover as follows:
Rate of Return Profit Margin on Asset Turnover

= x
on Assets Sales
$9,672 $9,672 $65,030

= x
($113,644 + $102,908) $65,030 ($113,644 + $102,908)
/2 /2
8.93% = 14.87% x .60
LO 7 Explain how to report and analyze property,

10-136
plant, equipment, and natural resources.
APPENDIX 11A INCOME TAX DEPRECIATION
Modified Accelerated Cost Recovery System

MACRS differs from GAAP in three respects:
1. a mandated tax life, which is generally shorter than the

economic life;
2. cost recovery on an accelerated basis; and
3. an assigned salvage value of zero.
10-137 LO 8 Describe income tax methods of depreciation.


Tax Lives (Recovery Periods)
Illustration 11A-1


Tax Depreciation Methods
Illustration 11A-2


Illustration: Computer and peripheral equipment purchased
by Denise Rode Company on January 1, 2013.


Illustration:
Illustration 11A-3


Illustration: Using the rates Illustration 11A-4
from the MACRS depreciation

rate schedule for a 5-year class
of property, Rode computes
depreciation as follows
For GAAP, Rode

used straight-line, Illustration 11A-5
with $16,000
salvage value and
a useful life of 7
years.
10-142 LO 8
Optional Straight-Line Method

Applies to six classes of property previously described.
Applies the straight-line method to the MACRS recovery

periods.
Ignores salvage value.

Tax Versus Book Depreciation

Tax laws and financial reporting have different objectives. The
purpose of:
taxation is to raise revenue from constituents in an
equitable manner.
financial reporting is to reflect the economic substance of

a transaction as closely as possible and to help predict the
amounts, timing, and uncertainty of future cash flows.
The adoption of one method for both tax and book purposes in
all cases is not in accordance with GAAP.

RELEVANT FACTS - Similarities
The definition of property, plant, and equipment is essentially the same
under GAAP and IFRS.
Under both GAAP and IFRS, changes in depreciation method and
changes in useful life are treated in the current and future periods. Prior
periods are not affected. GAAP recently conformed to IFRS in this area.
The accounting for plant asset disposals is the same under GAAP and
IFRS.
The accounting for the initial costs to acquire natural resources is similar
under GAAP and IFRS.
Under both GAAP and IFRS, interest costs incurred during construction
must be capitalized. Recently, IFRS converged to GAAP.
LO 9 Compare the accounting for property, plant,

10-145 and equipment under GAAP and IFRS.
The accounting for exchanges of nonmonetary assets has recently
converged between IFRS and GAAP. GAAP now requires that gains on
exchanges of nonmonetary assets be recognized if the exchange has
commercial substance. This is the same framework used in IFRS.
GAAP also views depreciation as allocation of cost over an assets life.
GAAP permits the same depreciation methods (straight-line,
diminishing-balance, units-of-production) as IFRS.

RELEVANT FACTS - Differences
IFRS requires component depreciation. Under GAAP, component
depreciation is permitted but is rarely used.
Under IFRS, companies can use either the historical cost model or the
revaluation model. GAAP does not permit revaluations of property, plant,
and equipment or mineral resources.
In testing for impairments of long-lived assets, GAAP uses a two-step
model to test for impairments. As long as future undiscounted cash flows
exceed the carrying amount of the asset, no impairment is recorded. The
IFRS impairment test is stricter. However, unlike GAAP, reversals of
impairment losses are permitted.

ON THE HORIZON
With respect to revaluations, as part of the conceptual framework project, the
Boards will examine the measurement bases used in accounting. It is too early
to say whether a converged conceptual framework will recommend fair value
measurement (and revaluation accounting) for property, plant, and equipment.
However, this is likely to be one of the more contentious issues, given the long-
standing use of historical cost as a measurement basis in GAAP.

IFRS SELF-TEST QUESTION
Which of the following statements is correct?
a. Both IFRS and GAAP permit revaluation of property, plant, and
equipment.
b. IFRS permits revaluation of property, plant, and equipment but
not GAAP.
c. Both IFRS and GAAP do not permit revaluation of property,
plant, and equipment.
d. GAAP permits revaluation of property, plant, and equipment but
not IFRS.

Hilo Company has land that cost $350,000 but now a fair value of
$500,000. Hilo Company decides to use the revaluation method
specified in IFRS to account for the land. Which of the following
statements is correct?
a. Hilo Company must continue to report the land at $350,000.
b. Hilo Company would report a net income increase of $150,000
due to an increase in the value of the land.
c. Hilo Company would debit Revaluation Surplus for $150,000.
d. Hilo Company would credit Revaluation Surplus by $150,000.

Under IFRS, value-in-use is defined as:
a. net realizable value.
b. fair value.
c. future cash flows discounted to present value.
d. total future undiscounted cash flows.

Copyright
10-152
Intermediate
Intermediate
Accounting
Accounting
Prepared by
Coby Harmon Prepared by
University of California, Santa Coby
BarbaraHarmon
Intangible Assets
LEARNING OBJECTIVES
1. Describe the characteristics of intangible 6. Explain the accounting issues related to

assets. intangible-asset impairments.
2. Identify the costs to include in the initial 7. Identify the conceptual issues related to
valuation of intangible assets. research and development costs.
3. Explain the procedure for amortizing 8. Describe the accounting for research and
intangible assets. development and similar costs.
4. Describe the types of intangible assets. 9. Indicate the presentation of intangible
assets and related items.
5. Explain the accounting issues for
recording goodwill.
10-154
15th Edition
10-155
INTANGIBLE ASSET ISSUES
Characteristics Cola Companys

success comes from its
1. Lack physical existence. secret formula for
making Coca-Cola, not
2. Not financial instruments. its plant facilities.
Normally classified as long-term asset.
Common types of intangibles:
Patents Trademarks or trade names

Copyrights Goodwill
Franchises or licenses
10-156 LO 1 Describe the characteristics of intangible assets.

Valuation
Purchased Intangibles
Recorded at cost.
Includes all costs necessary to make the intangible asset

ready for its intended use.
Typical costs include:

Purchase price.
Legal fees.
Other incidental expenses.
10-157 LO 2 Identify the costs to include in the initial valuation of intangible assets.
Valuation
Internally Created Intangibles
Generally expensed.
Only capitalize direct costs

incurred in developing the
intangible, such as legal costs.
Google expensed the R&D costs incurred to develop its

valuable search engine.
10-158 LO 2 Identify the costs to include in the initial valuation of intangible assets.
Amortization of Intangibles
Limited-Life Intangibles
Amortize by systematic charge to expense over useful life.
Credit asset account or accumulated amortization.
Useful life should reflect the periods over which the asset
will contribute to cash flows.
Amortization should be cost less residual value.
Companies should evaluate the limited-life intangibles for

impairment.
10-159 LO 3 Explain the procedure for amortizing intangible assets.

Amortization of Intangibles
Indefinite-Life Intangibles
No foreseeable limit on time the asset is expected to
provide cash flows.
Must test indefinite-life intangibles for impairment at least

annually.
No amortization.

Amortization of Intangibles ILLUSTRATION 12-1

Accounting Treatment
for Intangibles

The importance of intangible asset Apparently, the company was overly
classification as either limited-life or optimistic about the expected future cash
indefinite-life is illustrated in the experience flows arising from the distributor
of Outdoor Channel Holdings. Heres what relationship. As a result of that optimism,
happened. Outdoor Channel recorded an income in the second year was
intangible asset related to the value of an overstated by $9.5 million, or 14 percent,
important distributor relationship, purchased and the impairment recorded in the third
from another company. At that time, it year amounted to 7 percent of assets.
classified the relationship as indefinite-life. From indefinite-life to limited-life to
Thus, in the first two years of the worthless in two short yearsinvestors
assets life, Outdoor Channel recorded no were surely hurt by Outdoors aggressive
amortization expense on this asset. In the intangible asset classification.
third year, investors were surprised
to find that Outdoor Channel changed the Source: Jack Ciesielski, The AAO
classification of the distributor relationship to Weblog, www.accountingobserver.
limited-life, with an expected life of 21.33 com/blog/ (January 12, 2007).
years (a fairly definite useful life) and,
shortly thereafter, wrote off this intangible
completely.

TYPES OF INTANGIBLE ASSETS
Six Major Categories:
(1) Marketing-related. (4) Contract-related.
(2) Customer-related. (5) Technology-related.
(3) Artistic-related. (6) Goodwill.
10-163 LO 4 Describe the types of intangible assets.

Marketing-Related Intangible Assets

Examples:
Trademarks or trade names, newspaper
mastheads, Internet domain names, and non-
competition agreements.
In the United States trademarks or trade names have

legal protection for indefinite number of 10 year
renewal periods.
Capitalize acquisition costs.
No amortization.

Customer-Related Intangible Assets

Examples:
Customer lists, order or production backlogs, and both
contractual and non-contractual customer relationships.
Capitalize acquisition costs.
Amortized to expense over useful life.

Illustration: Green Market Inc. acquires the customer list of a large
newspaper for $6,000,000 on January 1, 2014. Green Market
expects to benefit from the information evenly over a three-year
period. Record the purchase of the customer list and the
amortization of the customer list at the end of each year.
Jan. 1 Customer List 6,000,000

2014
Cash 6,000,000
Dec. 31 Amortization Expense 2,000,000

2014
Customer List * 2,000,000
2015
2016
10-166 * or Accumulated Amortization LO 4 Describe the types of intangible assets.

Artistic-Related Intangible Assets

Examples:
Plays, literary works, musical works, pictures,
photographs, and video and audiovisual material.
Copyright granted for the life of the creator plus 70 years.
Capitalize costs of acquiring and defending.
Amortized to expense over useful life.
and Mickey
Mouse
10-167 LO 4
Contract-Related Intangible Assets

Examples:
Franchise and licensing agreements, construction
permits, broadcast rights, and service or supply contracts.
Franchise (or license) with a limited life should be

amortized to expense over the life of the franchise.
Franchise with an indefinite life should be carried at cost

and not amortized.
10-168 LO 4
Technology-Related Intangible Assets

Examples:
Patented technology and trade secrets granted by the
U.S. Patent and Trademark Office.
Patent gives holder exclusive use for a period of 20 years.
Capitalize costs of purchasing a patent.
Expense any R&D costs in developing a patent.
Amortize over legal life or useful life, whichever is shorter.

