Difficulty: Intermediate | Prerequisites: Chapters 1–4 study notes
Source: Libby, Libby & Hodge, Financial Accounting 10th ed., Chapters 8, 9, 11 | Course: ACCT2010, Introduction to Financial Accounting
These three chapters round out the balance sheet. Chapter 8 covers property, plant, and equipment (PP&E), the long-lived tangible assets that companies use to operate. Chapter 9 introduces liabilities, from short-term payables to bonds and the time value of money. Chapter 11 examines stockholders' equity, including how companies issue stock, pay dividends, and execute stock splits. Together, these chapters are tested on Quiz 3 and form a major part of the final exam. If Chapters 1 through 7 taught you the left side and the operating layer of financial statements, these chapters complete the right side.
PP&E is recorded at cost and depreciated over its useful life; disposals create gains or losses. Liabilities range from simple accounts payable to bonds whose pricing depends on the time value of money. Stockholders' equity tracks what owners have invested and what the company has retained, and changes through stock issuances, dividends, and stock splits.
Tags: PP&E, property plant and equipment, depreciation, straight-line, declining balance, units of production, capitalise vs expense, useful life, residual value, salvage value, book value, asset impairment, disposal of assets, gain on sale, loss on sale, fixed asset turnover
Property, plant, and equipment (PP&E)
Long-lived tangible assets used in the operation of a business. Examples include land, buildings, machinery, vehicles, and furniture. They are not held for resale; they are held for use.
Capitalise
To record a cost as an asset (on the balance sheet) rather than as an expense (on the income statement). A cost is capitalised when it provides benefits beyond the current period.
In simple terms, if the spending will help the company for years, put it on the balance sheet; if it helps only this period, expense it now.
Depreciation
The systematic allocation of an asset's cost (minus its residual value) over its useful life. It is not a cash outflow and it is not a measure of declining market value. It is purely a cost allocation mechanism.
Residual value (salvage value)
The estimated amount the company expects to receive when it disposes of the asset at the end of its useful life.
Useful life
The estimated period over which the asset will be used by the company. This is a management estimate and may differ from the asset's physical life.
Straight-line depreciation
Allocates an equal amount of depreciation to each year of the asset's useful life. It is the most commonly used method.
Annual Depreciation = (Cost - Residual Value) / Useful Life
Declining-balance depreciation
An accelerated method that records higher depreciation in earlier years and lower depreciation in later years. The most common version is double-declining balance.
Double-Declining Balance Rate = (2 / Useful Life) x Book Value at Beginning of Year
Note: residual value is not subtracted from cost in the annual calculation, but depreciation stops once book value reaches the residual value.
Units-of-production depreciation
Bases depreciation on actual usage or output rather than time. Useful for assets whose wear depends on how much they are used (e.g., machinery, vehicles).
Depreciation per Unit = (Cost - Residual Value) / Total Estimated Units of Production
Annual Depreciation = Depreciation per Unit x Units Produced This Year
Accumulated depreciation
A contra-asset account that holds the total depreciation recorded on an asset since it was acquired. It reduces the asset's reported value on the balance sheet.
Book value (carrying value, net book value)
The asset's cost minus accumulated depreciation. It is not market value.
Asset impairment
A permanent decline in an asset's value below its book value. When impaired, the asset is written down to its fair value, and an impairment loss is recognised on the income statement.
Fixed asset turnover ratio
Measures how efficiently a company uses its PP&E to generate revenue.
Fixed Asset Turnover = Net Sales / Average Net PP&E
What costs are capitalised?
The cost principle requires that all costs necessary to acquire an asset and get it ready for its intended use are included in the asset's recorded cost. This includes the purchase price, sales tax, transportation, installation, and any site preparation costs.
After acquisition, expenditures are treated differently:
Capital expenditures (improvements that extend the asset's life or increase its capacity) are added to the asset's cost on the balance sheet.
Revenue expenditures (ordinary repairs and maintenance that keep the asset running) are expensed immediately.
