Chapter 6: Revenue and expense measurements.
Accelerated depreciation methods
Accelerated methods of depreciation
Accrual Adjusted Net Farm Income
Estimated useful life
Extraordinary gains and losses
Fraction of the year
Government loan programs
Net Farm Income
Net of tax
In Chapter 5, you learned the difference between an unadjusted trial balance and an adjusted trial balance; how to prepare financial statements; how to add adjustments to cash-basis financial statements to convert them into accrual-adjusted financial statements; how to prepare financial statements with market values; how to record closing journal entries and why it is necessary to record them; and how to calculate adjustments after the first year of operation.
You now have an understanding of accounting procedures. This is the first of four chapters that delve more deeply into the accounting principles and calculations involved in recording transactions and preparing financial statements. Performing calculations for financial statement items is often called measurement. You will learn about how to derive the numbers for transactions like those in Chapters 3, 4, and 5. Knowing how to perform these measurement procedures helps make financial statements understandable and reliable. The consistent use of these procedures allows for comparability from one year to the next or between farms.
This chapter introduces the rationale for the accounting procedures for revenues and expenses, including revenue recognition, and how it applies to the agricultural industry. You will learn how to account for government loans and how to calculate gains and losses, and will study the terms and methods related to depreciation. This chapter also teaches you how to calculate interest and Net Farm Income and, finally, how to define and recognize an extraordinary item.
Recall that you learned in Chapter 1 that one characteristic of useful financial statements is reliability for evaluating the financial position and financial performance of the farm operation. Reliable source documents can verify the information in the financial statements. The dollar amount of many revenue and expense items is easily determined from the source documents, but sometimes the amounts have to be calculated. In those cases, notes to the financial statements should verify the amount by disclosing information about the calculations. The disclosures are necessary because you can use more than one method of calculation for some items. Farm managers and accountants must be able to explain to outsiders the basis for the calculations for any specific operation. Without the knowledge of these methods, evaluations would be incomplete, and comparisons with previous years' financial statements or with other farm operations would most likely not be very useful.
At this point in your study of agricultural accounting, you should be familiar with the accounting procedures for such transactions as the selling of crops, market livestock and poultry, and livestock products (Chapter 3), and for changes in inventory and changes in accounts receivable in the accrual-adjusted system (Chapter 4). In this chapter's section on revenue recognition, you will learn about the rationale for reporting changes in inventories. Instead of just knowing how to report changes in inventory, you will know why to report these changes. Other topics in this chapter include reporting of revenue from government loans, and calculating gains and losses from selling and trading non-current assets.
You have also learned to record the cash expenses of a farm operation (Chapter 3). You are familiar with the accounting procedures for reporting year-end adjustments, such as changes in interest payable, changes in accounts payable, changes in prepaid insurance, changes in growing crops, and change in taxes payable in an accrual-adjusted system (Chapter 4). In this chapter, you will learn how to calculate depreciation and interest. You will also learn about the significance of the income statement item called Net Farm Income, used to evaluate the financial performance of the farm business. This chapter concludes with a discussion of a special topic called extraordinary items. Extraordinary items are unusual and infrequent circumstances that have a financial impact on the farm business.
Learning Objective 1 * To identify the two main issues for accurate and complete reporting of revenue and the types of revenue that can occur. Learning Objective 2 * To describe the general rule for revenue recognition and the exception to that rule for agricultural accounting.
In addition to verifying financial information from source documents, another feature of reliability in financial statements is accuracy and completeness (to the extent possible). Sometimes estimates have to be made. In those instances, accuracy may be compromised. Nevertheless, there should be a sound basis for the estimate. (We give an example of estimates in the topic of depreciation expense in this chapter.)
Two main issues concern the accurate and complete reporting of revenue. The first is the amount of revenue to record and the other is an issue called revenue recognition. In Chapter 1, you learned that revenue is defined as "money earned by the farm business from the production or sale of farm products." The concept of revenue recognition helps to explain how to determine when revenue has been earned.
Revenues for a farm operation can occur from several sources. Table 6-1 shows common sources of revenue for farm businesses. For some revenue transactions, the amount of revenue is the amount of the money from sales of farm products. In Chapter 3, you learned how to record cash sales. The check and other documents state the amount of each sale. Recall from Chapter 4 that in an accrual-adjusted system, gross revenue also includes "change" items that represent money earned from the production of farm products. Receipts or contracts can verify the amount of money owed to the farm business for calculating the change in accounts receivable. Gross revenue also includes changes in inventories and changes in the values of raised breeding livestock. The value of crop and livestock inventory depends on the amount that was paid when purchased (verified by receipts) or the current market value (verified by quoting a reliable source of market prices and a reasonable estimate of weight or number of units). In Chapter 4, you learned how to report these changes. You will learn more about the accounting procedures for changes in raised breeding livestock in Chapter 8.
Other sources of revenue reported by the farm operation might include money received from government programs and crop insurance claims. Chapter 3 includes an example of the accounting for a payment from a crop insurance claim. In the next section, you will learn about reporting revenue from participating in a government loan program. Later in this chapter, you will read about gains and losses from the sales of culled breeding livestock or other farm assets, and from extraordinary occurrences.
To report revenue as accurately as possible, the farm accountant must know the amount of revenue earned and when it occurred. Revenue recognition concerns when to record and report revenue (see Table 6-2). For most retail and manufacturing businesses, the general rule is that revenue must be recognized (that is, recorded and reported) when the revenue has been earned and when the goods or services are exchanged for cash or accounts receivable. Those two conditions must occur for reporting revenue on the income statement.
* In the first condition, the revenue has to be earned. That means that all of the activities creating the goods or services must be performed, that is, the product is ready for sale.
* In the second condition, an exchange must take place between the seller and a buyer, that is, the goods or services are sold for cash or on account to a buyer.
If a business produces a product, the sale price might not be determined until someone is willing to buy it. If a contract for producing a product exists between a seller and a buyer, but the seller has not produced the product yet, the activities have not yet been performed. In either case, revenue should not be recorded. The product has to be ready and it has to be sold. When these two conditions are met, a revenue transaction can be recorded and reported on the income statement, even if the cash has not yet been received.
