CHAPTER 8:

1. CHAPTER 8: Assets Accounting © 2007 by Nelson, a division of Thomson Canada Limited.

2. CHAPTER 8Assets Accounting Main topics in Chapter 8: • Historical cost valuation and some alternatives to it; • How to determine the cost of an asset; • Several specific topics, working down the asset side of the balance sheet: • Cash and temporary investments; • Accounts receivable; • Inventories and cost of goods sold; • Capital assets, amortization, and gains/losses on disposal; • Other assets, intangibles, and capital leases. © 2007 by Nelson, a division of Thomson Canada Limited.

3. Balance Sheet Valuation: Why is it an issue? Balance sheet numbers have to come from somewhere. Why not just from transactions (historical amounts)? There is a lot of discussion and argument surrounding this issue, which is fundamental to the whole meaning of the balance sheet. It also affects the income statement because of the articulation between the two financial statements. © 2007 by Nelson, a division of Thomson Canada Limited.

4. The Asset Valuation Issue So far in the course, asset values have been produced through accounting transactions, which probably has seemed natural. But there are questions about whether these assets values are appropriate, and much thought has been given to alternative ways of producing the asset numbers on the balance sheet (and the liability numbers, though the focus now is on assets). The Problem: • History is just that, history! Who cares? • Balance sheet values should be useful in people’s decision making. Is historical value the most useful valuation method if we want to look into the future? © 2007 by Nelson, a division of Thomson Canada Limited.

5. 7 Methods for Valuing Assets and Liabilities • Historical cost • Price-level Adjusted Historical Cost • Current or Market Value • Lower of Cost or Market • Fair Value • Value in Use • Liquidation Value © 2007 by Nelson, a division of Thomson Canada Limited.

6. 1) Historical Cost (acquisition cost) What is it? • Our traditional transaction-based valuation for assets at their original or acquisition cost. • Used since it is verifiable (purchase records) and the most conservative since a corporation would not pay more than the asset is worth Problems • The longer a balance sheet item has existed, the more out of date its valuation • Amortization is used to match the expense of the asset with its revenue generating potential but does not create a meaningful net book value. HC is the “default,” assumed unless there’s a problem

7. 2) Price-Level Adjusted Historical Cost What is it? Multiply HC valuation by some price index to adjust for inflation Why use it? It has had some theoretical support for 70 years and has been tried by some companies and countries Why should we not use it? The resulting numbers are hard to understand and do not really reflect company-specific current values PLAHC has been tried in situations with high inflation

8. 3) Current or Market Value • Values assets at their true value (what they could be sold for today) • Recognizes losses or gains even if the asset is not being sold • Input Market Value – amount it would cost to replace the asset • Output Market Value – amount the asset could be sold for now (“net realizable value) • Examples: Financial Instruments

9. 4) Lower of Cost or Market • Values assets using historical cost unless the market price is deemed to be lower • Most conservative of the seven methods since the lowest value will always be used 5) Fair Value • Similar to market value but used in more ‘hypothetical’ agreements where estimates have to be made • Must be an accurate estimate of a viable transaction that would involve ‘arm’s-length’ participants • Used frequently now in valuing stock option compensation

10. 6) Value in Use • Values assets by taking the net present value (remember the present value analysis from Ch. 10) of the future cash flows generated by an asset • Used rarely except with capital leases 7) Liquidation Value • Occurs when the company is no longer a going concern • Assets are valued at the price they can be sold off for

11. How to Implement a Balance Sheet Valuation Change from Historical Cost to Current Market Value? Assumptions: • The current market value of a major asset such as land has been reliably estimated; • The company decides to revalue the asset to current market value (not appropriate under Canadian GAAP but OK in some countries). • There are no income tax consequences to revaluing the asset © 2007 by Nelson, a division of Thomson Canada Limited.

12. Five Possible Approaches to Implementing a Change in Asset Value from Historical Cost to Current Market Value Possibilities: • Adjust land to market value and put the difference into income • Adjust land to market value and put the difference into retained earnings • Adjust land to market value and put the difference in a special equity account • Adjust land to market value only if market value is lower than cost • Don’t adjust the accounts; just disclose the information © 2007 by Nelson, a division of Thomson Canada Limited.

