Post on 18-Nov-2015
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Special Items in Accounting
Dheeraj Vaidya
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1Private and Confidential Not for Circulation
Dheeraj Vaidya
Corporate Bridge Academy
dheerajvaidya@corporatebridge.net
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Inventory Valuation Methods
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2Private and Confidential Not for Circulation
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Methods of Inventory Accounting
First-In First-Out (FIFO)
This method assumes that the first units purchased are the first units sold
The cost of most recent purchases is assigned to ending inventory
Last-In First-Out (LIFO)
The LIFO inventory costing method assumes that the last units purchased are the first to be sold
The costs of beginning inventory and earlier purchases go to ending inventory
Weighted average costing
This method assumes that the units are sold without regard to the order in which they are purchased
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Private and Confidential Not for Circulation 3
Instead, it computes COGS and ending inventories as a simple weighted average
Example
Summary Inventory Records No. of units $/unit Total cost
Inventory on January 1st, 2006 600 100 60,000
Inventory purchased in 2006 200 150 30,000
Cost of goods available for sale in 2006 800 90,000
Inventory sold in 2006 550 250 137,500
Calculate gross profit for the following methods of inventory valuation
a) FIFO
b) LIFO
c) Weighted Average Costing
Also show the Balance sheet and Income Statement Flow
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Methods of Inventory Accounting
FIFO:
Calculation of gross profit
Balance Sheet Effect
Assets Liability Shareholders Equity= +
$55,000 flows $55,000
FIFO
Sales 137,500
COGS (550 @ $100) (55,000)
Gross Profit 82,500
Inventory cost as on January 1st, 2006 is taken
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Private and Confidential Not for Circulation 4
LIFO:
Calculation of gross profit
Balance Sheet Effect
$55,000 flows through the Income Statement as expense
$55,000
cost of goods sold
LIFO
Sales 137,500
COGS (200 units @ $150) (30,000)
COGS (350 units @ $100) (35,000)
Gross Profit 72,500
Assets Liability Shareholders Equity= +
$65,000 flows through the Income Statement as expense
$65,000
cost of goods sold
Last purchased inventory taken first and the remaining from the
beginning of the year inventory
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Methods of Inventory Accounting
Weighted Average Cost
Calculation of Weighted average cost
Calculation of gross profit
Weighted average cost taken as per calculation above
Total cost 90,000
Total units 800
Average cost 112.5
Weighted Average cost
Sales 137,500
COGS (550 @ $112.5) (61,875)
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Balance Sheet Effect
Summary
Assets Liability Shareholders Equity= +
$61,875 flows through the Income Statement as expense
$61,875
cost of goods sold
Gross Profit 75,625
Summary COGS Ending Inventory
FIFO Costing 55,000 35,000
LIFO Costing 65,000 25,000
Average Costing 61,875 28,125
FIFO: 200*150+50*100 = $35,000
LIFO: =250*100 = $25,000
Average Costing: = 112.5 * 250 = $28,125
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Financial Statement Effects
In an environment of Stable Prices
All three inventory valuation methods (FIFO, LIFO and Weighted Average costs) will yield the same results for Inventory, COGS and Earnings
In an environment of Rising Prices and Increasing or Stable Inventory
Item LIFO FIFO
COGS Higher Lower
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Ending Inventory and Working Capital
Lower as inventory reflects the prices of items purchased at lower prices
Higher as inventory reflects the most recently purchased items
Net WorthLower because earnings and inventory
is lowerHigher because earnings and inventory
is higher
Taxes Lower Taxes Higher Taxes
Earnings Lower because COGS is higher Higher because COGS is lower
Pre-tax Cash Flows Same Same
After-tax Cash flows Higher because of lower tax outgo Lower because of higher tax outgo
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Analytical adjustments
Profitability
LIFO produces higher COGS balances and are better measure of true economic costs
In an environment of rising prices, LIFO produces income that are lower than FIFO
Gross margins and profit margins are lower due to lower income under LIFO
For FIFO firms, profitability ratios should be recalculated using estimates of what COGS would have been under FIFO
Liquidity
FIFO produces inventory figures that are higher and are a better measure of economic value
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Private and Confidential Not for Circulation 7