PATENT BATTLES
From online retailing to cell phone features, for infringing on Apples patented feature
global competition is bringing to the boiling that allows screens to detect more than
point battles over patents. For example, to one finger touch at a time. This
protect its patented one-click shopping facilitates the popular zoom-in and out.
technology that saves your shipping and HTC, in turn, sued Apple for infringing on
credit card information when you shop patented technology that helps extend
online, Amazon.com filed a complaint battery life.
against Barnesandnoble.com, its rival in the
e-tailing wars. The smartphone industry is Source: Adapted from L. Rohde,
another patent battleground. For example, Amazon, Barnes and Noble
Nokia fi led patent lawsuits against Settle Patent Dispute, CNN.com (March
Apple (and Apple countersued) over cell 8, 2002); and J. Mintz, Smart Phone
phone features such as swiping gestures on Makers in Legal Fights over Patents,
touch screens and the app store for Wisconsin State Journal (December 19,
downloading software. Apple also targeted 2010), p. F4.
HTC

Illustration: Harcott Co. incurs $180,000 in legal costs on January
1, 2014, to successfully defend a patent. The patents useful life is
20 years, amortized on a straight-line basis. Harcott records the
legal fees and the amortization at the end of 2014 as follows.
Jan. 1 Patents 180,000

Cash 180,000
Dec. 31 Amortization Expense 9,000

Patents (or Accumulated Amortization) 9,000

SECRET FORMULA
After several espionage cases were others). Distilling natural products like
uncovered, the secrets contained within the these is complicated since they are made
Los Alamos nuclear lab seemed easier of thousands of compounds. One
to check out than a library book. But The ingredient you will not find, by the way, is
Coca-Cola Company has managed to keep cocaine. Although the original formula did
the recipe for the worlds best-selling soft contain trace amounts, todays Coke
drink under wraps for more than 100 years. doesnt. When was it removed? That too
The company offers almost no information is a secret. Some experts indicate that
about its lifeblood, and the only written copy the power of the Coca-Cola formula
of the formula resides in a bank vault in and related brand image account for
Atlanta. This handwritten sheet is available almost $72 billion, or roughly 6 percent, of
to no one except by vote of Coca-Colas Cokes $1,128 billion stock value.
board of directors. Cant science offer some
clues? Coke purportedly contains 17 to 18 Source: Adapted from Reed Tucker, How
ingredients. That includes the usual caramel Has Cokes Formula Stayed a Secret?
color and corn syrup, as well as a blend of Fortune (July 24, 2000), p. 42; and Best
oils known as 7X (rumored to be a mix of Global Brands 2011,
orange, lemon, cinnamon, and www.interbrand.com (accessed July 5,
2012).

Goodwill
Conceptually, represents the future economic benefits arising
from the other assets acquired in a business combination that
are not individually identified and separately recognized.
Only recorded when an entire business is purchased.
Goodwill is measured as the excess of ...
cost of the purchase over the FMV of the identifiable net assets
(assets less liabilities) purchased.
Internally created goodwill should not be capitalized.
10-173 LO 5 Explain the accounting issues for recording goodwill.

RECORDING GOODWILL
Illustration: Multi-Diversified, Inc. decides that it needs a parts

division to supplement its existing tractor distributorship. The
president of Multi-Diversified is interested in buying Tractorling
Company. The illustration presents the statement of financial position
of Tractorling Company.
ILLUSTRATION 12-3

RECORDING GOODWILL
Illustration: Multi-Diversified investigates Tractorlings underlying

assets to determine their fair values.
ILLUSTRATION 12-4
Tractorling Company decides to accept Multi-Diversifieds offer of

$400,000. What is the value of the goodwill, if any?

RECORDING GOODWILL
Illustration: Determination of Goodwill.

ILLUSTRATION 12-5

RECORDING GOODWILL
Illustration: Multi-Diversified records this transaction as follows.
Cash 25,000
Accounts Receivables 35,000
Inventory 122,000
Property, Plant, and Equipment 205,000
Patents 18,000
Goodwill 50,000
Liabilities 55,000
Cash 400,000

RECORDING GOODWILL
Example: Global Corporation purchased the net assets of Local
Company for $300,000 on December 31, 2014. The balance sheet of
Local Company just prior to acquisition is:
Assets Cost FMV

Cash $ 15,000 $ 15,000
Receivables 10,000 10,000
Inventories 50,000 70,000
Equipment 80,000 130,000
Total $ 155,000 $ 225,000 FMV of Net
Assets =
Liabilities and Equities $200,000
Accounts payable $ 25,000 $ 25,000
Common stock 100,000
Retained earnings 30,000
Total $ 155,000 $ 25,000

RECORDING GOODWILL
Company for $300,000 on December 31, 2014. The value assigned to
goodwill is determined as follows:
Book Value = $130,000

Revaluation
$70,000
Fair Value = $200,000
Goodwill
$100,000
Purchase Price = $300,000

RECORDING GOODWILL
Company for $300,000 on December 31, 2014. The value assigned to
goodwill is determined as follows:
Calculation of Goodwill:
Cash $ 15,000
Receivables 10,000
Inventories 70,000
Equipment 130,000
Accounts payable (25,000)
FMV of identifiable net assets 200,000
Purchase price 300,000
Goodwill $ 100,000

RECORDING GOODWILL
Company for $300,000 on December 31, 2014. Prepare the journal entry
to record the purchase of the net assets of Local.
Journal entry recorded by Global:

Cash 15,000
Receivables 10,000
Inventory 70,000
Equipment 130,000
Goodwill 100,000
Accounts payable 25,000
Cash 300,000

RECORDING GOODWILL
Goodwill Write-Off
Goodwill considered to have an indefinite life.
Should not be amortized.
Only adjust carrying value when goodwill is impaired.
Bargain Purchase
Purchase price less than the fair value of net assets
acquired.
Amount is recorded as a gain by the purchaser.

IMPAIRMENT OF INTANGIBLE ASSETS
Impairment of Limited-Life Intangibles

Same as impairment for long-lived assets in Chapter 11.
1. If the sum of the expected future net cash flows (undiscounted) is
less than the carrying amount of the asset, an impairment has
occurred (recoverability test).
2. The impairment loss is the amount by which the carrying amount

of the asset exceeds the fair value of the asset (fair value test).
The loss is reported as part of income from continuing

operations, Other expenses and losses section.
10-183 LO 6 Explain the accounting issues related to intangible-asset impairments.

Illustration: Lerch, Inc. has a patent on how to extract oil from shale
rock. Unfortunately, several recent non-shale oil discoveries adversely
affected the demand for shale-oil technology. As a result, Lerch
performs a recoverability test. It finds that the expected future net
cash flows from this patent are $35 million. Lerchs patent has a
carrying amount of $60 million. Discounting the expected future net
cash flows at its market rate of interest, Lerch determines the fair
value of its patent to be $20 million. Perform the recoverability test.
Expected future net cash flows $ 35,000,000

Carrying value 60,000,000
Asset impaired $ (25,000,000)

Illustration: Perform the fair value test and the journal entry (if any)
to record the impairment of the asset.
Carrying amount of patent $ 60,000,000

Fair value 20,000,000
Loss on impairment $ 40,000,000
Loss on impairment 40,000,000

Patents 40,000,000
Companies may not recognize restoration of the previously recognized

impairment loss.

Impairment of Indefinite-Life Intangibles Other

than Goodwill
Should be tested for impairment at least annually.
Impairment test is a fair value test.

If the fair value of asset is less than the carrying
amount, an impairment loss is recognized for the
difference.
Recoverability test is not used.

Illustration: Arcon Radio purchased a broadcast license for
$2,000,000. Arcon Radio has renewed the license with the FCC
twice, at a minimal cost. Because it expects cash flows to last
indefinitely, Arcon reports the license as an indefinite-life intangible
asset. Recently the FCC decided to auction these licenses to the
highest bidder instead of renewing them. Arcon Radio expects cash
flows for the remaining two years of its existing license. It performs an
impairment test and determines that the fair value of the intangible
asset is $1,500,000.
ILLUSTRATION 12-7

Impairment of Goodwill
Two Step Process:
Step 1: If fair value is less than the carrying amount of the net
assets (including goodwill), then perform a second step
to determine possible impairment.
Step 2: Determine the fair value of the goodwill (implied value of

goodwill) and compare to carrying amount.

Illustration: Kohlbuy Corporation has three divisions. It purchased one
division, Pritt Products, four years ago for $2 million. Kohlbuy
management is now reviewing the division for purposes of recognizing an
impairment. Illustration 12-8 lists the Pritt Divisions net assets, including
the associated goodwill of $900,000 from the purchase.
ILLUSTRATION 12-8
Assume that the fair value of the Pritt Division is $1,900,000.
10-189 LO 6
Illustration: Prepare the journal entry (if any) to record the impairment.
ILLUSTRATIONS 12-9 and 12-10
Step 1: The fair value Step 2:

of the reporting unit is Fair value $ 1,900,000
below its carrying Carrying amount, net of goodwill 1,500,000
value. Therefore, an Implied goodwill 400,000
impairment has Carrying value of goodwill 900,000
occurred. Loss on impairment $ (500,000)
Loss on impairment 500,000

Goodwill 500,000

Impairment Summary
ILLUSTRATION 12-11

IMPAIRMENT RISK
As shown in the chart below, goodwill impairments spiked in 2008 and 2009, coinciding
with the stock market downturn in the wake of the financial crisis.

RESEARCH AND DEVELOPMENT COSTS
Research and development (R&D) costs are not in

themselves intangible assets.
Frequently results in something that a company patents or

copyrights such as:
new product, formula,
process, composition, or
idea, literary work.
Companies must expense all research and development costs

when incurred.
10-193 LO 7 Identify the conceptual issues related to research and development costs.
Companies spend considerable sums on research and

development.
ILLUSTRATION 12-12
Identifying R & D Activities

ILLUSTRATION 12-13
Research Activities Examples

Planned search or critical investigation Laboratory research aimed at discovery of
aimed at discovery of new knowledge. new knowledge; searching for applications of
new research findings.
Development Activities Examples

Translation of research findings or other Conceptual formulation and design of
knowledge into a plan or design for a possible product or process alternatives;
new product or process or for a construction of prototypes and
significant improvement to an existing operation of pilot plants.
product or process whether intended for
sale or use.
Accounting for R & D Activities

Costs Associated with R&D Activities:
Materials, Equipment, and Facilities.
Personnel.
Purchased Intangibles.
Contract Services.
Indirect Costs.
10-196 LO 8 Describe the accounting for research and development and similar costs.
E12-1: Indicate how items on the list below would generally be reported in
the financial statements.
Item Classification
1. Investment in a subsidiary company. 1. Long-term investments

2. Timberland. 2. PP&E
3. Cost of engineering activity required to 3. R&D expense
advance the design of a product to the 4. Prepaid rent
manufacturing stage.
5. PP&E
4. Lease prepayment.
6. R&D expense
5. Cost of equipment obtained.
6. Cost of searching for applications of
new research findings.
10-197 LO 8
Item Classification
7. Cost incurred in the formation of a 7. Expense

corporation. 8. Operating loss
8. Operating losses incurred in the 9. Expense
start-up of a business.
10. Intangible
9. Training costs incurred in start-up of
11. Not recorded
new operation.
12. R&D expense
10. Purchase cost of a franchise.
11. Goodwill generated internally.
12. Cost of testing in search of product
alternatives.
Item Classification
13. Goodwill acquired in the purchase 13. Intangible

of a business. 14. R&D expense
14. Cost of developing a patent. 15. Intangible
15. Cost of purchasing a patent from 16. Intangible
an inventor.
17. Intangible
16. Legal costs incurred in securing a
patent.
17. Unrecovered costs of a successful legal
suit to protect the patent.
Item Classification
18. Cost of conceptual formulation of 18. R&D expense

possible product alternatives. 19. Intangible
19. Cost of purchasing a copyright. 20. R&D expense
20. Research and development costs. 21. Long-term investment
21. Long-term receivables. 22. Expense
22. Cost of developing a trademark. 23. Intangible
23. Cost of purchasing a trademark.
Costs Similar to R & D Costs

