Chapter 8:

Noncurrent Assets used in Operations

Tangible assets assets with physical substance that are used in operations
Land impairment Buildings, fixtures and equipment depreciation Natural resources depletion

Intangible assets assets without physical substance

that are used in operations Patents, copyrights, franchises amortization Trademarks, Goodwill impairment

Recall Asset Recognition Criteria

Probable future benefit to the company Acquired via a past transaction or event Owned or controlled by the company Relevant to users Can be reliably measured

Chapter 8 covers Acquisition, Use, and Disposal of Noncurrent Assets used in Operations

Acquisition
When are expenditures with potential future benefits assets versus expenses? 1. Human resources (cost of training) 2. Drilling an oil well (what if a dry hole?) 3. Research and development expenditures What costs are included in the value of an asset?

Use
Should asset be depreciated or not? Is so, how? Over what period? Using what pattern? How should changes in estimates be treated? How should substantial declines in market value be treated?

Disposal
How are disposals treated? Should potential disposal costs be anticipated and accrued as liabilities?
Purchase an existing manufacturing facility for $100K in cash and assume the cost of clean up (estimated at $20K) at end of useful life: Land, Bldgs, Equipt 120K Cash 100K Disposal Liability 20K

Acquisition
Operational

assets should be recorded at acquisition cost plus any other costs incurred in acquiring and readying the asset for use Costs are Capitalized . What does that mean? Assets can be acquired for cash, debt, equity, noncash assets, or by construction.

Acquisition Example
General Works acquires land and a building for a factory and incurs the following costs in searching for and acquiring both. What costs should be included for land? For building? Purchase price of land with an existing building, $1,000,000 Cost split between land and building Fees paid to lawyer in handling purchase contracts, $10,000 Cost split between land and building

Acquisition Example continued

Transfer taxes paid to local real estate taxing authorities, $2,000 Cost of land only, or split between land and building Salaries earned by management personnel during the search for the site and the negotiation of its purchase, $8,000 Cost could be assigned to land and building, but management salaries are typically expensed Operating expenditures for company automobiles used during the search, $75 Expense as incurred not material

Acquisition Example continued

Depreciation of company automobiles used during the search, $65 Expense does not pass cost/benefit test to allocate such small amounts Fees paid to consulting engineer for a report on the structural soundness of the building, its current value, and estimated cost of making needed repairs Cost of Building

Acquisition Example continued

Uninsured cost to repair automobiles damaged in a multi vehicle accident during the search, $3,000 Expense accident did not add value to property Profits lost on sales the company failed to make because during the search management paid insufficient attention to a potential new customer, $20,000 Not recognized as a cost. If you included as a cost, what account would you credit? Land 10,000 Building 10,000 ?????? 20,000

Acquisition by Construction
Suppose a company constructs its own plant and finances the construction through a bank loan. Should the company include interest incurred on the loan as a part of the cost of the plant or treat interest as a period expense? The companys options were: Purchase existing facility Build using debt financing Build using equity financing

Basket Purchases
For

multiple assets purchased in a single transaction, the cost for each asset should be measured and recorded separately. (Why?) Example: On January 1 the Louie Company purchased land and building for $200,000 cash. The appraised value of the building was $162,500 and the land was appraised at $87,500 (total appraised value of both is $250,000). At what amounts will the assets be recorded?

Acquisition as a Basket Purchase Example

Asset Land Building Total Appraised Value a $ 87,500 162,500 $ 250,000 % of Value Purchase Price Assigned Cost b* c b c 35% $ 200,000 = $ 70,000 65% 200,000 = 130,000 100% $ 200,000

* $87,500 $250,000 = 35%

Journal entry to record purchase: Land Building Cash 70,000 130,000 200,000

Accounting during use

Repairs: Minor repairs that maintain the original expected life and use of the asset (expensed) versus Major repairs that extend the life or enhance the productivity of the asset (capitalized) Depreciation Impairments