The three depreciation methods
Straight-line: equal expense each year. Simplest. Most widely used. Best when the asset provides equal benefits each period.
Declining balance (e.g., double-declining): front-loads the expense. Better for assets that lose productivity quickly or are technologically sensitive.
Units of production: expense varies with usage. Best for assets whose wear is driven by output (e.g., a delivery truck based on kilometres driven).
All three methods produce the same total depreciation over the asset's life. They differ only in timing.
Disposal of PP&E
When a company sells or disposes of an asset, it must:
Record depreciation up to the date of disposal.
Remove the asset's cost and accumulated depreciation from the books.
Record any cash received.
Recognise a gain or loss.
Gain or Loss = Cash Received - Book Value at Disposal
If Cash Received > Book Value, there is a gain. If Cash Received < Book Value, there is a loss.
Asset impairment
At each reporting date, companies must assess whether there are indicators that an asset's value may be impaired. If the asset's book value exceeds its recoverable amount (the higher of fair value less costs to sell and value in use), the asset is written down.
Entry: Debit Impairment Loss, Credit Equipment (or Accumulated Depreciation).
Impairment losses are usually non-recurring and can significantly affect reported earnings.
Straight-Line Depreciation = (Cost - Residual Value) / Useful Life
Double-Declining Balance = (2 / Useful Life) x Beginning Book Value
Units-of-Production = [(Cost - Residual Value) / Total Estimated Units] x Units This Period
Book Value = Cost - Accumulated Depreciation
Gain or Loss on Disposal = Proceeds - Book Value
Fixed Asset Turnover = Net Sales / Average Net PP&E
Airlines capitalise aircraft costing hundreds of millions of dollars and depreciate them over 20 to 30 years. The choice of depreciation method, useful life estimate, and residual value assumption can materially affect reported profits. When an airline retires a fleet early (as many did during the pandemic), the remaining book value creates a large loss on disposal.
Students often think depreciation measures an asset's loss of market value. It does not. It is a cost allocation tool. An asset's market value can rise while its book value falls through depreciation.
Students confuse capital expenditures (capitalised) with revenue expenditures (expensed). The test is whether the spending extends the asset's life or capacity beyond original expectations.
Students sometimes apply the residual value deduction when calculating double-declining balance depreciation. The formula uses book value without subtracting residual value, though depreciation stops when book value equals residual value.
Students forget to update depreciation before recording a disposal. The asset must be depreciated up to the disposal date.
⚠️ Be able to calculate depreciation under all three methods for a given set of facts.
⚠️ Know how to record the disposal of an asset and calculate the gain or loss.
⚠️ Understand the difference between capital and revenue expenditures.
⚠️ Know what asset impairment is and how it is recorded.
⚠️ Be able to compute and interpret the fixed asset turnover ratio.
True or False: Depreciation is a cash expense.
Fill in the blank: Book Value = Cost - _______.
True or False: Under double-declining balance, you subtract residual value from cost before applying the rate.
Fill in the blank: A gain on disposal occurs when proceeds _______ book value.
True or False: Land is depreciated over its useful life.
Answers: 1. False (depreciation is a non-cash expense). 2. Accumulated Depreciation. 3. False (the rate is applied to book value; residual value is not subtracted, but depreciation stops at residual value). 4. Exceed. 5. False (land has an unlimited useful life and is never depreciated).
Q: Equipment costs $40,000, has a residual value of $4,000, and a useful life of 4 years. Calculate straight-line depreciation for year 1.
A: ($40,000 - $4,000) / 4 = $9,000 per year.
Q: Using the same equipment, calculate double-declining balance depreciation for year 1 and year 2.
A: Rate = 2 / 4 = 50%. Year 1: $40,000 x 50% = $20,000. Book value at start of year 2: $40,000 - $20,000 = $20,000. Year 2: $20,000 x 50% = $10,000. (In year 3, depreciation would be limited so that book value does not fall below the $4,000 residual value.)
Q: A company sells equipment with a cost of $50,000 and accumulated depreciation of $35,000 for $12,000 cash. Record the journal entry.
