Category: Accounting News

With more than 14 million electric vehicle (EV) registrations in 2023 worldwide and 2023 seeing an increase in EV sales over 2022 by 35 percent, manufacturers are probably happy – but not those producing the traditional internal combustion engine (ICE) vehicles. This is according to the International Energy Agency’s Global EV Outlook 2024: Trends in Electric Cars.

This statistic is important because it illustrates how assets can be rendered less useful and potentially turn into stranded assets. A stranded asset, defined, is an asset that’s no longer able to provide its owner the profitable payback they originally expected. The difference is based on shifts, primarily negative, that impact the asset’s expected productive performance.

How & Why Assets Become Stranded

When an asset loses its earning power, normally due to extraneous circumstances, like the invention of a more efficient battery, it can become stranded. For example, a machine that’s exclusively capable of making an internal combustion engine (ICE) vehicle can be considered stranded as the transition to electric vehicles (EV) is made. Since the machine is less valuable because it makes fewer and fewer ICE vehicles, it could be impaired or stranded.

This example illustrates that new technology, especially one that moves forward, can render equipment less useful than previously expected. Other ways assets can be stranded include administrative modifications, evolving societal conventions, etc.

Considerations for Stranded Assets by Testing an Asset for Impairment

The primary way to establish if an asset is stranded is to run an impairment test on it. Stranded assets impact the income statement via a non-cash loss, along with impacting the balance sheet by reducing asset value. Therefore, companies must report a loss on the income statement as it’s completely written off the balance sheet.

Whether it’s through the lens of International Financial Reporting Standards (IFRS) or generally accepted accounting principles (GAAP), whether an asset is intangible or tangible, when its value issue is less than book value or impaired, it must be written down.

GAAP Standard

The first step is to determine the carrying value. This is calculated by subtracting the accumulated depreciation from the asset’s original cost. From there, the asset’s projected undiscounted future cash flows (UFCF) are analyzed against the asset’s carrying value. If the total UFCF is less than the carrying value, an asset is considered impaired.

IFRS Standard

The first step also looks at an asset’s carrying value. From there, if either of the following two values is lower than the carrying value, it’s considered impaired:

• Present value of future cash flows generated by the asset (the so-called “fair value in use” consideration)
• Fair value less costs to sell the asset

Financial Statement Considerations

If an asset is impaired or stranded, whatever amount the asset drops by, it lowers the business’ asset’s value on the balance sheet. Looking at the income statement, it’s considered a loss. Additionally, since a devaluation is not considered a cash event, it doesn’t trigger any cash outflows. A real-world example can better illustrate this.

The following assumes a business reports its accounting under GAAP. It could be a company that produces fracking equipment to recover natural gas and crude oil. With the uncertainty of domestic fossil fuel policy, specifically where land can be explored, the threat of OPEC and/or Iran being able to determine their production, and the threat of increased government spending on green energy, fracking equipment has a current carrying value of $10 million. However, with increased competition from the three different factors, the same assets can produce an aggregate of $7.5 million in undiscounted future cash flows.

Based on GAAP, since the carrying value is $2.5 million more than the total undiscounted future cash flows, the business would need to record the same amount for an impairment loss. The journal entries would be:

Loss from Impairment Debit:. $2.5 million

Provision for Impairment Losses Credit:  $2.5 million

Conclusion

When it comes to accounting for stranded assets, it’s important to ensure guidelines are followed based on the type of accounting standards businesses must follow.

According to EY, the convertible debt market saw whipsaw action in issuances. Between 2015 and 2019, average issuance varied between $40 billion and $45 billion. However, it dropped to $22 billion in 2022 but re-accelerated to $52 billion in 2023. While the levels of issuance varied, the way this type of debt is accounted for has remained much calmer.

Defining a Convertible Bond

A convertible bond is a type of debt security that gives the investor the right to exchange the bond, at certain milestones, for a pre-determined percentage of equity in the issuing company. This investment vehicle has both equity and debt features.

Since this type of investment gives investors the potential for equity conversion into a company, the debt/bond side of it may present investors with a nominal coupon remittance or a potentially zero-coupon payment. However, there are important accounting considerations for this type of investment vehicle via generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS).

