In this case, the purchases of stationery and supplies were recorded outright expense. In reality, not all of this stationery and supplies is use at the end of the year. There will be left unused. This is the part where adjusting entries are used. Before closing the temporary accounts (income and expenses) of books, the company will adjust. For example, at the end of the year, the company realize that some stationery and supplies are still unused. Since the company uses the expense method, it was recorded previously as an expense account. Therefore, at the end of the year, the company will make adjusting entries to realize the unused supplies.

Why do we need to do adjusting entries?

The reason we do adjusting entries is to make the financials accurate and realistic. For instance, the long-term asset depreciation (cost allocation) expense. The factors we use in depreciating the assets are useful life, the method of depreciation, and the salvage value. These factors are merely estimates. When the company realizes that the useful life estimates made are unrealistic in the succeeding years, the company will adjust. Making adjustments is bringing the unrealistic figures to a realistic one. This is to help financial end-users and the decision-maker, decide correctly. Overstated or understated balances affect the decision-making of the financial end-users.

Moreover, the company itself. Assuming the estimated useful life of the assets was realize overstated in the succeeding years. And the company didn’t make any adjustments. As a result, understatement of depreciation expense. The understatement of expense makes the income overstated. Overstatement of income means over remittance of taxes. Not only taxes but also the decision-making of the management for instance in giving bonuses. In addition, wrong cost allocation (depreciation) of an asset. The company is expecting the assets to perform more years but in reality, it can only perform a year or less. Adjusting entries is very important. 

Accounts that need adjusting entries

1.) Supplies

The adjusting entries will depend on what method the company uses. The company should realize expenses given that it uses asset method. On the other hand, if the company uses the expense method, it should realize an asset account for unused supplies.

2.) Prepaid Expenses

These are the prepaid rent, prepaid insurance, and prepaid subscriptions. The adjustment will also depend on the original entries made. The company adjust the unexpired prepayments if previously recorded as an expense. On the other hand, if the company initially records it as an asset account then it should realize an expense once incurred.

3.) Unearned Revenue

This is a liability account. Unearned income is the advance payment of customers which not yet delivered or rendered. Sometimes the company mistakenly records the advances as revenue or income earned. Otherwise, if the company uses the cash method of accounting it records income based on cash flows. In this case, at the end of the year, the company will make adjusting entries for the unfulfilled or undelivered cash advances.

4.) Depreciation / Depletion Expense

It is the cost allocation of long-term assets. Since the factors in depreciating the assets are estimates when the company changes estimate it records adjusting entries. 

Note: The above accounts are examples that need adjustments, but are not limited to them. Errors made also need adjustments. Errors can happen anytime. Wrong posting of accounts, overlooked amounts, double posting, and no posting are some common errors . These errors require adjusting entries to correct the balances of financial statements.

Conclusion (adjusting entries):

We use adjusting entries to correct the balances, the estimates, and the errors made. Adjusting entries also used to bring the wrong balance of financial statements to accurate data. Supplies, prepayments, unearned income, depreciation are accounts that usually have the adjusting entries. Adjusting entries are important because not doing so could affect the financial end-users and the company itself. 

Related Blogs: Depreciation and Depletion

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When you issue a bond, you will receive cash and recognize a liability at the same time. Stated, coupon or nominal rate is equal to the rate written in the bond indenture. The bond issuer sets the rate. Remember that the stated rate written in the bond is irrevocable regardless of the change in economic condition. That’s why in the sale of bonds, the basis of the transaction is the market rate. Market rate or effective yield is equal to the rate that is acceptable to the creditor. The rate should provide a return commensurate to the issuer’s risk. The relation of stated and market rates is the computation of interest. The computation of periodic interest paid to the bondholder each period is based on the stated rate (stated rate multiplied by the face amount of the bond). Market rate – used for the computation of discount or premium amortization.

Discount or Premium on Bonds Payable

We mentioned that the stated interest rate written in the bond indenture is irrevocable regardless of economic condition. The question is why do creditors agree to lend money given that the stated interest rate of the bond is irrevocable. The answer is that the bonds can be sold at a discount or premium. This means that when the market rate is higher than the stated rate, the bonds are sold at a discount.

On the other hand, the bonds are sold at a premium when the market rate is lower than the stated rate. When the bond is sold at discount, the cash received by the debtor is lower than the face amount of the bond. Moreover, when the bond is sold at a premium, the cash is more than the face value of the bonds. Another question is how to compute the cash proceeds of the bonds sold. The computation is based on the market or yield rate. First, we get the present value of the principal. Then, we get the present value of the ordinary annuity of the periodic interest payment. The total of the present value of principal and the present value of periodic interest will be the cash proceeds.

Types of Bonds Payable

Secured Bonds Payable

A type of bond that has collateral or pledge of a company’s assets. It could either be land or building. This is to give the creditor assurance if the company fails to meet its bond obligations.

Debenture or Unsecured bonds Payable

These bonds don’t have a pledge or collateral. These bonds don’t guarantee the creditor an assurance in case of payment failure.

Registered Bonds

A type of bond that keeps the record of the names and addresses of all the bondholders and pays the interest only to the names registered to the bonds.

Coupon Bonds

This is the opposite of registered bonds, it doesn’t have a record of names and addresses. Moreover, it pays interest to the bondholder who can prove the ownership of the bonds.

Term Bonds

these types of bonds mature in one single sum on a specified future date.

Serial Bonds

Bonds mature in a series of installments.

Callable Bonds

These bonds have a term or serial that the issuer can redeem at any time at a specified price.

Convertible Bonds

These bonds are called traded bonds. Otherwise, converted to other financial securities after a specified period.

