Sample Module

Introduction to Financial Accounting II

Depreciation Expense

As you are learning in your course, the revenues and expenes of a firm should reflect the economic events of the accounting period in question. This principle is called matching; revenues and expenses should be matched to each other and to the appropriate acounting period. When a piece of equipment or machinery is purchased, it benefits the firm for a number of years; its useful life. The cost of the equipment should be apportioned over the item's useful life in order to meet the matching principle; the cost of the equipment matched to the benefits it generates. That apportionment is called depreciation expense.

There are several ways to compute depreciation. In this sample module, the focus will be on 2 depreciation methods that are based on the passage of time; the straight-line method, and the double declining balance method.

Straight-line Method

The straight-line method of computing depreciation is the simplest one. The depreciable cost of the equipment is depreciated over the its useful life in equal annual amounts. As you are learning in your course, the total capital cost of a fixed asset is its purchase price, transportation and delivery costs, installation costs, and any testing and calibration costs. In short, all expenditures needed to make the fixed asset ready for productive use comprise its capital cost. Many fixed assets can be sold for scrap at the end of their useful lives. This price is called the salvage value. The depreciable cost of piece of equipment is its capital costs less its salvage value.

The annual depreciation expense is the depreciable cost divided by the number of years of useful life.

Example 1.

A firm bought a machine for \$90,000. Delivery and installation costs amounted to \$7,000. Calibration costs were \$3,000. The machine is expected to last 10 years with no salvage value.

The capital cost of the machine is the sum of its purchases price, other costs to make it ready for use, less its salvage value. That yields \$90,000 + \$7,000 + \$3,000 = \$100,000. The entry to record the cost of the machine, purchased with cash, is as follows:

```       Equipment   ................................     100,000.00
Cash   ................................                  100,000.00
To record the purchase of a machine.
```

The amount of depreciation per year is the depreciable cost of \$100,000 divided by the number of years of useful life, 10 years. This yields an amount of \$10,000 in annual depreciation expense. The entry to record depreciation expense is as follow:

```       Depreciation Expense   .....................      10,000.00
Accumulated Dep.   ....................                   10,000.00
To record depreciation expense.
```

After three years, the amount of acumulated depreciation is 3 * \$10,000 = \$30,000. The amount of net fixed assets for this machine is its costs less the accumulated depreciation; \$100,000 - \$30,000 = \$70,000.

Double Declining Balance Method

It can be argued that the benefits from equipment are greater in the early years of its useful life than in its later years. The matching principle would suggest that depreciation should be larger early in its useful life than later. The straight-line method of computing depreciation yields equal annual amounts so depreciation may be too small in the early years and too large in the later years. The double declining balance method of computing depreciation remedies that weakness. Depreciation is large in the early years and declines over the useful life of the fixed asset.

The double declining balance method starts with the straight-line method. The depreciable cost, years of useful life, and annual depreciation amount is determined according to the striaght-line method. The annual depreciation, as a percent of the depreciable cost, is computed. This percent value is doubled (hence the name of this method) and that doubled value is used to compute annual depreciation expense. It is the percent of the remaining undepreciated value of the fixed asset.

Example 2.

A firm bought a machine for \$90,000. Delivery and installation costs amounted to \$7,000. Calibration costs were \$3,000. The machine is expected to last 10 years with no salvage value.

The amount of depreciation per year is the depreciable cost of \$100,000 divided by the number of years of useful life, 10 years. This yields an amount of \$10,000 in annual depreciation expense. The annual depreciation as a percent of the depreciable cost is \$10,000 / \$100,000 = 10%. Doubling this value yields 20%. Depreciation each year will be 20% of the remaining undepreciated balance of the fixed asset. For the first year, depeciation will be 20% * \$100,000 = \$20,000. The entry to record depreciation expense is as follow:

```       Depreciation Expense   .....................      20,000.00
Accumulated Dep.   ....................                   20,000.00
To record depreciation expense.
```

In the second year, the remaining undepreciated balance is the depreciable cost less the accumulated depreciation; \$100,000 - \$20,000 = \$80,000. For the second year, depeciation will be 20% * \$80,000 = \$16,000. The entry to record depreciation expense is as follow:

```       Depreciation Expense   .....................      16,000.00
Accumulated Dep.   ....................                   16,000.00
To record depreciation expense.
```

After three years, the amount of acumulated depreciation is \$20,000 + \$16,000 + \$12,800 = \$48,800. The amount of net fixed assets for this machine is its costs less the accumulated depreciation; \$100,000 - \$48,800 = \$51,200.

