Interpeting Reliability and Comparability of Financial Statements Module 4 Flashcards
Where Are Changes in Accounting Methods Found?
In the Footnotes of Audited Financial Statements and Opinion Letter
How Is an Accounting Change Reported
- A Change In Accounting Principal Requires that the Cummulative effect of all prior periods be reported on the current balance sheet.
- Accounting estimates changes do not require cumulative adjustments
- Reporting Perod changes require restating of prior periods
- Error correction requires restating prior periods that were affected.
Methods of Revenue Recognition
- Accrual
- Before a sale - companies in the gold and silver mining industry recognize a sale before delivery or at the end of production
- During the Perfomance of Service
Straight LIne Depreciation
Purchase Price + Installation Price - Slavage Value= Depreciable Value
Double Declining Balance
Begin with the straight- line meth percetage of annual depreciation (20% fir a five-year useful life)
Double this annual percentage by to 40% and apply to underapreciated balance each subsequent year.
Sum-of-the-Year’s Digits Method
The sum-of-the-years-digits method uses the number of years in the asset’s useful life to develop a set of decreasing fractions. The denominator is the sum of the years of useful life. The numerator is the specific year of useful life taken in inverse order. This method must deduct salvage value from asset cost, as unlike the double-declining balance method, the math leaves no portion of the asset undepreciated.
um Of the Year’s Digits Example
Denominator 1 + 2 + 3 + 4 + 5 = 15 First-year depreciation expense 5/15 of $15,000 asset cost or $5,000 Second-year depreciation expense 4/15 of $15,000 or $4,000 Third-year depreciation expense 3/15 of $15,000 or $3,000 Fourth-year depreciation expense 2/15 of $15,000 or $2,000 Fifth-year depreciation expense 1/15 of $15,000 or $1,000
Impact of Depreciation Methods
In early years for companies using accelarated methods will show higher depreciation expense and lower net fixed assets. In later years that relationship reverses This also lowers taxable income.
Do Changes In Depreciation Methods Require Restatement of Financial Statements?
No, however companies must disclose current-perilod effects of the change and estimate effect on future periods.
What is the effect if Depreciation Expense is higher on the tax return than on Financial Statements
The company will have a deferred tax liability
Inventory Valuation
GAAP requires Inventory to be Shown on the balance at it historical cost or the current market value, whichever is lower.
What must a company do if Inventory Value has dropped.
Reduce the Inventory Value and recognize the value loss on the income statememnt
What Is Inventory Valuation
It is the process of assigning value to each cost layer of product sold.
Name Methods of Inventory Valuation
Specific Identification
Average Cost
First-In First Out (FIFO)
Last In, First Out (Lifo)
Specific Identification
Assigns a specific cost to each inventory item and can asign a specific cost to each sale.
Automobiles are a good example
Average Costs
Company determines the average cost of units avaiable for sale which includes units carried over from last period inventory and units acquired during the current period.
FIFO
First Items Purchased first Items Sold
LIFO
Periods Sales were from the company’s most recently purchase inventory.
What Happens if a Company Used FIFO during a period of Rising inventory costs
The company will report higher earning and higher taxes. than if using LIFO. Balance sheet will likely reflect current market valueations.
If a company uses LIFO
Inventory account may understate the current value of inventory on hand/
Does the Choice of Inventory Method contributed to defferred taxes
Inventory menthods used in the financial statments must be the same those in tax preparation
What is the most conservatvie method of inventory valutation during a period of rising inventory costs?
LIFO is the most conservative approach when reporting earnings. It also tends to understate the value of inventory on the balance sheet.
What must a company due it it wants to change inventory valuation method
It must demonstrate that the new method is preferrable
The company must disclose the change and its impact on the financial statements
The company must apply the new mehtod to all previously issued financial statments.
What must a company do if it uses LIFO
It must maintain reocords showing what inventory and COGS would have been under the FIFO menthod. The result is called the LIFO reserve
THe LIFO Reserve Does what
Accomulated over time when prices are rising
Has a lowerve inventory balance than if FIFO had been used
Measures the cummulative amount by which the LIFO method understates invormtory compared to FIFO
Grows each year prices rise.
What does a company that has a LIFO reservie have
Lower inventory Prices
Higher cumlative COGS
Lower cummulative pretax profit
LIFO memory method
LIFO begins with the letter L which stands for less profit and less inventory than if FIFO were used
LIFO reserve INCREASE a year means:
A company’s COGS for that is more thtn it would have been if FIFO had been used
LIFO Reserve Decrease
Lower COGS
Higher profits and income taxes
LIFO Reserve and Taxes
When prices are rising LIFO minimizes taxes
When prices fall or a company cuts bank its inventoryy a LIFO liquidation can occur, resulting in higher profits and higher taxes.
When are Costs Capitalized?
When they provide benenfits beyond the accounting period in which they are incurred
R & D is an exception.
Lease vs. Own
A company can by and assets, acquire and asset under a capital lease, or Acquire the asset under and Operating Lease.
Buy the Assets
A company can buy and asset and account for its costs over time by depreciating the asset. The asset is shown on the balance sheet
Capital Lease Agreement
Must be accounted for as a contract of sale
What Considerations cause and accountant to classify a lease as a capital lease
Which party retains the rights of ownership and the risks associated the assets
If the Lease Agreement fails any one of theses tests the lease is a capital lease and treat like sale
- At the end of the lease the lesse automatically received the title
At the end of the lease the lesee must pay only a nominal amount to purchase the assets - The lease term is equal to 75% or more of the estimated useful life of the asset
- The present value of the contract lease payments equal or exceeds 90% of FMV of the asset.
To Account for an Asset Acquired under a captial lease on the balance sheet.
The company leasing the asset includes the asset on the balance sheet.
Shows a liability that equals the financed value of the asset
To reflect a Capital Lease on the Income Statement.
The company depreciates the asset based on the economic life and recognized interest and expense that is implicit int he lease contract.
Operating Lease
If the lease transacton does not fail any of the ownership test, then it is an operating lease. The company recognizes the lease payment as rental expense. No effect on balance sheet.
Why Would A company Choose and Operating Lease
- Rental payments may be less than depreciation and interest expense maixmizing profits
- Operating lease’s payments represent only portion of the value of the assets. The company will not need the assets at the time the lease period ends.
- Operaing lease lower total leverage.
- Lower taxable income