Conclusion

Bonds Payable stated rate is irrevocable. In addition, bonds payable can be sold at market rate by selling on either discount or premium. Bonds payable have 8 types namely secured, debenture, registered, term, serial, callable, and convertible bonds. Moreover, the cash proceeds are the sum of the present value of principal and the present value of an ordinary annuity of periodic interest. 

Related Blog: Liabilities

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Accounting for Warranty

1.) Expense as incurred approach

This method is not following Generally Accepted Accounting Principles (GAAP). It is considered and allowed to use this method, especially for small businesses, because in reality, the volumes of transactions are minimal. Another term for this is cash method. Because the recording of expense is based on actual expense.

2.) Accrual approach

The accrual method is following GAAP. The assumption in the case that the problem is silent is to use accrual approach. Accrual means recording the expected expense incurred upon sale.

Illustration on expense as incurred approach:

ABC company sells a Sala set with a two-year warranty. The selling price per set is P30,000. The average repair per set is P3,000. The company experience 20% repair in the first year. Moreover, 40% repair in the second year of all the Sala sets sold. The total set sold in 2020 is 500 and 1,000 set in the year 2021. The total payment of warranty in 2020 is P300,000 and P350,000 in 2021.

To record the sale in the year 2020:

Cash                                      P15,000,000

                               Sales                                   P15,000,000

To record the payment of repair in the year 2020:

Warranty expense                          P300,000

                                               Cash                                  P300,000

Note: The provision expense is recorded when incurred.

The sales are computed by multiplying the selling price to the number of units sold (P30,000×500=P15,000,000).

To record the sale in the year 2021:

Cash                      P30,000,000

                               Sales                   P30,000,000

To record the payment of repairs in the year 2021:

Warranty expense                          P350,000

                                               Cash                                  P350,000

Illustration on Accrual approach:

ABC company sells a Sala set with a two-year warranty. The selling price per set is P30,000. The average repair per set is P3,000. The company experience 20% repair in the first year. Moreover, 40% repair in the second year of all the Sala sets sold. The total set sold in 2020 is 500 and 1,000 set in the year 2021. The total payment of warranty in 2020 is P300,000 and P350,000 in 2021.

To record the sale in the year 2020:

Cash                      P15,000,000

                               Sales                                   P15,000,000

To record estimated liability in the year 2020:

Warranty expense                          P900,000

                                               Warranty Liability                         P900,000

To record payment of repairs in the year 2020:

Warranty liability                              P300,000

                                               Warranty Expense                      P300,000

Note: In this approach, the provision liability is recorded on the date of sale. It means that the expected repair based on the company experience is the basis of recording the warranty liability. The sales are computed by multiplying the selling price by the number of units sold (P30,000×1000=P30,000,000). Warranty expense is computed as the number of units sold (500) multiply by the percentage of repair based on experience (20% and 40% = 60%). The product of the number of units and repair percentage is multiplied by the cost of repair per set (P3,000).

500 x 60% x P3,000 = P900,000

To record the sale in the year 2021:

Cash                      P30,000,000

                               Sales                   P30,000,000

To record estimated liability in the year 2021:

Warranty expense                          P1,800,000

                                               Warranty Liability                         P1,800,000

To record payment of repairs in the year 2021:

Warranty liability                              P350,000

                                               Warranty Expense                      P350,000

Conclusion:

Warranty can be in terms of quantity, quality or performance. It is classified as provision. The expiration and policy vary depending on the items subject for provisions. In addition, it has two methods of recording transactions.

Related Blog: Liabilities and GAAP Principles

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Wasting Asset

Wasting assets – also known as natural resources. When we say produce by nature it means it is irreplaceable. These are material objects with economic value and utility to man produced by nature. Once extracted and consumed, it will take more time to regenerate.

Depletion in Wasting Assets

Depletion is a counterpart of depreciation in property, plant, and equipment (PPE) and amortization in intangible assets. These three have a similarity. Depletion is the removal, extraction, or exhaustion of a natural resource. Moreover, it is the cost allocation of wasting asset depletable amount over the period it is extracted or produced. The depletable amount is computed by the cost of wasting asset less salvage value. The accounting method normally used for depletion is the output or production method. Depletion expense is equal to the rate multiply by units extracted during the year. Depletion expenses vary depending on the number of units extracted during the year. The higher the units of production the higher the depletion expense. In addition, the lower the units of production the lower the expense.

The depletion rate is equal to the cost of wasting asset less salvage value over its units estimated to be extracted. The rate is fixed unless there’s a change in the accounting estimate. The rate is not affected by the period it started even it started in December, the computation of depleted amount is still the same. Unlike depreciation, if it started in December, the depreciation expense is prorated within the year. The composition of wasting assets is the acquisition cost, exploration cost, development cost, and restoration cost. The first three are incurred at the beginning while the restoration cost is after the extraction. Restoration cost is computed at its present value. These four costs are capitalized meaning added to the cost of wasting assets.

Illustration:

ABC company has acquired the right to use a property to extract a natural resource. The acquisition cost was P5,000,000. The related exploration cost is P2,500,000, and the development cost is P1,500,000. In addition, the estimated total mineral deposit is P2,000,000 units.

Additional information:

First year: 200,000 units

Second year: 500,000 units

Third year: 800,000 units

Fourth year: 300,000 units

Fifth year: 200,000 units

What is the cost of wasting assets? Prepare a table for the five years’ depletion expense and journal the entry.

Answer:

The cost of wasting assets is P9,000,000

Acquisition cost + exploration cost +development cost

(P5,000,000+P2,500,000+P1,500,000)

Depletion rate = P9,000,000 / P2,000,000 = 4.5

Note: Carrying amount is the cost or the remaining cost of wasting assets.