The double declining balance will never depreciate an asset down to zero. The fixed asset will carry a balance until it is disposed of. This machine will have an undepreciated value of \$10,737 at the end of its useful life. This value will be used to compute any gain or loss on the disposal of the machine.

Common Stock

In one of your courses, whether accounting, business law, or management/organizations, you learned about the legal structure of a business: sole proprietorship, partnership, or corporation. These are different forms of ownership and they give rise to different methods of accounting for ownership. The ownership of a corporation is through its common stock. It is necessary to account for the corporation's sale of it ownership, redemption or recall of its ownership, and determining the value of each unit of ownership.

Common Stock Sales

The important aspect to understand is that common stock transactions that must be accounted for are those between the corporation and its owners, not those between owners or investors. The sale of common stock from one investor to another has no impact on the corporation's books and financial statements. The sale of common stock from the corporation to investors does have an impact on the corporation's books and gives rise to accounting entries.

When a corporation, whether public or private, decides to sell its stock to investors, it must first authorize the creation of the shares. This authorization is intially accomplished through the articles of incorporation at the time the corporation is brought into existence. There is no accounting entry made for the authorization of shares, however, the number of authorized shares is often disclosed in a note to the financial statements. Then the corporation issues a number of shares to investors. This issuance occurs simultaneously to the initial sale of the shares in question. The proceeds to the firm of the sale of shares is the value credited to the Common Stock account in the sale. Note that the Common Stock account is credited to increase its balance and debited to decrease it. It has a credit balance in the general ledger. Issuing common stock to investors is one of the ways a firm raises the funds to finance its assets. (Debt is the other way.)

Example 1.

A newly incorporated firm with 10,000,000 authorized shares, issued 100,000 shares to Jorge Goncalves for \$500,000 in cash. The entry to record to stock sale is as follows:

```       Cash   .....................................     500,000.00
Common Stock   ........................                  500,000.00
To record sale of common stock.
```

In the above example, the stock had no par-value. See your textbook for an explanation of the meaning and significance of par value. When a stock has a par value, there are 2 accounts credited in the sale of shares. One is the Common Stock account. The value credited to the Common Stock account is the product of the par value per share and the number of shares issued. The other account is called Paid-In Capital. It is credited with the excess of the share price over the par value. The sum of the Common Stock and Paid-In Capital credits should sum to the total proceeds of the stock sale.

Example 2.

A newly incorporated firm with 10,000,000 authorized shares with a par value of \$1.00. The firm issued 100,000 shares to Jorge Goncalves for \$500,000 in cash. The entry to record to stock sale is as follows:

```       Cash   .....................................     500,000.00
Common Stock   ........................                  100,000.00
Paid-In Capital   .....................                  400,000.00
To record sale of common stock.
```

Investors buying a firm's stock are not obliged to pay cash to the firm. Quite frequently, some other type of consideration is offered for the shares such as land, equipment, buildings, or shares of other firms. This type of transaction occurs when investors are transferring some asset to the firm. For example, a partnership may be converting to a corporation and the partners are transferring the net assets of the partnership to the corporation in exchange for its stock. Another example, one corporation is acquired by and merged into a second. The shares of first firm are purchased by the second firm, with the second firm issuing its own shares as payment. In these circumstances, the main concern is the determination of the fair market value of the assets serving as consideration for the stock.

Example 3.

A newly incorporated firm with 10,000,000 authorized shares, issued 100,000 shares to Jorge Goncalves. Goncalves gives the firm title to a building and the plot of land it is on. The fair market value of the land is \$150,000 and the fair market value of the building is \$350,000. The entry to record to stock sale is as follows:

```       Building   .................................     350,000.00
Land   .....................................     150,000.00
Common Stock   ........................                  500,000.00
To record sale of common stock.
```

Example 4.