Capital Expenditures Extraordinary Repairs & Maintenance

Major,

high-cost, long-term repairs that increase the economic usefulness of an asset by either:
improving efficiency e.g., installing solar panels

or
extending the useful life e.g., replacing roof
Recorded

as assets (additions to the original asset value) and depreciated over the remaining estimated life of the asset

Operating Expenditures Ordinary Repairs and Maintenance

Expenditures

for normal maintenance and upkeep of operational assets that are necessary to keep the assets in their usual condition e.g., replacing tires on trucks The expenditures are recorded as expenses when incurred

Depreciation
Depreciation is a cost allocation process that systematically matches acquisition costs of operational assets with periods benefitted by their use.
Balance Sheet Acquisition Cost (Unused) Cost Allocation Income Statement Expense (Used)

Depreciation
Depreciation Expense Depreciation for the current year Income Statement

Accumulated Depreciation

Total of depreciation to date on an asset

Balance Sheet

Depreciation on the Balance Sheet

Property, plant, and equipment: Land and buildings Machinery and equipment Office furniture and equipment Land improvements Total Less Accumulated depreciation Net property, plant, and equipment $ 150,000 200,000 175,000 50,000 $ 575,000 (122,000) $ 453,000

Net property, plant, and equipment is the depreciated cost (book value) of the plant assets.

Depreciation Concepts
The calculation of depreciation requires three amounts for each asset: 1 Acquisition cost 2 Estimated useful life 3 Estimated residual value

Depreciation Methods
v Straight-line v Accelerated Method
declining balance Sum of years digits

vActivity based
Units-of-production Service-hours

Straight-Line Method
Depreciation Expense per Year = Cost - Residual Value Estimated Life in Years

Produces the same amount of expense for each year over the estimated useful life of the asset

Accelerated Depreciation
Depreciation

expense is greater in the early years of the life of an asset compared with the later years This method matches higher depreciation with higher revenues in the early years.
$ Expense Straight line Accelerated Year

Double-Declining-Balance Method
Declining balance rate of 2 is double-declining-balance (DDB) rate i.e., two times the straight-line rate

Annual Book Depreciation = Value expense

2 / Useful Life in Years

Cost Accumulated Depreciation Annual computation ignores residual value.

Double-Declining-Balance Method
On January 1, Year 1, equipment is purchased for $50,000 cash. The equipment has an estimated useful life of 5 years and an estimated residual value of $5,000.
Calculate the depreciation expense for Year 1 and Year 2.

Double-Declining-Balance Method Example

Annual Depreciation = expense Yr 1 Depreciation: $50,000 Yr 2 Depreciation: ($50,000 $20,000) Book Value

2 Useful Life in Years

2 5 years

) = $20,000 (
2 5 years

) = $12,000

Double-Declining-Balance Method
Year Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Depreciation Expense (debit) $ 20,000 12,000 7,200 4,320 2,592 46,112 Accumulated Depreciation Balance $ 20,000 32,000 39,200 43,520 46,112 Undepreciated Balance (book value) $ 50,000 30,000 18,000 10,800 6,480 3,888

Below residual value

($50,000 $43,520)

2 5 years

) = $2,592

Double-Declining-Balance Method
Year Yr Yr Yr Yr Yr 1 2 3 4 5 Depreciation Expense (debit) $ 20,000 12,000 7,200 4,320 1,480 45,000 Accumulated Depreciation Balance $ 20,000 32,000 39,200 43,520 45,000 Undepreciated Balance (book value) $ 50,000 30,000 18,000 10,800 6,480 5,000

We usually have to force depreciation expense in the latter years to an amount that brings BV to residual value.