FIFO produces inventory figures that are higher and are a better measure of economic value
LIFO, however, uses prices that are outdated (in an environment of rising prices)
Liquidity ratios such as current ratios are higher under FIFO than in LIFO
For LIFO firms, Liquidity ratios should be recalculated using inventory balances that have been restated using LIFO reserve
Solvency
Solvency ratio like debt ratio, debt-to-equity ratio will be lower under FIFO because of higher denominator
For firms that use LIFO, ratios should be calculated using asset and equity figures restated by using LIFO reserve
Assets Liability Shareholders Equity= +
LIFO Reserve LIFO Reserve x Tax Rate
LIFO Reserve x (1-Tax Rate)
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Change in depreciation policy
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8Private and Confidential Not for Circulation
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Change in Depreciation Policy
Depreciation Policies
Straight Line Depreciation Method
Sum-of-years digit Method
Double declining method
Written Down value method
Effect of Changes in Depreciation Methods
Impact on Cash Flows
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Private and Confidential Not for Circulation 9
Impact on Cash Flows
NO IMPACT?
Impact on Earnings
Firm that chooses an accelerated method of depreciation instead of using straight-line will tend to have greater depreciation expense and lower net income
Will continue if the firm is investing in new assets that the lower depreciation on old asset is more than offset by the higher depreciation on new assets
Impact on Operating Performance
ROE?
Retained Earnings?
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Impact of Change in Depreciation Policy
Straight Line Accelerated (WDV)
Depreciaton Expense Lower Higher
Net Income Higher Lower
Assets Higher Lower
Equity Higher Lower
Return on Assets Higher Lower
Return on Equity Higher Lower
Turnover Ratios Lower Higher
Cash Flows Same Same
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Private and Confidential Not for Circulation 10
Change in depreciation policy of Jet Airways from WDV to SLM
Wrote back Rs9.2bn into its P&L, which helped the company to report profits during the quarter
It also helped Jet to report higher net worth, which will help in keeping reported gearing low
TCS, the software major, increased its depreciation policy on computers from 2 years to 4 years. As a result, 1QFY09 PBT was higher by an estimated Rs500m (c.4% of net profit in 1QFY09).
Cash Flows Same Same
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Operating and Financial leases
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11Private and Confidential Not for Circulation
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Introduction to Leases
Leases
Contractual agreement between the lessor (owner of asset) and the lessee (rents the asset)
Gives the lessee the right to use specific property
Specifies the duration of the lease and rental payments
Obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee
Who are the concerned parties?
Lessee: Transportation (Trucks, Aircrafts), Real Estate (Building), Construction Agriculture
Lessors: Captive Leasing companies, Banks and other Independents
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Rationale for leases
Disadvantages of leases?
Private and Confidential Not for Circulation 12
Operational
Leasing ready-to-use equipment can be more attractive if the asset requires lengthy preparation and set-up
Leasing avoids having to own the asset that will be required only seasonally, temporarily or sporadically (leasing contract can be tailored)
Leasing for short periods protects against obsolescence
Financial
Leases may not require any money down and may be a less costly means of financing
Lease payments can be tailored to suit the lessees cash flows (up to 100% financing, instead of 80% limit by banks)
Leases may contain less restrictive covenants than other types of lending arrangements
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Lessees Perspective: Capital Leases vs. Operating Leases
Operating Leases
Leases that do not transfer substantially all the benefits and risks of ownership are operating leases
Lessee rents the property
Lessee accrues rent expense
Capital lease
Capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is non-cancelable
Lessee economically owns the property
Lessee records the leased asset in the balance sheet (i.e. capitalizes the asset) and reflects the
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Lessee records the leased asset in the balance sheet (i.e. capitalizes the asset) and reflects the corresponding lease obligation
Leases that do not meet any of the four criteria are accounted for an Operating Lease
Test1: Transfer of ownership
Test 2: Bargain purchase option?