Revenue recognition for farm products is somewhat different from the products and services of retail or manufacturing businesses (see Table 6-2). The first condition, that the revenue has to be earned, applies to farm products in the same way as the general rule described above. While raising or growing the grain, livestock, or livestock products, the activities to produce them are not complete. When the crops are harvested, the eggs are gathered, the wool is sheared, the milk is stored, the market livestock have reached an appropriate market weight, and so on, the farm products are ready to sell and the revenue has been earned. Until then, no revenue can be recorded. Only the expenses to produce the products are recorded as they occur.
The second condition in the general rule says that, in addition to the revenue being earned, a sale has to occur. However, revenue can be also recognized for farm products that are ready to sell if the financial statements need to be prepared before selling the product. This is an exception to the general rule above. As illustrated in Chapters 4 and 5, the income statement may report the revenue even though a sale has not yet taken place. Revenue is recognized from the production of farm products. The rationale is that for most farm products, there is little uncertainty about the market price and opportunity for the farm producer to sell the product, because active commodity markets exist.
In some cases, a sale is agreed to in advance of production. This type of situation occurs when a farm producer makes an agreement to deliver a crop after harvest, such as a forward contract, in which the producer is obligated to make delivery. In that case, the sale has already occurred but the product has not been produced, so no revenue is recorded until the product has been produced and is ready to be delivered. The first condition for revenue recognition still holds-that the revenue must be earned before any revenue can be recognized.
PRACTICE WHAT YOU HAVE LEARNED Can you apply the concepts of revenue recognition so that you know when revenue needs to be recorded and reported? Work on Problem 6-1 at the end of the chapter to test your knowledge.
Learning Objective 3 * To record revenue from government loans.
Government loan programs present a unique type of revenue situation. Under government loan programs, a farm producer is allowed to offer crops as collateral for a loan with the Commodity Credit Corporation (CCC) at a specified loan rate (principal) for up to nine months. When the cash is received, the farm accountant would record the transaction for the loan just as you learned in Chapter 3. Like other loans, the CCC loan should be shown as a current liability on the balance sheet (such as Notes Payable due within one year) until the loan is settled.
If the financial statements need to be prepared before the loan is settled, the balance sheet reports the crop pledged as collateral as Crop Inventory. Table 6-3 outlines how you would value the inventory. The balance sheet reports the value of the inventory as either the market value of the crop (on the day that the balance sheet is prepared) or the loan rate, whichever is the higher number. If the market value is higher than the loan rate, the balance sheet reports the loan at the loan rate (as Notes Payable due within the next year) and the crop inventory at market value. According to the FFSC Guidelines, the balance sheet reports the difference between the market value and the loan rate as accrued interest (Interest Payable).
Unlike most other loans, the producer has the option of either repaying the loan or forfeiting the crop to the CCC. A producer who forfeits the crop keeps the cash proceeds from the loan and makes no payment to the CCC. No interest is paid. The cash proceeds are recorded as revenue when title to the crop passes to the CCC. If the producer forfeits the crop instead of paying back the loan with cash, the liability for the loan is removed from the balance sheet and the revenue from government programs is reported on the income statement. The journal entry to record the repayment and the revenue from government programs is as follows:
(Date) 2310 Notes Payable due within one year XXX 4300 Proceeds from Government Programs XXX
If, instead, the producer pays back the loan to the CCC, the payment is recorded in the same way as for any other loan repayment. The producer then sells the crop in the usual manner (or perhaps has already sold it) and the revenue from the sale is recorded as you learned in Chapter 3.
Exercise 6-1 Refer to the Farmers' financial statements in Appendix A. Their balance sheet lists Notes Payable within one year, Interest Payable, and Crop Inventory Raised for Sale. Can you tell from the balance sheet whether they participated in a government loan program? Answer: No. You would have to read the notes to the financial statements and look for an explanation about their liabilities to find out if any of their loans came from a government loan program. Another way to tell is to look at the statement of cash flows to read whether they received any loans from the government. You would look in the financing activities section for an item listed as "Proceeds received from government loan program." There is no such entry for the Farmers. Another question: If the Farmers paid back the government loan or forfeited the crop, how could you tell if the Farmers had participated in a government loan program? Answer: The cash proceeds would be listed as "Proceeds received from government loan program" on the income statement and in the operating activities section of the statement of cash flows.
GAINS AND LOSSES
Learning Objective 4 * To calculate the gain or loss on a sale or trade-in of an asset and to recognize where these gains and losses are reported.
In addition to revenues and expenses, the income statement reports gains and losses. As you learned in Chapter 1, gains are financial benefits from various activities. Losses are the opposite of gains. Gains result in an increase in equity and losses result in decreases in equity. The gains and losses discussed in this section include gains and losses from the sales of culled breeding livestock and gains and losses from sales or trade-ins of other farm assets.
Sale of Farm Assets Other Than Inventory
Revenue is sometimes recorded (as a gain) when farm assets are sold. Sometimes these transactions could result in a loss instead of a gain. The amount of the gain or loss from these sales is the difference between the amount of cash received and the book value of the sold asset. Book value is the current market value of the asset or its original cost minus its accumulated depreciation. These amounts are shown on the last prepared balance sheet. The farm accountant performs two steps (outlined in Table 6-4) to determine the amount of the gain or loss to record after the sale of an asset.
In Chapter 3, the Farmers sold a bull for $900. They had paid $1,000 for the bull when they purchased it. When they sold it to the neighbor, the depreciation amounted to $300. In Step 1, the book value is the original cost minus the accumulated depreciation of the bull. Step 1: Book value = $1,000 - 300 = $700 In Step 2, the $900 cash received is compared to the $700 book value, resulting in a $200 gain. Step 2: Cash received - book value = $900 - 700 = $200 gain
When culled breeding livestock are sold, the gain or loss on the sale is included in the computation of Gross Revenue (see Chapter 1). If other non-current assets (land, machinery, or equipment, breeding livestock not sold as culled) are sold, the gain or loss is reported as Gains/Losses on the Sale of Farm Capital Assets and is added (or subtracted) from Net Farm Income from Operations.
Exercise 6-2 Refer to the Farmers' financial statements in Appendix A. Did they report any gains or losses from the sale of farm assets? If so, what gains or losses did they report and how much were the amounts? Answer: Yes. The Farmers reported a loss of $250 on the sale of culled breeding livestock and a loss of $800 on the sale or trade-in of other farm assets.