IFRS

When it comes to IFRS, convertible bonds are considered blended securities because they are partially debt and partially equity. The debt piece is accounted for by discounting the principal and interest paid out to the bondholder at the company’s cost of straight debt. The following example illustrates how it’s calculated:

The business presents a 10-year, $250 million convertible bond, providing investors with a 2.5 percent coupon rate and a 9.5 percent straight cost of debt. Based on discounting these variables, the present value of the principal and coupon payments is: $182,805,096 (assuming end-of-year, annual coupons). To determine the equity proportion, we must take $250 million and subtract $182,805,096, which equals $67,194,904.

Looking at the journal entry, we have the following breakdown:

Cash: Debit $250,000,000

Convertible Debt Component – Liability = $182,805,096

Equity Component – Shareholder’s Equity = $67,194,904

Looking at the interest expense this is calculated as follows:

The 9.5 percent (straight debt cost) is multiplied by the net present value of the beginning debt liability balance of the first year ($182,805,096), which is $17,366,484.12. Since there’s a coupon payment of (2.5 percent X $250,000,000 = $6,250,000), the difference between $17,366,484.12 and $6,250,000 = $11,116,484.12 should be “accreted” to the debt liability or the debt balance.

The journal entry would be as follows:

Debit: Interest Expense $17,366,484.12

Credit: Cash $6,250,000

Credit: Accretion of Debt Discount – Liability = $11,116,484.12

Now, if at the bond’s maturity, the investor is unable to convert the bond to equity according to the terms of the convertible note, the entire $250 million bond will be paid back to the investor. The journal entry will be as follows:

Debit: Convertible Debt $250,000,000

Credit: Cash $250,000,000

If, however, the investor of the convertible bond is favorable to it being exchanged, the journal entry will be as follows:

Debit: Convertible Debt $250,000,000

Credit: Share Capital – Shareholder’s Equity = $250,000,000

This explanation assumes that convertible bonds are only able to be converted into company equity. However, if the bond is cash-settled, there are alternate considerations. It’s also assumed that the bond is issued at year’s end and makes its coupon payments once a year.

GAAP

Under generally accepted accounting principles (GAAP), present standards treat it as straight debt. This accounting practice changed from GAAP’s previous treatment of bifurcating it, similar to IFRS’ current treatment.

At issuance, the journal entries are as follows:

Debit: Cash $250,000,000

Credit: Convertible Debt $250,000,000

With this accounting treatment, it’s recognized as an interest expense. Since this contrasts with IFRS, no accretion is required under GAAP. This assumes there are no additional debt issuance costs when calculating interest expenses. Therefore, assuming the same initial debt amount at par and the coupon rate for year one, it’s the rate for the debt issuance multiplied by the full debt amount ($250,000,000).

The journal entry is as follows:

Debit: Interest Expense $6,250,000

Credit: Cash $6,250,000

If the convertible debt doesn’t present a good opportunity for the investor, they’ll receive the principal back. The journal entry is as follows:

Debit: Convertible Debt $250,000,000

Credit: Cash $250,000,000

If, however, the convertible debt presents the investor with an opportunity to convert to equity, and it’s exercised, the journal entry is presented as follows:

 Debit: Convertible Debt $250,000,000

 Credit: Share Capital – Shareholder’s Equity $250,000,000

Conclusion

While these examples do not explore all the potential scenarios when accounting for convertible debt, they show what considerations accountants must keep in mind when analyzing a transaction.

Comprehensive income (CI), which is defined as the sum of net income (NI) and other comprehensive income (OCI), gives both the internal and external audiences a 30,000-foot perspective of a company’s valuation. Understanding how it’s broken down, how it’s accounted for, and how it’s interpreted by different audiences is essential to making favorable impressions.

In the banking industry, the Government Accountability Office (GAO) found 2,705 material restatements occurred between the beginning of January 1997 and the first half of 2006. Businesses that fail to report financial information accurately the first time are not uncommon – but this can have harmful effects on their bottom line.

Comprehensive Income Components Defined

Net income, which is the first component of comprehensive income, is the difference between a company’s total revenue and the taxes, interest, and expenses. This shows how profitable a company is during a certain accounting time frame. It’s important to keep in mind that net income, along with all of the deductions taken from the total revenue, are reflected on the income statement because this financial document recognizes only incurred expenses and earned income during a set accounting period. 