Test 3: Lease term > = 75% of economic life ?
Test 4: Present value of payments >= 90% Fair Market Value?
Private and Confidential Not for Circulation 13
Capital LeaseYes
No
Operating Lease
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Lessees Perspective: Classification of Leases
Example : Lessees Perspective: Classification of Leases
An equipment with a market price of (FMV) of US$100,000 and useful life of 5 years is leased
to a lessee for a period of 4 years. The lease payments are US$26,000 a year. The borrowing
rate for the firm is 8%, and the rate implicit in the lease is 7%. There is no provision for
Lessee to purchase asset at the end of the lease term, nor any bargain purchase option.
Test 1
Does the lease transfer ownership of the property to the lessee by the end of the
non-cancellable lease term?
Answer No
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Private and Confidential Not for Circulation 14
Answer No
Test 2
Does the lease contain an option to purchase the leased property at a bargain price?
Cost to purchase asset at end of lease na
Estimated asset value at end of lease na
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Lessees Perspective: Classification of Leases
Test 3
Is the lease term greater than or equal to 75% of the estimated economic life of the
leased property?
Estimated useful life (years) 5.0
75% of estimated useful life 3.8
Non-cancellable Lease term (years) 4.0
Difference -0.25Difference is negative implies capital LeaseDifference is negative implies capital Lease
Test 4
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Private and Confidential Not for Circulation 15
Does the present value of rental and other minimum lease payments, excluding that portion
of the payments representing executory cost, equal or exceed 90 percent of the fair value
of the leased property?
Value of leased asset $100,000
90% of value of leased asset (at lease inception) $90,000
"Present Value" of lease $88,067
Difference $1,933If difference is negative, then Capital Lease
If difference is negative, then Capital Lease
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Lessees Perspective: Operating Lease Accounting
Operating Lease ( At inception)
Operating Lease ( as payments are made)
Assets Liability Shareholders Equity= +
No Entry No Entry
Assets Liability Shareholders Equity= +
Cash reduced by periodic lease
Flows through Income statement as rent
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Effect on Cash Flows
Total lease payment reduces cash flow from operations
Operating leases do not affect the lessees liabilities and hence, are referred to as off-balance sheet financing
Footnote disclosure of lease payment for each of the next five years is required
Private and Confidential Not for Circulation 16
Cash reduced by periodic lease payments
Flows through Income statement as rent expense
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Lessees Perspective: Capital Lease Accounting
Capital Lease ( at inception)
Capital Lease ( as payments are made)
Assets Liability Shareholders Equity= +
Present value of minimum lease payment
Assets Liability Shareholders Equity= +
Present value of minimum lease payment
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Interest expense = Discount rate times the Lease liability at the beginning of the period
Depreciation Period calculations
If lease transfers ownership, depreciate asset over the economic life of the asset.
If lease does not transfer ownership, depreciate over the term of the lease.