Trading in an Old Asset
Trade-ins are slightly more complicated. Gains or losses are determined by comparing the book value of the traded asset and the cash paid for the new asset with the value of the new asset purchased. Step 1 is the same as above. Table 6-5 outlines Step 2 for calculating the gain or loss on a trade-in.
In the Farmers' case of the trade-in of the old tractor for a new one (Chapter 3), the gain or loss is the difference between what they are giving in the deal (the book value of the old tractor and the cash they paid) and what they are receiving in return (a new tractor with a value of $50,000). They had purchased the old tractor for $30,000. It was fully depreciated at the time of the trade-in (accumulated depreciation = $25,000) and, therefore, had a book value of $5,000. Step 1: Book value = $30,000 - 25,000 = $5,000 The dealer gave them a $4,000 trade-in allowance on the old tractor. The purchase price of the new tractor is $50,000. The $4,000 trade-in allowance means that the Farmers had to pay $46,000. Step 2 involves comparing what the Farmers received with what they gave in the deal. They received a $50,000 tractor and they gave a $5,000 tractor and $46,000 cash. The result is a $1,000 loss. Step 2: New asset received - book value of asset given up - cash paid = $50,000 - 5,000 - 46,000 = -$1,000 loss
When non-current assets are traded, the gain or loss is reported as Gains/Losses on the Sale of Farm Capital Assets and is added (or subtracted) from Net Farm Income from Operations.
PRACTICE WHAT YOU HAVE LEARNED At this point, you should be able to calculate gains and losses on sales and trade-ins. Complete Problem 6-2 at the end of the chapter to test your knowledge.
Learning Objective 5 * To explain the meanings of the terms "depreciation expense," "accumulated depreciation," "book value," and "market value." Learning Objective 6 * To calculate depreciation expense using the straight-line method and to describe how to report depreciation in the notes to the financial statements. Learning Objective 7 * To explain the meaning of the terms "tax-based depreciation" and "accelerated methods of depreciation." Learning Objective 8 * To apply various depreciation methods to calculate depreciation expense.
The recording and reporting of many operating expenses is straightforward because the receipt, bill, or canceled check verifies the amount. However, as you learned in Chapters 4 and 5, sometimes the farm accountant has to estimate the amount of an expense by comparing the unused amount at the end of the year with the amount that was unused at the beginning of the year. Estimates are also made for allocating the cost of non-current assets, such as breeding livestock, perennial crops, machinery and equipment, buildings and improvements, and leased assets. The cost is allocated because the asset is used for more than one period. Let us review some definitions and key concepts about cost allocation from Chapters 4 and 5.
* Depreciation is the process of allocating the cost of non-current assets (except land) over the useful life of the assets (the years that the asset will be useful in the farm operation).
* Depreciation expense is the amount of depreciation reported for a single year.
* Accumulated depreciation is a contra account to non-current assets that reports the total amount of the cost allocated since the asset was put into use.
* Land is not depreciated because land is not used up to the point where it cannot be used for some purpose. Land can last forever but other non-current assets last only for a limited period, so the cost of land does not have a time to use in the allocation. Unlike other assets, the farm operation can sell the land virtually in its original form at any time.
* Salvage value refers to the amount that a non-current asset can expected to be sold for at the end of its useful life.
Depreciation is not a method of determining the market value of non-current assets. Market value is the price that a buyer and a seller can agree upon in an exchange of an asset. Frequently, the market value and the book value are not the same for several reasons. The condition of the asset is one circumstance that affects its market value when it is appraised. Book value, on the other hand, is a computation that depends upon the original price of the asset and the method used to allocate its cost. Sometimes the allocation method tracks well with the deterioration of the asset, but not always.
Exercise 6-3 Refer to the Farmers' financial statements in Appendix A. How much depreciation expense did the Farmers report and which financial statement reports it? How much accumulated depreciation did the Farmers report and which financial statement reports it? Answer: The income statement reports the depreciation expense and the balance sheet reports the accumulated depreciation. Both are reported for $22,150 in the Farmers' first year of operation.
To determine the amount of depreciation to record in a given year, three items are required: the original cost of the asset (the purchase price), the estimated useful life (length of time in years that the asset will be used by the farm operation), and any salvage value. The farm accountant estimates the useful life of each asset based on experience in the use of farm assets. For example, a brood cow might have an estimated life of eight years. The farm manager might estimate that the cow could be sold for approximately $250 at the end of her useful life. The $250 represents the estimated salvage value. When the original cost is unknown, the balance sheet reports only the current market value with no depreciation.
The amount of depreciation expense depends on the method used to calculate depreciation. The simplest method of depreciation is the straight-line method, in which the amount of depreciation expense is the same amount each year. Depreciation is calculated in the following manner according to the straight-line method:
Depreciation expense = (Original cost = Salvage value) / Estimated life
The original cost minus the salvage value represents the base or the amount of the cost allocated during the life of the asset. The base is divided by the estimated useful life to determine the amount of depreciation expense to record each year. Depreciation expense is recorded for the same amount every year that the asset is owned and used. Because of the ease of the calculation, many businesses, both farm and non-farm, use this method.
If Steve and Chris assume that the tractor that they purchased for $50,000 (journal entry (7) in Chapter 3) would last about 15 years and they decide to allocate the cost evenly over the estimated 15-year life of the tractor, the depreciation expense is $3,333 per year ($50,000 = 15 years). They make similar calculations for each of their non-current assets. Steve and Chris estimate a 4-year life for the office furniture, a 5-year life for the truck, a 10-year life for the perennial crop, a 15-year life for the leased harvester, and a 25-year life for the farm buildings. The following schedule shows calculations for depreciation expense (using the straight-line method): Asset Cost Life Depreciation Expense per Year Office Furniture $ 1,000 4 $ 250 Buildings, Improvements 110,000 25 4,400 Tractor 50,000 15 3,333 Truck 15,000 5 3,000 Leased Harvester 100,000 15 6,667 Orchard 45,000 10 4,500 Total Annual Depreciation $22,150 The income statement reports the total amount of depreciation expense for $22,150.
For the sake of simplicity, each of the assets in the example had no salvage value. However, most farm operators would agree that some of these assets would have salvage value. In the previous example, the culled breeding cow has salvage value because the cow can be sold for slaughter. If any of the assets listed above would have any salvage value, the salvage value should also be included in the table. The table should be included in the notes to financial statements to clarify for the readers how the amount of depreciation was calculated.
