XYZ Enterprise Part 1

XYZ ENTERPRISE BALANCE SHEET ON DECEMBER, 31, N ASSET LIABILIY Bulding : 2,000,000 Capital ………………………. : 3,000,000 Inventory (Merchandise) : 400,000 Accounts receivable…… : 600,000 TOTAL………. : 3,000,000 TOTAL………… : 3,000,000 Suppose that the values in this balance sheet are the values at fair market. The owner of this company wants to sell it to another MN company who is ready to pay 4,500,000 Fr even if the net asset acquired worth 3,000,000 Frw. Why the purchaser is ready to pay 1,500,000 Fr more than the net asset acquired??? The reason is that, probably, in the asset of this company, there are others intangible elements not recorded under generally accepted accounting principles, and therefore the purchaser can expect to obtain higher than normal earnings. These elements are called Goodwill. In his accounting, MN Company, the purchaser will record this acquirement as following: _________________ _______________________ 20.6 Goodwill……………….. : 1,500,000 22.1 Building ……………… : 2,000,000 30 Inventory…….…………… : 400,000 41.0 Account receivable……... : 600,000 56 Bank…………………….. : 4,500,000 Purchase Price of Company – Net Assets at Fair Market Value = Goodwill Suppose that later, MN Company estimates the recorded goodwill downed at 1,000,000 Frw in place of 1,500,000 kept in the books. The Company would make this entry: _________________ __________________________ Loss on Goodwill…………………………: 500,000 Goodwill………………………………: 500,000 _______________ (To record loss on goodwill)______________ General principles of recording asset are following: Dt 21,22,23 : Property Plant Equipment Ct Purchase price + all necessary expenditures before ready for use Dt 25 Long-term loan Ct Loans and all receivables over 1 year Dt 26 Long-term securities Ct Securities Bonds suppose you purchase land and a building at the combined purchase price for Frw 20,000,000. An independent valuer indicates that the land’s market (sales) value is Frw10.000.000 and the building Frw 15,000,000 if they were acquired separately. First, figure the ration of each asset’s market value to the total for both assets combined. The total appraised value is Frw 25,000,000: Land (F 10,000,000) + Building (F 15,000,000). The land makes up 40% of the total market value, and the building 60%, as follows: Land: 10,000,000 /25,000,000 = 40% Building: 15,000,000 / 25,000,000 = 60% The cost at which to record each asset is determined as follows: Asset Market value Relative fair market value Land Building 10,000,000 15,000,000 40% 60% Total 25,000,000 100% The journal entry to record the acquisition is: Total purchase price 20,000,000 20,000,000 Land.....................................................: 8,000,000 Building...............................................: 12,000,000 Cash............................................ : 20,000,000 (To record the acquisition of land and building) Note that the sum of the amounts recorded for the land and the building is Fr 20,000,000, which is the total acquisition cost and not the total appraisal value of Fr 25,000,000. To illustrate, assume that a business paid 60,000,000 Frw for the mining rights to a mineral deposit estimated at 500,000 tons. The depletion rate is 120 Fr per ton (60,000,000 Fr/500,000 T). If 150,000 T are extracted during the year, the periodic depletion is 120 Fr/T * 150,000 T = 18,000,000 Fr. The process of allocating the cost of intangible assets to expenses (Note that Goodwill and Trademarks are not subject to amortization). Even Amortization proceeds in the same way as depreciation process, but their meanings are not exactly the same. When depreciation corresponds to a wear due of use, amortization consists to spread an amount of fees capitalized over many years. Example: Start up fees of 2,500,000 Fr are paid in 2003 and must be amortized on 5 Years. At the end of year 2003, the account Amortization expense will be debited of 500,000 Fr and the account 20 Startup fees will be credited, and it will be so at the end of the 4 futures years. Process amortization is the same of process depreciation except that amortization is credited in “The asset’s account directly (not in the accumulated amortization (Direct amortization)). Also, amortization uses Straight line method. : Some important terminologies Before studying the factors, which must be considered in determining the amount depreciation, make sure you understand the following definitions. - Historical Cost or Acquisition cost (Coût d’acquisition): The amount assigned to a particular asset, usually the ordinary and necessary amount expended