A: Book value = $50,000 - $35,000 = $15,000. Proceeds = $12,000. Loss = $12,000 - $15,000 = $3,000 loss. Debit Cash $12,000, Debit Accumulated Depreciation $35,000, Debit Loss on Sale of Equipment $3,000, Credit Equipment $50,000.
Q: What is the difference between a capital expenditure and a revenue expenditure?
A: A capital expenditure extends the asset's useful life, increases its capacity, or improves its efficiency beyond original expectations; it is capitalised (added to the asset's cost). A revenue expenditure maintains the asset in its current condition; it is expensed in the current period.
Depreciation was first introduced as an adjusting entry in Chapter 4. PP&E sits under non-current assets on the classified balance sheet from Chapter 2. The fixed asset turnover ratio joins the receivables turnover (Chapter 6) and inventory turnover (Chapter 7) as key efficiency ratios for the final exam.
Tags: liabilities, current liabilities, long-term liabilities, accounts payable, notes payable, bonds payable, time value of money, present value, future value, working capital, accounts payable turnover, contingent liabilities
Current liabilities
Obligations the company expects to settle within one year or one operating cycle, whichever is longer. Examples include accounts payable, wages payable, taxes payable, the current portion of long-term debt, and unearned revenue.
Long-term liabilities (non-current liabilities)
Obligations not due within the next year. Examples include bonds payable, long-term notes payable, and lease obligations.
Accounts payable
Amounts owed to suppliers for goods or services purchased on credit. This is typically the largest current liability for merchandising companies.
Notes payable
Formal written promises to pay a specific amount at a future date, usually with interest. They can be short-term (current) or long-term.
Bonds payable
Long-term debt instruments issued to raise large amounts of capital. The company (issuer) promises to pay periodic interest and return the principal (face value) at maturity. Bonds are traded on public markets.
Face value (par value) of a bond
The amount the issuer will pay back at maturity. Also the amount on which periodic interest payments are calculated.
Stated interest rate (coupon rate)
The interest rate printed on the bond. It determines the periodic cash interest payment: Face Value x Stated Rate.
Market interest rate (yield)
The rate investors demand given current market conditions. When the market rate differs from the stated rate, the bond is issued at a premium or discount.
Bond issued at par
When the stated rate equals the market rate. The bond sells for its face value.
Bond issued at a discount
When the stated rate is below the market rate. Investors pay less than face value to compensate for the below-market interest payments.
Bond issued at a premium
When the stated rate exceeds the market rate. Investors pay more than face value because the interest payments are above market.
Time value of money
The principle that a pound today is worth more than a pound in the future because today's pound can be invested and earn a return. This concept underpins bond pricing.
Present value
The current worth of a future sum of money, given a specified rate of return. Bond prices are calculated as the present value of future interest payments plus the present value of the face value at maturity.
Working capital
Current Assets - Current Liabilities. It measures a company's short-term liquidity and its ability to meet obligations as they come due.
Accounts payable turnover ratio
Measures how quickly a company pays its suppliers.
Accounts Payable Turnover = Cost of Goods Sold / Average Accounts Payable
Average Payment Period = 365 / Accounts Payable Turnover
Current liabilities in detail
Common current liabilities and how they arise:
Accounts payable: purchasing goods on credit.
Wages payable: employee compensation earned but not yet paid (an accrued expense from Chapter 4).
Taxes payable: income taxes or sales taxes owed to the government.
Unearned revenue: cash received from customers before delivering goods or services.
Current portion of long-term debt: the amount of long-term debt due within the next 12 months.
Notes payable
When a company borrows by signing a note:
At issuance: Debit Cash, Credit Notes Payable.
Interest accrual at period end: Debit Interest Expense, Credit Interest Payable.
At repayment: Debit Notes Payable, Debit Interest Payable (or Interest Expense), Credit Cash.
Interest = Principal x Annual Rate x (Time / 12) for monthly periods, or (Time / 365) for daily.