PRACTICE WHAT YOU HAVE LEARNED To practice these calculations, complete Problem 6-3 at the end of the chapter.
The straight-line method is simple to use, but there are other depreciation methods. The amount of depreciation expense that is reported could vary substantially from one farm to another due to different calculations for depreciation. When an outside party compares one income statement with another that uses a different depreciation method, some knowledge of the calculations allows the outside party to analyze this difference accordingly. Although straight-line depreciation is permitted for tax purposes, many businesses are advised to use accelerated methods of depreciation. Accelerated methods calculate a greater amount of depreciation during the early years of the asset's life and less in the later years than the straight-line method would. The amount of depreciation declines each year, so the depreciation expense must be calculated each year. For that reason, accelerated methods create more complexity in record keeping.
Some farm businesses might use tax-based depreciation, which is calculated according to tax rules. The calculations are not presented in this book primarily because tax accountants use this method. Tax-based depreciation is an accelerated method, and more complicated than straight-line depreciation. Even so, many farm accountants might use it to make depreciation expense on the farm financial statements consistent with the amount shown on the tax return. The advantage is that farm accountants do not need to calculate depreciation expense; they simply ask the tax accountant to perform the calculations as if for the tax return, and then they record the amount of depreciation calculated by the tax accountant. However, the financial statements can be prepared using the straight-line (or some other) method while the tax return can be prepared using a tax-based method. The notes to the financial statements should disclose the method of depreciation method used, along with schedules (tables) showing the calculations.
In the straight-line method, depreciation expense is an allocation of the asset's cost evenly throughout the asset's expected useful life. The amount of depreciation expense is the same every year that the asset is used, unless the asset's useful life or salvage value is re-estimated for some reason. Learning Objective 6 in this chapter discusses these changes.
The straight-line method is easy to apply because it only has to be calculated once, when the asset is purchased. The farm accountant records the same amount of depreciation expense each year. Because of its simplicity, this method is the most popular depreciation method for financial reporting. The method is quite useful for buildings and improvements, perennial crops, breeding livestock, and some machinery and equipment because of regular use during its life.
Some machinery and equipment might be used more in some years than others. In that case, an alternative method, called the activity method of depreciation, is appropriate for calculating depreciation expense. To use this method, the farm accountant has to decide on a measure of activity. Because many assets do not have such a measure, this method can be useful only for assets such as vehicles and tractors. Vehicles have an odometer that measures miles and tractors have a similar device that measures hours of use.
* To calculate depreciation expense under the activity method, the farm accountant has to estimate the total amount of miles or hours of operation for the vehicle or equipment during its entire useful life.
* Divide the base by the total estimated hours or miles and then multiply by the amount of hours or miles operated in the current year.
Depreciation expense = (Base / total estimated hours or miles) x actual hours or miles this year.
Activity depreciation expense has to be recalculated each year because the number of actual hours or miles will vary from year to year. However, the activity method is more accurate than the straight-line method for some assets because of the varying amounts of use. It is useful for those assets for which the amount of activity can be measured.
The Farmers estimated that their pickup truck has a useful life of 100,000 miles before they will trade it for a new truck. If they purchased it for $15,000 and they estimate that the trade-in (market) value will be approximately $3,000, then the base is $12,000. If they drove the truck 22,000 miles in the year 20X1, under the activity method they would divide the $12,000 base by the total estimated miles of 100,000 and then multiply that by the 22,000 miles that they drove to determine depreciation expense: Depreciation expense = ($12,000 / 100,000) x 22,000 = $2,640 If the Farmers chose to use the straight-line method and they estimated the useful life of the truck to be five years, then they would calculate depreciation expense as follows: Depreciation expense = $12,000 / 5 = $2,400
Another group of depreciation methods are known as accelerated depreciation methods. In these methods, depreciation expense is quite high the first year and then declines each year. The reason for using one of the accelerated methods is that for some assets, the repair expenses are low when the asset is new and they increase as the asset gets older. To offset the increasing repairs, lower amounts of depreciation expense are recorded as the asset gets older. When the asset is new and repairs are low, the depreciation expense is higher. As a result, net income is more "level" or "smoothed out." These methods are appropriate for assets that require high maintenance costs as the asset gets older, such as machinery or land improvements. The farm accountant has to decide whether these methods would be worth the extra computations required to apply them.
One of the accelerated methods is called the sum-of-years-digits method.
* In this method, the farm accountant multiplies the base by a fraction each year to compute depreciation expense. The fraction is smaller and smaller with each consecutive year, so depreciation expense declines each year. The fraction is based on a mathematical formula that makes this possible.
Depreciation expense = Base x Fraction
* The denominator is the sum of the digits of the estimated years in the life of the asset. A shortcut way to calculate the denominator is the formula [n = (n = 1)] / 2, where "n" is the number of years in the asset's life.
* The numerator in the fraction is the number of years remaining in the asset's life. This number declines every year, so the fraction declines every year.
The Farmers' truck with a 5-year life would have the denominator calculated in this way: 1 + 2 + 3 + 4 + 5 = 15 The formula yields the same result as calculated above: [5 x (5 + 1)] / 2 = [5 x 6] / 2 = 30 / 2 = 15 The numerator in the first year that the Farmers owned the truck is 5. The second year, the numerator is 4, and so on. A depreciation schedule showing how the Farmers calculated depreciation appears in the disclosure notes as follows: Depreciation expense = Basis x Fraction Year 1: $12,000 = (5/15) = $4,000 Year 2: 12,000 = (4/15) = 3,200 Year 3: 12,000 = (3/15) = 2,400 Year 4: 12,000 = (2/15) = 1,600 Year 5: 12,000 = (1/15) = 800 Total $12,000 At the end of Year 5, the truck will be completely depreciated and they will record no more depreciation expense for the truck even if they keep using it.
Another type of accelerated method is called the declining-balance method.
* In this method, the farm accountant multiplies a multiple of the straight-line rate by the book value of the asset (not the base) to calculate depreciation expense. The straight-line rate is 1 / the number of years in the asset's life (n).
Straight-line rate = 1 / n
Depreciation expense x Book value x Multiple x Straight-line rate
* In the first year, the book value is the original cost.
* The second year (and each subsequent year), the book value is the original cost minus all of the depreciation recorded in previous years (accumulated depreciation).
* A multiple of the straight-line rate is some number multiplied times 1 = n. If the multiple were 2, then the straight-line rate of 1 = n would be multiplied times 2. Any multiple can be used, but 1.5 and 2 are common.