Effect on Cash Flows
Only portion of the lease payment that is considered interest payment reduces CFO
Part of the lease payment considered payment on principal reduces CFF
Private and Confidential Not for Circulation 17
a) Cash reduced by periodic lease payments
b) Leased property is reduced by depreciation amount
Flows through Income statement as Interest expense and Depreciation expense
Lease obligation is reduced by periodic lease payment LESS Interest payment
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Lessees Perspective: Example
Operating Lease
Example (continued) : Operating lease and Capital Lease
An equipment with a market price of (FMV) of US$100,000 and useful life of 5 years is leased
to a lessee for a period of 4 years. The lease payments are US$26,000 a year. The borrowing
rate for the firm is 8%, and the rate implicit in the lease is 7%. There is no provision for Lessee
to purchase asset at the end of the lease term, nor any bargain purchase option
If we assume that the lease is an Operating Lease
a) Balance Sheet: No Impact
b) Income Statement Effect: Lease payments of $26,000 treated as expense
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Capital Lease
In the earlier illustration, the lease was a capital Lease
Private and Confidential Not for Circulation 18
Assets Liability Shareholders Equity= +
US$88,097 US$88,097
Balance Sheet at Inception
a) Present value at 7% is $88,067
b) Both Asset and Liability increases by the present value of lease payments at inception
c) Cash Flow: Lease payment of $26,000 treated as outflow for Cash flow from operations
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Lessees Perspective: Accounting
Capital Lease: Balance Sheet Effect (as payments are made)
Capitalized lease calculations
Assets Liability Shareholders Equity= +
a) Cash reduced by periodic lease payments of US$26,000
b) Leased property is reduced by depreciation amount of US$22,017
Flows through Income statement as Interest expense of US$6,165 and Depreciation expense of US$22,017
Lease obligation is reduced by periodic lease payment US$26,000 LESS US$6,165
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Capitalized lease calculations
Private and Confidential Not for Circulation 19
Note: a) The book value of assets decline each year by the depreciation amount as shown in column (f)
b) Depreciation (term of 4 years) = $88,067/4 = $22,017
c) Principal repayments equals the lease payments LESS interest expense
d) The asset (column f) is being depreciated at a rate that is different from the rate of amortization for
the liability (column d), the two values are equal only at the inception and termination of the lease
Year
(a)
Beginning
Leasehold
Value
(b)
Interest
Expense (a) X
7%
(c)
Lease
payment
(d)
Ending
Leasehold value
(a+b-c)
(e)
Depreciation
Expense
(f)
Book Value
of Assets
0 $88,067 $88,067
1 $88,067 $6,165 $26,000 $68,232 $22,017 $66,051
2 $68,232 $4,776 $26,000 $47,008 $22,017 $44,034
3 $47,008 $3,291 $26,000 $24,299 $22,017 $22,017
4 $24,299 $1,701 $26,000 $0 $22,017 $0
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Comparison of Operating and Capital Leases
Income Statement Effect
Income Statement Effect
$29
Income Statement Effects
Operating
Operating Lease
Year
Operating Expense =
Total Expense Operating Expense
Non-operating
expense Total Expense
1 $26,000 $22,017 $6,165 $28,181
2 $26,000 $22,017 $4,776 $26,793
3 $26,000 $22,017 $3,291 $25,307
4 $26,000 $22,017 $1,701 $23,718
Capital Lease
Operating income is higher for capital lease Operating income is higher for capital lease
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Cash Flow Effect
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$21
$22
$23
$24
$25
$26
$27
$28
$29
1 2 3 4
Exp
en
se (
'00
0 $
)
Years
Capital lease
Operating lease
Operating Lease
Year
Cash flow from
operations
Cash flow from
operations
Cash flow from
financing
1 ($26,000) ($6,165) ($19,835)
2 ($26,000) ($4,776) ($21,224)
3 ($26,000) ($3,291) ($22,709)
4 ($26,000) ($1,701) ($24,299)
Capital Lease
Operating income is higher for capital lease
(This is because depreciation expense for capital lease
is lower than the lease payments)
Net income is lower in early years for capital lease
Operating income is higher for capital lease
(This is because depreciation expense for capital lease
is lower than the lease payments)
Net income is lower in early years for capital lease
In operating lease, the total cash payment reduces
cash flow from operations
In capital lease, the part of lease payment considered payment on principal reduces cash flow from financing activities
Total CF is unaffected by the accounting treatment
In operating lease, the total cash payment reduces
cash flow from operations
In capital lease, the part of lease payment considered payment on principal reduces cash flow from financing activities
Total CF is unaffected by the accounting treatment
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Lessees Perspective: Ratio Effects
Effect on Financial Statements
Financial Statement Capital Lease Operating Lease
Assets Higher Lower
Liabilities Higher Lower
Net Income (in early years) Lower Higher
Cash flow from operations Higher Lower
Cash flow from financing Lower Higher
Total Cash Flow Same Same
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Effect on Ratios
Private and Confidential Not for Circulation 21
Financial Statement Capital Lease Operating Lease
Current ratio Lower Higher
Working Capital Lower Higher
Asset Turnover Lower Higher
Return on assets Lower Higher
Return on equity Lower Higher
Debt/Equity Higher Lower
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Capitalization vs Expensing
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22Private and Confidential Not for Circulation
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Capitalization versus expensing
Capitalize
Means show the cost as an asset on the balance sheet
These assets have future benefits
Expense
Benefits are immediate
Or future benefits are too uncertain or immaterial
Costs flow through the financial statements
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Management discretion in exercising these choices can significantly impact the financial statements and the ratios
Cost incurred
Balance Sheet
Net Income
(Depreciation or Amortization Expense)
CFI Outflow
Income Statement
Net Income
(Expense)CFO outflow
Capitalization Expensing
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WorldCom Case
Most infamous example of inflating earnings through improper capitalization of expenses
Regulators?
