Chapter 9 Long-Term Assets Skyline College Lecture Notes.

Chapter 9

Long-Term Assets

Skyline College

Lecture Notes

Copyright © Houghton Mifflin Company. All rights reserved. 9–2

Long-Term Assets

Useful life of more than one yearUsed in the operation of a business

Not intended for resale

Long-term assets might include: Equipment Vehicles Property Trademarks


Carrying Value

The unexpired cost of an asset (also called book value)

Unexpired Cost = Cost – Accumulated Depreciation

On the Balance Sheet:


Classification of Long-Term Assets and Methods of Accounting for Them


Asset Impairment

When is an asset deemed impaired?

When a long-term asset loses some or all

of its potential to generate revenue

before the end of its useful life

Asset Impairment

The carrying value of a long-term asset exceeds

its fair value


Acquiring Long-Term Assets

How do companies make the decision to acquire long-term assets?

Capital Budgeting Method of Evaluation

Net Present Value Method

Evaluates the purchase based on the net present value of acquisition cost, net annual savings in

cash flows, and disposal price


Apple Computer is considering the purchase of a $50,000 customer relations software package. Management estimates that the company will save $20,000 in net cash flows per year for four years, the usual life of the software. The software should be worth $10,000 at the end of that period. The interest rate is 10 percent compounded annually.

20x5 20x6 20x7 20x8 Acquisition cost ($50,000) Net annual savings in cash flows $20,000 $20,000 $20,000 $20,000 Disposal price 10,000 Net cash flows ($30,000) $20,000 $20,000 $30,000

Cash flows related to the purchase of the computer would be as follows:

Net Present Value Method

Present value Tables 3 and 4 can now be used to place the cash flows on a comparable basis.


Net annual savings in cash flows

Present value factor = 3.170 Table 4: 4 periods, 10% 3.170 x $20,000

63,400

Disposal price Present value factor = .683

Table 3: 4 periods, 10% .683 x $10,000

6,830

Net present value $20,230

20x5 20x6 20x7 20x8 Acquisition cost ($50,000) Net annual savings in cash flows $20,000 $20,000 $20,000 $20,000 Disposal price 10,000 Net cash flows ($30,000) $20,000 $20,000 $30,000

Acquisition cost Present value factor = 1.000 1.000 x $50,000

($50,000)

As long as the net present value is positive, Apple will earn a return of at least 10 percent.

The return is greater than 10 percent on the investment. Based on this analysis, Apple should purchase the software.

Example of Net Present Value Method (cont’d)


Financing Long-Term Assets

• Financing alternatives:Use cash flow from

operationsIssue common stockIssue long-term notesIssue bonds

Investors may investigate whether a company has

free cash flow to finance long-term assets.

Free cash flow is cash that remains after deducting funds committed to operations at current levels


The Matching Rule and Long-Term Assets

When a company purchases an asset, it may choose to capitalize it, thus deferring an expense to a later period

Favorably impacts profitability for that current period

Management uses ethical judgments in resolving two issues:

1. How much of the cost of a long-term asset should be allocated to expense in the current period?

2. How much should be retained on the balance sheet as an asset that will benefit future periods?


Long-Term Asset Accounting Policies

Each company must determine how it will treat long-term assets:

1. What is the cost of the long-term asset?

2. How should the expired portion of the cost of the asset be allocated against revenues over time?

3. How should subsequent expenditures, such as repairs and additions, be treated?

4. How should disposal of the long-term asset be recorded?


Discussion: Ethics on the Job

Brattman Company purchases a building and the land on which it is located for a lump sum. The accountant must allocate the purchase price between the building and the land. The accountant decides to allocate a larger portion of the price to the land since this will improve net income. (If he allocated more of the price to the building, depreciation expense would be higher, thus decreasing net income.)

Q. Is this decision ethical? What must the accountant base his decision on?


What Are Expenditures?

Payments or obligations to make a future payment for an asset or for a service

Capital Expenditure

Revenue Expenditure

Expenditure for the purchase or

expansion of a long-term asset

Expenditure for the repair, maintenance, and operation of a long-term asset


Capital Expenditures

Outlays for plant assets, natural resources, and intangible assets

Additions, which are enlargements to the physical layout of a plant asset

Betterments, which are improvements to a plant asset but that do not add to the plant’s physical layout

Extraordinary repairs, which are repairs that significantly enhance a plant asset’s estimated useful life or residual value


Acquisition Costs

Includes all expenditures reasonable and necessary to get an asset in place and ready for use

Installation costs Freight Insurance while in transit Testing and setup

Are these items considered acquisition costs?

