1. The inventory at your company consists of computer software that the company has developed and is selling. You capitalized (rather than expensed) the cost of duplicating the software, the instruction manuals, and training material that are sold with the software. 985 Software: 330 Inventory: 25 Recognition 25-1 The costs incurred for duplicating the computer software, documentation, and training materials from the product masters and for physically packaging the product for distribution shall be capitalized as inventory on a unit-specific basis.
The cost of duplicating the software, instruction manuals, and training materials that are sold with the software is capitalized and amortized to current and future periods. Any costs incurred beyond the Research and Development stage can be capitalized when it is pertaining to the development of software that is to be sold, leased, or otherwise marketed to third parties. Standard 985-330-25-1 applies to these costs as the FASB ASC defines the Product Masters as “a completed version, ready for copying, of the computer software product, the documentation, and the training materials that are to be sold, leased, or otherwise marketed”.
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The company has established technological feasibility for the software product and no longer has to charge to the R&D expense the costs incurred in creating the product. Technical feasibility is established when the company has the capability, in terms of software, hardware, personnel and expertise, for the completion of the project. The materials have obviously surpassed the Research and Development stage if they have been prepared for the duplication stage.
All R&D costs are expensed until technological feasibility; and it not until this point that some future development costs can be capitalized. There are no clear guidelines on this matter, but the Financial Accounting Standards Board did issue Interpretation No. 6, Applicability of Statement No. 2 to Computer Software (an interpretation of FASB Statement No. 2 February 1975). The bottom-line is up to the accountant and the company and how they would prefer to approach the capitalization of software costs which is not always black and white.
From an aggressive approach, the company is permitted to capitalize some future development costs to raise their current period income and assets and to lower their future period incomes. The conservative approach, on the other hand, would be to expense these costs which would consequently reduce the current operating cash flows. Whereas, the aggressive approach permits companies to record these capitalizations in the investing section of the statement of cash flows rather than the operating section which results in a comparatively higher operating cash flow.
If companies choose the aggressive approach, the capitalized software costs be establish a proper amortization pattern for such costs – either the Percent-of-revenue approach or the Straight-line approach. The company must use the approach with the greatest amortization charge. If the Straight-line approach fits the situation, the reported cost of the capitalization must be spread over the assumed economic life of the item – typically 3 to 5 years for Information Technology. Otherwise, the amount of amortization charged will be the ratio of current revenues to current and anticipated revenues.
The company has chosen the aggressive approach in capitalizing the costs (treating them as an asset) to benefit the company in the present and to reduce the income in the future periods through amortization. They adhered to GAAP principles and chose the path that would be most beneficial to them in the income statement. They established technical feasibility and proceeded to capitalize the costs incurred for the software and its related documentation. Intermediate Accounting 14 Edition, Kieso, Weyandt and Warfield. Shaw, H. Software Capitalization Clouds Comparisons. 2006. http://www. cfo. com/article. cfm/6994798? f=related] 2. Your company paid $2,000,000 for a 30-second commercial to be aired during the Super Bowl 5 months from today. The ad has already been produced at a cost of $1,000,000. You capitalized the $2,000,000 cost of showing the ad on television rather than expensing it. 340 Other Assets and Deferred Costs: 20 Capitalized Advertising Costs: 25 Recognition Criteria to Capitalize Direct-Response Advertising Costs 25-4 The costs of direct-response advertising shall be capitalized if both of the following conditions are met: a.
The primary purpose of the advertising is to elicit sales to customers who could be shown to have responded specifically to the advertising. Paragraph 340-20-25-6 discusses the conditions that must exist in order to conclude that the advertising’s purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising. b. The direct-response advertising results in probable future benefits. Paragraph 340-20-25-9 discusses the conditions that must exist in order to conclude that direct-response advertising results in probable future benefits.
The cost of the 30-second commercial ($2,000,000) is capitalized (treated as an asset) until the ad airs for the first time and will be amortized over future periods. Advertising costs are expensed when the related revenue is recognized which will be the first appearance of the ad in direct-response advertising. The company’s obligation for advertising expenditures it will make subsequent to recognizing revenues related to the accrued costs and to expense the costs when the company recognizes these related revenues.
The $1,000,000 development costs (idea development, advertising copywriting, artwork, printing, audio and video crews, actors, etc. ) of the commercial has yet to result in any significant income and thus can be recorded as assets. The Journal of Accountancy states that “the IRS has ruled that advertising must be capitalized only in unusual circumstances where it is directed at obtaining future benefits greater than those associated with ordinary product advertising or institutional or goodwill advertising”. The success of this direct-response advertising cannot be measured without viewership.