Multiple = Straight-line rate = 2 = (1 = n)
* When the book value is close to the salvage value, the amount of depreciation is only the amount that will bring the book value to the amount of the salvage value.
The Farmers' truck has a 5-year life and an estimated salvage value of $3,000. The straight-line rate for the Farmers' truck is 1 / 5. If the Farmers decide to use a multiple of 2, then 2 x (1 / 5) is multiplied by the book value of the truck. In the first year, the book value is the original cost of $15,000. The depreciation expense recorded the first year is: Depreciation expense = $15,000 x 2 x (1 / 5) = $6,000 The next year the book value is: Cost - Accumulated depreciation $15,000 - 6,000 = $9,000 The depreciation expense recorded the second year is: Depreciation expense = $9,000 = 2 = (1 = 5) = $3,600 The book value for the third year is: $15,000 - 6,000 - 3,600 = $5,400 The depreciation expense for the third year is: Depreciation expense = $ 5,400 x 2 x (1 / 5) = $2,160 The book value for the fourth year is: $15,000 - 6,000 - 3,600 - 2,160 = $3,240 The book value is only $240 above the salvage value, so depreciation expense for the fourth year is: Depreciation expense = $3,240 - 3,000 = $240 The book value is: $15,000 - 6,000 - 3,600 - 2,160 - 240 = $3,000
You can see the complexity of these methods in these examples. Because of this complexity, the accelerated methods are less commonly used than the straight-line method.
Table 6-6 compares the depreciation expense under the straight-line, sum-of-years-digits, and declining balance methods for the Farmers' truck. The Farmers would have to decide which of the methods discussed would be the most suitable for each of their non-current assets, and record depreciation expense accordingly. They also have to decide if it would be more suitable, instead, for them to use the depreciation amounts calculated by the tax accountant.
Table 6-6 illustrates the nature of the accelerated methods. Depreciation expense is less each year under the accelerated methods. In Years 1 and 2, the depreciation expense is greater under the accelerated methods than it is under the straight-line method. This situation reverses in later years when the straight-line depreciation expense is greater than accelerated depreciation expense.
PRACTICE WHAT YOU HAVE LEARNED Practice the depreciation methods by completing Problem 6-4 at the end of the chapter.
Learning Objective 9 * To apply depreciation methods to partial periods and revised estimates.
A partial period concerns the depreciation expense for part of the year. The farm accountant generally calculates depreciation expense for an entire year (12 months). If an asset was purchased at the beginning of the year, then the 12-month calculation is appropriate because the farm operation owns and uses the asset for approximately 12 months in the first year. However, most assets are not purchased right at the beginning of the year, so they are owned for only part of the first year. The farm accountant can choose to disregard the partial year, or may record only part of the 12-month depreciation in the year that the asset was purchased (see Figure 6-1).
* To calculate depreciation expense for a partial year, the farm accountant multiplies the amount of depreciation expense for 12 months by the fraction of the year that the asset was owned.
For example, if the Farmers purchased the truck on October 1, 20X1, they owned it for 3 months or 3/12ths of the year 20X1. Therefore, they record only 3/12ths of the depreciation in the year 20X1. Under the straight-line method, this approach is quite easy to apply. The 12-month amount of depreciation is multiplied by 3/12ths. Depreciation expense (for 20X1) = ($12,000 = 5) = 3/12 = $600 For each of the next four years, the amount of recorded depreciation is $2,400, the full 12-month amount. In the last year of ownership, the amount of depreciation is the amount left to depreciate. At the end of the fifth year, the accumulated depreciation is $10,200. 20X1: Depreciation expense = ($12,000 / 5) x 3/12 = $ 600 20X2: Depreciation expense = $12,000 / 5 = 2,400 20X3: Depreciation expense = $12,000 / 5 = 2,400 20X4: Depreciation expense = $12,000 / 5 = 2,400 20X5: Depreciation expense = $12,000 / 5 = 2,400 Accumulated depreciation $10,200 The amount left to depreciate is $12,000 = 10,200 = $1,800. Therefore, the amount of depreciation expense for the year 20X6 is $1,800.
[FIGURE 6-1 OMITTED]
This allocation for partial periods can also be performed for the sum-of-years-digits and declining-balance methods. Appendix J contains an example of calculating partial year's depreciation expense using accelerated methods. The activity method of depreciation does not calculate partial year depreciation expense because that method is not based on time, but rather on use. If an asset is used for only part of a year, depreciation expense is based on only the amount of miles or hours measured for that partial year.
PRACTICE WHAT YOU HAVE LEARNED Calculate partial year depreciation expense in Problem 6-5 at the end of the chapter.
Revised estimates concern re-estimating the useful life of an asset or its salvage value. The farm accountant estimates the length of the useful life and the salvage value when the asset is purchased. Sometimes, as the years go by, these estimates are no longer valid. For example, if a machine is damaged and cannot be used as long as originally thought, the depreciation expense should be recalculated to reflect the remaining number of years in the asset's useful life. If the price of culled breeding livestock changes substantially, the farm accountant should recalculate depreciation expense to reflect the change in salvage value. Only the book value of the asset should be used to recalculate depreciation expense, not the base or original cost.
To recalculate depreciation expense when the useful life or salvage value is re-estimated, the farm accountant should apply the following procedures.
* First, determine the book value of the asset. The amount for accumulated depreciation depends on the depreciation method used and how much time has passed since the asset was purchased.
Book value = Cost - Accumulated depreciation
* Next, subtract the estimated salvage value from the book value to calculate a new base. If you have re-estimated the salvage value, then subtract the new, re-estimated salvage value, not the old salvage value. If the salvage value is the same as before, then the old salvage value is subtracted.
New base = Book value - Estimated salvage value
* Depreciation expense is calculated using the new base and the remaining years that the asset is expected to be useful (if using the straight-line method).
