Module 5 - Lecture notes 2 PDF

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Financial Accounting: Advanced Topics Oktay Urcan

MEET PROFESSOR URCAN .............................................................................................. 2 MODULE 1(5) ................................................................................................................. 3 LESSON 1-1: OVERVIEW AND ASSET RECOGNITION CRITERIA ............................................ 3 LESSON 1-2: FIXED ASSETS ............................................................................................ 6 LESSON 1-3: DISPOSAL OF FIXED ASSETS ...................................................................... 11 LESSON 1-4: GROSS VS. NET PPE ................................................................................ 14 LESSON 1-5: ACCOUNTING FOR ASSET IMPAIRMENTS ...................................................... 20 LESSON 1-6: WALMART ASSETS .................................................................................... 22 MODULE 1 CASE .......................................................................................................... 27 EXPLORE THE IMBA! (OPTIONAL) ................................................................................... 67

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Financial Accounting: Advanced Topics Oktay Urcan

Meet Professor Urcan

Hello, my name is Oktay Urcan. I'm an Associate Professor of Accounting here at University of Illinois. [MUSIC] I teach finance that come new related classes at undergraduate, MBA executive MBA, and PhD levels. I have been associated with the University of Illinois for about two years. Before that I was an assistant professor of accounting at London Business School in United Kingdom. I conduct research in the archival capital markets area. My recent research interest are in the growing interdisciplinary research area called macro accounting which studies the interruption between macro economy and accounting. My research investigates how integrated accounting numbers help predict important macroeconomic variables including GDP growth, employment growth and inflation. I will be teaching financial accounting course in our IMBA program. Accounting is the language of business. Decision makers both written and outside of firms in business life need relevant and reliable information to make decision. In this class, you will develop a deep understanding of particular type of information provided by each financial statement and how decision makers can benefit from financial statements. Accounting knowledge also serves as a foundation for other classes you will take in IMBA program, this classes include finance and strategy. Welcome to financial accounting, let's begin.

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Financial Accounting: Advanced Topics Oktay Urcan

Module 1(5) Lesson 1-1: Overview and Asset Recognition Criteria

Hello, welcome first class of Financial Accounting class here at University of Illinois. Today we are going to talk about long-term assets. In particular, we are going to discuss accounting for long-term assets, accounting for depreciation, and accounting for asset disposals, as well as asset impairments.

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Financial Accounting: Advanced Topics Oktay Urcan

But before we start, let me briefly remind you of the asset recognition criteria, which is going to be quite important for this lesson. In accounting, not every expenditure is an asset. In other words, in accounting we do not capitalize every expenditure as an asset on the balance sheet. For an expenditure to be an asset, it has two satisfy two criteria. First, the benefit coming out of this asset needs to be quantifiable. And second, the rights to use this asset should be obtained because of some past transactions. Most of the time, in practice, the most important criterion is number one, whether the benefit coming out of this asset is quantifiable or not. Let me make a small note here. We have two groups of assets, tangible and intangible. Tangible assets are those where we can really touch them. Intangible assets are the ones that we cannot touch, but we can still see them on the balance sheet. I'm going to give you an example.

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Financial Accounting: Advanced Topics Oktay Urcan

Buildings, is buildings an asset? Yes. Why? First of all, is the benefit quantifiable? Yes. The money that you spend to build the buildings or to buy the buildings are quantity of or the value of that building. And the rights to use the buildings are coming out of some past transactions? Yes, I mean, in the past, we acquired those buildings through a contract, and therefore we have the right to use those buildings. And at the same time, by the way, buildings are some tangible assets. You can touch them. The same thing is also true for land. But how about R&D expenditures, research and development expenditures? Research and development expenditures in accounting are not an asset. Why? Because it doesn't satisfy the first asset recognition criterion, which is the benefit should be quantifiable. Research and development expenditures are certainly very important, but we cannot quantify the benefit coming out of research and development. Sometimes you spend lots of money on your R&D but you gain nothing out of this, and therefore R&D expenditures are not an asset. Instead, as soon as we spend the money on R&D, we immediately expense them. And the same thing is true, also, for advertising, as well as training. For example, advertising is very important, but the benefit coming out of advertising is not quantifiable. Therefore, advertising expenditures are not an asset. They're just normal expenditures. One very interesting asset here, which is patents acquired. Patents are, first of all, intangible assets. We cannot touch them. But when they are purchased from somebody else, we can create an asset for this patent. Why? Because the benefit is quantifiable. We have a value associated with this patent.