A newly incorporated firm with 10,000,000 authorized shares with a par value of \$2.00. The firm issued 100,000 shares to Jorge Goncalves. Goncalves gives the firm title to a building and the plot of land it is on. The fair market value of the land is \$150,000 and the fair market value of the building is \$350,000. The entry to record to stock sale is as follows:

```       Building   .................................     350,000.00
Land   .....................................     150,000.00
Common Stock   ........................                  200,000.00
Paid-In Capital   .....................                  300,000.00
To record sale of common stock.
```

Common Stock Purchases

A corporation can also buy its stock back from investors. See your textbook for a discussion of the many reasons for doing so. There are two things the firm can do with the shares its redeems or repurchases; cancel them or store them. The accounting treatment of a stock buyback depends on what the firm does with the redeemed shares.

The case of cancelling redeemed shares for cash is the simpler on. The accounting entry for the redeemed shares that are cancelled is the opposite of the entry made when the shares were issued and sold. The Common Stock account is debited and the Cash account is credited. In most jurisdictions, cancelled shares cannot be re-issued and have the effect of reducing the number of authorized shares. Some jurisdictions permit cancelled shares to return to their status of authorized but unissued. The number of cancelled shares should be disclosed in a note to the financial statements.

Example 5.

An incorporated firm, with 10,000,000 authorized shares and 4,000,000 issued and oustanding, decides to buyback 100,000 shares from Cuthbert Higginshire for \$500,000 in cash. The firm had initially sold these share at a price of \$5.00 each. The shares are cancelled. The entry to record to stock purchase is as follows:

```       Common Stock   .............................     500,000.00
Cash   ................................                  500,000.00
To record buyback of common stock.
```

Example 6.

An incorporated firm, with 10,000,000 authorized shares and 4,000,000 issued and outstanding, decides to buyback 100,000 shares from Cuthbert Higginshire for \$500,000 in cash. The firm had initially sold these share at a price of \$5.00 each. The shares have a par value of \$2.00. The shares are cancelled. The entry to record to stock purchase is as follows:

```       Common Stock   .............................     200,000.00
Paid-In Capital   ..........................     300,000.00
Cash   ................................                  500,000.00
To record buyback of common stock.
```

After the buyback, the firm has 10,000,000 authorized shares, 100,000 cancelled shares, and 3,900,000 issued and outstanding shares.

The case of storing the re-purchased shares, called Treasury Stock, is more complex. If the redeemed shares are not cancelled, there is the situation of a corporation owning itself through owning its own stock, receiving its own dividends, and voting for its own directors. In almost all jurisdictions, this is not a tolerable situation, so redeemed shares that are not cancelled are put into a state of limbo. These shares are issued but are no longer outstanding. They do not receive dividends, they do not carry a vote, they are not used in computing earning per share. They are held in abeyance until re-issued or cancelled. The Treasury Stock account has a debit balance and reduces total owners' equity in the firm. The entry for the re-purchase of stock is not influenced by whether the stock has a par value or not. The Common Stock and Paid-in capital accounts are not affected. Only the Treasury Stock account is debited. The value of the Treasury Stock account is determined only by the amount paid for the stock.

Example 7.

An incorporated firm, with 10,000,000 authorized shares and 4,000,000 issued and outstanding, decides to buyback 100,000 shares from Cuthbert Higginshire for \$500,000 in cash. The firm had initially sold these share at a price of \$5.00 each. The shares are held as treasury stock. The entry to record to stock purchase is as follows:

```       Treasury Stock   ...........................     500,000.00
Cash   ................................                  500,000.00
To record buyback of common stock.
```

Example 8.

An incorporated firm, with 10,000,000 authorized shares and 4,000,000 issued and outstanding, decides to buyback 100,000 shares from Cuthbert Higginshire for \$500,000 in cash. The firm had initially sold these share at a price of \$5.00 each. The shares have a par value of \$2.00. The shares are held as treasury stock. The entry to record to stock purchase is as follows:

```       Treasury Stock   ...........................     500,000.00
Cash   ................................                  500,000.00
To record buyback of common stock.
```

After the buyback, the firm has 10,000,000 authorized shares, 4,000,000 issued and outstanding shares, and 100,000 treasury shares. The examples in this module show the scenario in which the shares are re-purchased at the same price at which they were intially sold. The other important scenarios dealing with differing stgock prices are explained and discussed in the Intermediate Financial Accounting II module.