Units-of-Production Depreciation

The amount of expense recognized each year varies with the productive output of the asset (depreciation becomes a variable cost ) Depreciation expense using this method would typically be added to the cost of inventory and expensed when inventory is sold (as Cost of goods sold). This method keeps the depreciation portion of cost of inventory constant across production levels. 2 step process

Units-of-Production Method
Step 1:
Depreciation Rate =
Acquisition Cost - Residual Value Estimated output over the asset s life

Step 2:
Depreciation = included in Work in Process Depreciation Rate Number of Units Produced for the Year

Units-of-Production Method
On January 1, Year 1, equipment was purchased for $50,000 cash. The equipment is expected to produce 100,000 units during its useful life and has an estimated residual value of $5,000. If 22,000 units were produced in Year 1, what is the amount of depreciation added to Work in Process?

Units-of-Production Method
Example
Step 1:
Depreciation = Rate $50,000 - $5,000 100,000 units = $.45 per unit

Step 2:
Depreciation Added to WIP = $.45 per unit 22,000 units = $9,900

Units-of-Production Method
Year Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Units 22,000 28,000 32,000 18,000 100,000 Depreciation charged to WIP $ 9,900 Accumulated Depreciation Balance $ 9,900 Undepreciated Balance (book value) $ 50,000 40,100

Units-of-Production Method
Example
Year Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Units 22,000 28,000 32,000 18,000 100,000 Depreciation charged to WIP $ 9,900 12,600 14,400 8,100 45,000 Accumulated Depreciation Balance $ 9,900 22,500 22,500 36,900 45,000 Undepreciated Balance (book value) $ 50,000 40,100 27,500 27,500 13,100 5,000

Residual Value
No depreciation is recorded if the equipment is idle.

Depreciation Partial Year

What

if the PP&E is not acquired on the first day of the year? How much depreciation expense would you record? Use SL example --Assume a company purchases a delivery vehicle for $22,000 with an estimated residual value of $2,000 and an estimated life of 5 years. The asset was purchased on May 1.

Depreciation Partial Year

Annual depreciation expense = ($22,000 - $2,000) / 5 years = $4,000 Year 1 depreciation expense = $4,000 x 8/12 = $2,667 Companies may establish some arbitrary rules to ease computations e.g., full year s depreciation if acquired in first half year, no depreciation if acquired in last half year.

Changes in Depreciation Estimates

The calculation for depreciation involves two estimates:

Salvage value Useful life

If a company finds that these estimates need to be materially adjusted, then then depreciation should be recalculated for the remaining life of the asset
there is no restatement of prior periods financial statements for changes in estimates

Changes in Depreciation Estimates

If estimates change, straight-line depreciation is calculated as: Book value at Residual value at date of change date of change Remaining useful life at date of change

Change in Estimates Example

Cost when acquired Accumulated depreciation $ 450,000 196,000
(based on 30 year life and $30,000 residual value, SL Method)

In 2011 the company believes the estimates should be changed as follows: Residual value: $23,000 Useful life: 25 years (in total) Calculate a revised depreciation schedule
Hints: Calculate the book value Deduct the new estimated salvage value Determine the number of years remaining in the assets useful life

Change in Estimates Example

1. 2. Determine current book value 2011 Book value = $450,000 - $196,000 = $254,000 Determine remaining useful life
Original depreciation per year = ($450,000 - $30,000) / 30 yrs = $14,000

Age of asset = $196,000 / $14,000 = 14 years New estimate of remaining life = 25 yrs 14 yrs = 11 yrs 3. Calculate current year depreciation New depreciation per year = ($254,000 - $23,000) / 11 yrs = $21,000

Asset Impairment
Impairment is the loss of a significant portion of the utility of an asset through . . .
Casualty Obsolescence Lack of demand for the asset s services

A loss should be recognized when an asset suffers a permanent impairment.

Asset Impairment
Test for impairment: Total future cash flows that will be generated by the asset is less than book value of the asset => impairment has occurred Amount of impairment = Book value of asset market value of asset At what level do you want to test for impairment?