Conclusion:

You have learned that wasting assets are a natural resource. It is irreplaceable, and to recognize it is to deplete. In addition, the cost is compost of acquisition, exploration, development, and restoration cost. There’s two way to record the cost allocation of wasting assets. One is by the expense, and the other is by inventory. And lastly, the accounting method used to deplete wasting assets is the output or production method

Related Blog: Depreciation and Property Plant and Equipment

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Most PPE has huge costs and is useful for more than one reporting period (1 year). It is illogical for the company to expense PPE outright because it performs for more than one reporting period. Moreover, PPE outright expense will result in a net loss for the company which violates the matching principle. The matching principle is an accounting standard that mandates matching expenses with its revenue. Since PPE is useful for several years means that its contribution to generates income is good for more than 1 year. In addition, the bureau of internal revenue (BIR) does not allow the recording of depreciable assets as an outright expense. Moreover, if the amount is material.

Depreciation change in accounting estimate

There is no accounting standard regarding the useful life of a PPE asset. The company decides what is the useful life of an asset. The company uses this asset for whatever purpose it may serve. Therefore, they are familiar with what useful life the specific PPE normally has. Companies normally make an assumption based on the historical life of specific PPE. The company also considers how often the PPE is used. Moreover, other related factors to arrive at what the estimated number will be. In addition, some instances and/or events will somehow result in wrong estimates. And to make reliable financial statements, the company decides to change the accounting estimates. A change in accounting estimates could be a change in useful life, residual value, or depreciation method.

The application of a change in the accounting estimate of depreciation is prospective. Prospective application means that the balances from the past will stay as-is. In addition, the change in accounting estimates applies to current and future transactions. The adjustment on the balances starts when there are changes in accounting estimates. No need to adjust previous balances.

Change in useful life

Some company changes the useful life of PPE when the company discovers that the asset will have a more or less useful life. Based on perspective application, any adjustments will be made in the current or future transactions (depreciation). When the company decides to add the useful life of a specific asset, the treatment is moving forward. The adjustment will be remaining balance over remaining useful life (new useful life minus years of depreciation equals the remaining useful life)

Illustration I:

CD company purchase a truck for P5,000,000 on August 18, 2021. The estimated useful life of the truck is 5 years, and the salvage value is P350,000. The company uses the straight-line method of depreciation.

In the third year, CD company encounters unexpected sales for two consecutive years. The truck was used more than its useful routine. CD company assess that the truck no longer has a useful life of 5 years but 4 years. The company decided to change the estimates from 5 years to 4 years on the third depreciation. The question is what will be the depreciation expense of the truck? Prepare a complete depreciation table.

Computation:

Note: In the first two years the depreciation is P930,000 using the straight-line depreciation method. Notice the change in accounting estimates. The remaining balance is allocated to the new remaining useful life. Remember that depreciation is a way to allocate the cost. Since there’s a change in estimates, there will also be a change in cost allocation on the agreed remaining useful life.

Change in depreciation method

In reality, most companies use the straight-line method of depreciation because it’s easy to compute. Some companies use the double declining method for the reason that as PPE depreciates, the output decreases. Moreover, the double-declining method of depreciation lowers taxes in earlier years. The double-declining method or acceleration method has higher depreciation in earlier years and lower in later years. It is allowed by the bureau of internal revenue (BIR) as long as the company can justify its method.

Nevertheless, there are factors that make the company change its method. For instance, if the company wants its financial statements to be realistic. The company will assess its PPE and use a method that is applicable to the performance of the PPE. If the depreciation method happens to be inappropriate, then the company will change the method. The changes will be accepted as long as the company can justify the change. There is no right or wrong in selecting the method of depreciation as long as it is justified.

Illustration II:

ABC company purchase a truck for P5,000,000 on August 18, 2021. The useful life of the truck is 10 years, and the salvage value is P350,000.

Additional information:

ABC company used the double-declining balance DDB method. After 5 years, ABC company decided to change the DDB method to the straight-line method. ABC company projected that the truck will have a new salvage value of P500,000. Prepare depreciation schedule.

Computation of Double declining balance method:

Cost x 2 / useful life

Computation of straight-line method:

Carrying amount less new salvage value over the useful life

Change in accounting estimate of residual value

Change in residual value usually happens. It is because the economy changes from time to time. The estimates on the PPE acquisition are with the assumption of the present economy. Moreover, it considers the prediction of the economy in the future. The projections or assumptions could either be over or underestimates. As a result, the company adjusts based on economic status and what residual value of PPE will be realistic in succeeding years.

Illustration III:

CD company purchase a truck for P5,000,000 on August 18, 2021. The estimated useful life of the truck is 5 years, and the salvage value is P350,000. The company uses the straight-line method of depreciation.

In the fifth year, the company predicts that the truck will no longer have a residual value. The company decides to depreciate the full amount in the fifth year. What will be the depreciation expense in the fifth year?

Change in accounting estimate conclusion:

Accounting estimates are used in depreciating PPE with a useful life of more than 1 year and don’t have a fixed useful life. The goal of the estimates is to allocate the cost of PPE over its useful life congruent to its output. Although it’s just an estimate it doesn’t make the financial statements unreliable because the cost that is allocated is fixed. The only estimates are the method used, the residual value at the time of disposal, and useful life. These estimates don’t affect the PPE cost which is reliable in financial statements. Moreover, these estimates don’t violate accounting equations and accounting standards. Lastly, if the estimates are proven wrong in later years, the company can always amend or adjust its estimates to make them realistic.

Related Blog: Depreciation and Property Plant and Equipment

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IAS 16: Property Plant and Equipment

Property plant and equipment are tangible items that:

a.) are held for use in the production or supply of goods or services, for rental to others, or administrative purposes.

b.) are expected to be used during more than one period.

