Lesson 9: Breaking Down the Balance Sheet

Transcription

1 Lesson 9: Breaking Down the Balance Sheet As we touched upon in previous lessons, a balance sheet is divided into three categories: Assets, Liabilities, and Owner s Equity. This lesson will go over each one of these categories and list the common accounting principles associated with the main items. 9.1 Assets If you recall our brief discussion on balance sheets, assets are broken down into two groups: current and noncurrent. Much of our course has been focused on current assets (cash, accounts receivable, prepaid expenses, etc), however, we will now shift our focus to non current assets Acquiring Fixed Assets Fixed assets are the main type of non-current assets are often referred to as Property, Plant, and Equipment (PPE). These assets are usually prevalent in capital intensive companies such as a manufacturing company. Some common examples include: Land Buildings Vehicles Furniture Equipment Computers Machinery Often times, purchasing fixed assets has some complexities that are not apparent in simple assets. One frequent question you will find yourself asking is What amount do I record the fixed asset at in my books? A. Land & Buildings Land and buildings are usually purchased together at one lump sum price, yet for depreciation purposes (discussed later) they are separately tracked. The most common method to allocate the purchase price is to use the market value method. We will illustrate with the following set of facts: Purchase Price (Land & Building): $120,000 Market Value of Land: $75,000 Market Value of Building: $25,000

2 Generally the market value will be indicated in an appraisal report. If the market value is not readily apparent, using a comparable market value will also be appropriate. To allocate the 120,000 purchase price to land and buildings, you would take the ratio of market values for each respective part and multiply accordingly: Asset Market Value Market Value Ratio Asset Basis Land 75,000 75,000/100,000=.75.75*120,000= 90,000 Building 25,000 25,000/100,000=.25.25*120,000=30,000 Thus, you will record on your books the Land at 90,000 and Building a 30,000. B. Equipment Often times when you purchase equipment, you will also incur a variety of charges that are related to the asset. The general rule is to include expenditures that are ordinary and necessary to bring the equipment to its intended use. These expenses include, but are not limited to, the purchase price, shipping, installation charges, sales tax, and permits. However, if charges are not ordinary and necessary, then these must be expensed. These include repair costs for damage during installation or insurance purchased for the equipment Disposing of Assets When you sell an asset, you will always have a gain or loss. The formula to determine the amount of gain or loss is: Sales Price Basis = Gain/Loss Sales Price: the amount you received as consideration. Often times this is also referred to as the amount realized. Basis: What You Paid For (Cost Basis) Depreciation The cost of an asset is usually allocated through its useful life through a method known as depreciation. Depreciation is an expense and will result in a tax deduction. You depreciate the basis using the amount you paid as a starting point; NOT the market value. Depreciation is tracked through an account known as Accumulated Depreciation. The cost of the asset minus the accumulated depreciation will give you the basis at a certain point in time. Gain/Loss- The difference between Sales Price and Basis. Gains are recorded with a credit, while losses are recorded using a debit.

3 To illustrate the following concepts, we will use this example. Assume you purchased an asset on January 1 st, 2012 for $100,000. The asset has a salvage value of $20,000 with an 8 year life. Two years later, on January 1 st, 2014, you sell the same asset for $90,000. What is the gain or loss upon the sale? The first task is to figure out the amount of accumulated depreciation as of the date of sale on 1/1/2014. Salvage value is the value an asset will be able to be sold for upon the end of its useful life. Thus, for depreciating purposes, you take the cost less the salvage value as your starting point and in this case 80,000 (100,000 20,000). With an useful life of 8 years, you can easily see depreciation will be 10,000/year. With 2 years passed, the accumulated depreciation is 20,000. The journal entry to record depreciation would be: Depreciation Expense 10,000 Accumulated Depreciation 10,000 This depreciation entry would be booed in both 2012 and 2013 to arrive at the total accumulated depreciation of 20,000. Next, we must determine the basis of our asset. The purchase price was 100,000 and accumulated depreciation was 20,000. Thus, at the date of sale, the basis of the asset is 80,000. Note for depreciation purposes, we take cost less salvage value; however, for sales purposes we take cost less accumulated depreciation. With a selling price of 90,000 and basis of 80,000, the gain on the sale would be 10,000. The journal entry would be as follows: Cash 90,000 Equipment 100,000 Accumulated Depreciation 20,000 Gain 10,000 Netting the equipment and accumulated depreciation, we would arrive at our calculated basis at date of sale of 80,000. Furthermore, as Sales is a credit account, it makes intuitive that a gain on a sale would also be a credit. There are a couple issues with depreciation you should be aware of. First, let s assume we instead sold our asset on March 31 st, What would be the depreciation expense we book for 2013? Using the straight line method, we would pro-rate the depreciation over 12 months and take 3 months worth. Thus, the depreciation for 2013 would be 3/12 * 10,000 or 2,500. Alternatively, you could take the 80,000 divide it by 96 months (8 years) and find that that depreciation per month would be With 2013 only having 3 months worth of depreciation, you would multiply by 3 and to arrive at 2,500.