Depreciation expense = New base / Estimated remaining years of useful life
Suppose that the Farmers' truck wears out faster than they expected. In 20X4, they decided that they would not wait until 20X6 to trade it in and purchase a new truck. Rather, they will purchase a new truck in 20X5. Depreciation expense should be recalculated in 20X4 for the years 20X4 and 20X5. At the end of 20X3, the book value for the truck is determined by subtracting the depreciation expense from 20X1, 20X2, and 20X3 (the accumulated depreciation) from the original cost. The Farmers used the straight-line method for depreciation. Just to show you the difference between the straight-line and the accelerated methods, the book values for the Farmers' truck for each of these methods are calculated below (using partial year depreciation in the first year): Straight- Sum-of-Years- Declining Line Digits Balance Original cost: $15,000 $15,000 $15,000 Less accumulated depreciation: 20X1: 600 1,000 1,500 20X2: 2,400 3,800 5,400 20X3: 2,400 3,000 * 3,240 ** Book value: $ 9,600 $ 7,200 $ 4,860 * $3,000 = (266.67 x 9) + [(2400 / 12) x 3] (See Appendix J). ** $3,240 = (300 x 9) + [(2400 / 12) x 3] (See Appendix J). The Farmers are assuming that the salvage value will be the same as they originally thought. They subtract the old salvage value of $3,000 from the book value to calculate the new base. For each of the methods, the new base is calculated as follows: Straight Sum-of-Years Declining -Line -Digits Balance Book value: $ 9,600 $ 7,200 $ 4,860 Old salvage value: - 3,000 - 3,000 - 3,000 New basis: $ 6,600 $ 4,200 $ 1,860 Under the straight-line method, they calculate the revised depreciation expense by dividing the new base by the two remaining years (20X4 and 20X5): Depreciation expense (for 20X4 and 20X5) = $6,600 / 2 = $3,300 Under the sum-of-years-digits method, a new fraction is calculated by adding 1 = 2 for the denominator, and using 2 as the numerator for the year 20X4 and using 1 as the numerator for the year 20X5: Depreciation expense (for 20X4) = $4,200 x 2/3 = $2,800 Depreciation expense (for 20X5) = $4,200 x 1/3 = $1,400 Under the declining balance method, the straight-line rate is 1/2, so twice the straight-line rate is 2 x (1 / 2) or 1. The entire new base is depreciated in 20X4. Depreciation expense (for 20X4) = $4,860 - 3,000 = $1,860 The truck is fully depreciated down to the salvage value under each of these methods by the end of the year 20X5. Straight- Sum-of-Years Declining Line -Digits Balance Book value at Jan. 1, 20X4: $ 9,600 $ 7,200 $4,860 Depreciation: 20X4: 3,300 2,800 1,860 20X5: 3,300 1,400 0 Book value at Dec. 31, 20X5: $ 3,000 $ 3,000 $3,000 PRACTICE WHAT YOU HAVE LEARNED Practice revised estimates for depreciation expense by completing Problem 6-6 at the end of the chapter.
Learning Objective 10 * To calculate simple interest and to prepare an amortization schedule.
Lenders charge interest on loans as a cost for using money. Interest expense is a function of the amount of the principal of the loan, the interest rate, and time. The general formula for calculating interest expense is the following:
Interest expense = Principal = Annual interest rate = Fraction of the year
This equation is the calculation for simple interest. Simple interest is interest that is not compounded (added to the principal periodically before the loan is paid off). Chapter 9 outlines the calculations for compounded interest. The principal is the amount borrowed. The interest rate is usually stated as an annual rate of interest, which is the percentage of the principal that would be paid in the form of interest after one year. The fraction of the year refers to the amount of time covered by the loan period. The general formula for interest considers how much time is covered by the loan when calculating interest expense.
In Chapter 3, Steve and Chris borrowed $50,000 to purchase a tractor on March 1, 20X1 in journal entry (7). Suppose that the interest rate was 12 percent. The interest rate represents an annual rate, so the amount of interest that the Farmers will pay is $6,000 ($50,000 = 12 percent). To determine how much of that interest has accrued by the end of 20X1, the $6,000 is multiplied times the fraction of the 12-month loan period that pertains to 20X1. They borrowed the money on March 1. March 1 to December 31, 20X1 is a 10-month period; therefore the $6,000 is multiplied by 10/12, the fraction of the 12-month period pertaining to the period from March 1 to December 31, 20X1. Interest expense = Principal x Annual interest rate x Fraction of the year = $50,000 x 12% x 10/12 = $5,000 This amount, $5,000 ($6,000 x 10/12), is the amount of accrued interest that should be reported on the balance sheet as Interest Payable for 20X1. In Chapter 4, they recorded accrued interest in journal entry (40).
On short-term loans, usually paid back within one year, only one payment, covering both interest and the principal amount, is made at the end of the term of the loan. Non-current loans are often paid back in several payments (installments). In each installment payment, interest accrued since the last payment and a certain amount of principal are paid back. The total amount of each payment is the same each year (or month, as the case may be), but the amount of the interest and the amount of the principal varies with each payment. Generally, each subsequent payment involves less interest and more principal than the previous payment. A table, known as an amortization table, lists the amounts of principal and interest paid with each cash payment. The calculations are as follows:
Interest = Balance from previous line x Interest rate Principal = Cash payment x Interest Balance = Balance from previous line - Principal
The information in the amortization table is useful for several reasons. The balance indicates the amount of the principal left to be paid and is reported on the balance sheet as Notes Payable. The interest column indicates how much interest was paid and reported as Interest Expense on the income statement each year. Because the amount of interest varies each payment, the information from the table is necessary for recording the correct amount of interest expense when the payment occurs.
Returning to the Farmers' example, Steve and Chris borrowed $10,000 on October 1, 20X0 at a 12 percent interest rate due a year later. Suppose instead that they were to pay it back over the next seven years. If their annual payment is $2,191, an amortization table would show the following amounts: Date Cash Payment Interest Principal Balance Oct. 1, 20X0 $10,000 Oct. 1, 20X1 $2,191 $1,200 $ 991 9,009 Oct. 1, 20X2 $2,191 1,081 1,110 7,899 Oct. 1, 20X3 $2,191 948 1,243 6,656 Oct. 1, 20X4 $2,191 799 1,392 5,264 Oct. 1, 20X5 $2,191 632 1,559 3,704 Oct. 1, 20X6 $2,191 444 1,747 1,958 Oct. 1, 20X7 $2,193 * 235 1,958 0 * Rounding errors result in a slightly higher payment.
Sometimes payments are made every month. The purchase of a car or truck is usually arranged with monthly payments. The amount of interest in the table is affected when that is the case. Interest rates are usually stated at an annual rate, which means that the interest expense based on this rate is for an entire year. When payments are made every month, the amount of interest in the payment is only for one month. Therefore, the calculation of interest in the amortization table is altered by dividing the annual interest rate by 12 to derive a monthly rate for interest.
