300622 Flashcards
On January 1, Year 1, Alpha Co. signed an annual maintenance agreement with a software provider for $15,000 and the maintenance period begins on March 1, Year 1. Alpha also incurred $5,000 of costs on January 1, Year 1, related to software modification requests that will increase the functionality of the software. Alpha depreciates and amortizes its computer and software assets over five years using the straight-line method. What amount is the total expense that Alpha should recognize related to the maintenance agreement and the software modifications for the year ended December 31, Year 1?
$13,500
$5,000
$20,000
$16,000
$13,500
The annual expenses would be the $15,000 maintenance contract multiplied by 10/12 of the year covered, or $15,000 × 10/12 = $12,500 from March to the end of the year. Also, expenses would cover 1/5 ($1,000) of the $5,000 from the other costs for one of the five years: $12,500 + $1,000 = $13,500 total.
Amortization
Amortization is an accounting process for reducing an asset or liability by periodic payments or writedowns that are distributed across the time the organization gains a value from or has obligation for the item. Specifically, it is the process of reducing a liability recorded as a result of a cash receipt (e.g., unearned revenue) by recognizing revenues or reducing an asset recorded as a result of a cash payment (e.g., prepaid expenses) by recognizing expenses or costs of production.
SFAC 6.142
Amortization is an allocation process to orderly reduce bond premium, bond discount, and bond issue costs by allocating the cost of an intangible asset to expense over time.
Depreciation
Depreciation is the process of systematic, rational allocation of the cost of operational assets to the accounting periods benefited. Depreciation is not a process of valuation (FASB ASC 360-10-35-4), does not represent a reserve to replace the asset, and does not mean that cash will be available to replace the asset. Depreciation allowed for tax purposes often differs from depreciation allowed for accounting.
Accounting depreciation attempts to match the cost of the asset to the revenues generated over the life of the asset. It represents accrual accounting and has no effect on cash flows (a noncash expense). Depreciation expense must be added back to accounting income when reconciling to cash from operations using the indirect method.
Computation of depreciation requires the following:
Acquisition cost
Estimated useful life
Estimated residual (salvage) value
Depreciation method (four GAAP alternatives):
Straight-line
Sum-of-the-years’-digits
Double-declining balance
Units of production—units of product and machine hours
Factors which cause the need for depreciation include the following:
Physical factors:
Wear and tear
Effects of time and other elements
Deterioration and decay
Functional factors:
Inadequacy of capacity
Obsolescence
In the macroeconomic sense, depreciation is the part of business earnings/gross profit that is considered the replacement of capital stock used or worn out during the period. It is not included in net profit and is not a factor payment. (It is not a claim on the value of output by a factor of production.) Depreciation represents replacement investment, the amount that must be reinvested to maintain the existing level of capital stock, and the amount by which capital contributes to current production. It is a component of GNP (approximately 10%) and is computed by the income approach to national income accounting. Depreciation is the difference between gross and net investment.
In the foreign exchange sense, depreciation is the decline in the value of one currency against or in relation to another, in the sense that it now takes more of a particular currency to buy a unit of a foreign currency. Devaluation is the official change in the value of a country’s currency.
Example: Country A has an inflation rate of 5% and Country B has an inflation rate of 10%. The goods of Country A become relatively cheaper because the relative prices have changed, thus:
increasing the demand in Country B for Country A’s goods,
increasing the demand for Country A’s currency (to be able to import Country A’s goods), and
decreasing the demand for (i.e., depreciating) Country B’s currency by approximately 5% (10%–5%).
Straight-Line Method
The straight-line method is a depreciation method based on an equal allocation of the cost of operational assets with the passage of time. It assumes that the useful life of the asset is used up evenly over time and charges a fixed amount per period to expense.
The computation for the straight-line (SL) method is:
Straight-line depreciation expense per year = (Cost - Residual value) ÷ Useful life (years)
The advantage of the straight-line method is that it is simple to compute. The disadvantage is that the passage of time may not be representative of the use of the asset’s benefits and may not match cost to revenue.
Straight-line rate = 1 ÷ Useful life (years)
The straight-line method is a method of allocation such that a constant dollar amount is recognized as revenue or expense each period. The straight-line method is commonly used for depreciation.
Example: An asset costing $100,000, with a salvage value of $5,000, to be depreciated over 10 years by the straight-line method of depreciation would be depreciated at $9,500 per year (($100,000 - $5,000) ÷ 10).
2273.01
Guidance for recognizing expenses and losses is as follows (SFAC 5.85):
a. Consumption of benefit: Expenses are generally recognized when an enterprise’s economic benefits are consumed in revenue-earning activities or otherwise.
b. Loss or lack of benefit: Expenses or losses are recognized if it becomes evident that previously recognized future economic benefits of assets have been reduced or eliminated, or that liabilities have been incurred or increased, without associated economic benefits.
2273.02
Expenses are outflows of assets or incurrences of liabilities, during a period, from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. Losses are decreases in net assets other than from expenses or withdrawals by owners.
2273.03
Expenses are accrued (expensed) based on the matching principle. The matching principle states that the accrual basis of accounting correctly matches the revenue from the sale of goods with the historical cost of the inventory sold, the salesperson’s salary, and other applicable costs and expenses. Net income or loss for an accounting period is determined by the process of associating realized revenues with those expenses and expired costs necessary to generate them. This often requires estimates and allocations.
2273.04
Following are some of the most common expenses and costs:
a. Cost of goods sold
b. Depreciation
c. Interest
d. Uncollectible accounts (i.e., bad debt)
e. Post-acquisition costs (i.e., maintenance and repairs)
f. Amortization and impairment