Bond pricing and the time value of money
A bond's price is the present value of two streams:
The annuity of periodic interest payments (Face Value x Stated Rate per period), discounted at the market rate.
The lump sum of the face value returned at maturity, discounted at the market rate.
Bond Price = PV of Interest Payments + PV of Face Value
If the market rate equals the stated rate, the bond sells at par. If the market rate is higher, the bond sells at a discount. If the market rate is lower, the bond sells at a premium.
Working capital and liquidity
Working capital is a quick measure of whether the company can meet its short-term obligations. Positive working capital means current assets exceed current liabilities. Negative working capital is a warning sign, though some companies (like large retailers) operate with negative working capital by managing cash conversion cycles tightly.
Long-term liabilities on the balance sheet
Long-term liabilities are reported at their carrying value. For bonds, the carrying value is face value plus any unamortised premium or minus any unamortised discount. Over the life of the bond, the carrying value converges toward face value.
Interest = Principal x Rate x Time
Bond Price = PV of Annuity (Interest Payments) + PV of Lump Sum (Face Value)
Working Capital = Current Assets - Current Liabilities
Accounts Payable Turnover = COGS / Average Accounts Payable
Average Payment Period = 365 / Accounts Payable Turnover
Companies issue bonds to fund large capital projects, such as building factories or acquiring other businesses. When central banks raise interest rates, newly issued bonds must offer higher stated rates (or sell at deeper discounts) to attract investors. This is why bond markets react strongly to monetary policy announcements.
Students often confuse the stated rate with the market rate. The stated rate is fixed on the bond; the market rate fluctuates with economic conditions. The difference between them determines whether the bond is issued at par, a discount, or a premium.
Students forget to accrue interest at period end for notes payable. If the period ends between interest payment dates, an adjusting entry is needed.
Students sometimes think a bond issued at a discount is a bad deal for the issuer. It simply reflects that the issuer's stated rate is below market; the discount compensates investors.
Students mix up working capital (a dollar amount) with the current ratio (a ratio). Both measure liquidity, but they are calculated differently.
⚠️ Be able to record journal entries for issuing and repaying notes payable, including interest accrual.
⚠️ Understand bond pricing at a conceptual level: know when bonds sell at par, at a discount, or at a premium.
⚠️ Be comfortable with basic present value calculations.
⚠️ Know how to compute working capital and the accounts payable turnover ratio.
⚠️ Understand the distinction between current and non-current liabilities.
True or False: A bond sells at a discount when the stated rate exceeds the market rate.
Fill in the blank: Working Capital = Current Assets - _______.
True or False: Interest on a note payable must be accrued at period end if payment has not yet been made.
Fill in the blank: A bond's price is the present value of its _______ payments plus the present value of its face value.
True or False: Accounts payable is a long-term liability.
Answers: 1. False (a bond sells at a discount when the stated rate is below the market rate). 2. Current Liabilities. 3. True. 4. Interest. 5. False (accounts payable is a current liability).
Q: A company signs a $100,000, 6%, 3-month note payable on 1 November. What is the adjusting entry on 31 December?
A: Two months of interest have accrued (November and December). Interest = $100,000 x 6% x 2/12 = $1,000. Debit Interest Expense $1,000; Credit Interest Payable $1,000.
Q: A $1,000 face value bond has a stated rate of 5% and the market rate is 6%. Will the bond sell at par, a premium, or a discount? Why?
A: At a discount. The stated rate (5%) is below the market rate (6%), so investors will not pay full face value. They demand a lower price to compensate for the below-market interest payments.
Q: Define working capital and explain what a negative working capital figure means.
A: Working capital = Current Assets - Current Liabilities. Negative working capital means the company's current liabilities exceed its current assets, which may signal liquidity risk. However, some companies manage this deliberately through efficient cash conversion.
Q: What is the time value of money, and how does it relate to bond pricing?
A: The time value of money is the principle that money available today is worth more than the same amount in the future because it can earn a return. A bond's price is calculated by discounting its future cash flows (interest payments and face value) to their present value using the market interest rate.
