Question

1. Indicate how the following items are recorded in the accounting records in the current year of Coronet Co. (a) Impairment of goodwill. (b) A change in depreciating plant assets from acceler- ated to the straight-line method. (c) Large write-off of inventories because of obsolescence. (d) Change from the cash basis to accrual basis of accounting. (e) Change from LIFO to FIFO method for inventory valuation purposes. (f) Change in the estimate of service lives for plant assets.

Answer 1

(a) Impairment of Goodwill

Goodwill impairment is a charge that companies record when goodwill's carrying value on financial statements exceeds its fair value. In accounting, goodwill is recorded after a company acquires assets and liabilities, and pays a price in excess of their identifiable value. Goodwill impairment arises when there is deterioration in the capabilities of acquired assets to generate cash flows, and the fair value of the goodwill dips below its book value.

Goodwill impairment is an earnings charge that companies record on their income statements after they identify that there is persuasive evidence that the asset associated with the goodwill can no longer demonstrate financial results that were expected from it at the time of its purchase. Because many companies acquire other firms and pay a price that exceeds the fair value of identifiable assets and liabilities that the acquired firm possesses, the difference between the purchase price and the fair value of acquired assets is recorded as a goodwill. However, if unforeseen circumstances arise that decrease expected cash flows from acquired assets, their fair value can be lower than what was originally paid for them, and a company must book a goodwill impairment

Goodwill is an asset, but it does not amortize or depreciate like other assets. Instead, GAAP rules require companies to "test" goodwill every year for impairments.

For example, let's assume that Company XYZ purchases Company ABC. The book value of Company ABC's assets is $10 million, but for various good reasons, Company XYZ pays $15 million for Company ABC. Because Company XYZ paid $15 million for $10 million worth of assets, Company XYZ records $5 million of goodwill as an asset on its balance sheet.

After the acquisition, Company ABC's sales fall by 40% over the year because Company XYZ changed its product line, which proved unpopular. Also, a competitor introduced a newer, lighter, faster, and cheaper product. As a result, Company ABC's fair market value falls to $8 million.

A year has now passed, and for Company XYZ, this means comparing the fair value of Company ABC to the book value on XYZ's financial statements. If the fair value of Company ABC is less than the book value (that is, if Company XYZ were to sell Company ABC today, it wouldn't get a price equal to or greater than its recorded value), Company XYZ must make a goodwill impairment.

In this example, Company XYZ would compare Company ABC's current fair market value of $8 million plus the $5 million of goodwill (a total of $13 million) to the $15 million it has recorded as Company ABC's value on its books. The difference between the two is $2 million, and Company XYZ must therefore reduce the goodwill on its books by that amount. The goodwill entry on its balance sheet goes from $5 million to $3 million, and its total assets fall correspondingly.

(b) A change in depreciating plant assets from acceler- ated to the straight-line method.

Accelerated method is also called double-declining balance method .

The double-declining balance method is a type of accelerated depreciation method that calculates a higher depreciation charge in the first year of an asset’s life and gradually decreases depreciation expense in subsequent years.

To calculate depreciation expense, use double the straight-line rate. For example, suppose a business has an asset with a cost of 1,000, 100 salvage value, and 5 years useful life. First, calculate the straight-line depreciation rate. Since the asset has 5 years useful life, the straight-line depreciation rate equals (100% / 5) or 20% per year. With double-declining-balance, double that rate to arrive at 40%. Apply the rate to the book value of the asset (cost subtracted by accumulated depreciation) and ignore salvage value. At the point where book value is equal to the salvage value, no more depreciation is taken.

(c) Large write-off of inventories because of obsolescence

Obsolete inventory is a term that refers to inventory that is at the end of its product life cycle. This inventory has not been sold or used for a long period of time and is not expected to be sold in the future. This type of inventory has to be written down and can cause large losses for a company.

For example, a company identifies $8,000 worth of obsolete inventory. It then estimates that the inventory can still be sold in the market for $1,500 and proceeds to write down the inventory value. Since the value of inventory has fallen from $8,000 to $1,500, the difference represents the reduction in value that needs to be reported in the accounting journal, that is, $8,000 - $1,500 = $6,500.

Provision for Obsolete Inventory
Account	Debit	Credit
Inventory Obsolescence	6,500
Allowance for Obsolete Inventory		6,500

The allowance for obsolete inventory account is a reserve that is maintained as a contra asset account so that the original cost of the inventory can be held on the inventory account until disposed of. When the obsolete inventory is finally disposed of, the allowance for obsolete inventory is cleared. For example, if the company disposes of its obsolete inventory by throwing it away, it would not receive the sales value of $1,500. Therefore, in addition to writing off the inventory, the company also needs to recognize an additional expense of $1,500. The allowance for obsolete inventory will be released by creating this journal entry:

Account	Debit	Credit
Allowance for Obsolete Inventory	6,500
Inventory Obsolescence	1,500
Inventory		8,000

The journal entry removes the value of the obsolete inventory both from the allowance for obsolete inventory account and from the inventory account itself.

(d) Change from the cash basis to accrual basis of accounting

Under the cash basis of accounting, business transactions are only recorded when the cash related to them is either issued or received. Thus, you would record a sale under the cash basis when the organization receives cash from its customers, not when it issues invoices to them. The cash basis is commonly used in small businesses, since it requires only a limited amount of accounting expertise. However, it may be necessary to convert to the accrual basis of accounting, perhaps to have the company's books audited in preparation for its sale, or to go public, or to obtain a loan. The accrual basis is used to record revenues and expenses in the period when they are earned, irrespective of actual cash flows. To convert from cash basis to accrual basis accounting, follow these steps:

• Add accrued expenses. Add back all expenses for which the company has received a benefit but has not yet paid the supplier or employee. This means you should accrue for virtually all types of expenses, such as wages earned but unpaid, direct materials received but unpaid, office supplies received but unpaid, and so forth.
• Subtract cash payments. Subtract cash expenditures made for expenses that should have been recorded in the preceding accounting period. This also means reducing the beginning retained earnings balance, thereby incorporating these expenses into the earlier period.
• Add prepaid expenses. Some cash payments may relate to assets that have not yet been consumed, such as rent deposits. Review expenditures made during the accounting period to see if there are any prepaid expenses, and move the unused portion of these items into an asset account. If you choose to do the same for expenditures made in prior periods, adjust the beginning retained earnings balance to remove the expenses that are now being shifted into a prepaid expenses asset account.
• Add accounts receivable. Record accounts receivable and sales for all billings issued to customers and for which no cash has yet been received from them.
• Subtract cash receipts. Some sales originating in a prior period may have been recorded within the current accounting period based on the receipt of cash in that period. If so, reverse the sale transaction and record it instead as a sale and account receivable in the preceding period. This will require an adjustment to the beginning retained earnings account.
• Subtract customer prepayments. Customers may have paid in advance for their orders, which would have been recorded as sales under the cash basis of accounting. You should instead record them as short-term liabilities until such time as the company has shipped the related goods or provided the indicated services.