Start-up costs for a new operation.
Initial operating losses.
Advertising costs.
Computer software costs.
E12-17: Compute the amount to be reported as research and
development expense.
$280,000 / 5 = $56,000
R&D
Expense
Cost of equipment acquired that will have alternative
uses in future R&D projects over the next 5 years. $330,000 $56,000
Materials consumed in R&D projects 59,000 59,000
Consulting fees paid to outsiders for R&D projects 100,000 100,000
Personnel costs of persons involved in R&D projects 128,000 128,000

Indirect costs reasonably allocable to R&D projects 50,000 50,000
Materials purchased for future R&D projects 34,000 0
$393,000
BRANDED
For many companies, developing a strong brand Occasionally you may find the value of a brand
image is as important as developing the products included in a companys financial statements
they sell. As the following chart indicates, the value under goodwill. But generally you will not find
of brand investments is substantial. Coca-Cola the estimated values of brands recorded in
heads the list with an estimated brand value of companies balance sheets. The reason? The
about $69 billion. subjectivity that goes into estimating a brands
value. In some cases, analysts base an
estimate of brand value on opinion polls or on
some multiple of ad spending. For example, in
estimating the brand values shown above,
Interbrand Corp. estimates the percentage of
the overall future revenues the brand will
generate and then discounts the net cash flows,
to arrive at a present value. Some analysts
believe that information on brand values is
relevant. Others voice valid concerns about the
reliability of brand value estimates due to
subjectivity in the estimates for revenues, costs,
and the risk component of the discount rate.
Source: Best Global Brands 2011

www.interbrand.com (accessed July 5, 2012).
PRESENTATION OF INTANGIBLES
Presentation of Intangible Assets

Balance Sheet
Intangible assets shown as a separate item.
Reporting is similar to the reporting of property, plant, and

equipment.
Contra accounts are not normally shown for intangibles.
Companies should report as a separate item all intangible

assets other than goodwill.
10-204 LO 9 Indicate the presentation of intangible assets and related items.

Presentation of Intangible Assets and

Research and Development Costs
Income Statement
Report amortization expense and impairment losses in
continuing operations.
Total R&D costs charged to expense must be disclosed.

ILLUSTRATION 12-15

ILLUSTRATION 12-16

RELEVANT FACTS
Like GAAP, under IFRS intangible assets (1) lack physical substance and (2) are
not financial instruments. In addition, under IFRS an intangible asset is identifiable.
To be identifiable, an intangible asset must either be separable from the company
(can be sold or transferred) or it arises from a contractual or legal right from which
economic benefits will flow to the company. Fair value is used as the
measurement basis for intangible assets under IFRS, if it is more clearly evident.
IFRS and GAAP are very similar for intangibles acquired in a business
combination. That is, companies recognize an intangible asset separately from
goodwill if the intangible represents contractual or legal rights or is capable of
being separated or divided and sold, transferred, licensed, rented, or exchanged.
In addition, under both GAAP and IFRS, companies recognize acquired in-process
research and development (IPR&D) as a separate intangible asset if it meets the
definition of an intangible asset and its fair value can be measured reliably.
10-208 LO 10 Compare the accounting for intangible assets under GAAP and IFRS.
RELEVANT FACTS
IFRS permits revaluation on limited-life intangible assets. Revaluations are not
permitted for goodwill and other indefinite-life intangible assets.
IFRS permits some capitalization of internally generated intangible assets (e.g.,
brand value) if it is probable there will be a future benefit and the amount can be
reliably measured. GAAP requires expensing of all costs associated with internally
generated intangibles.
IFRS requires an impairment test at each reporting date for long-lived assets and
intangibles, and records an impairment if the assets carrying amount exceeds its
recoverable amount. The recoverable amount is the higher of the assets fair value
less costs to sell and its value-in-use. Value-in-use is the future cash flows to be
derived from the particular assets, discounted to present value. Under GAAP,
impairment loss is measured as the excess of the carrying amount over the
assets fair value.
RELEVANT FACTS
IFRS allows reversal of impairment losses when there has been a change in
economic conditions or in the expected use of limited-life intangibles. Under
GAAP, impairment losses cannot be reversed for assets to be held and used; the
impairment loss results in a new cost basis for the asset. IFRS and GAAP are
similar in the accounting for impairments of assets held for disposal.
Under IFRS, costs in the development phase of an research and development
project are capitalized once technological feasibility (referred to as economic
viability) is achieved.
ON THE HORIZON
The IASB and FASB have identified a project, in a very preliminary stage, which would
consider expanded recognition of internally generated intangible assets. As indicated,
IFRS permits more recognition of intangibles compared to GAAP. Thus, it will be
challenging to develop converged standards for intangible assets, given the long-
standing prohibition on capitalizing intangible assets and research and development in
GAAP.
Learn more about the timeline for the intangible asset project at the IASB website
http://www.iasb.org/current_Projects/IASB_Projects/IASB_Work_Plan.htm.
Research and development costs are:

a. expensed under GAAP.
b. expensed under IFRS.
c. expensed under both GAAP and IFRS.
d. None of the above.
A loss on impairment of an intangible asset under IFRS is the assets:
a. carrying amount less the expected future net cash flows.
b. carrying amount less its recoverable amount.
c. recoverable amount less the expected future net cash flows.
d. book value less its fair value.
Recovery of impairment is recognized for all the following except:
a. patent held for sale.
b. patent held for use.
c. trademark.
d. goodwill.
COPYRIGHT
10-215
kieso
weygandt
warfield
INTERMEDIATE
Intermediat
Intermediat
team for success
ACCOUNTING
e e
Accounting
Accounting
Prepared by
Coby Harmon
Prepared by
Harmon
Westmont
Barbara
15th Edition
10-217
Current Liabilities
and Contingencies
LEARNING OBJECTIVES
1. Describe the nature, type, and valuation of 4. Identify the criteria used to account for
current liabilities. and disclose gain and loss contingencies.
2. Explain the classification issues of short- 5. Explain the accounting for different types
term debt expected to be refinanced. of loss contingencies.
3. Identify types of employee-related 6. Indicate how to present and analyze
liabilities. liabilities and contingencies.
10-218
Current Liabilities
What is a Liability?
The FASB, defined liabilities as:
Probable Future Sacrifices of Economic Benefits arising
from present obligations of a particular entity to transfer assets
or provide services to other entities in the future as a result of
past transactions or events.
10-219 LO 1
Current Liabilities
Recall: Current assets are cash or other assets that companies

reasonably expect to convert into cash, sell, or consume in
operations within a single operating cycle or within a year.
Current liabilities are obligations whose liquidation is

reasonably expected to require use of existing resources
properly classified as current assets, or the creation of other
current liabilities.
Operating cycle: period of time elapsing between the acquisition of

goods and services and the final cash realization resulting from sales and
subsequent collections.
10-220 LO 1 Describe the nature, type, and valuation of current liabilities.

Current Liabilities
Typical Current Liabilities:

Accounts payable. Customer advances and
deposits.
Notes payable.
Unearned revenues.
Current maturities of long-
term debt. Sales taxes payable.
Short-term obligations Income taxes payable.

expected to be refinanced.
Employee-related liabilities.
Dividends payable.

Current Liabilities
Accounts Payable (trade accounts payable)

Balances owed to others for goods, supplies, or services
purchased on open account.
Time lag between the receipt of services or acquisition of
title to assets and the payment for them.
Terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually

state period of extended credit, commonly 30 to 60 days.

Current Liabilities
Notes Payable
Written promises to pay a certain sum of money on a
specified future date.
Arise from purchases, financing, or other transactions.
Classified as short-term or long-term.
May be interest-bearing or zero-interest-bearing.

Current Liabilities
Interest-Bearing Note Issued

Illustration: Castle National Bank agrees to lend $100,000 on
March 1, 2014, to Landscape Co. if Landscape signs a $100,000,
6 percent, four-month note. Landscape records the cash received
on March 1 as follows:
Cash 100,000
Notes Payable 100,000

Current Liabilities
If Landscape prepares financial statements semiannually, it

makes the following adjusting entry to recognize interest
expense and interest payable at June 30:
Interest calculation = ($100,000 x 6% x 4/12) = $2,000

Interest Payable 2,000

Current Liabilities
At maturity (July 1), Landscape records payment of the note and

accrued interest as follows.
Notes payable 100,000

Cash 102,000

Current Liabilities
Zero-Interest-Bearing Note Issued

Illustration: On March 1, Landscape issues a $102,000, four-
month, zero-interest-bearing note to Castle National Bank. The
present value of the note is $100,000. Landscape records this
transaction as follows.
Cash 100,000
Discount on Notes Payable 2,000

Current Liabilities
Discount on Notes Payable is a contra account to Notes

Payable, and therefore is subtracted from Notes Payable on the
balance sheet. Illustration 13-1
Balance Sheet
Presentation of Discount
Discount on notes payable:

Represents the cost of borrowing.
Debited to interest expense over the life of the note.
Represents interest expense chargeable to future periods.

Current Liabilities
Illustration: (Accounts and Notes Payable) The following are

selected 2014 transactions of Darby Corporation.
Sept. 1 - Purchased inventory from Orion Company on account

for $50,000. Darby records purchases gross and uses a
periodic inventory system.
Oct. 1 - Issued a $50,000, 12-month, 8% note to Orion in

payment of account.
Oct. 1 - Borrowed $75,000 from the Shore Bank by signing a

12-month, zero-interest-bearing $81,000 note.
Prepare journal entries for the selected transactions.

Current Liabilities
Sept. 1 - Purchased inventory from Orion Company on

account for $50,000. Darby records purchases gross and uses
a periodic inventory system.
Sept. 1 Purchases 50,000

Accounts Payable 50,000

Current Liabilities
Oct. 1 - Issued a $50,000, 12-month, 8% note to Orion in payment

of account.
Oct. 1 Accounts Payable 50,000

Dec. 31 Interest Expense 1,000


Current Liabilities
Oct. 1 - Borrowed $75,000 from the Shore Bank by signing a 12-

month, zero-interest-bearing $81,000 note.
Oct. 1 Cash 75,000

Interest calculation = ($6,000 x 3/12) = $1,500


Current Liabilities
Current Maturities of Long-Term Debt

Portion of bonds, mortgage notes, and other long-term
indebtedness that matures within the next fiscal year.
Exclude long-term debts maturing currently if they are to be:
1. Retired by assets accumulated that have not been shown as

current assets,
2. Refinanced, or retired from the proceeds of a new debt issue,

or
3. Converted into capital stock.

Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-234
Current Liabilities
Short-Term Obligations Expected to Be

Refinanced
Exclude from current liabilities if both of the following
conditions are met:
1. Must intend to refinance the obligation on a long-term basis.
2. Must demonstrate an ability to refinance:
Actual refinancing.
Enter into a financing agreement.
10-235 LO 2
Current Liabilities
Short-Term Obligations Expected to be Refinanced

NO
Management Intends of Refinance Classify as
YES Current
Liability
Demonstrates Ability to Refinance
NO
YES
Actual Refinancing after Financing Agreement
balance sheet date but or Noncancellable with Capable
before issue date Lender
Exclude Short-Term Obligations from Current

Liabilities and Reclassify as LT Debt
10-236 LO 2
Current Liabilities
Illustration: On December 31, 2014, Alexander Company had

$1,200,000 of short-term debt in the form of notes payable due
February 2, 2015. On January 21, 2015, the company issued 25,000
shares of its common stock for $36 per share, receiving $900,000
proceeds after brokerage fees and other costs of issuance. On
February 2, 2015, the proceeds from the stock sale, supplemented by
an additional $300,000 cash, are used to liquidate the $1,200,000
debt. The December 31, 2014, balance sheet is issued on February
23, 2015.
Instructions:
Show how the $1,200,000 of short-term debt should be presented on
the December 31, 2014, balance sheet, including note disclosure
10-237 LO 2
Current Liabilities
Liability of $1,200,000 Issued stock Liability of Financial
How to classify? for $900,000 $1,200,000 statements
paid off issued
December 31, 2014 January 21, 2015 February 2, 2015 February 23, 2015
Balance sheet date
Partial Balance Sheet

Current liabilities:
Notes $300,000
payabledebt:
Long-term
Notes payable refinanced 900,000
Total liabilities $1,200,000
10-238 LO 2
WHATS YOUR
WHAT ABOUT PRINCIPLE
THAT SHORT-TERM DEBT?
The evaluation of credit quality involves less, when interest rates were low.
more than simply assessing a companys However, in light of expectations that the
ability to repay loans. Credit analysts also Fed would raise interest rates, analysts
evaluate debt management strategies. began to worry about the higher interest
Analysts and investors will reward what costs GE would pay when it refinanced
they view as prudent management these loans. Some analysts recommended
decisions with lower debt service costs and that it was time to reduce dependence on
a higher stock price. The wrong decisions short-term credit. The reasoning goes that
can bring higher debt costs and lower stock a shift to more dependable long-term debt,
prices. thereby locking in slightly higher rates for
General Electric Capital Corp., a the long-term, is the better way to go.
subsidiary of General Electric, Thus, scrutiny of GE debt strategies led
experienced the negative effects of market to analysts concerns about GEs earnings
scrutiny of its debt management policies. prospects. Investors took the analysis to
Analysts complained that GE had been heart, and GE experienced a two-day 6
slow to refinance its mountains of short- percent drop in its stock price.
term debt. GE had issued these current Source: Adapted from Steven Vames, Credit Quality,
obligations, with maturities of 270 days or Stock Investing Seem to Go Hand in Hand, Wall Street
Journal (April 1, 2002), p. R4.
10-239 LO 2
Current Liabilities
Dividends Payable
Amount owed by a corporation to its stockholders as a
result of board of directors authorization.
Generally paid within three months.
Undeclared dividends on cumulative preferred stock not

recognized as a liability.
Dividends payable in the form of additional shares of

stock are reported in stockholders equity.
10-240 LO 2
Current Liabilities
Customer Advances and Deposits

Returnable cash deposits received from customers and employees.
To guarantee performance of a contract or service or
As guarantees to cover payment of expected future

obligations.
May be classified as current or long-term liabilities.
LO 2 Explain the classification issues of short-term

10-241
debt expected to be refinanced.
Current Liabilities
Unearned Revenues
Payment received before delivering goods or rendering
services?
Illustration 13-3
Unearned and Earned
Revenue Accounts

10-242
Current Liabilities
Illustration: Allstate University sells 10,000 season football

tickets at $50 each for its five-game home schedule. Allstate
University records the sales of season tickets as follows.
Aug. 6 Cash 500,000

Unearned Sales Revenue 500,000
(10,000 x $50 = $500,000)
As each game is completed, Allstate makes the following entry.
Dec. 31 Unearned Sales Revenue 100,000

Sales Revenue 100,000
($500,000 5 games = $100,000 per game)
10-243 LO 2
WHATS YOUR
MICROSOFTS PRINCIPLE
LIABILITIES-GOOD OR BAD?
Users of financial statements generally examine liability (unearned revenue) the value of future
current liabilities to assess a companys liquidity upgrades to the software that it owes to
and overall financial flexibility. Companies must customers.
pay many current liabilities, such as accounts Market analysts read such an increase in
payable, wages payable, and taxes payable, unearned revenue as a positive signal about
sooner rather than later. A substantial increase in Microsofts sales and profitability. When
these liabilities should raise a red flag about a Microsofts sales are growing, its unearned
companys financial position. revenue account increases. Thus, an increase in
This is not the case for all current liabilities. For a liability is good news about Microsoft sales. At
example, Microsoft has a current liability entitled the same time, a decline in unearned revenue is
Unearned revenue of $14,830 million in 2010 bad news. As one analyst noted, a slowdown or
that has increased year after year. Unearned reversal of the growth in Microsofts unearned
revenue is a liability that arises from sales of revenues indicates slowing sales, which is bad
Microsoft products such as Internet Explorer and news for investors. Thus, increases in current
Windows XP. Microsoft also has provided liabilities can sometimes be viewed as good signs
coupons for upgrades to its programs to bolster instead of bad.
sales of its Xbox consoles. At the time of a sale, Source: Adapted from David Bank, Some Fans Cool to
customers pay not only for the current version of Microsoft, Citing Drop in Old Indicator, Wall Street
the software but also for future upgrades. Journal (October 28, 1999); and Bloomberg News,
Microsoft recognizes sales revenue from the Microsoft Profit Hit by Deferred Sales; Forecast Raised,
The Globe and Mail (January 26, 2007), p. B8.
current version of the software and records as a
10-244 LO 2
Current Liabilities
Sales Taxes Payable

Retailers must collect sales taxes from customers on
transfers of tangible personal property and on certain services
and then remit to the proper governmental authority.

10-245
Current Liabilities
Illustration: Prepare the entry to record sales taxes assuming

there was a sale of $3,000 when a 4 percent sales tax is in effect.
Cash 3,120
Sales Revenue 3,000
Sales Taxes Payable ($3,000 x 4% = $120) 1,800
10-246 LO 2
Current Liabilities
Many companies do not segregate the sales tax and the amount of
the sale at the time of sale. Instead, the company credits both
amounts in total in the Sales Revenue account.
Illustration: Assume the Sales Revenue account balance of

$150,000 includes sales taxes of 4 percent. Prepare the entry to
record the amount due the taxing unit.
Tax calculation = ($150,000 1.04 = $144,230.77 - $150,000 = $5,769.23)
Sales Revenue 5,769.23

Sales Taxes Payable 5,769.23
10-247 LO 2
Current Liabilities
Income Tax Payable

Businesses must prepare an income tax return and compute the income tax
payable.
Taxes payable are a current liability.
Corporations must make periodic tax payments.
Differences between taxable income (tax law) and

accounting income (GAAP) sometimes occur (Chapter 19).

10-248
Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-249
Current Liabilities
Employee-Related Liabilities
Amounts owed to employees for salaries or wages are
reported as a current liability.
Current liabilities related to employee compensation may

include:
Payroll deductions.
Compensated absences.
Bonuses.
10-250 LO 3 Identify types of employee-related liabilities.

Current Liabilities
Payroll Deductions
Most common types of payroll deductions are taxes,
insurance premiums, employee savings, and union dues.
Social Security Taxes (since January 1, 1937).

Federal Old Age, Survivor, and Disability Insurance
(OASDI) benefits for certain individuals and their families.
Funds from taxes levied on both employer and employee.
Current rate 6.2 percent based on the employees gross pay

up to a $110,100 annual limit.
OASDI tax is usually referred to as FICA.

10-251 LO 3
Current Liabilities
Payroll Deductions
In 1965, Congress passed the first federal health insurance
program for the agedpopularly known as Medicare.
Alleviates the high cost of medical care for those over age 65.
Hospital Insurance tax, paid by both employee and employer

at the rate of 1.45 percent on the employees total
compensation.
OASDI tax (FICA) and the federal Hospital Insurance Tax is

referred to as the Social Security tax.
10-252 LO 3
Current Liabilities
Payroll Deductions
Unemployment Taxes.
Provides a system of unemployment insurance.

Federal Unemployment Tax Act (FUTA):
Only employers pay the unemployment tax.
Rate is 6.2 percent on the first $7,000 of compensation paid

to each employee during the calendar year.
If employer is subject to a state unemployment tax of 5.4

percent or more it receives a tax credit (not to exceed 5.4
percent) and pays only 0.8 percent tax to the federal
government.
10-253 LO 3
Current Liabilities
Payroll Deductions
Unemployment Taxes.
State unemployment compensation laws differ both from the

federal law and among various states.
Employers must refer to the unemployment tax laws in each

state in which they pay wages and salaries.
10-254 LO 3
Current Liabilities
Payroll Deductions
Income Tax Withholding.
Federal and some state income tax laws require employers to
withhold from each employees pay the applicable income tax
due on those wages. Illustration 13-5
Summary of Payroll Liabilities
10-255 LO 3
Current Liabilities
Illustration: Assume a weekly payroll of $10,000 entirely subject to

F.I.C.A. and Medicare (7.65%), federal (0.8%) and state (4%)
unemployment taxes, with income tax withholding of $1,320 and union
dues of $88 deducted. The company records the salaries and wages
paid and the employee payroll deductions as follows:
Salaries and Wages Expense 10,000

Withholding Taxes Payable 1,320
FICA Taxes Payable 765
Union Dues Payable 88
Cash 7,827

Current Liabilities

dues of $88 deducted. The company records the employers payroll
taxes as follows:
Payroll Tax Expense 1,245

FUTA Taxes Payable 80
SUTA Taxes Payable 400

Current Liabilities
Compensated Absences
Paid absences for vacation, illness, and holidays.
Accrue a liability if all the following conditions exist.
The employers obligation is attributable to employees

services already rendered.
The obligation relates to rights that vest or accumulate.
Payment of the compensation is probable.
The amount can be reasonably estimated.

Current Liabilities
Illustration 13-6
Balance Sheet Presentation
of Accrual for Compensated
Absences

Current Liabilities
Illustration: Amutron Inc. employs 10 individuals and pays each

$480 per week. Employees earned 20 unused vacation weeks in
2014. In 2015, the employees used the vacation weeks, but now they
each earn $540 per week. Amutron accrues the accumulated vacation
pay on December 31, 2014, as follows.