Transaction$3.8bn 2001-02 expenditure on line costs
What was required as per
What WorldCom WorldCom declared
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Private and Confidential Not for Circulation 24
Financial Statement Effects
Accounting Treatment
Regulators? required as per GAAP
$3.8bn must be treated as operating expense
Pre-tax Income should be deducted by $3.8bn
What WorldCom did?
WorldCom capitalized the
costs
$3.8bn was capitalized and put on the
balance sheet (for
amortization)
WorldCom declared bankruptcy in July 2002.
Chief accounting and finance executives charged
with securities fraud
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Financial Statement Effects
Income Statement Effects
Income Statement Expensing Capitalizing
Income Variability Greater variability Smoothening effect on net income from year to year
Matching of revenues Less matching of revenues and costs
Cost deferred and matched with revenues
Profitability (Early years) Lower as all expenses flow through the IS
Higher as cost is amortized
Profitability (Later years) Higher as all cost has been expensed
Lower due to amortization of capitalized cost
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Private and Confidential Not for Circulation 25
Balance Sheet Effects
Cash flow effects
Balance Sheet Expensing Capitalizing
Asset and Liability Lower Higher
Leverage Ratios (debt/equity,debt/asset)
Higher Lower due to higher base
Book Value/Share Lower Higher
Cash Flow Expensing Capitalizing
Cash Flow from Operations Lower Higher
Cash Flow from Investing Higher Lower
Total Cash Flows Same Same
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Capitalization of interest
Capitalized interest is the interest incurred during the construction of long-lived assets.
Capitalized interest is included as the initial cost of the asset on the balance sheet instead of being charged off as interest expense on the income statement
Qualifying assets for capitalized interest
They must require a period of time to make them ready for use
Assets under construction for use in operations
Discrete assets intended for sale or lease
What is the Capitalization period?
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Private and Confidential Not for Circulation 26
What is the Capitalization period?
Capitalization period begins when
Expenditures for the asset have been made
Activities for readying the asset are in progress
Interest costs are being incurred
Capitalization period ends when
Asset is substantially complete and ready for its intended use
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Intangibles Assets
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27Private and Confidential Not for Circulation
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Intangibles Capitalized or Expensed
Patents
Goodwill
Advertisements
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Intangibles Capitalized or Expensed
Accounting for Research and Development
Future benefits from R&D expenditures is highly uncertain at the start of a project
SFAS 2 requires virtually all R&D expenditures to be expensed as incurred
Principle of conservatism is applied in case of R&D
However, when one firm buys another firm, the total purchase price must be apportioned among the individual assets acquired
$4,000$4,000In-process
R&D (no future
Immediately written off
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Private and Confidential Not for Circulation 29
SFAS 2 requires that a portion of purchase price be allocated to in-process R&D and be immediately written off
Managers have a strong incentive to allocate a large portion of the purchase price to purchased in-process R&D
$4,000$4,000
$600$600
$400$400
In-process R&D with almost certain future
Tangible Assets
Purchase price
$5,000$5,000
R&D (no future alternative)
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Intangibles Capitalized or Expensed
Accounting for Software Development Costs
More liberal for accounting internal expenditures for software development
Software development cost is a major costs for many small, growth service companies and thats their main asset
This prompted FASB to be more liberal while formulating SFAS 86
Research Research Development
expenditures
Development
expenditures
Technologically feasibleExpensed as
incurred
Capitalized and
amortized
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Private and Confidential Not for Circulation 30
expendituresexpenditures expendituresexpenditures
Before After
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Intangibles Example
How much is recognized as intangible assets
How much is recognized is expensed
Example: Intangibles
An enterprise is developing a new production process. During the year 2001, expenditure incurred
was Rs. 10 lakhs, of which Rs. 9 lakhs was incurred before 1 December 2001 and 1 lakh was incurred
between 1 December 2001 and 31 December 2001. The enterprise is able to demonstrate that, at