13. Have you ever wondered what “Building Cost $X” actually includes? What exactly is the cost of a noncurrent asset? The cost of a noncurrent asset is anything that is needed to make the asset suitable for its intended use. This usually only includes the costs prior to putting the asset into service.

14. Have you ever wondered what “Inventory Cost $X” actually includes? What exactly is the cost of a current asset? The cost of a current asset follows the same historical transaction “cost to make it suitable” idea for a noncurrent asset. Historical cost is used only if it is lower than the market value and market value is used only if it is lower than the historical cost: “Lower or cost or market.”

15. Asset Cost Asset cost is the acquisition cost and preparation costs that are required to put the asset into service. Asset Cost, Amortization, and Betterment Dollars Point asset is put into service Time

16. Asset Cost, Amortization, and Betterment Net Book Value Asset Cost Dollars Point asset is put into service Time After this point the asset is put into service. Its cost is amortized against the revenue it helps to earn. Any expenditures are included as maintenance expenses (except for “betterment” of the asset). The net book value goes down as the asset is amortized.

17. Asset Cost, Amortization, and Betterment Betterment Dollars Point asset is put into service Time If an expenditure on the asset is made and the asset undergoes an apparent improvement where its productivity or efficiency has increased or its useful life extended then there has been a betterment of the asset and the cost should be capitalized.

18. Asset Cost, Amortization, and Betterment Net Book Value Betterment Dollars Point asset is put into service Time Betterments are recorded by adding the expenditure to the net book value of the asset.

19. Summary of GAAP for Balance Sheet Valuation • At date of acquisition, it is assumed that HC=MV=Value in Use • Current assets are valued at lower of cost or market • Noncurrent assets are valued at historical cost (minus accumulated amortization representing economic value used), but if their value is impaired are written down to value in use or market value. • All liabilities are at historically determined amounts © 2007 by Nelson, a division of Thomson Canada Limited.

20. Let’s do an example: “A Jolt of Java,” a well known café, is opening up a new location in a nearby city. In order to get the business started, several payments were made. Included in this long list is the cost of the building, the cost of the new coffee grinders and the cost of manufacturing special decorative bags filled with flavored coffee beans to be sold in the café. These bags are manufactured in a factory owned by “A Jolt of Java.” Given a list of potential costs for each category, the company decided whether each potential cost should be part of the asset cost, or should be included as an expense.

21. Building Cost Does the cost include: Purchase price of the land? No Building materials costing $400,000 (included $5,000 in materials wasted due to workers inexperience)? Yes. $395,000 worth Machinery installation charges? No Grading and draining of site? Yes Parking lot grading and paving? Maybe Replacement of building windows shot out by vandals before production start-up? No Architect’s fees? Yes

22. Coffee Grinders Cost (ordered specially from Italy) Does the cost include: The invoice price of the grinders? Yes Customs duties paid on machines? Yes The cost of the manager’s trip to the grinder manufacturing plant to choose the machine? Maybe The cost of painting “A Jolt of Java” on the machines? Maybe Estimated revenue lost because the machines were late arriving? No Interest on bank loan used to financing the machines? No

23. Decorative Bags Full of Coffee Beans Does the cost include: Cost of raw materials used to make the bags? Yes Cost of coffee beans? Yes Labour required to make the bags? Yes Supervision costs? Maybe Electric utilities at the factory? Maybe © 2007 by Nelson, a division of Thomson Canada Limited.

24. Cash What is included in cash? Cash includes all varieties of unrestricted cash on hand and in banks. • Cash on hand, including petty cash • Cash in savings and chequing accounts • “Cash in transit” that is on its way from other banks or countries © 2007 by Nelson, a division of Thomson Canada Limited.

25. Cash What is not included in cash? Cash does not include any amounts not available for immediate use. • Bad cheques received from customers • Cash not available for immediate use, including term deposits and investments that can not be withdrawn • Cash subject to other countries’ exchange or currency controls that limits its availability for immediate use © 2007 by Nelson, a division of Thomson Canada Limited.

26. Cash • Cash on the balance sheet is different than the company’s actual bank balance • Cheques that have not cleared the bank or other adjustments may be taken into account • Underlines the importance of Bank Reconciliation © 2007 by Nelson, a division of Thomson Canada Limited.