Salaries and Wages Payable ($480 x 20) 9,600
In 2015, it records the payment of vacation pay as follows.
Salaries and Wages Payable 9,600

Cash ($540 x 20) 10,800
10-260 LO 3
Current Liabilities
Bonus Agreements
Payments to certain or all employees in addition to their
regular salaries or wages.
Bonuses paid are an operating expense.
Unpaid bonuses should be reported as a current

liability.

Current Liabilities
Illustration: Palmer Inc. shows income for the year 2014 of

$100,000. It will pay out bonuses of $10,700 in January 2015. Palmer
makes an adjusting entry dated December 31, 2014, to record the
bonuses as follows.

In 2015, Palmer records the payment of the bonus as follows.

Cash 10,700
10-262 LO 3
Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-263
Contingencies
An existing condition, situation, or set of circumstances

involving uncertainty as to possible gain (gain
contingency) or loss (loss contingency) to an enterprise
that will ultimately be resolved when one or more future
events occur or fail to occur.*
* FASB ASC 450-10-05-4. [Predecessor literature: Accounting for

Contingencies, Statement of Financial Accounting Standards No. 5
(Stamford, Conn.: FASB, 1975), par. 1.]
10-264 LO 4
Contingencies
Gain Contingencies
Typical Gain Contingencies are:
1. Possible receipts of monies from gifts, donations, asset
sales, and so on.
2. Possible refunds from the government in tax disputes.
3. Pending court cases with a probable favorable outcome.
4. Tax loss carryforwards (Chapter 19).
Gain contingencies are not recorded.

Disclosed only if probability of receipt is high.
10-265 LO 4
Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-266
Contingencies
Loss Contingencies
Involves possible losses.
Likelihood of Loss
FASB uses three areas of probability:
Probable.
Reasonably possible.
Remote.
10-267 LO 5
Loss Contingencies
Probability Accounting
Probable Accrue
Reasonably
Footnote
Possible
Remote Ignore
10-268 LO 5
Loss Contingencies
Illustration: Scorcese Inc. is involved in a lawsuit at December 31,

2014. (a) Prepare the December 31 entry assuming it is probable
that Scorcese will be liable for $900,000 as a result of this suit. (b)
Prepare the December 31 entry, if any, assuming it is not probable
that Scorcese will be liable for any payment as a result of this suit.
(a) Lawsuit Loss 900,000

Lawsuit Liability 900,000
(b) No entry is necessary. The loss is not accrued because it

is not probable that a liability has been incurred at
12/31/14.
10-269 LO 5
Loss Contingencies
Illustration 13-10
10-270 LO 5
Loss Contingencies
Common loss contingencies:

1. Litigation, claims, and assessments.
2. Guarantee and warranty costs.
3. Premiums and coupons.
4. Environmental liabilities.
10-271 LO 5
Loss Contingencies
Litigation, Claims, and Assessments

Companies must consider the following factors, in determining
whether to record a liability with respect to pending or
threatened litigation and actual or possible claims and
assessments.
Time period in which the action occurred.
Probability of an unfavorable outcome.
Ability to make a reasonable estimate of the loss.
10-272 LO 5 Explain the accounting for different types of loss contingencies.

Loss Contingencies
Guarantee and Warranty Costs

Promise made by a seller to a buyer to make good on a
deficiency of quantity, quality, or performance in a product.
Cash-Basis Method.
Expense warranty costs as incurred, because
1. it is not probable that a liability has been incurred, or
2. it cannot reasonably estimate the amount of the

liability.

Loss Contingencies

Accrual-Basis Method.
Charge warranty costs to operating expense in the year of sale.
1. Method is the generally accepted method.

2. Referred to as the expense warranty approach.

Loss Contingencies
Illustration: Denson Machinery Company begins production on a

new machine in July 2014, and sells 100 units at $5,000 each by its
year-end, December 31, 2014. Each machine is under warranty for
one year. Denson estimates that the warranty cost will average $200
per unit. Further, as a result of parts replacements and services
rendered in compliance with machinery warranties, it incurs $4,000 in
warranty costs in 2014 and $16,000 in 2015.
1. Sale of 100 machines at $5,000 each, July through December

2014:
Cash or Accounts Receivable 500,000


Loss Contingencies
2. Recognition of warranty expense, July through December 2014:
Warranty Expense 4,000

Cash, Inventory, Accrued Payroll 4,000
Warranty Liability 16,000
3. Recognition of warranty costs incurred in 2015 (on 2014 sales):


Loss Contingencies
Premiums and Coupons

Companies should charge the costs of premiums and
coupons to expense in the period of the sale that benefits
from the plan.
Company estimates the number of

outstanding premium offers that
customers will present for redemption.
Company charges the cost of

premium offers to Premium Expense
and credits Premium Liability.
10-277 LO 5
Loss Contingencies
Illustration: Fluffy Cakemix Company offered its customers a large,

nonbreakable mixing bowl in exchange for 25 cents and 10 boxtops.
The mixing bowl costs Fluffy Cakemix Company 75 cents, and the
company estimates that customers will redeem 60 percent of the
boxtops. The premium offer began in June 2014 and resulted in the
transactions journalized below. Fluffy Cakemix Company records
purchase of 20,000 mixing bowls as follows.
Inventory of Premiums 15,000

Cash 15,000
$20,000 x .75 = $15,000

Loss Contingencies
Illustration: The entry to record sales of 300,000 boxes of cake mix

would be:
300,000 x .80 = $240,000
Cash 240,000
Fluffy records the actual redemption of 60,000 boxtops, the receipt

of 25 cents per 10 boxtops, and the delivery of the mixing bowls as
follows.
Cash [(60,000 10) x $0.25] 1,500

Premium Expense 3,000
Computation: (60,000 10) x $0.75 = $4,500
10-279 LO 5
Loss Contingencies
Illustration: Finally, Fluffy makes an end-of-period adjusting entry

for estimated liability for outstanding premium offers (boxtops) as
follows.

Premium Liability 6,000

WHATS YOUR
FREQUENT PRINCIPLE
FLYERS
Numerous companies offer premiums to When airlines first started offering frequent-
customers in the form of a promise of flyer bonuses, everyone assumed that they
future goods or services as an incentive for could accommodate the free-ticket holders
purchases today. Premium plans that have with otherwise-empty seats. That made the
widespread adoption are the frequent-flyer additional cost of the program so minimal
programs used by all major airlines. On the that airlines didnt accrue it or report the
basis of mileage accumulated, frequent- small liability. But, as more and more
flyer members receive discounted or free paying passengers have been crowded off
airline tickets. Airline customers can earn flights by frequent-flyer awardees, the loss
miles toward free travel by making long- of revenues has grown enormously. For
distance phone calls, staying in hotels, and example, United Continental Holdings at
charging gasoline and groceries on a credit one time reported a liability of $2.4 billion
card. Those free tickets represent an for frequent-flyer tickets.
enormous potential liability because people Although the profession has studied the
using them may displace paying accounting for this transaction, no
passengers. authoritative guidelines have been issued.
10-281 LO 5
Loss Contingencies
Environmental Liabilities
A company must recognize an asset retirement obligation
(ARO) when it has an existing legal obligation associated with
the retirement of a long-lived asset and when it can reasonably
estimate the amount of the liability.
AROs should be recorded as fair value.

Loss Contingencies
Obligating Events. Examples of existing legal obligations,
which require recognition of a liability include, but are not
limited to:
Decommissioning nuclear facilities;
Dismantling, restoring, and reclamation of oil and gas

properties;
Certain closure, reclamation, and removal costs of mining

facilities;
Closure and post-closure costs of landfills.
10-283 LO 5
Loss Contingencies
Illustration: On January 1, 2014, Wildcat Oil Company erected an

oil platform in the Gulf of Mexico. Wildcat is legally required to
dismantle and remove the platform at the end of its useful life,
estimated to be five years. Wildcat estimates that dismantling and
removal will cost $1,000,000. Based on a 10 percent discount rate,
the fair value of the asset retirement obligation is estimated to be
$620,920 ($1,000,000 x .62092). Wildcat records this ARO as
follows.
Drilling Platform 620,920

Asset Retirement Obligation 620,920

Loss Contingencies
Illustration: During the life of the asset, Wildcat allocates the asset
retirement cost to expense. Using the straight-line method, Wildcat
makes the following entries to record this expense.
December 31, 2014 through 2018
Depreciation Expense ($620,920 5) 124,184


Loss Contingencies
Illustration: In addition, Wildcat must accrue interest expense each

period. Wildcat records interest expense and the related increase in
the asset retirement obligation on December 31, 2014, as follows.
December 31, 2014
Interest Expense ($620,092 x 10%) 62,092


Loss Contingencies
Illustration: On January 10, 2019, Wildcat contracts with Rig

Reclaimers, Inc. to dismantle the platform at a contract price of
$995,000. Wildcat makes the following journal entry to
record settlement of the ARO.
January 10, 2019
Asset Retirement Obligation 1,000,000

Gain on Settlement of ARO 5,000
Cash 995,000

Loss Contingencies
Self-Insurance
Self-insurance is not insurance, but risk assumption.
There is little theoretical justification for the establishment of a liability based

on a hypothetical charge to insurance expense.
Illustration 13-12
Disclosure of Self-Insurance
10-288 LO 5
Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-289
Presentation of Current Liabilities

Usually reported at their full maturity value.
Difference between present value and the maturity
value is considered immaterial.
Companies may list the accounts in
Order of maturity,
Descending order of amount, or
Order of liquidation preference.
10-290 LO 6 Indicate how to present and analyze liabilities and contingencies.

Illustration 13-13
10-291 LO 6

If a company excludes a short-term obligation from current
liabilities because of refinancing, it should include the
following in the note to the financial statements:
1. A general description of the financing agreement.
2. The terms of any new obligation incurred or to be incurred.
3. The terms of any equity security issued or to be issued.


Actual Refinancing of Short-Term Debt Illustration 13-14

Presentation of Contingencies
Disclosure should include:
Nature of the contingency.
An estimate of the possible loss or range of loss or a

statement that an estimate cannot be made.
Companies should disclose certain other contingent liabilities.

1. Guarantees of indebtedness of others.
2. Obligations of commercial banks under stand-by letters of
credit.
3. Guarantees to repurchase receivables (or any related property)
that have been sold or assigned.
10-294 LO 6
Illustration 13-15
Disclosure of
Loss
Contingency
through
Litigation
10-295 LO 6
Analysis of
Illustration 13-13
Current Liabilities
Two ratios to help
assess liquidity are:
Illustration 13-19
10-296 Advance slide in presentation mode to reveal answers. LO 6

Similar to U.S. practice, IFRS requires that companies present current
and non-current liabilities on the face of the statement of financial
position (balance sheet), with current liabilities generally presented in
order of liquidity. However, many companies using IFRS present non-
current liabilities before current liabilities on the statement of financial
position.
LO 7 Compare the accounting procedures for current

10-297 liabilities and contingencies under GAAP and IFRS.
The basic definition of a liability under GAAP and IFRS is very similar. In
a more technical way, liabilities are defined by the IASB as a present
obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources
embodying economic benefits. Liabilities may be legally enforceable via
a contract or law but need not be. That is, they can arise due to normal
business practices or customs.
IFRS requires that companies classify liabilities as current or non-current
on the face of the statement of financial position (balance sheet), except
in industries where a presentation based on liquidity would be
considered to provide more useful information (such as financial
institutions).