As stated in IAS 16. Tangible assets which mean it has physical existence or can be touch. Property, plant, and equipment are subject to depreciation. It is under long-term assets.

Note: IAS 16 does not apply to PPE classified as held for sale (IFRS 5), biological assets (except bearer plants, IAS 41), exploration and evaluation assets (IFRS 6), and mineral rights/reserves. IAS and IFRS are the same. The difference between them is IAS represents old accounting while IFRS represents new accounting. The reason we refer to IAS and IFRS is that these standards are adopted in the Philippines. Thus, PAS and PFRS function the same as IAS and IFRS. The difference between these standards are the terminologies used. Don’t be overwhelmed by the accounting standards mentioned in this blog. These are mentioned in special case transactions. But we will not go deep into special case transactions. We will only concentrate on the usual recording of property, plant and equipment cost, and valuations.

Examples of Property Plant and Equipment:

• Land 
• Land Improvements
• Building
• Building Improvements
• Machinery
• Furniture and Fixtures
• Equipment
• Pattern, Molds, and Dies
• Tools
• Vehicles such as company motorcycles, cars, buses, airplanes, and ships
• Bearer plants

Measurement of Property Plant and Equipment

Initial measurement is the cost or purchase price, including directly attributable costs to bring the asset into use. Directly attributable cost like cost in bringing the asset to the location. Moreover, the initial cost of dismantling, removing, and restoration of the site (building), etcetera. Examples of directly attributable costs are delivery charges and installation costs.

Subsequent measurement – this is the measurement following the initial measurement. It is either a cost model or revaluation model. The cost model is computed as cost less accumulated depreciation and any accumulated impairment losses. The revaluation model is computed as a fair market value less any subsequent accumulated depreciation and impairment losses.

Modes of acquisition

1.) Cash basis Lump sum or basket purchase – bought property, plant, and equipment paid in cash. Lump-sum/basket purchase is the term used for buying a combination of two or more properties, plants, and equipment. 

2.) On account subject to cash discount – accounts payable

3.) Installment – notes payable

4.) Issuance of share capital – equity instrument

5.) Issuance of bonds payable – a debt instrument

6.) Exchange – two firms exchange their property, plant, and equipment asset. Observing commercial substance in recording the cost of an asset. Commercial substance means different cash flows.

7.) Donation – shareholder or non-shareholder

8.) Government grant – given by the government 

9.) Construction – applicable to building or machinery

Illustration I:

Cash price (Lump sum)

ABC company purchase land and building for P6,000,000 on August 18, 2021. This includes an appraiser fee of P65,000. The appraised value of the land – P2,000,000 with the original cost of P1,000,000. The building had an appraised value of P3,000,000 with the original cost of P2,500,000. What is the cost of land and building? Moreover, prepare the journal entry to record transactions. 

Insights:

In the accounting standard, the relative value is used in recording PPE. Relative value or relative fair market value – is not mentioned in the problem. The problem uses the appraised value. In this case, we will use the appraised value. The appraised value is the representation of relative value. The appraised value is the same as relative value, relative fair value, and fair market value. An example of directly attributable cost is the appraise fee. Directly attributable costs – are costs necessary to bring the asset to the location and condition necessary for an asset to be in use. Therefore, the appraiser fee is included in the cost of the PPE which is the land and building. Included because the appraisal is necessary for us to determine the value of the PPE.

Answer:

Get the ratio of land and building. We will use the appraised value as a basis. In this problem the ratio will be land (2/5) P2,400,000 and building 3/5) P3,600,000 computed as follows: 

PPE account Appraised Value Ratio Initial Cost 

Land P2,000,000 2/5 P2,400,000

Building P3,000,000 3/5 P3,600,000

Total: P5,000,000 5/5 P6,000,000

Journal Entry :

8/18/2021           Land P2,400,000

                             Building P3,600,000

                                                              Cash P6,000,000

To record purchase of land and building

Illustration II:

On account subject to cash discount

ABC Company purchased the machine on August 18, 2021. The invoice price of P500,000 was subject to a cash discount of 10% which was not taken. ABC company incurred a cost of P5,000 in removing the old machine to install the new machine. What is the cost of the machine? Prepare journal entries.

Insights:

Rule on cash discount: The cash discount is deducted to invoice price or cash price, whether taken or not.

Answer:

P500,000 x .10 = P50,000 (cash discount). P500,000 less P50,000 (cash discount) equals P450,000. The cost of the machine is P450,000. There will be two journal entries. The entry for date of purchase and the payment entry. This is to show how the P450,000 was recorded.

Journal Entry:

Date of purchase:

8/18/2021           Machine                               P500,000

                                                               Accounts payable                  P500,000

To record purchase of machine on account

Date of payment:

9/18/2021           Accounts Payable                              P500,000

                                                               Cash                 P500,000

To record payment of machine dated August 18, 2021

9/18/2021           Purchase Discount Loss                              P50,000

                                                               Machine                 P50,000

To record purchase discount not taken

Illustration III:

Installment (with cash price equivalent)

ABC Company purchased equipment on installment dated August 18, 2021.

Terms:

a.) P5,000 down payment

b.) 4 quarterly payments of P5,000, the first payment/note will be on September 18, 2021

The same equipment was available at a cash price of P22,500.

What is the cost of the equipment? How much is the discount? Prepare the journal entry.

Insights:

On an installment mode of acquisition, when the cash price equivalent is available, the cash price equivalent will be the cost of PPE acquired.

Answer:

The cost of equipment is P22,500 and the cash discount is P2,500.