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Financial Accounting: Advanced Topics Oktay Urcan

Lesson 1-2: Fixed Assets

Now's a good time to start our topic of today, which is fixed assets. So what do we know about fixed assets? Fixed assets are the ones which has a life more than one year. Buildings are fixed assets, lands are fixed asset because they generally have a life more than one year. When we have fixed assets, the question now becomes what is the value that I need to put associated with these fixed assets on the balance sheet? During the acquisition, the general principle is, any money that you spend in the acquisition of the fixed assets as well as preparing to use this fixed asset can be capitalized on the balance sheet. For example, for a farm if they buy a truck as a fixed asset. Purchase costs, transportation of the truck to the facility as well as for example, insurance during the transportation can be capitalized. So one more time, any money that you spend until the fixed asset is ready to use can be capitalized on the balance sheet. A small note here, for assets that are constructed, any cost that we spend on constructing this asset can be capitalized. Any construction cost, is also includes interest. So these are costs that can be capitalized during the acquisition. Now my question is, is there any cost that can capitalize after the acquisition of the asset and the answer is, it depends. If the expenditure increase useful life. Decrease operating costs or increase productivity, then we can capitalize this expenditures as a form of fixed assets. On the other hand for example, if you spend money on maintenance of the fixed assets, it cannot be capitalized, it has to be immediately expense.

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Financial Accounting: Advanced Topics Oktay Urcan

Okay now, we have a fixed asset on our balance sheet. It has a value associated with this, what's going to happen? First, we are going to use this fixed asset or what its useful life. During this useful life usage, what we need to do is that we need to allocate some of the value of this asset to income statement as an expenditure. Since we are using this asset, there should be an expenditure associated with this usage. And this process is called depreciation for fixed assets, amortization for intangible assets, and depletion for natural resources. Very important note here, depreciation has nothing to do with current market value. Depreciation is due to the fact that we have this asset, we use it and therefore, associated with this asset. At the end of every year or every quarter, there should be some form of expenditure, depreciation expenditure on the income statement. My question right now is how am I going to estimate, how am I going to calculate this depreciation expense? In order to calculate depreciation, you need to estimate three things. These are salvage value.

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Financial Accounting: Advanced Topics Oktay Urcan

Salvage value is the value of the assets after you consume all of it's useful life. Let's say, If we have a truck, it has a useful life of ten years. The question here is, after the ten years of usage, what is the value of this truck? That is salvage value. Second unit, the estimate of useful life and third to fourth, you need to come up with the depreciation methods. There are many depreciation methods that you can choose. The most common one is the straight line one over which the estimate depreciation. And then the depreciation expense is the same every year over the useful life of the asset. And there is another popular one which is accelerated depreciation. Under accelerated depreciation, we initially have a lot of depreciation expense and then gradually, the amount of depreciation expense goes down. As I said, the most common one is a straight line and for that purpose, I'm going to do an exercise about a straight line depreciation.

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Financial Accounting: Advanced Topics Oktay Urcan

Under straight line depreciation, depreciation expense is calculated as annually. Purchase cost minus salvage value, divided by useful life. And here is an example. Illini supermarket purchases a new truck by paying $35, 000. This truck has a useful life of ten years, it has a salvage value of $2000. My question here is, what is the accounting for depreciation of this asset? But first of all, here are my accounts that I'm going to use to record this transaction. I have cash. Second of all, I have PPE, which stands for plant, property and equipment. Any fixed asset that I acquire should be classified under this account, plant, property and equipment. Third of all, I have accumulated depreciation. Accumulated depreciation is the account that I'm going to book the depreciation expense of planned property and equipment. And then I have under shareholder's equity, IS, which is income statement, and I also have retained earnings, RE. First of all, we need to acquire this asset and we need to record acquisition of this asset. What's going to happen? We pay cash, therefor there would be a cash decline of $35,000. And we create a new asset truck on our PPE account, which is $35,000. And then we use this asset for a year. My question here is this, what is the amount of depreciation and how am I going to record this? But first of all, we need to calculate the amount of depreciation expense. If you look at the IS column, what is the amount of depreciation expense? Well, we just followed the formula we have just talked about. It is, origin of purchase cost, $35,000 minus $2,000 of salvage value, divided by ten, which is going to give you any of depreciation associated with this truck of 3,300. Notice that it is a depreciation expense. It is important, this is under income statement.

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Financial Accounting: Advanced Topics Oktay Urcan

Question now is, what is the second leg of this transaction? Well, since we are using this asset, there should be a decline in the value of the asset on the asset side. And this is where accumulative depreciation comes into picture. I'm not directly reducing PPE account for this depreciation. Instead, I am creating this accumulated depreciation account, which is a counter asset. It's an asset, but it has a value of negative. And as you see here, I record the other side of the depreciation as 3,300 reduction from accumulated depreciation. So the message here is that, accumulated depreciation is used to record the depreciation of PPE account. It has a balance of negative almost all the time. The maximum that you have on the accumulated depreciation account could be zero, it was never positive.

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Financial Accounting: Advanced Topics Oktay Urcan

Lesson 1-3: Disposal of Fixed Assets

Now we are going to talk about disposal of fixed assets. When we acquire fixed asset, it doesn't necessarily mean that we use these assets until the end of their useful life. There are a lot of cases where fixed assets are sold before their useful life. And in this scenario, you need to calculate two things for accounting purposes. The first one is net book value, NBV. Net book value is equal to original cost of this fixed asset minus all accumulated depreciation of this fixed assets. And the second thing that you need to calculate when you dispose of an asset is gain or loss coming out of this disposal. It is calculated as sale price- NBV that you have just calculated. Let me give you an example.