As the FASB ASC states, the cost of the direct-response advertising shall be capitalized until its first appearance because its primary purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising and to result in probable future results. Even though “the AcSEC concluded the future economic benefits of most advertising cannot be measured with the degree of precision required to report an asset in the financial statements” (Tanenbaum and Volkert), the company can still reasonably estimate probable future benefits.
According to the FASB ASC, “The probable future benefits of direct-response advertising activities are probable future revenues arising from that advertising in excess of future costs to be incurred in realizing those revenues”. Demonstrating that direct-response advertising will result in probable future benefits requires persuasive evidence that its effects will be similar to those of past direct-response advertising that resulted in future benefits.
The company chose to capitalize the Direct-Response advertising cost to raise their current period income and assets and to reduce their future revenues. The amounts reported as assets will be amortized over the estimated benefit period based on the proportion of current-period revenue from the advertising to probable remaining future revenues (Tanenbaum and Volkert). The company chose capitalization and amortization in hopes that the future benefits outweigh the present costs – being beneficial in not only the short run, but the long run as well.
Intermediate Accounting 14 Edition, Kieso, Weyandt and Warfield. Maples, L. and Earles, M.. When Should Advertising Be Capitalized? 1999. [http://www. journalofaccountancy. com/Issues/1999/May/maples. htm] Tanenbaum, J. and Volkert, L.. Reporting on Advertising Costs. 1993. [http://www. questia. com/googleScholar. qst? docId=5001669311] 3. Your company sells a product in which the “right of return” exists. The amount of future returns cannot be reasonably estimated, therefore, you do not record the sale or cost of goods sold until the return privilege has expired. 05 Revenue Recognition: 15 Products: 25 Recognition Sales of Product when Right of Return Exists 25-1 If an entity sells its product but gives the buyer the right to return the product, revenue from the sales transaction shall be recognized at time of sale only if all of the following conditions are met: a. The seller’s price to the buyer is substantially fixed or determinable at the date of sale. b. The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product.
If the buyer does not pay at time of sale and the buyer’s obligation to pay is contractually or implicitly excused until the buyer resells the product, then this condition is not met. c. The buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product. d. The buyer acquiring the product for resale has economic substance apart from that provided by the seller. This condition relates primarily to buyers that exist on paper, that is, buyers that have little or no physical facilities or employees.
It prevents entities from recognizing sales revenue on transactions with parties that the sellers have established primarily for the purpose of recognizing such sales revenue. e. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer. f. The amount of future returns can be reasonably estimated (see paragraphs 605-15-25-3 through 25-4). Because detailed record keeping for returns for each product line might be costly in some cases, this Subtopic permits reasonable aggregations and approximations of product returns.
As explained in paragraph 605-15-15-2, exchanges by ultimate customers of one item for another of the same kind, quality, and price (for example, one color or size for another) are not considered returns for purposes of this Subtopic. Sales revenue and cost of sales that are not recognized at time of sale because the foregoing conditions are not met shall be recognized either when the return privilege has substantially expired or if those conditions subsequently are met, whichever occurs first. It is the practice in some industries for customers to be given the right to return a product to the seller under certain circumstances.
In the case of sales to the ultimate customer, the most usual circumstance is customer dissatisfaction with the product. For sales to customers engaged in the business of reselling the product, the most usual circumstance is that the customer has not been able to resell the product to another party. According to the FASB ASC, if an entity sells its product but gives the buyer the right to return the product, revenue from the sales transaction will only be recognized at the time if the six conditions have been met in principle 25-1.
In this scenario, the sales revenue and cost of sales are not recognized at time of sale because the six conditions have not been met and the revenue shall not be recognized until the return privilege exists. “If there is considerable uncertainty regarding the amount of potential sales returns, then a company may be forced to not recognize any revenue at all until the right of product return has passed” (Putra). The company is forced to not record the sale or cost of goods sold at the time of the sale because the amount of future returns cannot be reasonably estimated (Condition 25-1 F is not met).
A company typically takes this approach if it foresees a high rate of returns. It only make sense to postpone recording the sales on the books until the return privilege has expired – only at that time have the risks and rewards of ownership have transferred. Otherwise, we could assume that one of the other conditions (disregarding Condition 25-1 F) have not been met such as the seller’s price was not fixed or determinable during the initial transaction. The buyer has the duration of the privilege to return their merchandise which would decrease the amount of sales on the seller’s books.