Under IFRS, the measurement of a provision related to a contingency is
based on the best estimate of the expenditure required to settle the
obligation. If a range of estimates is predicted and no amount in the
range is more likely than any other amount in the range, the midpoint
of the range is used to measure the liability. In GAAP, the minimum
amount in a range is used.
Both IFRS and GAAP prohibit the recognition of liabilities for future
losses. However, IFRS permits recognition of a restructuring liability,
once a company has committed to a restructuring plan. GAAP has
additional criteria (i.e., related to communicating the plan to employees)
before a restructuring liability can be established.

IFRS and GAAP are similar in the treatment of asset retirement
obligations (AROs). However, the recognition criteria for an ARO are
more stringent under GAAP: The ARO is not recognized unless there is
a present legal obligation and the fair value of the obligation can be
reasonably estimated.
Under IFRS, short-term obligations expected to be refinanced can be
classified as non-current if the refinancing is completed by the financial
statement date. GAAP uses the date the financial statements are issued.

IFRS uses the term provisions to refer to estimated liabilities. Under
IFRS, contingencies are not recorded but are often disclosed. The
accounting for provisions under IFRS and estimated liabilities under
GAAP are very similar.
GAAP uses the term contingency in a different way than IFRS.
Contingent liabilities are not recognized in the financial statements under
IFRS, whereas under GAAP, a contingent liability is sometimes
recognized.

Under IFRS, a provision is the same as:
a. a contingent liability.
b. an estimated liability.
c. a contingent gain.

A typical provision is:
a. bonds payable.
b. cash.
c. a warranty liability.
d. accounts payable.

In determining the amount of a provision, a company using IFRS
should generally measure:
a. using the midpoint of the range between the lowest possible
loss and the highest possible loss.
b. using the minimum amount of the loss in the range.
c. using the best estimate of the amount of the loss expected to
occur.
d. using the maximum amount of the loss in the range.

Copyright
10-305
kieso
weygandt
warfield
INTERMEDIATE
Intermediat
Intermediat
team for success
ACCOUNTING
e e
Accounting
Accounting
Prepared by
Coby Harmon
Prepared by
Harmon
Westmont
Barbara
15th Edition
10-307
Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-308
Current Liabilities
What is a Liability?
The FASB, defined liabilities as:
Probable Future Sacrifices of Economic Benefits arising
from present obligations of a particular entity to transfer assets
or provide services to other entities in the future as a result of
past transactions or events.
10-309 LO 1
Current Liabilities
Recall: Current assets are cash or other assets that companies

reasonably expect to convert into cash, sell, or consume in
operations within a single operating cycle or within a year.
Current liabilities are obligations whose liquidation is

reasonably expected to require use of existing resources
properly classified as current assets, or the creation of other
current liabilities.
Operating cycle: period of time elapsing between the acquisition of

goods and services and the final cash realization resulting from sales and
subsequent collections.

Current Liabilities
Typical Current Liabilities:

Accounts payable. Customer advances and
deposits.
Notes payable.
Unearned revenues.
Current maturities of long-
term debt. Sales taxes payable.
Short-term obligations Income taxes payable.

expected to be refinanced.
Employee-related liabilities.
Dividends payable.

Current Liabilities
Accounts Payable (trade accounts payable)

Balances owed to others for goods, supplies, or services
purchased on open account.
Time lag between the receipt of services or acquisition of
title to assets and the payment for them.
Terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually

state period of extended credit, commonly 30 to 60 days.

Current Liabilities
Notes Payable
Written promises to pay a certain sum of money on a
specified future date.
Arise from purchases, financing, or other transactions.
Classified as short-term or long-term.
May be interest-bearing or zero-interest-bearing.

Current Liabilities
Interest-Bearing Note Issued

Illustration: Castle National Bank agrees to lend $100,000 on
March 1, 2014, to Landscape Co. if Landscape signs a $100,000,
6 percent, four-month note. Landscape records the cash received
on March 1 as follows:
Cash 100,000

Current Liabilities
If Landscape prepares financial statements semiannually, it

makes the following adjusting entry to recognize interest
expense and interest payable at June 30:


Current Liabilities
At maturity (July 1), Landscape records payment of the note and

accrued interest as follows.
Notes payable 100,000

Cash 102,000

Current Liabilities
Zero-Interest-Bearing Note Issued

Illustration: On March 1, Landscape issues a $102,000, four-
month, zero-interest-bearing note to Castle National Bank. The
present value of the note is $100,000. Landscape records this
transaction as follows.
Cash 100,000

Current Liabilities
Discount on Notes Payable is a contra account to Notes

Payable, and therefore is subtracted from Notes Payable on the
balance sheet. Illustration 13-1
Balance Sheet
Presentation of Discount
Discount on notes payable:

Represents the cost of borrowing.
Debited to interest expense over the life of the note.
Represents interest expense chargeable to future periods.

Current Liabilities
Illustration: (Accounts and Notes Payable) The following are

selected 2014 transactions of Darby Corporation.
Sept. 1 - Purchased inventory from Orion Company on account

for $50,000. Darby records purchases gross and uses a
periodic inventory system.
Oct. 1 - Issued a $50,000, 12-month, 8% note to Orion in

payment of account.
Oct. 1 - Borrowed $75,000 from the Shore Bank by signing a

12-month, zero-interest-bearing $81,000 note.
Prepare journal entries for the selected transactions.

Current Liabilities
Sept. 1 - Purchased inventory from Orion Company on

account for $50,000. Darby records purchases gross and uses
a periodic inventory system.
Sept. 1 Purchases 50,000

Accounts Payable 50,000

Current Liabilities
Oct. 1 - Issued a $50,000, 12-month, 8% note to Orion in payment

of account.
Oct. 1 Accounts Payable 50,000



Current Liabilities
Oct. 1 - Borrowed $75,000 from the Shore Bank by signing a 12-

month, zero-interest-bearing $81,000 note.
Oct. 1 Cash 75,000

Interest calculation = ($6,000 x 3/12) = $1,500


Current Liabilities
Current Maturities of Long-Term Debt

Portion of bonds, mortgage notes, and other long-term
indebtedness that matures within the next fiscal year.
Exclude long-term debts maturing currently if they are to be:
1. Retired by assets accumulated that have not been shown as

current assets,
2. Refinanced, or retired from the proceeds of a new debt issue,

or
3. Converted into capital stock.

Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-324
Current Liabilities
Short-Term Obligations Expected to Be

Refinanced
Exclude from current liabilities if both of the following
conditions are met:
1. Must intend to refinance the obligation on a long-term basis.
2. Must demonstrate an ability to refinance:
Actual refinancing.
Enter into a financing agreement.
10-325 LO 2
Current Liabilities
Short-Term Obligations Expected to be Refinanced

NO
Management Intends of Refinance Classify as
YES Current
Liability
Demonstrates Ability to Refinance
NO
YES
Actual Refinancing after Financing Agreement
balance sheet date but or Noncancellable with Capable
before issue date Lender
Exclude Short-Term Obligations from Current

Liabilities and Reclassify as LT Debt
10-326 LO 2
Current Liabilities
Illustration: On December 31, 2014, Alexander Company had

$1,200,000 of short-term debt in the form of notes payable due
February 2, 2015. On January 21, 2015, the company issued 25,000
shares of its common stock for $36 per share, receiving $900,000
proceeds after brokerage fees and other costs of issuance. On
February 2, 2015, the proceeds from the stock sale, supplemented by
an additional $300,000 cash, are used to liquidate the $1,200,000
debt. The December 31, 2014, balance sheet is issued on February
23, 2015.
Instructions:
Show how the $1,200,000 of short-term debt should be presented on
the December 31, 2014, balance sheet, including note disclosure
10-327 LO 2
Current Liabilities
Liability of $1,200,000 Issued stock Liability of Financial
How to classify? for $900,000 $1,200,000 statements
paid off issued
December 31, 2014 January 21, 2015 February 2, 2015 February 23, 2015
Balance sheet date
Partial Balance Sheet

Current liabilities:
Notes $300,000
payabledebt:
Long-term
Notes payable refinanced 900,000
Total liabilities $1,200,000
10-328 LO 2
WHATS YOUR
WHAT ABOUT PRINCIPLE
THAT SHORT-TERM DEBT?
The evaluation of credit quality involves less, when interest rates were low.
more than simply assessing a companys However, in light of expectations that the
ability to repay loans. Credit analysts also Fed would raise interest rates, analysts
evaluate debt management strategies. began to worry about the higher interest
Analysts and investors will reward what costs GE would pay when it refinanced
they view as prudent management these loans. Some analysts recommended
decisions with lower debt service costs and that it was time to reduce dependence on
a higher stock price. The wrong decisions short-term credit. The reasoning goes that
can bring higher debt costs and lower stock a shift to more dependable long-term debt,
prices. thereby locking in slightly higher rates for
General Electric Capital Corp., a the long-term, is the better way to go.
subsidiary of General Electric, Thus, scrutiny of GE debt strategies led
experienced the negative effects of market to analysts concerns about GEs earnings
scrutiny of its debt management policies. prospects. Investors took the analysis to
Analysts complained that GE had been heart, and GE experienced a two-day 6
slow to refinance its mountains of short- percent drop in its stock price.
term debt. GE had issued these current Source: Adapted from Steven Vames, Credit Quality,
obligations, with maturities of 270 days or Stock Investing Seem to Go Hand in Hand, Wall Street
Journal (April 1, 2002), p. R4.
10-329 LO 2
Current Liabilities
Dividends Payable
Amount owed by a corporation to its stockholders as a
result of board of directors authorization.
Generally paid within three months.
Undeclared dividends on cumulative preferred stock not

recognized as a liability.
Dividends payable in the form of additional shares of

stock are reported in stockholders equity.
10-330 LO 2
Current Liabilities
Customer Advances and Deposits

Returnable cash deposits received from customers and employees.
To guarantee performance of a contract or service or
As guarantees to cover payment of expected future

obligations.
May be classified as current or long-term liabilities.