P22,500 (cost) – P5000 (cash payment) = P17,500

P5,000 (installment) x 4 = P20,000

P20,000 – P17,500 = P2,500 (cash discount)

Journal Entry:

8/18/2021         Equipment P22,500

                          Discount on notes payable P2,500

                                                                Cash P5,000

                                                                Notes Payable P20,000

To record purchase of equipment on installment

Installment (without cash price equivalent)

ABC Company purchased machinery on installment dated August 18, 2021.

Terms:

a.) P5,000 down payment

b.) 4 quarterly payments of P5,000, the first payment/note will be on September 18, 2021

The fair value of the machinery is not determinable. The prevailing interest rate is 10%.

PV of 1 0.683

PV of ordinary annuity of 1 3.170

What is the cost of the machinery? Moreover, prepare the journal entry.

Insights:

When cash equivalent is not included in the problem, use the present value PV of 1 to compute the cost. The formula of PV of 1 is (1+.10)^-4 to get 0.683. The formula to get the PV value of ordinary annuity of 1 is (1-(1+.10)^-4/.1) to get 3.170.

Answer:

PV of installment + cash paid (if any)

P5,000 x 3.17 + P5,000 = P20,850. The cost of the machinery is P20,850.

Journal Entry:

8/18/2021          Machinery                                      P20,850

                           Discount on notes payable          P4,150

                                                                            Cash                               P5,000

                                                                            Notes Payable              P20,000

To record purchase of machinery on installment

Illustration IV:

Issuance of share capital

A piece of land is acquired by issuing 30,000 shares with a par value of P100 on August 18, 2021. The fair value of the land is P3,500,000. The share is quoted at P140 per share. What is the cost of the land? Prepare the journal entry.

Insights:

In the issuance of share capital mode of acquiring PPE, there is the order of priority in recording the PPE (land). 

The Order of priority:

1.) Fair value of the asset received 

2.) Fair value of share capital

3.) PAR value of share capital

Answer:

PPE under the issuance of share capital mode of acquisition we follow the order of priority. In this case, the fair value is P3,500,000. Therefore, the cost of land is P3,500,000

Journal Entry:

Date of purchase:

8/18/2021           Land                               P3,500,000

                                                               Share Capital                 P3,000,000

                                                               Share Premium              P500,000

To record purchase of land

Illustration IV:

Issuance of bonds payable

A building was acquired by issuing bonds payable with a face amount of P3,000,000 on August 18, 2021. At the time of acquisition, the fair value of bonds payable is P4,000,000 and the building is P3,500,000. What is the cost of the building? Prepare the journal entry.

Insights:

In the issuance of bonds payable mode of acquiring PPE, there are the order of priority in recording the PPE (land). 

The Oder of priority:

1.) Fair value of bonds payable 

2.) Fair value of the asset received

3.) Face amount of bonds payable

Answer:

Under the issuance of bonds mode of acquisition, we follow the order of priority. In this case, the fair value of bonds is P4,000,000. Therefore, the cost of building is P4,000,000

Journal Entry:

8/18/2021           Building                              P4,000,000

                                                               Bonds Payable                  P3,000,000

                                                              Premium on Bonds Payable             P500,000

To record purchase of the building

Illustration VI:

Exchange (with commercial substance)

ABC company exchange an old machine with a cost of P1,000,000 on August 18, 2021. The machine was 50% depreciated. ABC paid a cash difference of P200,000. The fair value of the old machine was determined to be P700,000. Assuming there is a commercial substance, what is the cost of a new machine? In addition, prepare the journal entry. 

Insights:

The general rule on exchange: The cost of PPE in exchange for a nonmonetary asset. Otherwise, a combination of a monetary and nonmonetary asset is measured at fair value except:

a.) Exchange lacks commercial substance

b.) The fair value of either the asset given or received cannot be measured reliably 

In that case, the cost of PPE is measured at the carrying amount of asset given.

Order of priority:

1.) Fair value of the asset given

2.) Fair value of the asset received 

3.) Carrying amount of asset given

Note: If cash is paid the cash is added. On the other hand, if cash is received, it is deducted

Answer:

The cost of new machine is the fair value of asset given plus cash payment. P700,000 + P200,000 = P900,000.

Computation of gain on exchange:

P1,000,000 (cost of old machine) x 50% depreciation = P500,000

P1,000,000 – P500,000 + P200,000 (cash paid) = P700,000

P900,000 (new machine) less P700,000 (old machine) = P200,000 (gain on exchange) 

Journal Entry:

8/18/2021           Machine (new) P900,000

                             Accumulated Depreciation P500,000

                                                              Machine (old) P1,000,000

                                                              Cash P200,000

                                                              Gain on exchange P200,000

To record exchange for the new machine

Illustration VII:

Donation

ABC company shareholders decided to donate workout machines for officers and staff use on August 18, 2021. The workout machines have a fair value of P200,000. What is the cost of the workout machine? In addition, prepare the journal entry. 

Insights: 

Donation from shareholder = journal entry is debit to an asset received at fair value and credit to Donated Capital (Equity account part of share premium)

Donation from non-shareholders = journal entry is debit to an asset received at fair value and credit to Income

Note: All expenses incurred related to the donation is deducted to donated capital/income

Journal Entry:

8/18/2021 Workout machines P200,000

                                                  Donated Capital P200,000

To record shareholder’s workout machines donation to officers and staff

Illustration VIII:

Government Grant

The government granted land to ABC charity for the construction of an additional school building for less fortunate children on August 18, 2021. The fair value of the land at the time of grant is P200,000.

Insights: 

The same with a donation, the cost of PPE is measured at the fair value of the asset received plus directly attributable costs. 

Journal entry:

8/18/2021 Land P200,000

                                                         Income P200,000

To record land government grant

Illustration IX:

Construction

ABC company purchase land with an old building for P4,000,000 on August 18, 2021. The old building was demolished to give room for the construction of the new building. How much is the cost of the land? How much is the cost of the new building? Prepare journal entries.