There is no assurance that the products are successfully sold until the privilege has expired and no goods have been returned to the buyer. In the case that there are goods returned to the buyer, the seller decreases the associated sales revenue and cost of sales of the actual returns. The company has to take this approach to ensure the sales are recorded accurately. Intermediate Accounting 14 Edition, Kieso, Weyandt and Warfield. Revenue Recognition When Right of Return Exists. Putra. 2008. [http://accounting-financial-tax. om/2008/12/revenue-recognition-when-right-of-return-exists/] 4. Your company has goods primarily held for resale. You have been asked whether or not they are considered nonmonetary assets. 845 Nonmonetary Transactions 10 Overall 05 Overview and Background Nonmonetary Exchanges 05-6 Many nonmonetary transactions are exchanges of nonmonetary assets or services with another entity. Examples include the following: a. Exchange of product held for sale in the ordinary course of business (inventory) for other property as a means of selling the product to a customer . Exchange of product held for sale in the ordinary course of business (inventory) for similar product as an accommodation – that is, at least one party to the exchange reduces transportation costs, meets immediate inventory needs, or otherwise reduces costs or facilitates ultimate sale of the product—and not as a means of selling the product to a customer c. Exchange of productive assets—assets employed in production rather than held for sale in the ordinary course of business – for other productive assets or for an equivalent interest in other productive assets.
For example: 1. Trade of player contracts by professional sports organizations 2. Exchange of leases on mineral properties 3. Exchange of one form of interest in an oil-producing property for another form of interest 4. Exchange of real estate for real estate. Nonmonetary assets are assets (equipment, inventory, land, or plant) that do not have a fixed exchange cash value, but whose value depends on economic conditions. They are items whose price in terms of the monetary unit may change over time.
Whereas, monetary assets – cash and short-term and long-term accounts and notes receivable – are fixed in terms of units of currency by contract or otherwise. Inventories are short-term corporate assets, which a company usually purchases (for resale) or manufactures in its production facilities. Inventory is usually classified as (a) finished goods (goods held for resale), (b) work in process, or (c) raw materials.. Inventories are considered short-term assets, as they serve in operating activities for less than 12 months. Nonmonetary assets are non-physical resources that are quickly convertible into cash.
Monetary assets include securities and other investment instruments, such as bonds, stocks and options. Goods held for resale are recognized as inventory and thus fit the definition of nonmonetary assets overall and through the nonmonetary transactions of the company. According to the FASB ASC, many nonmonetary transactions are exchanges of nonmonetary assets or services. The example of a nonmonetary transaction that stands out the most to me is the: “Exchange of product held for sale in the ordinary course of business (inventory) for other property as a means of selling the product to a customer” (Madray).
This citation clarifies that inventory (goods held for resale) are classified as nonmonetary assets when it comes to using them within nonmonetary transactions. The only case in which a nonmonetary asset would be considered a monetary asset would be if the transaction included a boot (cash). The exchange would now be considered a monetary transaction. Goods held for resale are nonmonetary assets just the same as property, plant and equipment. Intermediate Accounting 14 Edition, Kieso, Weyandt and Warfield. Accounting for Inventory Costs and Nonmonetary Exchanges. [http://www. do. com/publications/assurance/finrptnl/fr_feb_05/nonmonetary. asp] Madray, J.. Special Issues Related to Nonmonetary Transactions. [http://www. madray. com] 5. Your company has an unconditional legal obligation to perform an asset retirement activity (asset retirement obligation) in the future. The only uncertainty is whether the obligation will be enforced. Should you record the asset retirement obligation? 410 Asset Retirement and Environmental Obligations: 20 Asset Retirement Obligations: 25 Recognition Obligations with Uncertainty in Timing or Method of Settlement 5-7 The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Thus, the timing and (or) method of settlement may be conditional on a future event. Accordingly, an entity shall recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. In some cases, sufficient information about the timing and (or) method of settlement may not be available to reasonably estimate fair value.
An expected present value technique incorporates uncertainty about the timing and method of settlement into the fair value measurement. Uncertainty is factored into the measurement of the fair value of the liability through assignment of probabilities to cash flows. The unconditional obligation associated with the retirement of plant, property or equipment should be recognized whenever the fair value of the liability can be reasonably estimated. The Securities and Exchange Commission prefers that the recognition of the liability should not be delayed by the company due to significant uncertainty.