to get an asset in place and in condition for its intended use. - Estimated useful life (Durée de vie) It is the length of the service period expected from the asset. Useful life may be expressed in years, output, or miles. For example, a building’s life is stated in years, an airplane in the number of miles it can fly, a Xerox copier in the number of copies it can make, a Generator in the hours it is expected to run. - Estimated Salvage value or residual value (Valeur résiduelle): is the asset’s expected cash value at the end of its useful life. It is an estimated value, if any, which a company expects to receive by selling or exchanging an asset at the end of its useful life. For example, you may anticipate using a vehicle for five years and then replace it. The small anticipated sales amount at the end of the service life is the salvage value or residual value, called also trade-in value. Estimated residual value is not depreciated because you expect to receive this amount at the end. If there’s no residual value, then depreciate the full cost of the asset. Cost minus residual value is called Depreciable cost. - Depreciable cost or Depreciable base (Base ou assiette d’amortissement) equals to the Historical cost minus the asset’s expected salvage value. The total amount of depreciation expense assigned to an asset never exceeds the asset’s depreciable cost. If there is no salvage value estimated for an asset, Depreciable cost equals Historical cost. - Annual depreciation (Annuité d’amortissement) is amount of depreciation assigned to a year in particularly. Because of Matching principle, at each year, it is allocated his depreciation expense. - Accumulated depreciation: total depreciation amount from the beginning up to a given date. - Depreciation rate (Taux d’amortissement): is a percentage used to calculate annual depreciation. This percentage is determined by dividing the number 100 by the number of years of useful life. For example, if a useful life of a machine is 5 years, the depreciation rate would be 100/5 = 20%. In the above example, the annual depreciation of Fr 10,000,000 of machine can be computed by multiplying the depreciable cost of 10,000,000 Fr by 20%. e.g. 10,000,000 F * 20% = 2,000,000 Fr. - Accumulated depreciation: cumulative depreciation from the beginning to a given date. - Net Book value (Valeur comptable nette) is an asset’s total cost (Historical cost) minus the accumulated depreciation assigned to the asset. Don’t confuse net book value with Market value, which is the price someone would pay for the asset. These two values are usually different. In fact, the market value of an asset, such as a building, may increase while the asset is being depreciated. Net book value simply represents the portion of an asset’s cost that has not been allocated to expense. Example: Cost value of a truck acquired at 01/01/2016 : 10,000,000 Fr Annual depreciation for year 2016…………. : (2,000,000 Fr) Net book value at 31/12/2016…………..... : 8,000,000 Fr The net book value at a given time of its useful life = Historical cost-Accumulated depreciation at this time II.3.4.3.1 : Straight-line depreciation method (méthode d’amortissement annuel constant ((ou méthode d’amortissement linéaire)) Under this method, it is assumed that during each financial year, the amount of depreciation remains the same. The main characteristic of the straight-line depreciation method therefore consists in charging to the results of each financial year an identical fraction of the acquisition cost. The method supposes that the asset’s wear is the same during its useful life. Under this method, depreciable cost is divided by useful life to determine annual depreciation. annual depreciation expense is then calculated by: - dividing the asset’s depreciable cost by the number of years in the asset’s useful life; - or by multiplying the depreciable cost by annual depreciation rate The equation for SL deprecation is as follows: Asset’s historical cost – Estimated residual value Annual depreciation = -----------------------------------------------------------Useful life, in years Depreciation rate: Remember that the annual depreciation rate is expressed in percentage (%) determined by dividing the number 100 by the useful life in years. Example: Usually useful life for a vehicle is estimated at 5 years. Therefore, its depreciation rate is 100/5 = 20%. Then, if this vehicle has been bought at 7,000,000 Fr and if we suppose that the residual value of this car will be zero at the end of its useful life, its annual depreciation is computed as