Asset Impairment Example 1

Plant cost = $1,000,000 Accumulated depreciation = $550,000 Estimated future cash flows = $600,000 Estimated market value = $300,000 Test for impairment Total future cash flows $600k > book value $450k => no impairment recognized (and no entry made)

Asset Impairment Example 2

Plant cost = $1,000,000 Accumulated depreciation = $550,000 Estimated future cash flows = $400,000 Estimated market value = $300,000 Test for impairment Total future cash flows $400k < book value $450k => impairment should be recognized Amount of impairment $150,000 = $450,000 (BV) - $300,000 (MV) Entry: Impairment loss Acc. Depreciation Plant 150,000 550,000 700,000

International standards
May

account for PPE as in U.S. (keep at cost, depreciate annually, evaluate for impairment) Or, may revalue each period to fair value (e.g., some approximation of market value)

International standards
Impairment

rule is more conservative

than U.S. One step process (no hurdle ) if market value has declined, then recognize impairment.

Disposal of Operational Assets

When

an operational asset is sold, the cost of the asset and the related accumulated depreciation must be removed from the accounts The sale of an operational asset usually results in a gain or loss that is reported in the income statement [Note sale of an operational asset is always a peripheral activity of the business]

Disposal Example
On September 30, Year 7, Evans Company sold a machine that originally cost $100,000 for $60,000 cash. The machine was placed in service on January 1, Year 1. It was depreciated using the straight-line method with an estimated salvage value of $20,000 and a useful life of 10 years.

Disposal Example
Compute depreciation expense in Year 7? Annual depreciation expense = ($100,000 - $20,000) / 10 yrs = $8,000 Depreciation (Yr 7) = $8,000 x 9/12 = $6,000 And record depreciation for 9 months Depreciation Expense 6,000 Accumulated Depreciation 6,000

Disposal Example
Machine s book value on September 30, Year 7?
Depreciation (Year 1 Year 6) = $8,000 x 6 yrs = $48,000 Accumulated depreciation on 9/30/Yr 7 = $48,000 + $6,000 = $54,000

Book value on 9/30/Yr 7 = $100,000 - $54,000 = $46,000

Disposal Example
Gain or loss upon sale?
$60,000 $46,000 = $14,000
Cash received Book value GAIN

Disposal Example
Journal entry to record Evans sale of the machine on September 30, Year 7. Cash Accumulated depreciation Equipment Gain on sale 60,000 54,000 100,000 14,000

What goes on the Cash Flow Statement?

Natural Resources
When

a company purchases natural resources (ex. oil reserves, timber tracts, mineral deposits), the resource is recorded as an asset and expensed (depleted) over its useful life. Depletion expense is usually calculated based on an estimate of the units of output that can be withdrawn from the resource over its life
similar to the units of production method

Intangible Assets

Intangible assets include:

patents copyrights franchises and licenses trademarks customer lists goodwill

Intangible assets are generally recorded in the accounts only if they are purchased (and not when they are internally developed). WHY?

Intangible Assets: Amortization

Most

intangible assets must be amortized to expense over their estimated useful lives expense is calculated in the same manner as straight-line depreciation expense

Amortization

Intangible Assets -- Goodwill Goodwill is recognized only when one company buys another.
The amount by which the purchase price exceeds the fair market value of net identifiable assets acquired. [Conceptually, what does goodwill represent?]

Intangible Assets: Impairment

Some intangibles with potentially unlimited lives do not require amortization. These include goodwill and brand names. Instead, these intangibles require annual evaluation for impairment of value. Test for impairment: comparison of book value of intangible asset with its future cash flows (correct handout) Amount of impairment loss (if any) = Book value of asset Market or Fair value of asset

Depreciation, Depletion & Amortization: Effect on Cash Flows

Depreciation and amortization expense (unlike many other expenses) do not require a cash outflow Because Depreciation and amortization are expenses, they reduce income and therefore the cash outflow related to the payment of taxes

Fixed Asset Turnover Ratio

Fixed Asset Turnover Ratio =

Net sales Average Fixed Assets (net of acc.depr.)

Measures how efficiently a company uses its investment in PPE Netflix FAT ratio = 11.5 Blockbuster FAT ratio 12.1