Notes payable and bonds payable sit in the liabilities section of the balance sheet introduced in Chapter 2. Interest accrual is an adjusting entry from Chapter 4. Working capital connects current assets (Chapters 6 and 7) to current liabilities. The accounts payable turnover ratio complements the receivables turnover (Chapter 6) and inventory turnover (Chapter 7) to give a full picture of the cash conversion cycle.
Tags: stockholders' equity, common stock, preferred stock, par value, additional paid-in capital, retained earnings, dividends, cash dividends, stock dividends, stock splits, treasury stock, capital structure, authorised shares, issued shares, outstanding shares
Common stock
The basic ownership shares of a corporation. Common stockholders have voting rights, receive dividends (when declared), and have a residual claim on assets in liquidation (after creditors and preferred stockholders are paid).
Preferred stock
Shares that typically carry a fixed dividend rate and have priority over common stock for dividends and asset distribution in liquidation. Preferred stockholders usually do not have voting rights.
Think of preferred stock as a hybrid between debt and equity: it has some features of each.
Par value
A nominal, often very small, legal value assigned to each share of stock when it is authorised. It has little economic meaning today but affects how issuance is recorded.
Additional paid-in capital (APIC, capital in excess of par)
The amount stockholders paid above par value when they purchased shares. If stock with a $1 par value is issued at $25, the $24 difference goes to APIC.
Retained earnings
The cumulative net income earned by the company since its inception, minus all dividends ever declared. It represents profits that have been reinvested in the business rather than distributed to owners.
Dividends
Distributions of a corporation's earnings to its stockholders. Cash dividends reduce both retained earnings and cash. Stock dividends distribute additional shares rather than cash.
Cash dividends
Payments of cash to stockholders. Three key dates:
Declaration date: the board announces the dividend. A liability (Dividends Payable) is created.
Record date: determines which stockholders will receive the dividend. No journal entry.
Payment date: cash is paid. The liability is removed.
Stock dividends
Distribution of additional shares to existing stockholders in proportion to their holdings. A small stock dividend (less than 20-25% of outstanding shares) is recorded at market value. A large stock dividend (greater than 20-25%) is recorded at par value.
Stock dividends do not change total stockholders' equity. They simply move value from retained earnings to contributed capital accounts.
Stock splits
An increase in the number of shares outstanding with a proportional decrease in par value per share. For example, a 2-for-1 split doubles the number of shares and halves the par value. Total stockholders' equity is unchanged, and no journal entry is required (only a memo entry).
In simple terms, stock splits are like cutting a pizza into more slices: more pieces, same pizza.
Treasury stock
Shares that the company has issued and later repurchased. Treasury stock is reported as a contra-equity account (it reduces total stockholders' equity). Treasury shares do not receive dividends and do not have voting rights.
Authorised, issued, and outstanding shares
Authorised shares: the maximum number the company is legally permitted to issue.
Issued shares: shares that have been sold to investors at some point.
Outstanding shares: issued shares minus treasury stock. These are the shares currently held by investors.
The role of stock in the capital structure
Corporations raise capital in two primary ways: debt (borrowing) and equity (issuing stock). Equity financing does not require repayment or interest payments, but it dilutes existing owners' percentage of ownership. The mix of debt and equity is called the company's capital structure.
Recording common stock issuance
When stock is issued:
Debit Cash (total amount received) Credit Common Stock (number of shares x par value) Credit Additional Paid-in Capital (the excess over par)
Example: a company issues 1,000 shares of $1 par stock at $30 per share. Debit Cash $30,000; Credit Common Stock $1,000; Credit APIC $29,000.
Recording cash dividends
Declaration date: Debit Retained Earnings (or Dividends Declared), Credit Dividends Payable.
Payment date: Debit Dividends Payable, Credit Cash.
The record date requires no journal entry.
Stock dividends vs. stock splits
Both increase the number of shares outstanding. The key differences:
Stock dividends move value from retained earnings to common stock and APIC. They require a journal entry.