10-331
Current Liabilities
Unearned Revenues
Payment received before delivering goods or rendering
services?
Illustration 13-3
Unearned and Earned
Revenue Accounts

10-332
Current Liabilities
Illustration: Allstate University sells 10,000 season football

tickets at $50 each for its five-game home schedule. Allstate
University records the sales of season tickets as follows.
Aug. 6 Cash 500,000

Unearned Sales Revenue 500,000
(10,000 x $50 = $500,000)
As each game is completed, Allstate makes the following entry.
Dec. 31 Unearned Sales Revenue 100,000

($500,000 5 games = $100,000 per game)
10-333 LO 2
WHATS YOUR
MICROSOFTS PRINCIPLE
LIABILITIES-GOOD OR BAD?
Users of financial statements generally examine liability (unearned revenue) the value of future
current liabilities to assess a companys liquidity upgrades to the software that it owes to
and overall financial flexibility. Companies must customers.
pay many current liabilities, such as accounts Market analysts read such an increase in
payable, wages payable, and taxes payable, unearned revenue as a positive signal about
sooner rather than later. A substantial increase in Microsofts sales and profitability. When
these liabilities should raise a red flag about a Microsofts sales are growing, its unearned
companys financial position. revenue account increases. Thus, an increase in
This is not the case for all current liabilities. For a liability is good news about Microsoft sales. At
example, Microsoft has a current liability entitled the same time, a decline in unearned revenue is
Unearned revenue of $14,830 million in 2010 bad news. As one analyst noted, a slowdown or
that has increased year after year. Unearned reversal of the growth in Microsofts unearned
revenue is a liability that arises from sales of revenues indicates slowing sales, which is bad
Microsoft products such as Internet Explorer and news for investors. Thus, increases in current
Windows XP. Microsoft also has provided liabilities can sometimes be viewed as good signs
coupons for upgrades to its programs to bolster instead of bad.
sales of its Xbox consoles. At the time of a sale, Source: Adapted from David Bank, Some Fans Cool to
customers pay not only for the current version of Microsoft, Citing Drop in Old Indicator, Wall Street
the software but also for future upgrades. Journal (October 28, 1999); and Bloomberg News,
Microsoft recognizes sales revenue from the Microsoft Profit Hit by Deferred Sales; Forecast Raised,
The Globe and Mail (January 26, 2007), p. B8.
current version of the software and records as a
10-334 LO 2
Current Liabilities
Sales Taxes Payable

Retailers must collect sales taxes from customers on
transfers of tangible personal property and on certain services
and then remit to the proper governmental authority.

10-335
Current Liabilities
Illustration: Prepare the entry to record sales taxes assuming

there was a sale of $3,000 when a 4 percent sales tax is in effect.
Cash 3,120
Sales Revenue 3,000
Sales Taxes Payable ($3,000 x 4% = $120) 1,800
10-336 LO 2
Current Liabilities
Many companies do not segregate the sales tax and the amount of
the sale at the time of sale. Instead, the company credits both
amounts in total in the Sales Revenue account.
Illustration: Assume the Sales Revenue account balance of

$150,000 includes sales taxes of 4 percent. Prepare the entry to
record the amount due the taxing unit.
Tax calculation = ($150,000 1.04 = $144,230.77 - $150,000 = $5,769.23)
Sales Revenue 5,769.23

Sales Taxes Payable 5,769.23
10-337 LO 2
Current Liabilities
Income Tax Payable

Businesses must prepare an income tax return and compute the income tax
payable.
Taxes payable are a current liability.
Corporations must make periodic tax payments.
Differences between taxable income (tax law) and

accounting income (GAAP) sometimes occur (Chapter 19).

10-338
Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-339
Current Liabilities
Employee-Related Liabilities
Amounts owed to employees for salaries or wages are
reported as a current liability.
Current liabilities related to employee compensation may

include:
Payroll deductions.
Compensated absences.
Bonuses.

Current Liabilities
Payroll Deductions
Most common types of payroll deductions are taxes,
insurance premiums, employee savings, and union dues.

Federal Old Age, Survivor, and Disability Insurance
(OASDI) benefits for certain individuals and their families.
Funds from taxes levied on both employer and employee.
Current rate 6.2 percent based on the employees gross pay

up to a $110,100 annual limit.
OASDI tax is usually referred to as FICA.

10-341 LO 3
Current Liabilities
Payroll Deductions
In 1965, Congress passed the first federal health insurance
program for the agedpopularly known as Medicare.
Alleviates the high cost of medical care for those over age 65.
Hospital Insurance tax, paid by both employee and employer

at the rate of 1.45 percent on the employees total
compensation.
OASDI tax (FICA) and the federal Hospital Insurance Tax is

referred to as the Social Security tax.
10-342 LO 3
Current Liabilities
Payroll Deductions
Unemployment Taxes.
Provides a system of unemployment insurance.

Federal Unemployment Tax Act (FUTA):
Only employers pay the unemployment tax.
Rate is 6.2 percent on the first $7,000 of compensation paid

to each employee during the calendar year.
If employer is subject to a state unemployment tax of 5.4

percent or more it receives a tax credit (not to exceed 5.4
percent) and pays only 0.8 percent tax to the federal
government.
10-343 LO 3
Current Liabilities
Payroll Deductions
Unemployment Taxes.
State unemployment compensation laws differ both from the

federal law and among various states.
Employers must refer to the unemployment tax laws in each

state in which they pay wages and salaries.
10-344 LO 3
Current Liabilities
Payroll Deductions
Income Tax Withholding.
Federal and some state income tax laws require employers to
withhold from each employees pay the applicable income tax
due on those wages. Illustration 13-5
Summary of Payroll Liabilities
10-345 LO 3
Current Liabilities

dues of $88 deducted. The company records the salaries and wages
paid and the employee payroll deductions as follows:

Withholding Taxes Payable 1,320
Union Dues Payable 88
Cash 7,827

Current Liabilities

dues of $88 deducted. The company records the employers payroll
taxes as follows:
Payroll Tax Expense 1,245

FUTA Taxes Payable 80
SUTA Taxes Payable 400

Current Liabilities
Paid absences for vacation, illness, and holidays.
Accrue a liability if all the following conditions exist.
The employers obligation is attributable to employees

services already rendered.
The obligation relates to rights that vest or accumulate.
Payment of the compensation is probable.
The amount can be reasonably estimated.

Current Liabilities
Illustration 13-6
Balance Sheet Presentation
of Accrual for Compensated
Absences

Current Liabilities
Illustration: Amutron Inc. employs 10 individuals and pays each

$480 per week. Employees earned 20 unused vacation weeks in
2014. In 2015, the employees used the vacation weeks, but now they
each earn $540 per week. Amutron accrues the accumulated vacation
pay on December 31, 2014, as follows.

Salaries and Wages Payable ($480 x 20) 9,600
In 2015, it records the payment of vacation pay as follows.

Cash ($540 x 20) 10,800
10-350 LO 3
Current Liabilities
Bonus Agreements
Payments to certain or all employees in addition to their
regular salaries or wages.
Bonuses paid are an operating expense.
Unpaid bonuses should be reported as a current

liability.

Current Liabilities
Illustration: Palmer Inc. shows income for the year 2014 of

$100,000. It will pay out bonuses of $10,700 in January 2015. Palmer
makes an adjusting entry dated December 31, 2014, to record the
bonuses as follows.

In 2015, Palmer records the payment of the bonus as follows.

Cash 10,700
10-352 LO 3
Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-353
Contingencies
An existing condition, situation, or set of circumstances

involving uncertainty as to possible gain (gain
contingency) or loss (loss contingency) to an enterprise
that will ultimately be resolved when one or more future
events occur or fail to occur.*
* FASB ASC 450-10-05-4. [Predecessor literature: Accounting for

Contingencies, Statement of Financial Accounting Standards No. 5
(Stamford, Conn.: FASB, 1975), par. 1.]
10-354 LO 4
Contingencies
Gain Contingencies
Typical Gain Contingencies are:
1. Possible receipts of monies from gifts, donations, asset
sales, and so on.
2. Possible refunds from the government in tax disputes.
3. Pending court cases with a probable favorable outcome.
4. Tax loss carryforwards (Chapter 19).
Gain contingencies are not recorded.

Disclosed only if probability of receipt is high.
10-355 LO 4
Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-356
Contingencies
Loss Contingencies
Involves possible losses.
Likelihood of Loss
FASB uses three areas of probability:
Probable.
Reasonably possible.
Remote.
10-357 LO 5
Loss Contingencies
Probability Accounting
Probable Accrue
Reasonably
Footnote
Possible
Remote Ignore
10-358 LO 5
Loss Contingencies
Illustration: Scorcese Inc. is involved in a lawsuit at December 31,

2014. (a) Prepare the December 31 entry assuming it is probable
that Scorcese will be liable for $900,000 as a result of this suit. (b)
Prepare the December 31 entry, if any, assuming it is not probable
that Scorcese will be liable for any payment as a result of this suit.
(a) Lawsuit Loss 900,000

Lawsuit Liability 900,000
(b) No entry is necessary. The loss is not accrued because it

is not probable that a liability has been incurred at
12/31/14.
10-359 LO 5
Loss Contingencies
Illustration 13-10
10-360 LO 5
Loss Contingencies
Common loss contingencies:

1. Litigation, claims, and assessments.
2. Guarantee and warranty costs.
3. Premiums and coupons.
4. Environmental liabilities.
10-361 LO 5
Loss Contingencies
Litigation, Claims, and Assessments

Companies must consider the following factors, in determining
whether to record a liability with respect to pending or
threatened litigation and actual or possible claims and
assessments.
Time period in which the action occurred.
Probability of an unfavorable outcome.
Ability to make a reasonable estimate of the loss.

Loss Contingencies

Cash-Basis Method.
Expense warranty costs as incurred, because
1. it is not probable that a liability has been incurred, or
2. it cannot reasonably estimate the amount of the

liability.

Loss Contingencies

Accrual-Basis Method.
Charge warranty costs to operating expense in the year of sale.
1. Method is the generally accepted method.

2. Referred to as the expense warranty approach.

Loss Contingencies
Illustration: Denson Machinery Company begins production on a

new machine in July 2014, and sells 100 units at $5,000 each by its
year-end, December 31, 2014. Each machine is under warranty for
one year. Denson estimates that the warranty cost will average $200
per unit. Further, as a result of parts replacements and services
rendered in compliance with machinery warranties, it incurs $4,000 in
warranty costs in 2014 and $16,000 in 2015.
1. Sale of 100 machines at $5,000 each, July through December

2014:
Cash or Accounts Receivable 500,000


Loss Contingencies
2. Recognition of warranty expense, July through December 2014:

3. Recognition of warranty costs incurred in 2015 (on 2014 sales):


Loss Contingencies
Premiums and Coupons

Companies should charge the costs of premiums and
coupons to expense in the period of the sale that benefits
from the plan.
Company estimates the number of

outstanding premium offers that
customers will present for redemption.
Company charges the cost of

premium offers to Premium Expense
and credits Premium Liability.
10-367 LO 5
Loss Contingencies
Illustration: Fluffy Cakemix Company offered its customers a large,

nonbreakable mixing bowl in exchange for 25 cents and 10 boxtops.
The mixing bowl costs Fluffy Cakemix Company 75 cents, and the
company estimates that customers will redeem 60 percent of the
boxtops. The premium offer began in June 2014 and resulted in the
transactions journalized below. Fluffy Cakemix Company records
purchase of 20,000 mixing bowls as follows.

