Applying GAAP to Record Assets Complete both sections 1 and 2. 1. Recording Asse

Question

Applying GAAP to Record Assets

Complete both sections 1 and 2.

1. Recording Assets

A. Smith Company has developed a computerized machine to assist in the production of appliances. It is anticipated that the machine will do well in the marketplace; however, the company lacks the necessary capital to produce the machine. Roseline Rowland, secretary-treasurer of Smith Company, has offered to transfer land to the company to be used as collateral for a bank loan. In exchange for the land transfer, Roseline will receive a five-year employment contract and a percentage of any profits earned from sales of the new machine. The title to the land is to be transferred unconditionally. If Smith defaults on the employment contract, a lump sum cash settlement for lost wages will be paid to Roseline. The land transfer may be a good business move, but it raises a number of questionable accounting issues. Smith’s controller has given you the task of writing a detailed report that summarizes the options available in accounting for the land transfer. Your report should outline the arguments both for and against recording the land as an asset on Smith’s books. Also, discuss how the land should be valued if it is recorded as an asset.

B. Two college students, Elizabeth Stephens and Rachel Marcus, organized Concept, Inc. Elizabeth and Rachel both used the internet extensively while in high school and became very proficient web surfers. Elizabeth has a special ability for designing web- based games that challenge the reasoning power of players. Rachel saw great potential in marketing Elizabeth’s products to other web users, and so the two began Concept. Sales have exceeded expectations, and they have added 10 employees to their company to design additional products, debug new programs, and produce and distribute the final software products. Because of its growing size, increased capital is needed for the company. The partners decide to apply for a $100,000 loan to support the growing cost of research. As part of the documentation to obtain the loan, the bank asks for audited financial statements for the past year. The company hired Timothy Pressly, CPA, to prepare the statements. Concept had produced a preliminary income statement that reported net income of $35,000. After reviewing the statement, Pressly indicates that the company actually had a $10,000 loss for the year. The major difference relates to $45,000 of wage and material costs that Concept had capitalized as an intangible asset, but that Pressly determined should be expensed.

The partners are confused because they thought they were applying the matching principle. Pressly allowed capitalization of the equipment but not the web development costs. The partners are worried that the loss calculated is unjustified and that they will not be profitable under “Pressly’s requirements.” What major issues are involved in this case? Which position best reflects GAAP?

2. Asset Write-Downs

Professor Linda DeAngelo (1988) found evidence suggesting that when management of a company is ousted under fire, the new management tends to take an earnings “bath” after gaining control. A “bath” is a large reduction in earnings due to asset write-downs, reorganization charges, discontinuance of segments, and other extraordinary charges.

What reasons could new management of a company have for wanting to “take a bath” in its first year?

Your well-written paper must be 2 to 3 pages in length.

Explanation / Answer

1.

As per the GAAP Guidelines, land forms an immovable asset, and can be considered as a part of Fixed Assets as defined in the Financial Standards Accounting Board (FASB) Principles.

Pros for treating the land as an asset in the books of account of Smith Limited

Cons for treating the land as an asset in the books of account of Smith Limited

The decision to be made by Smith Limited is about the additional costs which they may incur in case the sales of the appliances as forecasted by them does not occur, and they have to pay the employment costs and profit shares to Roseline as stipulated. Ideally, although land is an appreciable asset, the moot question is whether the production as envisaged by them can occur or not.

IAS 38 pertaining to Intangible Assets clearly states that Advertising Costs pertaining to the creation and marketing of any intangible asset cannot be capitalized and must be expensed off.

However, if orders can be placed and the Company can effectively show that there are probable future economic benefits then the costs may be able to be capitalised.

The main issues involved in this case are :

Ideally, the costs cannot be capitailsed, in line with GAAP. However, on clear evidence of economic gains being made through incurring the same, they can be considered for capitalization (refer above.)

2. Reasons for “Taking a Bath” in its first year

These are just some of the factors which are attributable for “Taking a Bath”. It is the first year of operations for the new management in which it is taking over a Shut Down Company for the purpose of reorganization.

Substantial write downs will take place in accordance with IAS 36 on Impairment of Assets, which clearly states that “an entity's assets are not to be carried at more than their recoverable amount (i.e. the higher of fair value less costs of disposal and value in use). With the exception of goodwill and certain intangible assets for which an annual impairment test is required, entities are required to conduct impairment tests where there is an indication of impairment of an asset, and the test may be conducted for a 'cash-generating unit' where an asset does not generate cash inflows that are largely independent of those from other assets.”

The moot question here is of a cash generating unit, which is not the case in this question, since the unit itself is a damaged one.

Hence, by writing down the values of the assets (including fixed assets) and liabilities to their realizable values in the first year of operations itself, the Company is ensuring that when it goes into full scale mode, no additional expenses are incurred for the write offs, and expected revenues will lead to equivalent earnings for the Company as a whole.             

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