Other comprehensive income (OCI), the second half of CI, is a way to account for and analyze unrealized or not yet booked gains or losses. This can include investing ventures, cash flow hedges, debt securities, foreign currency exchange rate adjustments, pension obligations, etc. It’s important to keep in mind that along with being reported on the company’s balance sheet, it may also be reported on the separate statement of comprehensive financial statement.  

Further Financial Statement Reporting Considerations

On June 17, 2011, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) 2011-05, Comprehensive Income – Topic 220: Presentation of Comprehensive Income.

One of the original three ways that was in effect but has been repealed with this modification from FASB was to report elements of other comprehensive income (OCI) as a portion of the statement of changes in stockholders’ equity. However, many professionals argued that this change simplified the reading and analysis of how OCI impacts a business’ total operations.

Based on FASB’s Accounting Standards Codification (ASC) 220-10-45-1, comprehensive income can be presented in either one statement or two discrete, successive statements.  

#1: Single, Successive Statement Option

Based on ASC 220-10-45-1A, the following figures are required to be reported:

Components of net income

Total net income

Components of other comprehensive income

Total for other comprehensive income

Total for comprehensive income

#2: Two Discrete, Successive Statements

Based on ASC 220-10-45-1B, the following two figures are required:

1. Statement of net income

2. Statement of other comprehensive income

The following data for each respective successive financial statement should be included:

1a. Components of net income

b. Total net income

2a. Components of other comprehensive income

b. Total for other comprehensive income

c. Total for comprehensive income

Conclusion

While each business has its own challenges and opportunities, when it comes to preparing financial statements it’s essential to prepare financial statements that are transparent and follow FASB reporting requirements to maintain attractiveness to internal and external stakeholders.

When a business is looking for a valuation, it needs to decide whether to use the calculation of value approach versus the conclusion of value option.

The conclusion of value calculation is a more rigorous and resource-intensive calculation of value. Both approaches are similarly dependable, and despite the calculation of value’s less in-depth approach, business owners can still benefit from this knowledge for their short- and long-term projection needs. However, there are some distinctions between the two approaches. 

Calculation of Value

This method can be conducted annually or once every 24 months. It’s often applied for internal needs, such as the owner looking to retire, selling the business or for critical strategy development. Calculation of value also can be used for planning purposes, such as the settlement stage of a divorce. However, since it’s not an opinion of value, it’s not seen during litigation. 

Calculation of value aims to get the company’s fair market value via comparable companies. It is an approximate value, calculated through either a single figure or a range.

Conclusion of Value

This is more comprehensive and has stricter standards that can meet those required by the IRS, lawsuits, the Department of Labor, potential business buyers, M&A activity, etc. Conclusion of value can take as long as six weeks to complete due to stricter reporting standards.  

It’s up to the discretion of the analyst, and the results can be a single figure or a range. There are three accepted forms of valuation: market, income and asset-based, necessitating additional time. These three approaches are defined further below.

Market-Based Valuation

This looks at charted data of transaction values to calculate a business’ financial worth. This works similar to how those in the real estate industry determine comparable business’ worth, which is based on substantially similar conditions.

Regardless of the type of business, it looks at financial metrics such as the client service model, business location, profitability, percentage of periodic revenue projections, overall revenue, growth rates, mean account sizes, etc.  

Income-Based Valuation

This type of analysis establishes fair value by looking at historical, present and projected future cash flows. It also looks at reasonable projected returns on future investments.  

Valuing investments via the discounted cash flow method (DCF) involves looking at after-tax, discretionary, and/or operating cash flow types. This approach is often utilized with businesses that have no to limited earning growth projections.

The Capitalization of Earnings/Cash Flow Method

This begins with determining the cash flow for a discrete period. Then, the cash flow is divided by the capitalization rate over the same period. The capitalization rate is determined by taking a property’s net operating income and dividing it by the present market value. Looking through a real estate lens, it’s interpreted as the percentage of return an investor is likely to obtain from an investment. It’s often calculated for mature/established businesses that grow at a reasonable/predictable rate.

Excess Earnings Valuation Methodology

This can be defined as looking at how much tangible and intangible assets earn for a company over a discrete period of time. 

Asset-Based Valuation

This values a company by looking at the net value of assets within a company or the post-liability deduction of the fair market value of the company’s total assets. It’s one way to determine how much a company would cost to re-create. 

While each business has its own needs for valuation, be it for internal or external audiences, understanding how to accomplish them and when to use each type is extremely helpful for overall operations.