4 Another common issue when dealing with depreciation is a change in estimate. Although there are guidelines in determining useful life and salvage file, these are still inherently estimates, and thus subject to change. To illustrate this concept, we will use the following scenario: On July 1 st 2011 you buy an asset for 120,000 with a 10 year useful life and 20,000 salvage value. You depreciate the asset using the straight line method. 2 years later, on January 1 st 2013, you find the useful life has increased for four more years and the salvage value is now 5,000. Step 1: Determine the Amount of Depreciation You Have Already Taken 2011: 100,000/10 years= 10,000 / year. Prorated for 6 months, you took 5,000 depreciation in : 100,000/10 years= 10,000 / year. Accumulated depreciation at January 1 st, 2013 will be 15,000. Step 2: Calculate Basis of Asset Purchase Price: 120,000 Depreciation Taken: 15,000 Basis at 1/1/2013: 105,000 Step 3: Begin Depreciating Over New Life Basis at 1/1/2013: 105,000 New Salvage value: 5,000 Revised Depreciable Base: 100,000 Remaining Life: 11.5 Years Depreciation for 2013: 8, Intangible Assets Intangible Assets are assets that are not physical in nature, but still provide value to a company like other assets do. However, intangible assets cannot be depreciated; instead they

5 are amortized. The concept is the same as depreciation- the cost of an intangible asset is allocated over the shorter of the assets useful or legal life. More often than not, companies will employ the straight-line method. Common intangible assets include patents, copyrights, trademarks, licenses, and goodwill. Patents provide exclusive rights to manufacture or sell certain items. Generally the legal life of a patent is 17 years. To illustrate, assume you purchased a patent that has been in existence for 2 years for 150,000. Upon purchasing, you believe the useful life is only 10 years. Thus, you would amortize the 150,000 over the lesser of the remaining life (15 years) or useful life (10 years). To record the purchase of the patent: Patent 150,000 Cash 150,000 To record annual amortization expense of 15,000. Amortization Expense 15,000 Patent 15,000 One thing to notice is that unlike depreciation, amortization is not tracked in a contra account like accumulated depreciation. Instead, the asset is directly decreased by the amount of amortization expense. Copyrights provide the right to reproduce and sell work. This is usually associated with artistic works such as novels, music, and movies. These are amortized over the useful life which is rest of the duration of the creator s life plus 70 years. Trademarks are a symbol or words that are legally registered and represent a company or product. A logo or company name is a common example. Generally these are amortized over the useful life. Licenses provide the right to own or use something or carry out a specific trade. An alcohol license is a common example. Generally these are amortized over the useful life. Goodwill is an asset that arises when a company is purchased. Goodwill is the difference between the purchase price of a company and the value of the net assets. Essentially it is a premium that is paid for a company. Goodwill is an asset on the balance sheet, but rather than being amortized, it can be impaired. Why would someone pay more than the value of net assets for a company? Goodwill can be a result of a positive reputation or strong customer loyalty. To illustrate we will use the following example: A company with assets of 100,000 and liabilities of 50,000 was purchased for 80,000. The amount of goodwill will be the difference between the purchase price, 80,000, and the net assets 50,000 (100,000-50,000), or 30,000. The journal entry to record the purchase will be:

6 Assets 100,000 Liabilities 50,000 Cash 80,000 Goodwill 30,000 As mentioned above, goodwill is not amortized, rather it is tested for impairment. Goodwill is impaired when the fair value is less than the carrying value. Fair market value of goodwill is determined by comparable transactions in the market, while the carrying value is the value on the balance sheet. If the goodwill is in fact impaired, you would book the following entry: Loss on Impairment XXX Goodwill XXX If the goodwill is not impaired, not entry will be necessary. In other words, there is no such thing as a gain from impairment. 9.2 Liabilities Like assets, liabilities are also broken down into current and non-current. We have focused much of our discussion on current liabilities. Below is a list of common current liabilities: Accounts Payable- an amount you owe when you purchase on credit Income Taxes Payable- income taxes yet to be paid out Accrued Compensation- salary yet to be paid out Unearned Revenue- service/product not yet delivered. Current Portion of Long Term Debt- payments due on a loan within the next year As we have discussed much of the short term liabilities, we will now shift the remainder of this section to long term liabilities. Long Term Liabilities (Non-Current) are liabilities that are not due within the current year. Common long term liabilities include: Loans Payable Notes Payable Bonds Payable Deferred Taxes Loans, notes, and bonds payable all have one central issue: they involve the payment of interest. Interest calculations are pretty straightforward, but require a lot of computation. We will illustrate the concept of interest payments with an example on bonds. Essentially bonds are a form of long term debt. They are issued by a company and purchased by an investor. As an

7 investor is essentially the lender, he or she will earn interest along the way. Thus there will be two types of payment: interest at certain intervals and the principal at the maturity date. The price of the bond is determined by the interest rate. If the market interest rate is higher than the bond s interest rate, the bond is said to be sold at a discount. If the opposite holds true, the bonds will be sold at a premium. We will illustrate the concept with an example. You run a company that issues the following bond: Bond is issued with a face value of 100,000 and a stated interest rate of 10% per year. The bond is dated January 1 st, 2013 and has a maturity date of December 31 st, The bond s interest payments are on June 30 and December 31 of each year. The market interest rate is 9%. The bond is issued for 104,000. Step 1: Record the Journal Entry for the Issuance of Bonds Cash 104,000 Bonds Payable 100,000 Premium on Bonds Payable 4,000 The premium on bonds payable account is the amount one pays over the face value. The reason an investor will pay a premium is because the interest rate of the bonds (10%) is greater than the market interest rate (9%) and thus, they will earn back the premium through the difference in interest rates. A company will account for the premium by amortizing it over the life of the bond. Most common, the straight line method is employed. Step 2: Record Interest Payment and Amortization of Premium A. Determine Amount of Interest Payment Because interest is paid semiannually, there will be a recording of interest on 6/30 as well as 12/31. The annual interest rate is 10%. The semi-annual interest rate will be half of that, 5%. Thus interest expense for every 6 months will be 5% * 100,000 or 5,000. B. Determine the Amount of Premium Amortized Premiums are only amortized once a year; however, they will be reduced on the same schedule as interest payments. The premium is 4,000 and the life of the bond is 4 years. Assuming the premium is amortized using the straight line method, 1,000 will be amortized each year and 500 will be amortized every 6 months. The journal entry to be booked on 6/30 and 12/31 will be:

8 Interest Expense 4,500 Premium on Bonds Payable 500 Cash 5,000 With the straight line method, interest expense will be a plug, the difference between cash and premium amortized. C. Amortizing Premium with the Effective Interest Rate Method There is another common method to amortize a premium, known as the effective interest rate method. Using the same information as above, we will illustrate this method. Keep in mind that the journal entries will be exactly the same; just the amounts will change. 1/1/2013 Date Interest Expense Cash Payment Amortization Carrying Value 1/1/ ,000 At the date of issuance, the bond will have a carrying value of the amount it was issued for, 104,000. 6/30/2013 Date Interest Expense Cash Payment Amortization Carrying Value 1/1/ ,000 6/30/2013 4,680 5, ,680 Interest Expense: This amount is found by taking the market interest rate (9%) and multiplying it by the carrying value. Because we pay interest in 6 months intervals, we would take half of that. 4.5% * 104,000= 4,680. Cash Payment: This amount is determined the same as it was before. It is the face amount of the bond multiplied by the stated interest rate. Thus, 100,000 face value multiplied by 10% gives you 1,000. Once again, you take half this amount as it is a semiannual payment. Amortization: The amortization of the premium will be the difference between the interest expense and cash payment. 5,000-4, You will amortize your premium by 320 every 6 months. Your carrying value will be reduced by the amount of the premium amortized. You will continue this process until the carrying value equals the face value; at that point, the premium of 4,000 will be fully amortized.