Repair costsInterest charges on purchase

No No


Acquiring Land

Costs that should be debited to the Land account include:

Purchase price Agent commissionsLegal feesAccrued taxes paid by

purchaserGradingLand preparation feesAssessments for local

improvements Landscaping

SampleAcquisition of Land

Net purchase price $170,000Brokerage fees 6,000Legal fees 2,000Tearing down old building $10,000Less salvage 4,000 6,000Grading 1,000Total cost $185,000

Improvements to real estate like fences, driveways, or parking lots have a limited life. They should be recorded in an account called Land Improvements, not the Land account.


Acquiring Buildings

Acquisition costs include:

Purchase price

Repairs and other expenditures required to put it in usable condition

Buildings are subject to depreciation because they have a limited useful life


Leasehold Improvements

Improvements to leased property that become the property of the lessor at the end of the lease

Classified as tangible assets in property, plant, and equipment section of the balance sheet

Costs of leasehold improvements are depreciated or amortized over the remaining term of the lease or the useful life of the improvement, whichever is shorter.


Acquiring Equipment

• Acquisition costs include:Purchase price (less cash discounts)All expenditures connected with purchasing the

equipment and preparing it for use• Freight• Insurance in transit• Excise taxes and tariffs• Buying expenses• Installation costs• Cost of test runs

Equipment is subject to depreciation because it has a

limited useful life


Group Purchases

Land and other assets may sometimes be purchased for a lump sum

Because buildings are depreciable and land is not, the purchase price

must be allocated to each asset

Appraisal Percentage Apportionment Land $ 10,000 10 % ($10,000 ÷ $100,000) $ 8,500 ($85,000 x 10%) Building 90,000 90 ($90,000 ÷ $100,000) 76,500 ($85,000 x 90%) Totals $100,000 100 % $85,000

ABC Co. buys a building and the land on which it is situated for a lump sum of $85,000. Assume that appraisals yield estimates of $10,000 for the land and $90,000 for the building if purchased separately. Allocate as follows:


What Is Depreciation?

The periodic allocation of the cost of a tangible asset (other than land and natural resources) over the asset’s estimated useful life

All tangible assets except land have a limited useful life (physical deterioration and obsolescence limit useful life)

Depreciation refers to the allocation of the cost of a plant asset to the periods that benefit from the asset, not to the asset’s physical deterioration or decrease in market value

Depreciation is not a process of valuation; it is a process of allocation


Four Factors That Affect the Computation of Depreciation

1. Cost Net purchase price of an asset plus all reasonable and necessary expenditures to get it in place and ready for use

2. Residual value

Estimated scrap, salvage, or trade-in value on the estimated date of its disposal

3. Depreciable cost

Cost less residual value

4. Estimated useful life

Total number of service units expected from a long-term asset


Depreciation Expense, Asset Name xxx Accumulated Depreciation, Asset Name xxx To record depreciation for the period

Accounting for Depreciation

Depreciation is recorded at the end of the accounting period by an adjusting entry


Methods of Accounting for Depreciation

Accelerated method of depreciation that results in larger amounts of depreciation in earlier years of the asset’s life and smaller amounts in later years

Spreads the depreciable cost evenly over the estimated useful life of the asset

Based on the assumption that depreciation is solely the result of use and that passage of time plays no role in the depreciation process

Declining-balance method

Straight-line method

Production method


Life UsefulEstimated

Value Residual– Cost on DepreciatiYearly

yearper $1,800 years 5

$1,000– $10,000

A delivery truck costs $10,000 and has an estimated residual value of $1,000 at the end of its estimated useful life of 5 years.

Straight-Line Method Illustrated


Cost

Yearly Depreciation

Accumulated Depreciation

Carrying Value

Date of purchase $10,000 — — $10,000 End of first year 10,000 $1,800 $1,800 8,200 End of second year 10,000 1,800 3,600 6,400 End of third year 10,000 1,800 5,400 4,600 End of fourth year 10,000 1,800 7,200 2,800 End of fifth year 10,000 1,800 9,000 1,000

The amount of depreciation is the same each year

Accumulated depreciation increases uniformly

The carrying value decreases uniformly until it reaches the estimated residual value

Depreciation Schedule,Straight-Line Method


A delivery truck costs $10,000 and has an estimated residual value of $1,000 at the end of its estimated useful life of five years. Assume the truck was driven 20,000 miles during year 1; 30,000 miles during year 2; 10,000 miles during year 3; 20,000 miles during year 4; and 10,000 miles during year 5.

Life Usefulof UnitsEstimated

Value Residual– Cost Cost on Depreciati

mileper $0.10 miles 90,000

$1,000– $10,000

The unit of output or use should be appropriate for

that asset

Production Method


Cost

Miles

Yearly Depreciation

Accumulated Depreciation

Carrying Value

Date of purchase $10,000 — — — $10,000 End of first year 10,000 20,000 $2,000 $2,000 8,000 End of second year 10,000 30,000 3,000 5,000 5,000 End of third year 10,000 10,000 1,000 6,000 4,000 End of fourth year 10,000 20,000 2,000 8,000 2,000 End of fifth year 10,000 10,000 1,000 9,000 1,000

There is a direct relation between the amount of depreciation each year and the units of output or use.

