Intermediate Accounting Essay
Nicholas Inc. is in need of a new punch press to increase its production output. Their company policy is to have the purchasing department obtain 3 different vendor bids for any major purchases. The engineering department of Nicholas Inc. has determined that each of the three vendor’s punch presses is substantially identical and each has an estimated useful life of 20 years. Maintenance on the machine is performed at year-end. With a cost of capital of 10%, it is our job to determine which vendor to purchase the new machine from.
The engineering department has determined the annual maintenance expense associated with the punch press to be $1000 per year for the first five years, $2000 per year for the next 10 years and $3000 per year for the last five years. To calculate the present value of these accumulated costs you need to calculate the present value of an ordinary annuity of $1,000 for the first five periods plus the present value of an ordinary annuity of $2,000 in periods 6 thru 15 plus the present value of an ordinary annuity in periods 16 thru 20. This is equal to: =1000 x PV of OA + 2000 x PV of OA + 3000 x PV of OA
=1000 x 3.79079 + 2000 x (7.60608-3.79079) + 3000 x (8.51356-7.60608) =$14,143.81
The value of the punch press from Vendor A is equal to $55,000 in cash at delivery and 10 year end payments of $18,000 each. To calculate the present value of the purchase, you need to calculate the present value of an ordinary annuity of $18,000 plus the initial payment of $55,000. This in preset value is equal to: =55000 + 18000 x PV of OA
=55000 + 18000 x 6.14457
Vendor A offers a separate 20-year maintenance service contract valued at $10000 made at the initial purchase. This would save the company $4,143.81 in maintenance costs over the life of the press. Including maintenance costs associated with this punch press, the total amount of money spent on this machine in present day dollars would be $175,602.26 The value of the punch press from Vendor B is equal to forty semiannual payments of $9,500 each, with the first payment due at the time of delivery. To determine the cost in present value dollars, you find the present value of an annuity due of $9500 for 40 periods at 5%, which is equal to: =9500 x PV of AD
=9500 x (17.15909 x 1.05)
Vendor B will perform all year-end maintenance associated with the press at no additional cost, so the present value amount spent on the equipment would be $171,161.92 The value of the punch press from Vendor C is equal to $150,000 cash at the initial time of delivery. Since no annual maintenance package is offered from Vendor C, we must assume the cost of maintenance will be equal to what the engineering department had determined above. The present value dollar costs associated with the purchase of the press from Vendor C is $164,143.81.
Nicholas Inc. should use Vendor C to purchase the new punch press. Using present value dollars to determine how much the press will cost today, Vendor C offers the cheapest purchase price for the machine. One factor other than the price of the equipment Nicholas Inc. should consider is the balance in their cash account. Do they have a large enough balance to cover the large initial payment of $150,000? Also, if they do have enough cash on hand to make a $150,000 initial purchase, will this result in Nicholas Inc. being short on the cash that it needs for other normal expenses like payroll, utilities and raw materials purchases?
If a cash shortfall would result from purchasing the press from Vendor C, then Nicholas Inc. may be forced to use Vendor B who offers a financing plan but will result in them paying more in present value dollars for the press. The most recent concept statement that deals with present value measurements in accounting is the Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements. This was issued in February of 2000. When observable dollar amounts are not available to determine the value of an asset or liability, accountants often turn to estimated cash flows to determine the carrying value of the asset or liability in question. Since those cash flows usually occur in one or more future periods, present value concepts of the future cash flows are used to determine the value of the asset or liability.
The goal here is to determine the difference in value between these cash flows if they were received today and when they are received in the future. Examples of assets and liabilities that would use present value concepts to determine their carrying value are notes payable, bonds payable, notes receivable and bonds receivable. The following are key terms related to present value and its use in accounting measurement practices. Best estimate is the single most likely amount in a range of possible estimated amounts.
Estimated cash flow refers to a single amount to be received or paid in the future. Expected cash flow refers to the probability-weighed amounts in a range of possible estimated amounts to be received or paid in the future. A fresh-start measurement is when the value of an asset or a liability is re-evaluated after its original period of valuation. Some fresh-start measurements are performed every period while others occur only after a certain situation or “trigger” occurs.
Interest methods of allocation refers to the process companies use to adjust the book value of assets or liabilities when their values have previously been determined using present value techniques. Interest methods of allocation will be used to determine the carrying value of the punch press for Nicholas Inc in future periods. Estimated cash outflows associated with each vendor were the basis to determine which vendor had the cheapest present value price of the equipment.
[ 1 ]. FASB, Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, Paragraph 1. February 2000. [ 2 ]. FASB, Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, February 2000.
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