Stock splits simply divide existing shares into more pieces with proportionally lower par value. No journal entry is needed, and no account balances change.
Neither changes total stockholders' equity. Neither changes each shareholder's proportional ownership.
Treasury stock
When a company buys back its own shares:
Debit Treasury Stock (at cost), Credit Cash.
Treasury Stock appears as a negative item in the equity section, reducing total stockholders' equity. Companies repurchase stock to return value to shareholders, use shares for employee compensation plans, or signal confidence in the company's value.
Outstanding Shares = Issued Shares - Treasury Shares
Book Value Per Share = Total Stockholders' Equity / Outstanding Shares
Dividend Yield = Dividends Per Share / Market Price Per Share
Tech companies like Apple have conducted massive share repurchase programmes, spending billions to buy back treasury stock. This reduces the number of outstanding shares, which increases EPS even if net income stays flat. Understanding treasury stock helps you see through this financial engineering.
Students often think stock dividends and stock splits are the same thing. They are similar in effect (more shares, same total value) but different in accounting treatment. Stock dividends require journal entries; stock splits do not.
Students confuse par value with market value. Par value is a legal formality, often $0.01 or $1. Market value is what investors pay on the stock exchange.
Students sometimes think retained earnings is a cash account. It is not. Retained earnings represents accumulated profits, but that cash may have been spent on equipment, inventory, or debt repayment long ago.
Students forget that treasury stock reduces equity, not increases it. It is a contra-equity account.
⚠️ Be able to record journal entries for issuing stock, declaring and paying cash dividends, recording stock dividends, and purchasing treasury stock.
⚠️ Know the difference between authorised, issued, and outstanding shares.
⚠️ Understand the three dates for cash dividends and which require journal entries.
⚠️ Be able to explain why stock dividends and stock splits do not change total equity.
⚠️ Know that treasury stock is a contra-equity account.
True or False: A stock split requires a journal entry.
Fill in the blank: Outstanding Shares = Issued Shares - _______.
True or False: Retained earnings represents cash available for distribution.
Fill in the blank: When stock is issued above par value, the excess is credited to _______.
True or False: Treasury stock increases total stockholders' equity.
Answers: 1. False (only a memo entry is made). 2. Treasury Shares. 3. False (retained earnings is an accumulated profit figure, not a cash balance). 4. Additional Paid-in Capital. 5. False (treasury stock is a contra-equity account and reduces total equity).
Q: A company issues 5,000 shares of $2 par value common stock at $40 per share. Record the journal entry.
A: Debit Cash $200,000 (5,000 x $40); Credit Common Stock $10,000 (5,000 x $2); Credit Additional Paid-in Capital $190,000 ($200,000 - $10,000).
Q: The board of directors declares a $0.50 per share cash dividend on 100,000 outstanding shares. Record the journal entries on the declaration date and the payment date.
A: Declaration date: Debit Retained Earnings $50,000 (100,000 x $0.50); Credit Dividends Payable $50,000. Payment date: Debit Dividends Payable $50,000; Credit Cash $50,000.
Q: Explain how a 10% stock dividend affects the financial statements.
A: A 10% stock dividend increases the number of shares outstanding by 10%. Retained earnings decreases by the market value of the new shares (since it is a small stock dividend). Common Stock and APIC increase by corresponding amounts. Total stockholders' equity remains unchanged. No cash leaves the company.
Q: A company repurchases 2,000 of its own shares at $35 per share. Record the entry.
A: Debit Treasury Stock $70,000 (2,000 x $35); Credit Cash $70,000. Total stockholders' equity decreases by $70,000.
Stockholders' equity is the right-hand side of the accounting equation from Chapter 1. Retained earnings ties back to net income (Chapter 3) and the closing process (Chapter 4). Dividends reduce retained earnings, which is why the statement of stockholders' equity (introduced in Chapter 1) shows both net income and dividends. The capital structure decision (debt vs. equity) links to Chapter 9's treatment of bonds and liabilities.
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