Accumulated depreciation increases each year in direct relation to units of output or use.

The carrying value decreases each year in direct relation to units of output or use until the estimated residual value is reached.

Depreciation Schedule,Production Method


Declining-Balance Method

Based on the passage of time

Assumes that many kinds of plant assets are most efficient when new

Is consistent with the matching rule

Any fixed rate can be used

Most common rate is twice the straight-line depreciation percentage (called double-declining-balance method)


Double-Declining-Balance Method Illustrated

A delivery truck costs $10,000 and has an estimated residual value of $1,000. Its estimated useful life is 5 years.

Under the straight-line method, the depreciation rate for each year is 20 percent:

percent 20 years 5 percent 100

Under the double-declining-balance method, the depreciation rate for each year is 40 percent:

percent 40 percent 20 2

This fixed rate is applied to the remaining carrying value at the end of each year.


Note that the fixed rate is always applied to the carrying value at the end of the previous year.

Depreciation is greatest in the first year and declines each year after that.

The depreciation in the last year is limited to the amount necessary to reduce the carrying value to the residual value.($1,296 - $1,000 = $296)

Cost

Yearly Depreciation Accumulated Depreciation

Carrying Value

Date of purchase $10,000 — $10,000 End of first year 10,000 (40% x $10,000) $4,000 $4,000 6,000 End of second year 10,000 (40% x $6,000) 2,400 6,400 3,600 End of third year 10,000 (40% x $3,600) 1,440 7,840 2,160 End of fourth year 10,000 (40% x $2,160) 864 8,704 1,296 End of fifth year 10,000 296 9,000 1,000

Depreciation Schedule,Double-Declining-Balance Method

*

* ($1,296 – $1,000 = $296)


Graphic Comparison of Three Methods of Determining Depreciation


Revising Depreciation Rates

Sometimes a company must revise its estimate of an asset’s useful life or its residual value

The periodic depreciation expense will increase or decrease depending on the adjustment

The remaining depreciable cost of the asset should be spread over the remaining years of useful life


Methods of Disposal

DiscardSell for cash Exchange for another asset

When plant assets are no

longer usefu…

1. Record depreciation for the partial year up to the date of disposal

2. Remove the carrying value of the asset


MGC Company purchased a machine on January 2, 20x2, for $6,500 and planned to depreciate it on a straight-line basis over its estimated useful life (8 years). Its residual value at the end of 8 years was estimated to be $500.

On December 31, 20x7, the balances of the relevant accounts were:

Machinery Accumulated Depreciation, Machinery

6,500 4,650

On January 2, 20x8, management disposed of the asset.

Disposal of a Depreciable Asset


Disposal of a Plant Asset

Remove the carrying value of the asset• Carrying value is computed by subtracting accumulated

depreciation from the acquisition cost of the asset• If the asset is fully depreciated, the carrying value is zero• If the asset is not fully depreciated, a loss is recorded

Jan. 2 Accumulated Depreciation, Machinery 4,650 Loss on Disposal of Machinery 1,850 Machinery 6,500 Discarded machine no longer

used in business

Accum. Depreciation, Machinery

4,650

Machinery

6,500 4,6506,500

Bal. -0- Bal. -0-

Gains and losses on disposal of plant assets are classified as other revenues and expenses on the income statement.


Selling a Plant Asset for Cash

In addition to removing the carrying value of the asset, you will also record the cash received

If cash received = carrying value, no gain or loss is recorded

If cash received < carrying value, loss is recorded

If cash received > carrying value, gain is recorded


Selling an Asset for CashCash Received = Carrying Value

Received $1,850 cash for sale of machinery.

Remove the carrying value of the asset and record receipt of cash:

Jan. 2 Cash 1,850 Accumulated Depreciation, Machinery 4,650 Machinery 6,500 Sale of machinery for carrying

value; no gain or loss


Selling an Asset for CashCash Received < Carrying Value


Jan. 2 Cash 1,000 Accumulated Depreciation, Machinery 4,650 Loss on Sale of Machinery 850 Machinery 6,500 Sale of machinery at less than carrying

value; loss of $850 recorded ($1,850 – $1,000)



Selling an Asset for CashCash Received > Carrying Value


Jan. 2 Cash 2,000 Accumulated Depreciation, Machinery 4,650 Gain on Sale of Machinery 150 Machinery 6,500 Sale of machinery at more than carrying

value; gain of $150 recorded ($2,000 – $1,850)



Exchanges of Plant Assets

May involve similar assets

May involve dissimilar assets

Old machine traded in for newer

model

Cement mixer

traded in for truck

Purchase price is reduced by the amount of the trade-in allowance

If trade allowance is greater than asset’s carrying value, gain realized. If trade allowance is less than asset’s carrying value, loss realized.