1 December 2001, the production process met the criteria for recognition as an intangible asset.
The recoverable amount of the know-how embodied in the process (including future cash outflows
to complete the process before it is available for use) is estimated to be Rs. 5 lakhs.
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How much is recognized is expensed
How much is recognized as intangible assets?
What is the impairment?
During the year 2002, expenditure incurred is Rs. 20 lakhs. At the end of 2002, the recoverable
amount of the know-how embodied in the process (including future cash outflows to complete
the process before it is available for use) is estimated to be Rs. 19 lakhs.
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Intangibles: Capitalize/ Expense
Intangible Asset Treatment as per US GAAP
Research and development Expensed as incurred
Patents and copyrightsCosts incurred in development are expensed but if a patent orcopyright is purchased then the cost is capitalized
Franchise and license costs Capitalized by the purchasing firm
Brands and trademarks Capitalized by the purchasing firm
Advertising costs Expensed as incurred
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GoodwillMay be recognized and capitalized only in purchase transactions.Under US GAAP goodwill is subject to an impairment test
Computer software &development costs
All costs incurred in feasibility studies are expensed but subsequent development costs of an established product can be capitalized
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Deferred Tax
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33Private and Confidential Not for Circulation
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Introduction to accounting for Income taxes
Difference between Financial & tax reporting
Indian GAAPIndian GAAP
Generally accepted accounting principles is a set of rules for preparing financial statements
Income Tax ActIncome Tax Act
Internal Revenue Services Code sets rules for preparing
tax returns
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Income tax expense from GAAP and income tax payable from Income Tax Act do not equal
When income and expense are treated differently on financial statements than it is on the companys tax returns results in Deferred tax asset or Deferred tax liabilities
Purpose of accounting for income tax
Recognize deferred tax liability or deferred tax asset for the tax consequences of amounts that will become taxable or deductible in future years as a result of transactions or events that already have occurred
Pretax Financial IncomePretax Financial Income
Income Tax Expense
Taxable IncomeTaxable Income
Income Taxes Payable
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Temporary differences
Difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements that will result in taxable amounts or deductible amounts in future years
Deferred Tax Liability
Accelerated depreciation on tax return (straight line on income statement)
Installment sales of property (installment method for taxes)
Accounting Income >
Taxable Income
Accounting Income >
Taxable Income
Future Taxable Amounts
Future Taxable Amounts
Deferred Tax Liability
Deferred Tax Liability
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Installment sales of property (installment method for taxes)
Unrealized gain from recording investments at fair value (taxable when asset is sold)
Deferred Tax Asset
Rent or subscriptions collected in advance
Warranty expenses are accrued on income statement (tax deductible only when warranty claims are paid)
Deferred compensation cost is recognized as it is earned (tax deductible only when payments are made)
Asset impairment
Post retirement benefit expenses
Accounting Income <
Taxable Income
Accounting Income <
Taxable Income
Future Deductible Amounts
Future Deductible Amounts
Deferred Tax Asset
Deferred Tax Asset
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Deferred tax Illustration Temporary Difference
Example 1: Deferred tax calculations
Toy & Co. purchases an asset each year for three years. Asset 1 in the first year, Asset 2 in the second year and
Asset 3 in the third year. The cost of each of these assets is US$10,000, with no salvage value and 4 years life.
Double declining balance method is used on tax returns and straight line for financial statements
Calculate the Deferred tax liability from Year 1 to Year 4.