follows: Annual depreciation = 7,000,000 Fr/5years = 1,400,000 Fr/year or = 7,000,000 Fr*20%=1,400,000 Fr/year That is to say at each year, the vehicle loses its value worth 1,400,000 Fr and at the end of the fifth year, its value (book value) will be zero. In this above example, we assumed that the first use of the vehicle occurred at the beginning of the first year (January 1st), and therefore a full year’s depreciation expense was recorded in the year of acquisition. However, in practice, this is not always the case, all the assets are not acquired 1st January of the year. Assets are usually purchased throughout the year. When an asset is used for only part of a year, the annual depreciation is prorated. Service useful period is converted in months or in days (and, of simplification, all the months are counted for 30 days). Example: A machine, which cost value is 6,800,000 Fr has been acquired and placed in service on November, 16, 2019. Useful life estimated: 10 years. Closing accounting year: December 31st , each year. In this case, Depreciation rate equals 100/10 = 10%. Service useful time of the first year (year of acquisition): from November, 16 th to December 31st, 2019, means 45 days (year of 360 days and month of 30 days), or 1,5 months. First annual depreciation (for the year 2019): (6,800,000 Fr*10%)*1.5/12=85,000 Fr (or (6,800,000 Fr*10%)*45d/360d). Second year, annual depreciation (for year 2020): 6,800,000 Fr*10%*12/12= 680,000 Fr Annual depreciation will be 680,000 Fr for ulterior years, 2028 included. The last annual depreciation (for year 2029): (6,800,000 Fr*10%)*10.5/12= 595,000 Fr (315 days are counted from January 1st to November 15th, 2029, means 315days/30days = 10.5 months) Verification: Accumulated depreciation= historical cost of the machine 85,000 Fr +(680,000 Fr*9) +595,000 Fr= 6,800,000 Fr The useful life of an asset is estimated by company’s management, depending on the nature of asset, the practice of the sector, etc. Estimates of expected useful lives are also available from various trade associations or revenue services. They are some useful lives which are usually applied on some categories of assets. Following are some of them and their corresponding rates: truck for which the acquisition cost is 24,000,000 Fr has a useful life of 4 years and has been acquired on September 1st , 2015. STRAIGHT-LINE DEPRECIATION SCHEDULE Depreciation rate 100/4= 25 % Residual value: 0 Fr Date Depreciation for the year Accumulated Netbook depreciation value (Cost-Acc Depreciation Depreciable deprec) Depreciation rate (%) cost (Fr) Fr Fr expense (Fr) st 1 Sept 25% 24,000,000 24,000,000 2015 0 0 31st 25% * 24,000,000*4/12 = 2,000,000 22,000,000 Dec2015 2,000,000 st 31 25% * 24,000,000 = 8,000,000 16,000,000 Dec2016 6,000,000 31st 25% * 24,000,000 = 14,000,000 10,000,000 Dec2017 6,000,000 31st 25% * 24,000,000 = 20,000,000 4,000,000 Dec2018 6,000,000 31st 25% * 24,000,000*8/12 = 24,000,000 0 Aug2019 4,000,000 Because the truck is placed in service from September 1 st , 2015, annual depreciation of the year 2015 is computed on prorate of 4 months, means: 4/12 * (25%*24,000,000 F) and the last annual depreciation (year 2019) will be computed on prorate of 8 months. II.3.4.3.2: Units-Of-Production (UOP) method or Activity Depreciation Method UOP or Activity depreciation method is a depreciation method in which the depreciation is based on the level of physical activity of the asset. The method allocates a fixed amount of depreciation to each unit of output. The activity (or use) of an asset may be measured in terms of the number of units the asset is expected to produce, the number of hours it is expected to operate, or the number of kilometers it is expected to run. Asset’s cost – Estimated residual value Depreciation per unit output = ------------------------------------------------Useful life, in units of production In the above example, assume that the truck is expected to run 100,000 Km: 10,000 Km in 2015 35,000 Km in 2016 25,000 Km in 2017 20,000 Km in 2018 10,000 Km in 2019 The depreciation rate could be computed on the basis of the number of Km as follows: Depreciation rate = Cost-Residual value = 24,000,000 Fr- 0Fr = 240 Fr/Km Useful life, in Km 100,000 Km Depreciation schedule is illustrated as follows: UNITS-OF-PRODUCTION DPERECIATION SCHEDUEL FOR A TRUCK Depreciation rate: 240 Fr/Km Residual value: 0 Fr Date Depreciation for the Accumulated year depreciation Depreciation Number of Depreciation per unit (Fr) unit (Km) Fr expense (Fr) 1st Sept 240 2015 0 31st 240 * 10,000 = 2,400,000 Dec2015 