9 12/31/2013 Date Interest Expense Cash Payment Amortization Carrying Value 1/1/ ,000 6/30/2013 4,680 5, ,680 12/31/2013 4,666 5, ,346 Interest Expense: The carrying value is now 103,680. Once again, you take the market interest rate of 4.5% and multiply it by 103,680 which gives you an interest expense of 4,666. Cash Payment: Cash payment amount will remain the same as the face value does not change. Amortization: Once again, you would take the difference between the cash payment and interest expense to figure out your amortization expense. After figuring out the premium amortized, you would once again reduce the carrying value. The rest of the amortization schedule will be as follows: Date Interest Expense Cash Payment Amortization Carrying Value 1/1/ ,000 6/30/2013 4,680 5, ,680 12/31/2013 4,666 5, ,346 6/30/2014 4,651 5, ,996 12/31/2014 4,635 5, ,631 6/30/2015 4,618 5, ,249 12/31/2015 4,601 5, ,851 6/30/2016 4,583 5, ,434 12/31/2016 4,565 5, ,998 6/30/2017 4,545 5, ,543 12/31/2017 4,456 5, ,000 Please note that since the present value factors that we used to determine carrying value were rounded, the calculations we use will not be precise and thus require a small adjustment at the end of However, in the real world, when a bond is issued, computer software will be available to make this adjustment accordingly. Bonds can also be issued at a discount. The methodology will be the same with small changes in journal entries. To depict, we will use the following example:

10 Bond is issued with a face value of 100,000 and a stated interest rate of 8% per year. The bond is dated January 1 st, 2013 and has a maturity date of December 31 st, The bond s interest payments are on December 31 of each year. The market interest rate is 9%. The bond is issued for 97,000. Step 1: Record the Journal Entry for the Issuance of Bonds Cash 94,000 Bonds Payable 100,000 Discount on Bonds Payable 6,000 Because the face value of the bond was greater than the cash received, the bond was issued at a discount. Furthermore, the stated interest rate is less than the market interest rate, thus another sign that this is a discount bond. Step 2: Record Interest Payment and Amortization of Discount A. Determine Amount of Interest Payment As the interest is paid annually, you would take the stated rate of 8% and multiply it by the face value of 100,000. Thus, annual cash interest payment is 8,000. B. Determine the Amount of Discount Amortized Using the straight line method, you would amortize the 6,000 discount over the life of the bond, 5 years. Thus, 1,200 is amortized annually. The journal entry to be booked on 12/31 of each year would be: Interest Expense 9,200 Discount on Bonds Payable 1,200 Cash 8,000 C. Amortizing Discount with the Effective Interest Rate Method 1/1/2013 Date Interest Expense Cash Payment Amortization Carrying Value 1/1/ ,000 At the date of issuance, the bond will have a carrying value of the amount it was issued for, 97,000.

11 Date Interest Expense Cash Payment Amortization Carrying Value 1/1/ ,000 12/31/2013 8,460 8, ,460 Interest Expense: This amount is found by taking the market interest rate (9%) and multiplying it by the carrying value. Because we pay interest annually, we would take 9% * 94,000= 8,460. Cash Payment: This amount is determined the same as it was before. It is the face amount of the bond multiplied by the stated interest rate. Thus, 100,000 face value multiplied by 8% gives you 8,000. Amortization: The amortization of the discount will be the difference between the interest expense and cash payment, 460. Your carrying value will be increased by the amount of the discount amortized. You will continue this process until the carrying value equals the face value; at that point, the discount of 6,000 will be fully amortized. The rest of the amortization schedule will appear as follows: Date Interest Expense Cash Payment Amortization Carrying Value 1/1/ ,000 12/31/2013 8,460 8, ,460 12/31/2014 9,446 8,000 1,446 95,906 12/31/2015 9,591 8,000 1,591 97,497 12/31/2016 9,750 8,000 1,750 99,246 12/31/2017 8,754 8, , Owner s Equity The last section of the balance sheet is owner s equity. As you may recall, owner s equity is the difference between assets and liabilities. If the company is a corporation with shareholders, the owner s equity section is referred to as stockholder s equity. Common stockholder equity accounts include: Common Stock Preferred Stock Treasury Stock Retained Earnings