They argue that if the liability is within a range, and no amount within the range is the best estimate, then management should recognize the minimum amount of the range. “Unfortunately, in many cases, zero may arguably be the low point of the range, resulting in no liability being recognized” (Kieso, Weyandt and Warfield). Both FASB Interpretation No. 47 and FASB ASC Standard 410:20:25:7 acknowledge instances in which a lack of necessary information prevents a company from making a reasonable estimate of the fair value of an asset retirement obligation because the timing and/or method of settlement is uncertain.
The FASB states that the timing and/or method of settlement is uncertain when: (1) the settlement date and the method settling the obligation has not been specified, (2) the company does not have the necessary information to estimate reasonably the settlement date or the method of settlement or the probabilities associated with potential settlement dates and methods of settlement. In this instance, both the timing and method of settlement are uncertain because there is a concern that the obligation will not be enforced.
Even though there is a concern that the obligation might not be enforced, the company should still have sufficient information to apply an expected present value technique to incorporate the uncertainty about the timing and method of settlement into the fair value measurement. With the concern being whether or not the company will be required to perform the activity, the Interpretation states that the company should assign a 50 percent probability to both outcomes – performing the activity and not performing the activity.
The summation of these calculations should be recorded on the books as an asset retirement obligation liability. According to the FASB, ARO (asset retirement obligation) fall into the scope of liabilities, or “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events”.
Whether recording the minimum of the range as recommended by the SEC or applying the 50 percent profitability to outcomes according to the Interpretation, the application will will result in (a) more consistent recognition ARO liabilities, (b) more information about expected future cash outflows associated with the ARO, and (c) more information about investments in long-lived assets because additional asset retirement costs will be recognized as part of the carrying amounts of the assets to be retired.
Intermediate Accounting 14 Edition, Kieso, Weyandt and Warfield. Trapani, D. ,Sarno J. , and Moline, D.. Heads Up. 2005. [http://www. deloitte. com/assets/Dcom-UnitedStates/Local%20Assets/Documents/AERS/ASC/us_assur_heads_up_040405. pdf] 6. You use accounting accruals to record probable loss contingencies. Does the recording of the accruals provide financial protection, for example, is it the same as setting aside specific assets to cover the probable claims? 450 Contingencies: 20 Loss Contingencies: 05 Overview and Background
Accruals of Loss Contingencies Do Not Provide Financial Protection 05-8 Accrual of a loss related to a contingency does not create or set aside funds to lessen the possible financial impact of a loss. Confusion exists between accounting accruals (sometimes referred to as accounting reserves) and the reserving or setting aside of specific assets to be used for a particular purpose or contingency. Accounting accruals are simply a method of allocating costs among accounting periods and have no effect on an entity’s cash flow.
Those accruals in no way protect the assets available to replace or repair uninsured property that may be lost or damaged, or to satisfy claims that are not covered by insurance, or, in the case of insurance entities, to satisfy the claims of insured parties. Accrual, in and of itself, provides no financial protection that is not available in the absence of accrual. The Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. The Company defends itself vigorously against any such claims.
One of these claims could be an existing loss contingency which is an uncertain situation involving potential loss depending on whether some future event occurs. Examples of loss contingencies include injury or damages caused by products sold and risk of loss or damage of property by fire, explosion, or other hazards. The verdict in this case is even though it is permissible to record an accrual for the loss of contingency as a liability on the books, the accrual provides no financial protection for the organization.
FASB ASC Standard 450:20:05:8 states that an “Accrual, in and of itself, provides no financial protection that is not available in the absence of accrual”. Even though the accrual method is generally accepted when recording loss contingencies as liabilities, they do not create or set aside funds to lessen the financial impact of a loss. Companies are permitted to records accruals on their books when the information available prior to the issuance of the financial statements indicates that it probable that a liability has incurred at the date of the financial statements and the amount of loss can be reasonably estimated.
A company can us its own experience, experience of other companies in the industry, engineering or research studies, legal advice, or educated guesses by qualified personnel to determine a reasonable amount of loss (Kieso, Weyandt and Warfield). Regardless of the liability recorded on the books, “accruals in no way protect the assets available to replace or repair uninsured property that may be lost or damaged, or to satisfy claims that are not covered by insurance, or, in the case of insurance entities, to satisfy the claims of insured parties”.
According to the FASB ASC, it is the company’s responsible to keep or obtain sufficient assets to replace or repair lost or damaged property or to pay claims if a loss occurs. Another option for financial protection would be to purchase insurance – vicariously transferring the risks to them. Obtaining the insurance reduces risks and the inherent earning fluctuations that accompany the risks. Regardless of the decision to protect the company from the loss contingency, the accrued credit balance will have no effect on the balance sheet. Intermediate Accounting 14 Edition, Kieso, Weyandt and