Additional information:

Insights:

The cost of self-constructed PPE shall include:

1.) Direct cost of material (ex. Cement, steel, and hollow blocks)

2.) Direct cost of labor (construction workers)

3.) Indirect cost and incremental overhead (specifically identifiable and traceable to the construction) (ex. Foreman salary, utilities)

Examples of building construction costs:

• Raw material (cash discount taken or not is a deduction)
• Building permit
• Architect fee
• Superintendent fee
• Excavation cost 
• Temporary building cost (shelter for construction workers and raw materials)
• Expenditures incurred during construction such as interest on construction loans and insurance 
• Expenditures for equipment and fixtures made a permanent part of the structure
• Cost of temporary safety fence around the construction site and cost of subsequent removal thereof
• Safety inspection fee

Philippine Interpretation Committee (PIC) Interpretation on land and building

1.) Land and old building purchased at a single cost

a.) If the old building is usable, the single cost is allocated between the land and building based on relative fair value 

b.) If the old building is unusable, the single cost is allocated to land only 

2.) The old building is demolished to make room for the construction of the new building 

a.) Any allocated carrying amount of the usable old building is recognized as a loss 

b.) The demolition cost less salvage value is included as the cost of the new building 

3.) The old building is demolished to prepare the land for the intended use but not to make room for the construction of the new building 

a.) Any allocated carrying amount of the usable old building is recognized as a loss

b.) The demolition cost less salvage value is included as the cost of the land   

Answer:

The cost of the land is P3,950,000 and the new building is P7,450,000. 

Computed as follows:

Land (P4,000,000 less fair value of old building P250,0000) + P150,000 (title insurance) + P50,000 (survey before construction) = P3,950,000

New building P 6,000,000 + P700,000 (architect fee) + P150,000 (building permit) + P200,000 (excavation cost) + P100,000 (insurance) + P300,000 (demolition cost) = P7,450,000.

Journal entry:

8/18/2021 Land P3,950,000

                           Building P7,450,000

                                                  Cash P11,400,000

To record purchase of land and building a new building

Conclusion:

Recording of Property Plant and Equipment varies depending on the mode of acquisition. Moreover, it is all subject to accounting standards. This is just one account of the many accounts in the financial statements. Now if you understand the measurement of this account title then you can also do bookkeeping. Bookkeeping and accounting is a simple addition and subtraction. The standards and guideline is what makes it difficult. Because you have to know the standards and guidelines before coming up to what arithmetic operation to use. The illustrations somehow help you do so. The question is what’s next. You might want to check the related blog which is the depreciation expense.

Related Blog: Depreciation

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1.) Principle of Regularity

Talks about the principles that accountants should use systematic policies. Otherwise, rules and regulations. The absence of such creates different directions. It also creates diverseness. As a result, financial statements are misleading. For instance, the recording of income. Recording of income has two options that are outright or staggered. If agreed to record income outright, accountants of a company should follow the rules. That being the case, every accountant next to the old will understand the history of records. Moreover, the accountant will relate the next recording of transactions.

2.) Principle of Consistency

This principle is about the consistency of standards used throughout the financial reporting process. For instance, a company used an accrual basis of accounting. The accrual basis of accounting means the financial statements have accounts receivables and payables accounts. This accrual method should be used throughout the financial reporting. Or else, it violates the principle of consistency so as the principle of regularity. The result is unreliable financial statements. Investors and Entrepreneurs don’t want to invest in unreliable financials.

3.) Principle of Sincerity

The principle of sincerity is GAAP compliance. Accountants are committed to accuracy and impartiality. For instance, the accuracy of recording of transactions. It is a mortal sin for an accountant to force the balances of accounts. Accountants make sure that they record the exact amount stated in documents or receipts to the best of their knowledge and ability.

With regards to impartiality, accountants follow records objectively. The power is in the accountants. They have recording options that are acceptable. That being the case, they might record income early or expense late. Especially if it’s preferring the benefit of one person over another for improper reasons. But because of this principle, accountants follow the rules and records transaction objectively regardless of whether it’s beneficial to the company or not. That’s why sometimes it’s advisable that entrepreneurs have knowledge of accounting. So that they can understand their business and manage it well. Moreover, they can assess if the accountant is messing up with them. It’s stressful if an accountant messes up with records. It cost money and so much time just to fix the mess. In reality, it rarely happens but it’s a serious thing.

4.) Principle of Permanence of Methods

The principle of Permanence of Methods talks about fixed or permanent records. For instance, the historical cost principle. Under the historical cost principle, fixed assets are recorded at acquisition price. The acquisition price on fixed assets is permanent. The company cannot change its price whatever happens. That’s why there is a depreciation process in accounting to decrease the price of fixed assets indirectly.

5.) Principle of Non-Compensation

This principle reports the company’s performance whether positive or negative. For instance, the pandemic fortuitous event. The accountant knew that putting allowances for a doubtful account will result in a net loss to the company. Even if the accountant knew, he/she will still record allowances to all doubtful accounts during this pandemic event.

6.) Principle of Prudence

The principle of Prudence talks about the fair presentation of financial data. The accountant takes into account the identified and expected risk and losses. For instance, no record of impairment loss on land. Although under the record is the acquisition price, it should be appraised every now and then as needed to meet the criteria of fair reporting of financial statements. Another example is the retirement benefits especially if it’s in the policy to give retirement pay to employees. Even though it takes time before this obligation arises, it should be recorded because it is expected. Otherwise, the understatement of financial liability.