12 Common Stock Common stock represents ownership in a corporation. When an investor gives a corporation money in exchange for an ownership interest, the ownership interest is known as stock. There are many different types of stock, the most prevalent one being common stock. Common stock shareholders often have a lot of benefits such as having the ability to elect a board of directors, potentially receiving dividends, and having the opportunity to earn returns on the investment. When a corporation sells some of its shares, the sold shares are known as issued shares. The total amount of stock sold and not reacquired by the firm is known as the outstanding shares. The stated or face value of a stock is known as the par value. Any excess money received for the stock will be credited to another account. To illustrate, we will use the following example. A corporation has stock with a par value of $0.50/share. On January 1 st, 2013, the corporation issues 1,000 shares at $5.00 per share. The amount of cash the company receives will be 1,000 shares multiplied by the issue price of $5.00/share, or $5,000. The amount of common stock issued will be recorded at par; with 1,000 shares at 0.50 par value, the company would credit common stock for 500. The amount the company receives over the par value will be tracked in a separate account, Additional Paid in Capital. The journal entry to record this transaction will be: Cash 5,000 Common Stock 500 Additional Paid in Capital 4,500 Preferred Stock Accounting for preferred stock is very similar to that of common stock, however, the rights that come with holding preferred stock are different. Most notably, preferred stockholders do not have the right to vote and give up the right to partake in a corporation s earnings beyond dividends. However, they will receive dividends before common stockholders and have priority over assets in the event of a liquidation. There are a common terms that are associated with preferred stock. 1. Participating verse Non-Participating: This term refers to the amount of dividend that the preferred shares has a right to. Participating allows for dividends greater than the stated dividend, while non-participating means that the preferred stock can earn no more than the stated dividend. 2. Cumulative verse Noncumulative: This is another term that refers to the amount of dividend that preferred shares receive. If the preferred share is cumulative, the holders of the share would have to be paid any past dividends that may have been omitted as well as current year dividend before common stock holders receive theirs. On the other hand, if the stock is

13 noncumulative, the dividend omitted in the past, known as dividend in arrears, will not be made up. However, noncumulative preferred shareholders will still receive dividends before common shareholders. 3. Convertible Stock: Sometimes the preferred stocks will have a provision that allows the preferred stocks to be converted into a certain number shares of common stock. When this feature is available, the stock is said to be convertible preferred. Accounting treatment is very similar to common stock. Take for example, a corporation issues 100 shares of 8% preferred stock with a par value of $100 at $110 per share. Right off the bat, you can see a primary difference being the 8%. This is the annual dividend rate. To find the amount of dividend to be paid out, you would take the 8% and multiply it by the par value of $100. Thus, you can expect $8/share of dividends to be paid out annually. To record the issuance of preferred stock on the books, you would use the same concepts as common stock: Cash 11,000 Preferred Stock 10,000 Additional Paid in Capital- Preferred Stock 100 Once again, you will notice that the amount received over par will be credited to another account. However, notice that the additional paid in capital is tracked in a separate account. When a company issues different types of stocks, it is important to track them all separately. Treasury Stock When a company issues stocks, but then reacquires them in the future, the reacquired stocks are known as treasury stock. Essentially, treasury stock is the difference between issued shares and outstanding shares. Accounting for treasury stock is a little different. Treasury stock is held in a contra stockholder equity account and reduces stockholder equity. The most common way to account for treasury stock is to use the cost method. Let s say the company buys back 100 shares of its common stock at $110/share. The journal entry will be as follows: Treasury Stock 11,000 Cash 11,000 Often times, companies will sell some of the treasury stock back to the public. Under these circumstances, there will be no gain or loss. Depending on the amount it sells for, the difference will be debited or credited into a paid in capital account. To illustrate, assume the company sells 50 shares of the same treasury stock at $150/share. The cash received will be the 50 shares multiplied by $150/share, or $7,500. From above, we know the cost of the treasury stock was $110; thus the cost of the 50 shares sold was $5,500. The difference of 2,000 will be allocated to an additional paid in capital account. The journal entry will be as follows:

14 Cash 7,500 Treasury Stock 5,500 Additional Paid in Capital- Treasury Stock 2,000 Retained Earnings A corporation can do one of two things with the money it earns. It can either pay it out in the form of dividends or keep it and re-invest it in the company. The amount of income it keeps for business activities will be kept in an account known as retained earnings. Retained earnings generally has a credit balance, however, if a company incurs heavy losses, it can also have a debit balance Owner s/stockholder s Equity Summary Now that we have gone over some of the main items that make up stockholder s equity, we will show you a sample of how it would appear on a balance sheet: Stockholder's Equity Common Stock, $1.00 par, 50,000 authorized, 1,000 issued and outstanding 1,000 Additional Paid in Capital- Common 24,000 Total Paid-in Capital 25,000 Retained Earnings 10,000 Total Stockholder's Equity 35,000