Advanced Financial Accounting
PHP: Chapter 4
Chapter 4: Accounting analysis: Accounting adjustments
Distortions in asset values arise because ambiguity about whether:
- The firm owns or controls the economic resources in question
- The economic resources can provide future economic benefits that can be measured
with reasonable certainty
- The fair value of assets falls below their book values
- Fair values estimates are accurate
Under- or overstatement of assets because of for example depreciation and amortization,
impairment, leased asset, intangible assets etc.
Distortions in liabilities generally arise because of ambiguity about whether 1) an obligation
has really been incurred and/or 2) the obligation can be measured.
Consequently, equity distortions arise from distortions in assets/liabilities. Also possible in
another way, for example, how firms account for contingent claims on their net assets
(employee stock options and conversion options on convertible bonds).
A&W: Chapter 4, 5, 6, 11
Chapter 5: Non-current assets and deprecation
The main issues with regard to the valuation of non-current assets can be divided into:
1) Acquisition cost – Determine appropriate value
2) Cost allocation (depreciation) schedule – How to recognize consumption/expensing
of the asset period by period
General valuation principles of non-current assets
Initially, non-current assets are recorded at cost that includes expenditure to get item ready
for use (historical cost or acquisition cost).
Acquisition cost = All costs associated with creating the asset in the form required by the
company to start productive use.
Subsequent costs = Added to the cost of an existing asset only if it will produce economic
benefits beyond its originally assessed performance.
Recoverable amount = Amount that the company expects to recover either by using the
asset or by selling it. If the asset cost is higher than recoverable amount, there is an asset
impairment issue
,Expensing non-current assets – Are acquired in order to generate profits by their use in its
operations over a number of periods.
Acquisition costs must be expensed in a systematic and rational way to the periods expected
to benefit from the use of the assets.
There two different kinds of reduction in the accounting value of assets:
1) Systematic expensing of the cost of an asset over the periods that benefit from its
use (depreciation/amortization), which takes place routinely every year
2) Special write-downs where all assets should be considered for impairment and their
depreciated accounting value compared with their recoverable value.
For determining the depreciation schedule, the following is involved:
1) The depreciable amount of the asset (acquisition cost + residual value)
2) The useful life of the asset (period that the asset is expected to be used by the
company)
3) The method of cost apportionment (depreciation method)
Depreciation methods:
- Straight-line method: A function of time rather than function of usage
Depreciable amount
= Annual depreciation expense
Estimated useful life
- Diminishing balance method (reducing balance method): Geometric reduction in the
charge in succeeding year (high proportion in early life of asset).
n R
D = depreciation rate
√
d=1−
A
N = number of accounting periods
R = residual value
A = acquisition cost
- Tax depreciation: Tax rules can have potentially distorting effect on the application
of depreciation rules and consequently comparison between companies
- Units of production method (depletion method): Expense asset as it is extracted for
sale (mineral resource companies)
Component’s approach: Long-term asset may be composed of several component parts
with different useful lives or with significantly different patterns of consumption of
economic benefits.
Disposal or retirement of a long-term asset when there are no future economic benefits are
expected from its use or disposal.
Intangible assets (IAS38) : Not physical in nature. Term amortization is used as a
depreciation synonym for intangible assets.
- R&D:
Distinction between research phase (expensed immediately) and development
(recognition) phase.
, - Brand names:
When a company buys a brand name, no problem. When a company creates a brand
name, problems with costs and measurement.
- Patents:
Recognized at cost and expensed over expected useful life. Historical value is clear
when company buys patent; inventing the patent gives rise to problem identifying
costs
- Purchase goodwill:
No recognition of goodwill as assets (not identifiable resource-controlled b company
that can be measured reliable at cost)
Tangible assets (IAS 16 : PPE)
- Land and buildings
- Plant and equipment
- Leased assets
Financial lease (all risks and rewards of ownership assets are transferred) vs
operating lease
Investments – Long-term assets of a financial nature.
Questions :
1) What is included in the acquisition cost of a long-term tangible asset? Give examples
of at least four costs that would be included in the acquisition cost of a new
production line
2) What are the most common causes of the depreciation of a long-term tangible
asset?
3) Under what conditions will the disposal of a long-term tangible asset lead to a loss?
How will the sale of a long-term asset affect the financial statements?
4) Discuss the recognition rules for research and development costs
5) Contrast the accounting consequences of financing the acquisition of a building
through a bank loan or as a finance lease
Chapter 6: Refining the accounting system
Accrued expenses and revenue (accruals) are previously unrecorded expenses and revenue
that need to be adjusted at the end of the accounting period to reflect the amount of
expenses incurred or revenue earned during the accounting period.
- Accrued expenses: Goods or services that have been received/supplied but not yet
been invoiced, paid or formally agreed with the supplier at year-end (telephone, gas,
electricity)
- Accrued revenue: Revenue will be recognized in the statement of profit/loss before
actual receipt of cash
Deferred expenses and revenue are previously recorded expenses and revenue and should
be adjusted at the end of the accounting period by deferring part of them to the following
accounting period.