7.) Principle of Continuity

It talks about continuity. The assumption is that the company will operate continuously regardless of events or circumstances. Management usually formulates a continuity plan. For instance, fortuitous events like earthquakes, heavy storms, recent pandemic events, and others. Management has plans to execute at times like these. They might divide employees into two teams. Another is they might set up a backup server in a different place far from the existing one. Usually, a continuity plan is good for 3-6 months. This is an exemption to the pandemic event that took years. 

8.) Principle of Periodicity

This talks about the standard accounting period of reporting. For instance, the recording of income and expenses. The company may record weekly, monthly, quarterly, or annually based on appetite.  

9.) Principle of Materiality

This principle is one of the most observed in 10 GAAP principles in accounting. This principle talks about the cost impact of assets, liability, or capital. The cost is material if the cost will have a significant impact on the company. If so, then the cost can be capitalized. Capitalized means instead of recording as an expense, it is recorded as an asset subject for amortization or depreciation. With regards to liability, the retirement benefit example, the company may record it on a staggered basis. Retirement benefits have a significant impact on the company. Another example is the purchase of IT expenses like computer parts. Some IT expenses have minimal cost but some have significant value like computer memory. Materiality is also based on how small or big the business is.

10.) Principle of Utmost Good Faith

The principle that talks about honesty. All involved parties are assumed to be in good faith. Good faith when it comes to starting the business, running the business, and so on. For instance, selling the business. All information in selling the business should disclose to the buyer regardless of how good or bad the operation is. Some buyer does due diligence before buying. To assure that all figures in the financial statements exist and are correct.

Learn more about Accounting Principle

Related Blog: Accounting Best Practice and GAAP Compliance; Bookkeeping Services

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Three factors you need to know:

First, determine the correct acquisition cost of the long-term assets. The cost for depreciation must be correct. Otherwise, the depreciation expense is understated or overstated. It could somehow make the financial statements wrong especially if the amount is material. 

Second, determine the estimated life of the asset. For instance, a truck is depreciated over its total mileage. In this case, the life of truck is the estimated total miles traveled. SYD is used as a denominator to get the fraction to be multiplied by monthly miles traveled. There will be no depreciation expense to any additional miles from the estimated total miles (denominator use). However, future purchase trucks will have new estimated total miles based on the previous experience of the same assets (truck). Remember that long-term assets like a truck are depreciated in different methods. In this example, we use the units-of-activity method. Aside from the units-of-activity method, we also have the straight-line method. In addition, the declining balance method, double declining, and sum-of-the-year method. 

The third is estimated salvage value. Otherwise, residual value. It is the estimated value of the asset at the end of its useful life or upon disposal.

What is Depreciation?

Depreciation means the cost allocation of long-term assets. It is an expense account. The journal entry to record the expense is a debit to depreciation expense and a credit to accumulated depreciation. The normal balance of depreciation expense is debit. A debit to depreciation expense will increase and a credit will decrease the depreciation expense account. The normal balance of accumulated depreciation is credit. A credit to accumulated depreciation will increase and a debit will decrease the account. It is a contra asset account which means a deduction related to its asset account. Contra asset account – presented in financial statements next to the related asset account. Moreover, indented to emphasize that it is a deduction to its related account.

Depreciation conventions

1.) Nearest month convention – depreciation is based on the approximate acquisition month of the asset.

2.) Full-year convention – full depreciation on the year of acquisition. In addition, no depreciation on the year of disposal. 

3.) Half-year convention – Half-year depreciation on the year of acquisition and the year of disposal

4.) Last year convention – No depreciation on the year of acquisition and full depreciation on the year of disposal 

Methods of Depreciation

1.) Straight Line Method

The computation of the straight-line method is equivalent to cost less salvage value over its useful life. Depreciation ends when the asset reached the salvage value. Otherwise when fully depreciated. Most of the companies used the straight-line method. Because it is easy to compute. Moreover, its corresponding values.

Illustration:

Given:

Cost of an asset (Office Equipment) – P100,000

Useful Life: 5 years

Salvage Value: 10,00

2.) Declining Balance Method

The formula of the Declining balance method is carrying amount multiplied by the rate over its useful life. Carrying amount means the book value of an asset. Often called the accelerating method. Because the depreciation is higher in the early years. And lower in later years. Some companies prefer this method because of the reason that assets perform best during the early years. Moreover, the output is greater during in early years.

Illustration:

Illustration:

Given:

Cost of an asset (Office Equipment) – P100,000

Useful Life: 5 years

Salvage Value: 10,000

Rate: 150%

Computation of Declining Balance Method and Double Declining Balance Method:

Note: Salvage value is not included in the declining balance method. Notice that the adjustment is made at the end of its useful life to end with the estimated salvage value. Instead of P5,880, the depreciation is P9,600. The double-declining balance method is almost the same as the declining balance. Instead of 1.50 multiply by 2.  

3.) Sum of the Year Digit (SYD) Method

SYD is computed first in this method. SYD is the total descending useful life of the asset. For instance, the SYD of 5 years is 15 computed as (5+4+3+2+1=15) or n(n+1)/2 where n is the total estimated life. Cost allocation expense is equal to cost less salvage value multiply by remaining useful life over SYD. Otherwise cost less salvage value multiply by SYD rate. 

Illustration

Given:

Cost of an asset (Office Equipment) – P100,000

Useful Life: 5 years

Salvage Value: 10,000

Rate computation:

1st Year: 5/15 = 33%

2nd Year: 4/15 = 27%

3rd Year: 3/15 = 20%

4th Year: 2/15 = 13%

5th Year 5: 1/15 = 7%

For a total of 100% Table of computation

Related blog: Depletion and Bookkeeping Services

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1.) Accounting Equation in Basic Accounting Terms

Accounting Equation – is the accounting identity. In the accounting equation, the asset should be equal to liabilities and owner’s equity combine. Another term for the asset is the total resources. In the overall resources, part of it is the initial investments or capital. The initial investment can generate income. To generate income, the business firm should do business operations.