Whether it’s a company firing on all cylinders or a company on the verge of liquidation, determining correct valuations is not a cut-and-dry process. Understanding the importance of going-concern values and liquidation values is essential when determining a business’ worth.

Quantifying Going-Concern Value

When it comes to defining this type of value, it factors in the likelihood of a business operating indefinitely with continued profitability. With a company’s demonstrated ability to maintain profitability comes inherent value, reducing the likelihood of a business going bankrupt. 

In contrast to a business’ liquidation value basis, which might only be $20 million due to unsold goods, real property and associated physical assets, the going-concern value might be worth $120 million. The difference and increase in value are due to the additional equity embedded in its competitive position in its industry, its projected future cash flows, goodwill, etc. Goodwill consists of the company’s name, its intellectual property (IP) patent, trademarks, customer loyalty, etc.

When one company looks to acquire another, the company bases its valuation on the calculated going-concern value of the acquiree. When formulating its offer to purchase the other, it will factor in its future profitability, intangible assets, customer loyalty, and goodwill.

Liquidation Value Defined

Liquidation value is determined by establishing the net value of a company’s physical or tangible assets if they were to go out of business. It’s important to distinguish that intangible assets (intellectual property, brand significance, and goodwill) are not included in liquidation sales. Assets are often sold at a loss because the seller must turn the assets into cash quickly. Generally, liquidation valuation is higher than salvage value but less than book value. Though, to contrast with a traditional, non-acquisition sale, intangible assets are considered part of the sale/offer price.

One important concept for determining liquidation value is the recovery rate. Cash is naturally the highest level, usually at 100 percent. From there, assets such as accounts receivable (AR), inventory, property, plant, and equipment (PPE) have progressively lower recovery values. Determining these values will accordingly govern the success of a liquidation sale.

Comparing Values: Market vs. Book vs. Liquidation vs. Salvage

It’s important to highlight the hierarchy of values to illustrate why these types of valuations differ so much. Market value is the highest, though market conditions can temporarily lower them below normal valuations. Book value is the second highest, also known as historical, and it is what’s listed on the company’s balance sheet. Book values must be looked at through the lens of history and relative to inflation, etc. Salvage value is the second lowest valuation, which is also referred to as scrap value, or when an item is “at the end of its useful life.” Liquidation is the lowest value because tangible assets must be sold quickly, lessening the chance to find a buyer at a fair price.

How Liquidation Works

Liquidation is the difference between a company’s tangible asset value and liabilities. For example:

  1. Liabilities of a business are $750,000

  2. Balance sheet assets show a book value of $1.5 million

  3. Salvage value of assets is $250,000

  4. Auction sale estimate value is $1.2 million, or 80 percent

Liquidation Value = Auction Value – Liabilities ($1.2 million – $750,000 = $450,000)

Many variables must be studied to effectively determine a company’s value, regardless of what spectrum is being evaluated. Employees and consultants who have a better grasp of these methods will provide everyone involved with a fair assessment.

The accounting term working capital is essential knowledge for all business owners. Basically, it is the ability of a business to meet its ongoing obligations. Learning about some of the different aspects of working capital is vital for any successful business owner.

Net operating working capital (NOWC) is the gap between a business’ current assets (accounts receivable, inventories, cash, though excluding marketable securities) and its non-interest-bearing liabilities (which are financial obligations a business must meet, except those not subject to interest payments).

This calculation looks at a business’ cash flow availability and determines available current assets able to be liquidated inside a calendar year.

The formula is as follows:

NOWC = Current Assets – Non-Interest-Bearing Liabilities

Operating Working Capital (OWC)

OWC measures a business’ current assets and calculates how much the company’s day-to-day operations cost. This includes meeting supplier invoices, turning accounts receivable (AR) into cash, obtaining inventory, and making sales on inventory and/or services.

The higher the OWC, the easier it is for a business to pay supplier invoices, leverage pre-pay or early pay discounts, maintain healthy inventory stocks, and offer customers favorable terms to grow sales further.

OWC is calculated as follows:

OWC = Current Assets – Non-Operating Current Assets

It’s important to remember that cash isn’t included because this asset is considered a non-operating asset. While cash isn’t immediately connected to operations, it can be re-considered an operating asset once supplies and related items are obtained with it.