27. Temporary Investments What are they? Temporary Investments are used to provide a better return on excess cash than bank deposits do. Examples are treasury bills, stocks, bonds, guaranteed investment certificates (GICs). How are they valued? Temporary Investments are valued on the balance sheet at the lower of cost or market. © 2007 by Nelson, a division of Thomson Canada Limited.

28. Accounts Receivable Trade accounts receivable - Recognized but uncollected revenue arising from the company’s day-to-day operations Receivables are reduced by an allowance contra (allowance for doubtful accounts) if their collectible value has fallen Other receivables - separated from trade receivables if important (e.g. notes receivable, loans to employees, tax refunds to be received) © 2007 by Nelson, a division of Thomson Canada Limited.

29. Allowance for Doubtful Accounts How is the allowance determined? 2 Methods: • Percentage-of-Sales (Income Statement) Approach - • Matches costs with revenues because it relates the • charge to the period in which the sale is recorded. • Percentage-of-Receivables (Balance Sheet) Approach - • Using past experience, the company estimates the • percentage of its outstanding receivables that will • become uncollectible. An aging schedule is often set • up to view the age of all receivables. © 2007 by Nelson, a division of Thomson Canada Limited.

30. Inventory Valuation and Cost of Goods Sold Why are we concerned with what the value of the Inventory account is? Inventory is the lifeline of most companies, containing the goods whose sale will produce the revenue the business needs. Without inventory most establishments cannot survive. How we value inventory will affect not only the balance sheet account, but also the income statement, via the cost of goods sold expense. © 2007 by Nelson, a division of Thomson Canada Limited.

31. Inventory Valuation and Cost of Goods Sold Inventory valuation follows the GAAP rule for all current assets: lower of cost or market. This means that all items in inventory are valued at either the cost they were purchased for or their current market value if it has fallen below cost. So, what is the cost of inventory? Total cost = quantity  unit cost How do we get the quantity and unit cost?

32. Inventory Valuation and Cost of Goods Sold Total cost = quantity  unit cost Getting Quantity: • Records • Counts • Estimates Getting Unit Cost: • Purchase invoices • Manufacturing cost records • Estimates In reality, tracking the cost for each item in inventory is difficult and costly, though less so as computer systems reduce information processing costs.

33. Inventory Valuation and Cost of Goods Sold The Problem: How do we allocate the total cost of goods available between the Income Statement for the period (COGS expense) and the Balance Sheet at the end of the period (ending Inventory asset)? The Solution: We assume a flow of inventory items and their costs through the business. The different cost flow assumptions just allocate the available cost differently between the B/S valuation and the I/S expense.

34. Gone: Cost of goods sold Cost of goods purchased Available cost + = OR Still here: Cost of ending inv. Inventory Valuation and Cost of Goods Sold Derivation and Allocation of Available Cost Cost of beginning inventory There would be no problem if the costs of inventory were constant, but for most companies, they constantly change. Inventory costs could dramatically change between March 1, when an item was purchased, and March 31, the balance sheet date.

35. Inventory Valuation and Cost of Goods Sold Before we begin looking at the different types of cost calculation methods we must understand the following points: • Unsold or unused inventory is on the B/S • Used or sold inventory is in the COGS expense • Begin + Purchase – Used/Sold (COGS) = End • Begin + Purchase = Available, and • Available = Used/Sold (COGS) + End • Policy: allocation of available cost between COGS (expense) and End (B/S) • The more in COGS, the less on B/S, and vice versa

36. Inventory Cost Policy There are at least four possible policies. They are: • “Actual” cost • “First in, first out” assumption • “Average” assumption • “Last in, first out” assumption © 2007 by Nelson, a division of Thomson Canada Limited.

37. "Actual" Cost • Use it when the specific inventory items can be identified • Computer systems are making this method more practical • Successfully applied in situations where a relatively small number of costly, easily distinguishable items are handled • Serially numbered items like cars, jewellery, houses © 2007 by Nelson, a division of Thomson Canada Limited.