Interest = Balance from previous line x (Annual interest rate / 12)
The remaining calculations are the same as those above.
Supplementary schedules are prepared for all loans and included in the notes to the financial statements. These schedules include the amount of the principal for each loan, the interest rate on each loan, the term of each loan, and the total amount of interest and principal paid for each loan during the year. Chapter 9, on measuring liabilities, includes further discussion of these schedules.
PRACTICE WHAT YOU HAVE LEARNED At this point, you should have some idea about how an amortization schedule is prepared. Complete Problem 6-7 to practice this procedure.
NET FARM INCOME
Learning Objective 11 * To define and calculate "Accrual Adjusted Net Farm Income."
Accrual Adjusted Net Farm Income (NFI) is defined as the return, or profit, of the farm business, and is reported on the income statement. Chapter 1 shows you how to calculate NFI. Included in the calculation are all revenues except for Miscellaneous Revenue and gains from Extraordinary Items. All expenses except for Miscellaneous Expenses, Income Tax Expense, and losses from Extraordinary Items are subtracted from the revenues to compute NFI (see Table 6-7). These items are excluded to present a profit number based primarily on ordinary farm activities. Gains and losses from the sale of farm capital assets and from changes in base values of breeding livestock are also included in the calculation of NFI because these items are based on normal activities of a farm business. NFI is the primary number used to evaluate the financial performance of the farm operation. Chapter 10 contains more information on the procedures to assess financial performance.
PRACTICE WHAT YOU HAVE LEARNED Complete Problem 6-8 at the end of the chapter.
Learning Objective 12 * To explain the nature and reporting of extraordinary items.
Extraordinary gains and losses are the result of transactions or occurrences that are unusual in nature and infrequent in occurrence. Examples of extraordinary items are discussed below. Extraordinary gains and losses are excluded from the computation of NFI so that NFI is not distorted by large amounts of one-time monetary events. Including extraordinary gains and losses would result in difficulties in assessing the financial performance of the farm business from one year to the next or between one farm and another. Extraordinary gains and losses are presented on the income statement, but are shown following NFI and are used to compute Accrual Adjusted Net Income. When extraordinary gains or losses are reported on the income statement, they are usually ignored when analyzing the financial performance of the farm business because they are not considered ordinary and are not expected to occur again in the near future.
For a transaction or circumstance to be classified as an extraordinary item for financial reporting purposes, the two criteria mentioned in the previous paragraph are required. "Unusual in nature" refers to a high degree of abnormality. In other words, the incidence is outside of the ordinary operating activities of the business. "Infrequent in occurrence" refers to an event that is not reasonably expected to occur in the near future, considering the environment in which the farm is located. For example, the loss of an animal herd due to a rare and incurable disease (such as mad cow disease) is extraordinary in nature. The loss of a grain crop in the Midwest due to a hailstorm is not considered extraordinary because hailstorms are a normal occurrence in that part of the country. Many farmers in that area purchase crop insurance for that very purpose. Determining whether or not a gain or loss is extraordinary is often a judgment by the owner or manager of the farm operation or the tax accountant.
The presentation of extraordinary gains and losses on the income statement differs from the reporting of other types of gains and losses. Extraordinary gains and losses are presented on the income statement following income tax expense so that income tax expense for the ordinary farm activities is not distorted by the effects of the extraordinary item. However, the extraordinary gain or loss does affect the income tax expense for the year. To show this effect, the extraordinary gain or loss is presented on the income statement net of tax. Net of tax means that the amount shown on the income statement indicates the amount of the gain or loss after the tax effect has been subtracted.
For example, if the total amount of an extraordinary loss is $100,000, this loss results in a tax deduction. If the tax rate is approximately 25 percent, the tax effect is: $100,000 x .25 = $25,000 The amount shown on the income statement is the amount of the loss less the tax effect: $100,000 - 25,000 = $75,000
This amount represents the net effect of the loss on net income. When a loss results in a tax deduction, the net effect is "less of a loss." The amount of the original loss and the amount of the tax effect should be shown either in the notes to the financial statements or on the income statement in parentheses, as shown below:
Extraordinary loss ($100,000 loss less $25,000 tax effect) $75,000
In this way, the tax effect of the extraordinary loss is shown separate from the ordinary income tax expense.
Exercise 6-4 Which of the following occurrences would be considered an extraordinary gain or loss? A. Major overhaul on a diesel tractor. B. Loss of a building due to a tornado. C. Insurance payment on the loss of crop due to hailstorm. D. Payment for the sale of gravel out of a gravel pit on the farm property. Answers: A. Not extraordinary. This type of expense is an ordinary occurrence for a farm operation even though it might not happen very often. B. Depends on the location. Some areas of the country do not experience tornadoes. If the tornado occurred in Kansas, however, this would probably not be considered extraordinary. C. Not extraordinary. The loss from the hailstorm is an unusual occurrence. However, a farmer who insured the crop must have anticipated that hailstorms and crop damage are frequent enough that they are not considered extraordinary. D. This payment is a gain. Whether or not it is considered extraordinary depends on whether or not it will reoccur and how unusual it is for the area in which the farm is located. It also depends on how much money was received in the payment. A small amount would not be extraordinary.
Topics in this chapter include concepts and measurement issues regarding farm revenues and expenses. Revenue recognition concerns when revenue should be recognized and recorded. Accounting for the special issue of revenue from participation in government loan programs is also discussed. The calculation of various gains and losses are based on book values and the amount received on a sale or trade-in. Measurement issues also include the calculation of depreciation, presented in this chapter with the widely used method called straight-line depreciation. Accelerated depreciation methods, partial periods, and revised estimates are also discussed. The measurement of interest expense involves the factor of time and interest rates. Other measurement issues covered in this chapter include Net Farm Income and extraordinary items. Although other issues involving revenues and expenses may arise in a farm business, these topics are common for many farm operations.
6-1 * For each of the cases below, indicate whether or not the conditions for revenue recognition have been met.
a. A wheat crop has been planted.
b. Calves are weaned.
c. Apple crop has been harvested.
d. Corn crop has been sprayed.
e. All feeder pigs have reached market weight.
f. Dairy cows have been milked.
g. Sheep have been shorn.
h. Hay crop has been sold.
i. A contract to deliver soybean crop has been signed.