Besides the income, to run the operations business firm has to pay for expenses either cash or on account (terms). Once the expenses incurred on account, the company has obligations or liabilities. If the income is on account, then the company has accounts receivable. Asset account, Liability account, Owner’s Equity account, Income account, and Expense account are the expanded accounting equation.

The Financial Statement

The financial statement composes of these five major accounts. Under each major account comprises several account titles. Account titles are classified as either asset account, liability account, owner’s equity account, Income account, and Expense account. Account title has normal balances namely debit balance and credit balance. Debit balance is the left side of the account title and credit balance is the right side of the account title. Account title is the determining factor. It determines whether the debit or credit entry is an addition or subtraction to the account. Asset and Expense account normally is a debit balance.

Liability, Owner’s Equity, and Income account normally is a credit balance. Posting an amount to the left side of the asset and expense account will increase both accounts. Conversely, posting on the right side of the asset and expense account will decrease the value of both accounts. Entry posted to the right side of liability, owner’s equity, and income will increase all accounts. However, entry posted to the left side of these three accounts will decrease the accounts.

2.) Journal Entry

Journal Entry – an accounting process to record identified economic events (transactions). The double-entry accounting method follows in making journal entries. Journal entry composes of debit entry credit entry. Entry/entries made to an account/s should always have a partner entry/entries. Debit entry should be equal to credit entry. See double-entry accounting rules.

Components of recording transactions:

a.) Account titles – account names to an item to identify the type of account.

                b.) Amount – a quantity of something. Represents the value of debit and credit.

                c.) Date – the day specified by a number. It is when the transaction takes place.

                d.) Description – explanation/s why you made the journal entry/ entries.

                e.) Debit and Credit – left side and right side of account respectively.

3.) Ledger

Ledger – often called the T-account. It is where we post the journal entries. All account titles recorded in the journal entries should make a ledger for the computation of total balances. A ledger has an account title, beginning balance, debit amount and/or credit amount, and ending balance. Account title is the basis of arithmetical operation. For instance, if the account title Cash has a debit entry it is an addition while credit entry is a subtraction. Another example, if the account title is an income account, a credit entry is an addition while a debit entry is a subtraction.

4.) Trial Balance

Trial Balance – the purpose of the trial balance is to bring both debit amount and credit amount balance or tally. Once balances are both tallies you can prepare financial reports for interested users. Moreover, if there are wrong posting of accounts it should correct by making adjusting journal entries. Adjusting entries are for the same ledgers and reflected trial balances to get adjusted balances.

5.) Matching principle

Matching principle – It is one of the accounting principles you need to remember. One of the bases of the bureau of internal revenue (bir) in computing taxes. The matching principle is the revenue recognition principle. It states that you should record revenue when earned and expense when incurred.

6.) Accruals and Deferrals

Accruals and Deferrals – the purpose of accruals and deferrals is to correct the figures stated in the financial statements. The accrual basis of accounting is in recording transactions. It is the recognition of the occurrence of something.

Example of Accruals in Basic Accounting Terms:

a.) Accrued expense – Interest earned from time deposit. A time deposit is a long-term deposit, interest-bearing with maturity. To follow the matching principle, you should accrue income earned even though the time deposit has not matured.

b.) Accrued expense – taxes and 13th-month pay. Taxes are usually a huge amount of expenses that’s why business firms accrue expenses monthly. The same is true with 13th-month pay it needs accrual because the expense is good for the entire year.

c.) Allowances – impairment loss allowance and allowance for bad debts. Impairment loss allowance is an allowance to degrading the value of the land. There should be an allowance to land so that the declared assets are in fair market value. We set allowance for bad debt to doubtful accounts. Debtors sometimes can’t pay their installment or amortization for 2-3 consecutive months.

When this occurs, you should set an allowance for possible bad debts. You don’t need to wait until the account became bad debt before you recognize and expense. Good thing there is accrual accounting. It prevents the business firm from recording huge expenses for one day. Huge expenses happen gradually it doesn’t happen in one day. In bookkeeping, the bookkeeper should identify the factor/s that may affect the financials in the future to set an allowance.

Example of Deferrals in Basic Accounting Terms:

a.) Airline tickets – Passengers buy tickets ahead of time. It is recorded as deferrals because cash is paid in advance but the service is not yet rendered.

b.) Prepaid rent – rental payment is paid in advance but the rental income is not yet earned. The rental income is recorded as deferred income or liability account.

7.) Cost principle

Cost principle – in this principle the recording of transactions is based on historical cost, not the current fair market value. This applies to land, loans, furniture, fixture, and equipment

8.) Premium and Discount

Premium and Discount – Premium the paid amount is more than or above the stated value of the account. For instance, in bond investment – any amount that exceeds the value of the bond certificate is a premium. However, if the paid amount is less than the value of the exchange, the difference is a discount.

9.) Depreciation and Amortization

Depreciation and Amortization – Depreciation is an expense gradually recorded based on the useful life of a fixed asset. Fixed assets normally cost a huge amount, it can’t be recorded as an expense one time. The depreciation method is used to decrease the value of a fixed asset. Amortization is the schedule of the amount computed periodically until maturity. In the amortization schedule, you can see the value of an asset account over time.

10.) Financial Statements

Financial Statements – these are the records of the financial affairs of a business. Transactions are recorded using double-entry accounting (Journal entry). The journal entries are posted to ledgers to summarize the amounts. The ending balances per ledger are carried over to trial balances. If the trial balance is tally, you can prepare the financial reports or financial statements Need help with bookkeeping services? Contact us.

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