Cash 15,000
$20,000 x .75 = $15,000

Loss Contingencies
Illustration: The entry to record sales of 300,000 boxes of cake mix

would be:
300,000 x .80 = $240,000
Cash 240,000
Fluffy records the actual redemption of 60,000 boxtops, the receipt

of 25 cents per 10 boxtops, and the delivery of the mixing bowls as
follows.
Cash [(60,000 10) x $0.25] 1,500

Computation: (60,000 10) x $0.75 = $4,500
10-369 LO 5
Loss Contingencies
Illustration: Finally, Fluffy makes an end-of-period adjusting entry

for estimated liability for outstanding premium offers (boxtops) as
follows.

Premium Liability 6,000

WHATS YOUR
FREQUENT PRINCIPLE
FLYERS
Numerous companies offer premiums to When airlines first started offering frequent-
customers in the form of a promise of flyer bonuses, everyone assumed that they
future goods or services as an incentive for could accommodate the free-ticket holders
purchases today. Premium plans that have with otherwise-empty seats. That made the
widespread adoption are the frequent-flyer additional cost of the program so minimal
programs used by all major airlines. On the that airlines didnt accrue it or report the
basis of mileage accumulated, frequent- small liability. But, as more and more
flyer members receive discounted or free paying passengers have been crowded off
airline tickets. Airline customers can earn flights by frequent-flyer awardees, the loss
miles toward free travel by making long- of revenues has grown enormously. For
distance phone calls, staying in hotels, and example, United Continental Holdings at
charging gasoline and groceries on a credit one time reported a liability of $2.4 billion
card. Those free tickets represent an for frequent-flyer tickets.
enormous potential liability because people Although the profession has studied the
using them may displace paying accounting for this transaction, no
passengers. authoritative guidelines have been issued.
10-371 LO 5
Loss Contingencies
A company must recognize an asset retirement obligation
(ARO) when it has an existing legal obligation associated with
the retirement of a long-lived asset and when it can reasonably
estimate the amount of the liability.
AROs should be recorded as fair value.

Loss Contingencies
Obligating Events. Examples of existing legal obligations,
which require recognition of a liability include, but are not
limited to:
Decommissioning nuclear facilities;
Dismantling, restoring, and reclamation of oil and gas

properties;
Certain closure, reclamation, and removal costs of mining

facilities;
Closure and post-closure costs of landfills.
10-373 LO 5
Loss Contingencies
Illustration: On January 1, 2014, Wildcat Oil Company erected an

oil platform in the Gulf of Mexico. Wildcat is legally required to
dismantle and remove the platform at the end of its useful life,
estimated to be five years. Wildcat estimates that dismantling and
removal will cost $1,000,000. Based on a 10 percent discount rate,
the fair value of the asset retirement obligation is estimated to be
$620,920 ($1,000,000 x .62092). Wildcat records this ARO as
follows.
Drilling Platform 620,920


Loss Contingencies
Illustration: During the life of the asset, Wildcat allocates the asset
retirement cost to expense. Using the straight-line method, Wildcat
makes the following entries to record this expense.
December 31, 2014 through 2018
Depreciation Expense ($620,920 5) 124,184


Loss Contingencies
Illustration: In addition, Wildcat must accrue interest expense each

period. Wildcat records interest expense and the related increase in
the asset retirement obligation on December 31, 2014, as follows.
December 31, 2014
Interest Expense ($620,092 x 10%) 62,092


Loss Contingencies
Illustration: On January 10, 2019, Wildcat contracts with Rig

Reclaimers, Inc. to dismantle the platform at a contract price of
$995,000. Wildcat makes the following journal entry to
record settlement of the ARO.
January 10, 2019
Asset Retirement Obligation 1,000,000

Gain on Settlement of ARO 5,000
Cash 995,000

Loss Contingencies
Self-Insurance
Self-insurance is not insurance, but risk assumption.
There is little theoretical justification for the establishment of a liability based

on a hypothetical charge to insurance expense.
Illustration 13-12
Disclosure of Self-Insurance
10-378 LO 5
Current Liabilities
and Contingencies
LEARNING OBJECTIVES
10-379

Usually reported at their full maturity value.
Difference between present value and the maturity
value is considered immaterial.
Companies may list the accounts in
Order of maturity,
Descending order of amount, or
Order of liquidation preference.

Illustration 13-13
10-381 LO 6

If a company excludes a short-term obligation from current
liabilities because of refinancing, it should include the
following in the note to the financial statements:
1. A general description of the financing agreement.
2. The terms of any new obligation incurred or to be incurred.
3. The terms of any equity security issued or to be issued.


Actual Refinancing of Short-Term Debt Illustration 13-14

Presentation of Contingencies
Disclosure should include:
Nature of the contingency.
An estimate of the possible loss or range of loss or a

statement that an estimate cannot be made.
Companies should disclose certain other contingent liabilities.

1. Guarantees of indebtedness of others.
2. Obligations of commercial banks under stand-by letters of
credit.
3. Guarantees to repurchase receivables (or any related property)
that have been sold or assigned.
10-384 LO 6
Illustration 13-15
Disclosure of
Loss
Contingency
through
Litigation
10-385 LO 6
Analysis of
Illustration 13-13
Current Liabilities
Two ratios to help
assess liquidity are:
Illustration 13-19
10-386 Advance slide in presentation mode to reveal answers. LO 6

Similar to U.S. practice, IFRS requires that companies present current
and non-current liabilities on the face of the statement of financial
position (balance sheet), with current liabilities generally presented in
order of liquidity. However, many companies using IFRS present non-
current liabilities before current liabilities on the statement of financial
position.

The basic definition of a liability under GAAP and IFRS is very similar. In
a more technical way, liabilities are defined by the IASB as a present
obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources
embodying economic benefits. Liabilities may be legally enforceable via
a contract or law but need not be. That is, they can arise due to normal
business practices or customs.
IFRS requires that companies classify liabilities as current or non-current
on the face of the statement of financial position (balance sheet), except
in industries where a presentation based on liquidity would be
considered to provide more useful information (such as financial
institutions).

Under IFRS, the measurement of a provision related to a contingency is
based on the best estimate of the expenditure required to settle the
obligation. If a range of estimates is predicted and no amount in the
range is more likely than any other amount in the range, the midpoint
of the range is used to measure the liability. In GAAP, the minimum
amount in a range is used.
Both IFRS and GAAP prohibit the recognition of liabilities for future
losses. However, IFRS permits recognition of a restructuring liability,
once a company has committed to a restructuring plan. GAAP has
additional criteria (i.e., related to communicating the plan to employees)
before a restructuring liability can be established.

IFRS and GAAP are similar in the treatment of asset retirement
obligations (AROs). However, the recognition criteria for an ARO are
more stringent under GAAP: The ARO is not recognized unless there is
a present legal obligation and the fair value of the obligation can be
reasonably estimated.
Under IFRS, short-term obligations expected to be refinanced can be
classified as non-current if the refinancing is completed by the financial
statement date. GAAP uses the date the financial statements are issued.

IFRS uses the term provisions to refer to estimated liabilities. Under
IFRS, contingencies are not recorded but are often disclosed. The
accounting for provisions under IFRS and estimated liabilities under
GAAP are very similar.
GAAP uses the term contingency in a different way than IFRS.
Contingent liabilities are not recognized in the financial statements under
IFRS, whereas under GAAP, a contingent liability is sometimes
recognized.

Under IFRS, a provision is the same as:
a. a contingent liability.
b. an estimated liability.
c. a contingent gain.

A typical provision is:
a. bonds payable.
b. cash.
c. a warranty liability.
d. accounts payable.

In determining the amount of a provision, a company using IFRS
should generally measure:
a. using the midpoint of the range between the lowest possible
loss and the highest possible loss.
b. using the minimum amount of the loss in the range.
c. using the best estimate of the amount of the loss expected to
occur.
d. using the maximum amount of the loss in the range.

Copyright
10-395

Ahihi

Caricato da

Informazioni sul documento

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Ahihi

Caricato da

Copyright:

Formati disponibili

kieso

1. Describe property, plant, and equipment. 5. Understand accounting issues related to

Property, plant, and equipment are assets of a durable

10-4 LO 1 Describe property, plant, and equipment.

1. Describe property, plant, and equipment. 5. Understand accounting issues related to

Acquisition of Property, Plant, and Equipment

Main reasons for historical cost valuation:

Historical cost is reliable.

LO 2 Identify the costs to include in initial valuation of

Land acquired and held for speculation is classified as an

Land held by a real estate concern for resale should be

LO 2 Identify the costs to include in initial valuation of

materials, labor, and overhead costs incurred during

professional fees and building permits.

LO 2 Identify the costs to include in initial valuation of

freight and handling charges,

insurance on the equipment while in transit,

cost of special foundations if required,

assembling and installation costs, and

costs of conducting trial runs.

LO 2 Identify the costs to include in initial valuation of

(a) Money borrowed to pay building contractor Notes Payable

(g) Architects fee on building Building

1. Describe property, plant, and equipment. 5. Understand accounting issues related to

2) Overhead can be handled in two ways:

2. Assign a portion of all overhead to the construction

Companies use the second method extensively.

10-14 LO 3 Describe the accounting problems associated with self-constructed assets.

1. Describe property, plant, and equipment. 5. Understand accounting issues related to

Interest Costs During Construction

Increase to Cost of Asset

10-16 LO 4 Describe the accounting problems associated with interest capitalization.

Interest Costs During Construction

Consistent with historical cost.

Capitalization considers three items:

10-17 LO 4 Describe the accounting problems associated with interest capitalization.

Two types of assets:

Assets under construction for a companys own use.

Assets intended for sale or lease that are constructed or

10-18 LO 4 Describe the accounting problems associated with interest capitalization.

2. Activities for readying the asset are in progress .

3. Interest costs are being incurred.

10-19 LO 4 Describe the accounting problems associated with interest capitalization.

2. Avoidable interest - the amount of interest cost during

10-20 LO 4 Describe the accounting problems associated with interest capitalization.

Interest Capitalization Illustration: Assume a company borrowed

Step 1 - Determine which assets qualify for capitalization of

Step 2 - Determine the capitalization period.

10-22 LO 4 Describe the accounting problems associated with interest capitalization.

Step 3 - Compute weighted-average accumulated

A company weights the construction expenditures by the amount of time

10-23 LO 4 Describe the accounting problems associated with interest capitalization.

Step 4 - Compute the Actual and Avoidable Interest.

Selecting Appropriate Interest Rate:

2. For the portion of weighted-average accumulated expenditures

10-24 LO 4 Describe the accounting problems associated with interest capitalization.

Accumulated Interest Avoidable

10-25 LO 4 Describe the accounting problems associated with interest capitalization.

Step 5 Capitalize the lesser of Avoidable interest or Actual

Avoidable interest $ 30,250

Journal entry to Capitalize Interest:

10-26 LO 4 Describe the accounting problems associated with interest capitalization.

Comprehensive Illustration: On November 1, 2013, Shalla