6-2 * For each of the cases below, calculate the amount of the gain or loss.
a. A truck with a cost of $32,000 and accumulated depreciation of $15,000 is sold for $15,000.
b. A truck with a cost of $32,000 and accumulated depreciation of $15,000 is sold for $18,000.
c. A truck with a cost of $32,000 and accumulated depreciation of $15,000 is traded for a new truck. The dealer is giving a trade-in allowance of $15,000 on the old truck and the farmer has to pay $18,000 to buy the new truck.
d. A truck with a cost of $32,000 and accumulated depreciation of $15,000 is traded for a new truck. The dealer is giving a trade-in allowance of $18,000 on the old truck and the farmer has to pay $15,000 to buy the new truck.
e. Cows with base values of $3,000 were sold for $3,500.
f. Cows with base values of $3,000 were sold for $2,700.
g. The last time land was appraised, a parcel of land was reported with a market value of $60,000. The land was sold for $56,000.
h. The last time land was appraised, a parcel of land was reported with a market value of $60,000. The land was sold for $65,000.
6-3 * Using the straight-line method, calculate the amount of depreciation expense for each asset and prepare a schedule that would be included in the notes to the financial statements.
Asset Cost Salvage Value Estimated life Truck $ 32,000 $5,000 6 years Tractor 45,000 3,000 14 years Corn planter 35,000 0 15 years Barn 100,000 6,000 30 years Fences 25,000 0 20 years Cattle squeeze chute 5,000 500 15 years Computer 3,000 300 5 years
6-4 * a. Calculate the amount of depreciation expense for one year for the buildings and improvements listed below if the buildings have an average estimated life of 20 years and the improvements have an average estimated life of 10 years with no salvage value. Use the straight-line method.
Buildings: Cost = $125,000
Improvements: Cost = $62,500
b. Use the activity method and calculate depreciation expense on the Farmers' truck for 20X2 and 20X3. They drove the truck 24,500 miles in 20X2 and 22,600 miles in 20X3.
6-5 * Suppose that the Farmers purchased the buildings and improvements in Problem 6-4 on April 1. Calculate the amount of partial year depreciation expense for the buildings and improvements for the first year.
6-6 * Suppose that the Farmers decided in 20X4 that they would keep the truck a year longer than they originally thought and will trade it and buy a new truck in 20X7. The salvage value will be $2,000 in 20X7. Calculate the revised amount of depreciation expense that they should record in 20X4, 20X5, and 20X6.
6-7 * Prepare an amortization schedule using the following information: $75,000 principal, 10 percent annual interest rate, five annual payments of $19,784.65 each.
6-8 * Calculate Accrual Adjusted Net Farm Income using the appropriate data below.
Gain Due to Changes in General Base Values of Breeding Livestock: $5,000
Income Tax Expense: $5,400
Loss on the Sale of Farm Capital Assets: $1,600
Net Farm Income from Operations: $175,643
Other Revenue: $300
Other Expenses: $160
TABLE 6-1 * Sources of revenues for a farm operation. Sales Sales of crops Sales of feed Sales of market livestock and poultry Sales of breeding livestock (breeding farms) Sales of livestock products (for example, eggs, milk, wool) Changes in accounts receivable Production Changes in crop inventories Changes in market livestock and poultry inventories Changes in breeding livestock inventory (breeding farms) Change in the value of raised breeding livestock due to changes in quantity Gains/losses due to changes in base values of raised breeding livestock Other Payments from government programs Payments from crop insurance claims Gains/losses from the sale of culled breeding livestock Gains/losses from the sale of non-current farm assets Extraordinary gains/losses TABLE 6-2 * Revenue Recognition rules. General Rule: Two conditions must occur. 1. Revenue must be earned (production is complete). 2. Exchange takes place (sale has occurred). Agriculture: First condition must occur. 1. Revenue must be earned (production is complete). Revenue is reported if financial statements are prepared before the sale. 2. Exchange takes place (sale has occurred). Revenue is reported when sale occurs also. TABLE 6-3 * Balance sheet reporting for government loans. Balance sheet prepared before loan is settled (loan rate > market value): Inventory Liabilities Crop Inventory (at loan rate) Notes Payable (at loan rate) Balance sheet prepared before loan is settled (loan rate < market value): Inventory Liabilities Crop Inventory (at market value) Notes Payable (at loan rate) Interest Payable (market value minus loan rate) TABLE 6-4 * Calculating the Gain or Loss on a sale of farm assets. Step 1: Determine book value or market value of the asset from the last balance sheet that was prepared. Book value = original cost - accumulated depreciation Or Book value = current market value Step 2: Compare book value with the amount of cash received. The difference is a gain or loss. Gain: When cash received is greater than book value. Loss: When cash received is less than book value. TABLE 6-5 * Calculating the Gain or Loss on a trade-in of non-current farm assets. Step 1: Determine book value or market value of the asset from the last balance sheet that was prepared. Book value = original cost = accumulated depreciation Or Book value = current market value Step 2: Compare value of asset received (purchased) with the amount of cash paid and the book value of asset given up (traded in) in the transaction. Gain: When value of asset received is greater than cash paid and asset given up. Loss: When value of asset received is less than cash paid and asset given up. TABLE 6-6 Comparison of different depreciation methods. Straight-Line Sum-of-Years-Digits Declining Balance Year 1: $2,400 $4,000 $6,000 Year 2: 2,400 3,200 3,600 Year 3: 2,400 2,400 2,160 Year 4: 2,400 1,600 240 Year 5: 2,400 800 0 $12,000 $12,000 $12,000 TABLE 6-7 * Calculation of Accrual Adjusted Net Farm Income. Partial Income Statement: Net Farm Income from Operations +/- Gains/Losses on the Sale of Farm Capital Assets +/- Gains/Losses Due to Changes in General Base Values of Breeding Livestock = Accrual Adjusted Net Farm Income + Other Revenue - Other Expenses = Income before Taxes - Income Tax Expense (farm business taxes only) +/- Change in Taxes Payable = Income before Extraordinary Items +/- Extraordinary Gain/Loss (net of tax) = Accrual Adjusted Net Income
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|Publication:||Introduction to Agricultural Accounting|
|Date:||Jan 1, 2008|
|Previous Article:||Chapter 5: Financial statement preparation and closing entries.|
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