38. FIFO Assumption • The items on hand, in inventory, are the newest • Therefore, the ones sold were older • This is used (usually) for goods that are for sale An advantage of the FIFO method is that the ending inventory amount is close to its current cost © 2007 by Nelson, a division of Thomson Canada Limited.

39. LIFO Assumption • The items just sold were the newest • Therefore, the items on hand are older • A little preposterous, but used in USA because it saves income tax there (not allowed for income tax purposes in Canada, so it is uncommon here) The cost assigned to the inventory remaining in the LIFO method would come from the earliest acquisitions © 2007 by Nelson, a division of Thomson Canada Limited.

40. Average Assumption • Those items on hand and sold were all taken from the same mixed-together group • This is used (usually) for raw materials, natural resources, non perishable items The average cost method may be viewed as a compromise between the FIFO and LIFO methods © 2007 by Nelson, a division of Thomson Canada Limited.

41. Oryx Inc. sells a single product. During a recent period, the company’s records showed: Units on hand, beginning of period 1,000 @ $10 cost Units in Purchase A 2,000 @ $14 cost Units sold in Sale 1 (1,500) Units in Purchase B 3,000 @ $15 cost Units sold in Sale 2 (2,800) Units on hand, end of period 1,700 Let’s do an example: ORYX INC.

42. ORYX INC. Calculate total “available cost” for the period and then allocate that cost between COGS expense and ending inventory asset by each of the indicated methods: Available cost =(1000  $10) + (2000  $14) + (3000  $15) =$83,000 Now let’s sketch out the flow of sales and purchases to have a better idea of inventory movement. © 2007 by Nelson, a division of Thomson Canada Limited.

43. 4500 on hand 3000 on hand Sold 2800 Bought 3000 @ $15 Sold 1500 Bought 2000 @ $14 1700 on hand 1500 on hand Time Inventory Balance and Changes 1000 on hand

44. a) Ending inventory cost 1700  $15 = $25,500 b) COGS expense Sale 1: (1000  $10) + (500  $14) = $17,000 Sale 2: (1500  $14) + (1300  $15) = $40,500 $57,500 ORYX INC. FIFO (First In, First Out) : Check: $25,500 + $57,500 = $83,000 = Total Available Cost © 2007 by Nelson, a division of Thomson Canada Limited.

45. Inventory Balance and Changes 3000 on hand Sold 2800 Sold 1500 Bought 2000 @ $14 1700 left over in inventory; purchased for $15 1700 on hand 1500 on hand Time 4500 on hand Bought 3000 @ $15 1000 on hand

46. a) Average cost = Total Available Cost/Total Units $13.8333 83,000/6000 units = b) Ending inventory cost $23,517 1700  $13.8333 = c) COGS expense 4300  $13,8333 = $59,483 ORYX INC. AVERAGE: Annual Weighted: Straight forward blended result of averaging all purchases and sales together. © 2007 by Nelson, a division of Thomson Canada Limited.

47. ORYX INC. AVERAGE : Moving Weighted: Average cost of goods is recalculated after each purchase. a) Weighted Average after first purchase W1 = (1000  $10 + 2000  $14) (1000 + 2000) = $12.6666 b) Weighted Average after second purchase W2 = (1500  $12.6666 + 3000  $15) (1500 + 3000) = $14.2222

48. ORYX INC. a) Ending inventory cost We are ignorant of the ups and downs during the period. We started with 1000 and ended with 1700, so: $19,800 (1000  $10) + (700  $14) = b) COGS expense (3000  $15) + (1300  $14) = $63,200 LIFO (Last In, First Out): Periodic: Check: $19,800 + $63,200 = $83,000 = Total Available Cost

49. Inventory Balance andChanges 1700 original items still in inventory Sold 2800 Sold 1500 1700 on hand 1500 on hand Last items purchased are first to be sold (1700 @ $14 and 3000 @ $15) Time 4500 on hand 3000 on hand Bought 3000 @ $15 Bought 2000 @ $14 1000 on hand

50. LIFO (Last In, First Out): Perpetual (keep track of inventory continuously: a) Ending inventory cost The lowest inventory point represents the goods that were never sold. The remainder come from purchases. ORYX INC. Using the graph, find the lowest point and analyze layers: © 2007 by Nelson, a division of Thomson Canada Limited.