Tax return calculations (DDB) Year 1 Year 2 Year 3 Year 4
Asset 1 5,000 2,500 1,250 1,250
Asset 2 - 5,000 2,500 1,250
Asset 3 - - 5,000 2,500
Total DDB depreciation 5,000 7,500 8,750 5,000
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If there is no reversal of deferred liability, the cumulative deferred liability will continue to increase as long as the firm continues to grow
Temporary difference reverses from Year 4
Year 1: (5,000 2,500) * (30%) = 750
Year 2: (7,500 5,000) * (30%) = 750
Year 3: (8,750 7,500) * (30%) = 375
Year 4: (5,000 7,500) * (30%) = -750
Year 1: (5,000 2,500) * (30%) = 750
Year 2: (7,500 5,000) * (30%) = 750
Year 3: (8,750 7,500) * (30%) = 375
Year 4: (5,000 7,500) * (30%) = -750
Income Statement (straight line) Year 1 Year 2 Year 3 Year 4
Asset 1 2,500 2,500 2,500 2,500
Asset 2 - 2,500 2,500 2,500
Asset 3 - - 2,500 2,500
Total SL depreciation 2,500 5,000 7,500 7,500
Cumulative Deferred Tax Liability Year 1 Year 2 Year 3 Year 4
Deferred liability @ 30% tax rate 750 750 375 -750
Cumulative Deferred liability 750 1,500 1,875 1,125
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Permanent differences
Permanent differences
Results mainly from revenues or expenses that affect pretax income or taxable income, but not both
No deferred liability or assets are created as these differences are permanent
Common sources of permanent difference
Tax-exempt interest received from US municipal bond obligations
Premium on life insurance policies where the company is beneficiary (not deductible for tax purposes)
Allowable tax credits
Goodwill amortization (under IAS)
As these differences are never deferred but are considered decreases or increases in the effective tax rate
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rate
If the only difference between taxable and pretax incomes were a permanent difference, then tax expense would be simply tax payable
Illustration: Permanent difference
Income Statement Tax Return
Preliminary Income 80,000 80,000
Tax-exempt interest income 20,000 -
Premiums paid on life insurance -5,000 -
Pretax Income / Taxable Income 95,000 80,000
Preliminary tax liability (40%) NA 32,000
Less eligible tax credits NA -4,000
Tax expense / tax liability 28,000 28,000
Effective tax rate/ Statutory tax rate 29.5% 40.0%
No deferred liability or assets are created
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Deferred Taxes
Study of BSE-100 companies
Source of Deferred Tax Companies % of total
Depreciation 78 companies 94.75%
Fiscal allowances on fixed assets HUL, ITC & M&M 2.15%
Interest Accrued Canara Bank, Allahbad Bank 0.67%
Lease Adjustments SBI, MRPL, HDFC 0.58%
Deferred Revenues ONGC 0.44%
Others Others 1.41%
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Others Others 1.41%
Source: Chartered Accountant Journal, July 2006
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Analysts note on Deferred Taxes
The analyst should consider the firms growth rate and capital spending levels when determining whether the difference will actually reverse
Impairment generally result in creation of Deferred tax assets since the write-down of assets is recognized immediately for financial reporting, but not for tax purpose until the asset is sold
Restructuring also leads to creation of Deferred tax assets since for financial reporting purpose the costs are recognized immediately when restructuring is complete, but not expensed for tax purpose until actually paid
Deferred tax liability or assets is expected to reverse
Valued for accounting purpose at its undiscounted value
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Valued for accounting purpose at its undiscounted value
Deferred tax liability or assets is NOT expected to reverse
The difference should be treated as Equity
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Contingent Liabilities
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Contingent Liability
Contingent liabilities represent potential expenses for a company where the outcome is dependent upon one of more future events
If it is probable the liability will crystallize then the full amount must be accrued in the financial statements
However, if payment is less than probably (usually interpreted to be a probability of less than 50%) then no entry is made in the balance sheet; although a contingency is disclosed in the notes to the accounts
Common contingencies include loan guarantees, product warranties and legal claims
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Do Nothing