Operating Working Capital Considerations

The OWC calculation determines how proficient the business is with its finances. Since it immediately reveals the amount of funds a business has, the larger the resulting figure, the lower the funds a company has available to complete its rotation.

Companies can lower their results by increasing the rate of inventory turnover, increasing the percentage of customer payment collection, and working with vendors for better provider terms. As a business improves this metric, it can free up funds to reduce its loans, pay dividends, and/or build out new or existing revenue streams. 

Net Working Capital (NWC)

Also referred to as working capital, NWC is defined as the difference between total current assets held by a business and its liabilities. It shows a business’ level of liquidity. This looks at how capable a company is in generating profits, chiefly when it comes to near-term financial obligations (paying wages, electric bills, leases, etc.). It also tells a business if and how much it’s able to re-invest to grow profits and increase product or service capabilities.

It’s calculated as follows:

NWC = Total Current Assets – Total Current Liabilities

Total Current Assets = Cash Assets + AR + Inventory  

Current liabilities are short-term financial obligations due within 12 months, including accounts payable (AP) and accrued expenses.

Considerations

Positive net working capital implies a business can meet current financial obligations and invest in other operational needs. If the NWC is too high, the business isn’t using its short-term assets efficiently. Since some current assets can’t be converted to cash easily, NWC isn’t always the best measure of liquidity. It can similarly signify underused resources.

While there are unique considerations for every business, the more business owners and management are versed in these concepts, the more likely they are to increase their chances of surviving and thriving.

A trial balance is an accounting tool that helps businesses determine if the double entry accounting system has any mathematical errors. Once the trial balance is worked through, and the total debits and total credits equal each other, we know there are no mathematical errors – but that doesn’t mean it is error free. It is important to determine how it is constructed and the considerations for each step in the process.

Raw Trial Balance

The first is the unadjusted trial balance. This looks at all the double entry bookkeeping journal entries, which records the business’ day-to-day transactions. When beginning to prepare for the adjusted trial balance, the eventual adjusted trial balance will have three column headers: 1. Account 2. Debit 3. Credit.

It should list all sub-ledger account balance totals, the account description and number, along with the final debit/credit balance. It also should document the accounting period, including the starting and final dates.

The next step is to address balancing for each sub-ledger. Sub-ledgers, such as Cash, Accounts Payable and Accounts Receivable, are balanced from the sub-ledgers’ “T” account; the resulting credit or debit balance must be noted. Depending on the resulting credit or debit balance, it must be put in the right “Debit” or “Credit” column. If there is a mathematical error, it means the previous steps in the accounting cycle might have errors in them.

Adjusted Trial Balance

Along with the trial balance having the credits and debits entered from each respective sub-ledger, the first thing to check is if the credit and debit balances line up. Then, the next step is to determine if other mistakes may exist. Examples of non-mathematical mistakes include:

• Original entry errors or double entry transactions that contain mistakes on both ends.
• Omission errors or errors that result from not being put into the accounting ledger.
• An error of reversal is an error with double-entry transactions that has the correct numbers but transposes credits and debits.
• A principal error is a transaction that correctly records the transaction, the figures, the right side (debit v. credit), but attributes it to the incorrect account.

Along with these potential mistakes, a business can identify and take corrective action when reviewing its transactions on specific accounts and when aggregating sub-ledgers into their trial balance. Examples of corrective action include tax adjustments, such as ensuring any tax deductions that were missed are then added.

If business transactions were made on a personal credit card, they need to be adjusted accordingly. When it comes to accrual considerations, if a payment is owed but not made during an accounting period, it must be adjusted to reflect the correct accounting period. Another consideration is for payments received, which is often referred to as a deferral. Past due payments that are applied to a later accounting period but were for a previous accounting period must be adjusted accordingly.

Conclusion

The last step is to prepare the post-closing trial balance. Once the closing entries have been finished, it can help a company use it as a starting point when they need to do it again for the next accounting cycle.

While trial balances are only a part of the bookkeeping and accounting process, taking steps to reduce errors can make the accounting process a more insightful business function.

As the name implies, a contingent liability for a business does not always happen and depends on how the future unfolds. When it comes to a business analyzing a contingent liability, it focuses on the probability of the business realizing it, the time frame within which the liability might occur, and the accuracy of the contingent liability’s estimated amount.  