PHP: Chapter 4
Chapter 4: Accounting analysis: Accounting adjustments
Distortions in asset values arise because ambiguity about whether:
- The firm owns or controls the economic resources in question
- The economic resources can provide future economic benefits that can be measured
with reasonable certainty
- The fair value of assets falls below their book values
- Fair values estimates are accurate
Under- or overstatement of assets because of for example depreciation and amortization,
impairment, leased asset, intangible assets etc.
Distortions in liabilities generally arise because of ambiguity about whether 1) an obligation
has really been incurred and/or 2) the obligation can be measured.
Consequently, equity distortions arise from distortions in assets/liabilities. Also possible in
another way, for example, how firms account for contingent claims on their net assets
(employee stock options and conversion options on convertible bonds).
A&W: Chapter 4, 5, 6, 11
Chapter 5: Non-current assets and deprecation
The main issues with regard to the valuation of non-current assets can be divided into:
1) Acquisition cost – Determine appropriate value
2) Cost allocation (depreciation) schedule – How to recognize consumption/expensing
of the asset period by period
General valuation principles of non-current assets
Initially, non-current assets are recorded at cost that includes expenditure to get item ready
for use (historical cost or acquisition cost).
Acquisition cost = All costs associated with creating the asset in the form required by the
company to start productive use.
Subsequent costs = Added to the cost of an existing asset only if it will produce economic
benefits beyond its originally assessed performance.
Recoverable amount = Amount that the company expects to recover either by using the
asset or by selling it. If the asset cost is higher than recoverable amount, there is an asset
impairment issue
,Expensing non-current assets – Are acquired in order to generate profits by their use in its
operations over a number of periods.
Acquisition costs must be expensed in a systematic and rational way to the periods expected
to benefit from the use of the assets.
There two different kinds of reduction in the accounting value of assets:
1) Systematic expensing of the cost of an asset over the periods that benefit from its
use (depreciation/amortization), which takes place routinely every year
2) Special write-downs where all assets should be considered for impairment and their
depreciated accounting value compared with their recoverable value.
For determining the depreciation schedule, the following is involved:
1) The depreciable amount of the asset (acquisition cost + residual value)
2) The useful life of the asset (period that the asset is expected to be used by the
company)
3) The method of cost apportionment (depreciation method)
Depreciation methods:
- Straight-line method: A function of time rather than function of usage
Depreciable amount
= Annual depreciation expense
Estimated useful life
- Diminishing balance method (reducing balance method): Geometric reduction in the
charge in succeeding year (high proportion in early life of asset).
n R
D = depreciation rate
√
d=1−
A
N = number of accounting periods
R = residual value
A = acquisition cost
- Tax depreciation: Tax rules can have potentially distorting effect on the application
of depreciation rules and consequently comparison between companies
- Units of production method (depletion method): Expense asset as it is extracted for
sale (mineral resource companies)
Component’s approach: Long-term asset may be composed of several component parts
with different useful lives or with significantly different patterns of consumption of
economic benefits.
Disposal or retirement of a long-term asset when there are no future economic benefits are
expected from its use or disposal.
Intangible assets (IAS38) : Not physical in nature. Term amortization is used as a
depreciation synonym for intangible assets.
- R&D:
Distinction between research phase (expensed immediately) and development
(recognition) phase.
, - Brand names:
When a company buys a brand name, no problem. When a company creates a brand
name, problems with costs and measurement.
- Patents:
Recognized at cost and expensed over expected useful life. Historical value is clear
when company buys patent; inventing the patent gives rise to problem identifying
costs
- Purchase goodwill:
No recognition of goodwill as assets (not identifiable resource-controlled b company
that can be measured reliable at cost)
Tangible assets (IAS 16 : PPE)
- Land and buildings
- Plant and equipment
- Leased assets
Financial lease (all risks and rewards of ownership assets are transferred) vs
operating lease
Investments – Long-term assets of a financial nature.
Questions :
1) What is included in the acquisition cost of a long-term tangible asset? Give examples
of at least four costs that would be included in the acquisition cost of a new
production line
2) What are the most common causes of the depreciation of a long-term tangible
asset?
3) Under what conditions will the disposal of a long-term tangible asset lead to a loss?
How will the sale of a long-term asset affect the financial statements?
4) Discuss the recognition rules for research and development costs
5) Contrast the accounting consequences of financing the acquisition of a building
through a bank loan or as a finance lease
Chapter 6: Refining the accounting system
Accrued expenses and revenue (accruals) are previously unrecorded expenses and revenue
that need to be adjusted at the end of the accounting period to reflect the amount of
expenses incurred or revenue earned during the accounting period.
- Accrued expenses: Goods or services that have been received/supplied but not yet
been invoiced, paid or formally agreed with the supplier at year-end (telephone, gas,
electricity)
- Accrued revenue: Revenue will be recognized in the statement of profit/loss before
actual receipt of cash
Deferred expenses and revenue are previously recorded expenses and revenue and should
be adjusted at the end of the accounting period by deferring part of them to the following
accounting period.