What Are Natural Resources?

Assets that are converted to inventory by cutting, pumping, mining, or other extraction methods

Timberlands

Oil and Gas Reserves

Mineral Deposits

Record at acquisition cost and show on the

balance sheet as long-term assets


Available UnitsofNumber Estimated

Value Residual - Resource Natural ofCost per Unit Cost Depletion

Depletion of Natural Resources

(1) The exhaustion of a natural resource and

(2) The proportional allocation of the cost of a natural resource to the units extracted

Costs are allocated much like the

production method of depreciation

Costs are allocated much like the

production method of depreciation


Recording Depletion Expense

A mine that cost $1,800,000 has an estimated 1,500,000 tons of coal. The estimated residual value of the mine is $300,000. During the first year, 115,000 tons of coal are mined and sold.

Available UnitsofNumber Estimated

Value Residual - Resource Natural ofCost per Unit Cost Depletion

per ton $1 tons1,500,000

$300,000 - $1,800,000

Dec. 31 Depletion Expense, Coal Deposits 115,000 Accumulated Depletion, Coal Deposits 115,000 To record depletion of coal mine: $1

per ton, 115,000 tons mined and sold

Natural resources that have been extracted but not sold are considered inventory and are not recorded as an expense until the year sold.


Development and Exploration Costs in the Oil and Gas Industry

Use one of these two accounting methods:

Successful efforts method

Cost recorded as an asset and depleted over the estimated life of the resource. For an unsuccessful effort, write off immediately as a loss.

Full-costing method

All costs, including costs of dry wells, are recorded as assets and depleted over the estimated life of the producing resources. Improves earnings performance in the early years.


What Is an Intangible Asset?

GoodwillTrademarks Brand namesCopyrightsPatentsLeaseholdsSoftwareCustomer Lists

Long-term, nonphysical asset whose value comes from the rights or advantages afforded its owner


Importance of Intangibles

For some companies, intangible assets make up a substantial portion of total assets


Accounting for Intangible Assets

Intangibles developed by a firm for its own

benefit

Intangibles acquired from others

Record as expense Record as asset; amortize over the shorter of useful life or legal life (not to exceed 40 years)


Difficult Issues When Accounting for Intangibles

How to account for the initial carrying value? How to account for that amount under

normal business conditions (periodic write-off or amortization)?

How to account for the amount if the value declines substantially and permanently?

How to estimate an intangible asset’s value and useful life?


Intangible Assets Illustrated

Soda Bottling Company purchases a patent on a unique bottle cap for $18,000. The patent will last for 20 years, but the product using the cap will be sold only for the next six years.

Patents 18,000 Cash 18,000 To record purchase of bottle cap

patent

Record the purchase of the patent:

Amortization Expense 3,000 Patents 3,000 To record amortization expense for

patent ($18,000 ÷ 6 years)

Record the annual amortization expense:

Notice that the Patents account is directly reduced by the amount of amortization expense, whereas depreciation or depletion is accumulated in separate contra accounts for other long-term assets.


Intangible Assets Illustrated (cont’d)

The patent becomes worthless after only 1 year. Record the write-off:

If the patent becomes worthless before it is fully amortized, the remaining carrying value is written off as a loss by removing it from the Patents account.

Loss on Patent 15,000 Patents 15,000 To record the write -off of a

worthless patent ($18,000 – $3,000)


Research and Development Costs

The FASB requires that all R&D costs be treated as revenue expenditures and charged to expense in the period in which they are incurred.

Why? Too difficult to trace specific costs to specific profitable

developments

Costs of R&D are continuous and necessary for the success of a business and are treated as current expenses

Studies show that 30 to 90 percent of all new products fail and 75 percent of new-product expenses are unsuccessful


Computer Software Costs

Costs incurred in developing computer software for sale or lease or for a firm’s internal use are research and development costs until the product has proved technologically feasible

Costs incurred before technologically feasible should be charged to expense as incurred

Once a working program is ready, all costs are recorded as assets

Amortize over the estimated economic life using the straight-line method


Goodwill

A company’s good reputationCustomer satisfactionGood managementManufacturing efficiencyGood location

Goodwill exists when a purchaser pays more for a business than the fair market value of the business’s net assets

Goodwill should not be recorded unless it is paid for in connection with the purchase of a whole business

Goodwill = Purchase price – FMV of identifiable net assets

Chapter 9 Long-Term Assets Skyline College Lecture Notes.

Documents

Transcript of Chapter 9 Long-Term Assets Skyline College Lecture Notes.