When to Record and Notify of Contingent Liabilities

Projected contingent liabilities are typically recorded if the contingent liability will materialize and can be reasonably projected with a high level of accuracy. Examples include a company making good on a large-scale product warranty, a business facing a government probe or ongoing litigation, or an organization having to satisfy a guarantee on debt.

When recording contingent liabilities, businesses must adhere to three accounting principles from generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS):

1. The Full Disclosure Principle

This requires consequential and pertinent financial details and essentials to be documented thoroughly in financial statements. Relevant fiscal circumstances that have a reasonable likelihood to negatively impact a business’s future net profitability, cash flow, and assets highlight the importance of why a company’s solvency is the primary focus of this tenant.   

2. The Materiality Principle

This focuses on the necessity of financial statement disclosure. Preparers of the financial statements must determine if including financial information (or not) on the business’s financial statements would give interested parties substantive information to help them determine whether or not to engage with the company.

3. The Prudence Principle

This last principle focuses on ensuring income and assets are reported accurately, along with requiring liabilities and expenses not to be reported too low. When applying this principle through the lens of contingent liabilities, if there’s more than a 50 percent chance of the event occurring, it and the associated expense are documented. Recording the liability gives a fair reporting of the expenses and obligations.  

Naturally, if there’s a strong likelihood of reducing a business’s ability to sustain profitability, it also can reduce investor interest in buying part (or all) of the company. Similarly, while being transparent by disclosing contingent liabilities, a business might not be able to secure lending if the lender doesn’t have faith that the debt will be repaid according to the loan’s terms.

Contingent liabilities that are expected to occur/settle in the short term are usually more impactful. Conversely, contingent liabilities that are anticipated to be settled over the long term are less impactful because there’s a smaller chance of the event actually materializing.     

Another consideration when it comes to generally accepted accounting principles is that there are three categories of contingent liabilities, which are all based on the probability of it occurring.

1. If the likelihood of the liability arising is more than 50 percent and the loss can be projected with relative certainty, this is recorded as an expense on the income statement and a liability on the balance sheet. This also can be referred to as a probable contingent liability that can be reasonably estimated (and reflected on financial statements).
2. If the contingency meets one, but not both, of the criteria of a high probability contingency, the contingent liability is required to be documented in the footnotes of the financial statements. This also can be referenced by stating that the liability is as likely to occur as not.
3. If a contingent liability does not meet either of the first two conditions, the rest fall into this category. Since the probability of a cost arising due to these liabilities is highly unlikely, and while reporting these in financial statements is not required, companies sometimes do disclose them.

With contingent liabilities being naturally uncertain, these approaches give business’ some level of certainty to evaluate and make reasonable judgment calls to manage internal and external expectations.

When it comes to business operations and measuring performance, the optimal production scale a company can sustain is an important metric to measure. If a business’ capacity can’t be realized and sustained – or the bottlenecks can’t be identified and addressed in a timely manner – a business will likely stagnate and fail. Understanding more about capacity management can help businesses reduce the chances of dealing with sub-optimal performance.

Capacity Defined

A business’ capacity is defined as its highest level of production on a consistent basis. By measuring the capacity of a business, we can calculate its ongoing revenue projections. This type of evaluation also can help a company determine how to manage production snarls and identify ways to increase capacity reserves to help it manage abnormally high production demands. 

Capacity Utilization Rate Defined

This ratio is the percentage of a business’ production capacity that’s currently utilized. If an organization has a capacity utilization rate of 60 percent, the firm is currently operating at 60 percent of its theoretical capacity. When it comes to analyzing a business, this percentage can determine how much capacity may be available for spikes in demand.

This is calculated by taking the actual output and dividing it by theoretical output, with the result multiplied by 100, or as follows:

(actual output/theoretical output) x 100 = capacity utilization rate

Activity Capacity Overview

Activity capacity assesses the scale of production of a particular task over a given time frame (a quarter, six months, or a 12-month fiscal year) while accounting for regular production factors. Common facets of production that affect output include worker rest periods, equipment upkeep, crew swaps, etc. This investigation allows a business to determine if it can accomplish projected production in the near term with existing equipment or if the business needs to analyze bottlenecks before reassessing.