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Financial Accounting: Advanced Topics Oktay Urcan

Again, my classic example Illini Supermarket acquires a truck by paying $35,000. It has estimated life of 10 years, salvage value of $2,000. Well what happens is that after the 5 years of usage, Illini Supermarket sells this asset for $20,000. So the question here is, how are we going to do the accounting for this? But first of all, you need to do accounting for the 5 years of usage of this fixed asset. So what's going to happen is that when you acquired this asset obviously there is a cash decrease of $35,000. There is a PPE, asset creation of $35,000. And then you need to record 5 years of usage of this asset under accumulated depreciation. As we have calculated in the previous video, annually, the amount of depreciation is 3,300 times 5 will give you 16,500 under accumulated depreciation. And note that same number also shows up under retained earnings. Why? Normally, accumulated depreciation will show up under income statement, but we know that the balances at the end of every year under income statement is transferred to retained earnings. That's why 16,500 also shows up under retained earnings. Now, at this point, we are going to sell this asset for $20,000 cash. Let's sell it. First of all, there is a cash increase of $20,000. Second of all, since we sold this asset, you need to close PPE account, as well as accumulated depreciation associated with this asset. Therefore notice that PPE account is closed by putting a negative $35,000. Notice also that accumulated depreciation is also closed by adding a positive 16,500. So now we are ready. And we said whenever we dispose of an asset, we need to calculate two things. The first one was net book value which is equal to original cost of this asset, in our case it is $35,000, minus accumulated depreciation of this asset which is 16,500. If you

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Financial Accounting: Advanced Topics Oktay Urcan

calculate this, you're going to come up with 18,500, which is the net book value at the time of sale of this asset. And the second that you need to calculate when you dispose of an asset was gain or loss, which is equal to the sale price, in our case it is $20,000, minus netbook value of this asset which is 18,500. It's going to give you a gain of 1,500. And that is going to be recorded under income statements.

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Financial Accounting: Advanced Topics Oktay Urcan

Lesson 1-4: Gross vs. Net PPE

Now, I'm going to tell you about gross versus net plant, property, and equipment. That's going to be quite important, especially when we are presenting these assets on our balance sheet. First of all, gross PPE, here we have total purchase cost of all fixed assets. It has nothing to do with depreciation. Whenever you spend money on acquisition of new assets, that's going to show up under gross plant, property, and equipment. Second of all, we have accumulated depreciation, which is the account where we record all depreciation expenses of all PPE. And finally, the difference between gross PPE, which is the original purchase cost, minus accumulated depreciation will give you net plant, property, and equipment. Why am I emphasizing this? I am emphasizing this because if you look at which we are going to look, real financial statements, there are a lot of cases where you don't have idea about gross original purchase cost of fixed asset or accumulated depreciation. Most of the time, if you look at real balance sheets, what you see is the net plant, property, and equipment, which is the difference between original purchase cost, gross, minus accumulated depreciation. Since these accounts quite important, what I'm going to do is I'm going to tell you now how does accounts change over a year. Let's start with the gross plant, property, and equipment. One more time in this account, we record original purchase costs. How does this account change? Well, there is a beginning balance.

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Financial Accounting: Advanced Topics Oktay Urcan

Gross PPE will go up whenever we acquire new assets, that's additions. Gross PPE will go down whenever we sell these assets. There is an asset disposal. But what is the reduction from gross PPE? It is the historical cost of this asset. It is undepreciated amount that's going to reduce from gross PPE. And finally we are going to come up with ending amount of gross plant, property, and equipment. Second of all, how does accumulated depreciation change over time? Well, as always there is the beginning amount of accumulated depreciation. Notice that the accumulated depreciation is always a negative number. Accumulated depreciation will go up whenever you have new depreciation expense. By go up, mean it's going to be much more negative. You're going to increase the size of accumulated depreciation. Accumulated depreciation will go down whenever you sell assets. As we have done in the previous video, whenever you sell an asset, you need to close accumulated depreciation associated with that asset. And finally, we have ending amount of accumulated depreciation. And, now, I'm going to also go through how net plant, property, and equipment change over time. But let's remember on more time, NET PPE is equal to gross PPE minus accumulated depreciation. Therefore, what I can do is that I can take the gross PPE column. I can also take accumulated depreciation column, and I can do a minus, a reduction, between these two columns. For example, gross opening balance of PPE minus opening balance of accumulated depreciation will give you opening balance of net plant, property, and equipment. Additions, can I reduce this with something else? No, so therefore additions will show up under Net PPE column directly. How about sales? Well, this is the sales original cost of a sold asset minus, here is another sales under accumulated depreciation column. Basically sales original cost of this PPE minus accumulated depreciation of this PPE will give you sales net book value. Remember net book value, which is purchase cost which is gross PPE minus accumulated depreciation. What else I have here, well I also have depreciation column under accumulated depreciation. What we were doing was gross PPE minus accumulated depreciation. Therefore, the sign of the depreciation will be negative on the net PPE column. And finally you have the ending balances of gross PPE minus ending balance of accumulated depreciation will give you ending balance of net PPE. I understand that this is a lot of things to go through. Therefore, let's do an exercise.

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Financial Accounting: Advanced Topics Oktay Urcan

Illini Supermarket has the fo...