2,400,000 st 31 240 * 35,000 = 10,800,000 Dec2016 8,400,000 31st 240 * 25,000 = 16,800,000 Dec2017 6,000,000 31st 240 * 20,000 = 21,600,000 Dec2018 4,800,000 31st 240 * 10,000 = 24,000,000 Aug2019 2,400,000 Netbook value Fr 24,000,000 21,600,000 13,200,000 7,200,000 2,400,000 0 To illustrate declining balance depreciation method, consider the truck discussed above (acquired at 24,000,000 Fr on September 1st, 2015 and which useful life is 4 years). Schedule of Declining depreciation for a truck Date of acquisition: September 1st, 2015 Useful life: 4 years, Cost acquisition: 24,000,000 Fr Residual value: 0 Fr Declining balance rate: 1.5*25%= 37.5 % Date Depreciation for the year Accumulated Netbook value depreciation Declining Depreciable Depreciation rate (%) cost (Fr) expense (Fr) Fr Fr 1st Sept 2015 37.5% 24,000,000 0 0 24,000,000 31st Dec2015 37.5% * 24,000,000*4/12 = 3,000,000(*) 3,000,000 21,000,000 st 31 Dec2016 37.5% * 21,000,000 = 7,875,000 10,875,000 13,125,000 st 31 Dec2017 50% * 13,125,000 = 6,562,500 17,437,500 6,562,500 31st Dec2018 50% * 13,125,000 = 6,562,500 24,000,000 0 (*) Annual depreciation of year 2015 : 24,000,000 Fr*37.5%*4/12= 3,000,000 Fr For the depreciation of subsequent years, the Net book value of the last year is multiplied by 37.5 % (e.g. : year 2016 : 21,000,000 Fr*37.5%=7,875,000 Fr). Notice 1. Despite the «Prorata temporis rule» applied on the 1st year of acquisition of the truck (year 2015), this first year is counted as an entire year in the calculating of asset’s useful life (4 years). 2. On December 31st , 2018 (end of the fourth year), the net book value of the truck is 5,126,953 Fr when it is supposed to be Zero because it is the end of its useful life, what is not normal. - - The first solution consists to add the 5,126,953Fr on the last annual depreciation calculated, means 5,126,953 Fr+ 3,076,172 Fr = 8,203,125 Fr, in order to bring to residual value (which is 0 Fr in our case). However, the challenge of this solution is that the last annual depreciation is more than its previous, therefore the declining sense of the method is lost. The second solution (accepted by the fisc) consists of applying straight-line rate over the two last years. In that case, on years 2017 and 2018, straight-line rate is applied on the net book value at the end of 2016 year. Then: Depreciation expense of the year 2017= 13,125,000 Fr * 50 % = 6,562,500 Fr Depreciation expense of the year 2018= 13,125,000 Fr * 50 % = 6,562,500 Fr 31st Dec2017 31st Dec2018 50% * 50% * 13,125,000 13,125,00 = 6,562,500 = 6,562,500 17,437,500 24,000,000 6,562,500 0 3. If the asset has a residual value, the last annual depreciation is simply obtained by subtracting the residual value on the net-book value at the end. 4. YEAR STRAIGHT-LINE UOP DECLINING BAL 2015 2,000,000 2,400,000 3,000,000 2016 6,000,000 8,400,000 7,875,000 2017 6,000,000 6,000,000 6,562,500 2018 6,000,000 4,800,000 6,562,500 2019 4,000,000 2,400,000 TOTAL 24,000,000 24,000,000 24,000,000 a machine acquired on January 1st, 2012 for an amount of 500,000 Fr, depreciated with Straight-Line method, for useful life of 5 years (assuming a zero-residual value). Theoretically, the “22.5 Machine” account should, at each year, be reduced (credited) by the annual depreciation, which is 100,000 Fr and, in counterpart, debit the Depreciation expense account (loss of the value of the machine). Depreciation recognition therefore consists of recording the debit in an expense account the loss of the asset’s value, by crediting an asset account (decreasing of the asset). The expense account reserved for recording depreciation is the account classified in class 6, account “68: Depreciation expense". The too simple solution, called Direct depreciation, would consist in making the following entry (see previous T-accounts): __________________ December 31st _________________ 68 Depreciation expense: 100,000 22.5 Machine………... : 100,000 __________________ __________________ In this way, the machine account balance at the end of the 1st year would be equal to its net book value, which, by the way, makes sense. Dt 22.5 Machine Ct 500,000 100,000 Balance: 400,000 Fr Fixed Asset account Buildings Store Equipment Office equipment Dt 22.5 Machine 400,000 Ct Contra asset account Accumulated depreciation - Buildings Accumulate Depreciation-Store equipment Accumulate depreciation- Office equipment Thus, in the case of the previous machine, the following entry would be made on December 31 st of each year: T Accounts 68.5 Depreciation expense 100,000 028 Accumulated depreciation- Machine 100,000