Budgeted Capacity

This method is used to approximate the manufacturing quantity scheduled for subsequent time frames. Criteria that’s analyzed for the plan hinges on forecasted market demand, resource availability and production capabilities. It’s an imperative consideration that impacts sales forecasts, indirect operational budgets, and the direct production budget.

Depending on the type of business, budgeted capacity can be represented in either hours or units. For example, a company would evaluate industry and economic demand trends, along with the time frame it’s trying to forecast and what resources the business has available for production. The following steps are commonplace during this process:

Step 1:

• The business plans to produce 480,000 widgets for the projected time frame.

Step 2:

• The business looks at how many shifts will be run, how much each shift can produce, how many days the company will operate, and the number of hours available for production for each shift. This will help the company determine production and resource availability for the projected time frame.  

Step 3:

• The business will look at what it’s able to produce based on its full capacity:
• Potential per shift = 100 widgets per hour x 8 hours a shift x 1 shift = 800 widgets
• Potential per day = 800 widgets per shift x 3 shifts per day = 2,400 widgets
• Annual production = 2,400 widgets per day x 275 working days per year = 660,000 widgets

Conclusion

The budgeted production of 480,000 widgets annually is approximately 73 percent of the business’s total production capacity. This leaves the business with ample room to respond to new clients and/or increased demand from existing clients for unexpected orders.

While each business is unique, taking steps to analyze and make more educated projections is one way to increase a company’s efficiency.

The first thing to define is what a lease itself is. It’s an agreement or contract where one party, the lessor, allows another individual or business, the lessee, to use their asset in return for payments or different assets. The next step is to define the following types of leases. The two types covered in this article are operating and finance (or capital) leases.

International Financial Reporting Standards (IFRS)

IFRS does not differentiate between operating and capital leases. However, depending on if the loan has certain characteristics of transferring generally accepted rewards and risks, it would resemble what’s otherwise considered a finance lease. When it comes to Canadian Accounting Standards for Private Enterprises (ASPE) and Generally Accepted Accounting Principles (GAAP), the terms capital lease and finance lease can be used interchangeably.

Operating Leases

Operating leases are used when the client wants to rent and not purchase. During and once the lease is up, the lessor is always in possession.

It can be cheaper to rent – and sometimes renting is the only option for small or medium-sized businesses that are unable to purchase assets. Another advantage for businesses is that they can stay competitive by being able to upgrade their assets since they don’t own it. Along with lessees generally only having to pay for asset maintenance costs, operating expenses for the leased assets are likely tax-deductible because they’re considered business costs. Agreements normally last three-quarters of an asset’s estimated economic life, and the present value of lease payments is usually less than 90 percent of an asset’s fair market value.

Finance (Capital) Leases

Once this agreement’s term is up, the lessee owns the formerly leased asset. Unlike an operating lease, it provides the lessee an opportunity to purchase the asset below fair market value through a bargain purchase option. It also differs in that the contract’s term spans a minimum of three-quarters of the asset’s estimated useful life. If the present value of the lease payments is at least 90 percent of the asset’s original cost, it qualifies as this type of loan.

Determining the Loan Type

Looking through the lens of IFRS, one way to decide what type of a lease to enter is to calculate the present value of the smallest lease financial obligations. Taking the following loan terms, we can determine what percentage of the minimum lease payments are of the asset’s fair value when the lease is signed. Here’s an example.

On the first day of the year, a business signed a lease agreement for five years for equipment that has a fair value of $150,000 and has an interest rate of 8.75 percent. A single installment of $33,750 will be paid at the start of each year. The equipment will be returned to the lessor at the end of the lease. The asset’s useful life is five years, with no residual value. The company chooses the straight-line depreciation method.

Since the equipment will be returned to the lessor, the bargain purchase option doesn’t apply. Also, since the economic life is five years and the lease term are the same length, it’s 100 percent, rendering the asset to have no alternative use once the lease is completed. Therefore, we can determine the present value as follows:

Number of Periods (NPER) = 5 annual payments over the loan’s life

Rate = 8.75 annual interest rate

FV = 0 (future value)

PMT = $33,750 (single payment per 12-month period)

Type 1 = (payment is made at the beginning of the year)

Calculated using Excel, the present value is $143,693. This present value divided by the initial cost means that the asset’s fair value when leased is 95.8% ($143,693/$150,000)

Based on this calculation, with the least lease payments’ net present value well above the 90 percent minimum threshold, it would be considered a finance or capital lease.