Property, Plant and Equipment and Other Long-lived Assets

Chapter 8 October 15 - 17

Classifying Long-lived Assets

Assets used in the business that have a useful life of more than one year and are not intended for resale are classified as long-lived or fixed assets. Depending on their nature, they may be further classified as:
Property, plant & equipment (aka PPE or tangible fixed assets) Natural resources Intangible assets.

Classifying Long-lived Assets

Property, plant and equipment
Tangible assets that are used in the production or sale of other assets or services, and have a useful life of more than one year.

These assets are not intended for sale to customers (or else they'll be classified as inventories) and should have useful lives of more than one year, or else they'll be considered supplies.
E.g. Land, and buildings, fixtures, and equipment.

Classifying Long-lived Assets

Natural Resources
Tangible assets that are physically removed or consumed and are restored to their previous form only by an act of nature. E.g. mines, timberlands, and oil fields.

Intangible Assets
Assets used in the normal operations of business that have no physical substance and generally have some degree of uncertainty concerning future benefits. E.g. copyrights, patents, trademarks, franchises, and goodwill.

Acquisition / Valuation of Long-Lived Assets

PPE
The cost of PPE includes both the acquisition cost plus any costs necessary to place the asset in working condition. This would include the invoice price (less any discounts), transportation, unpacking and assembly costs, and costs of conducting trial runs.

Natural Resources
The cost of natural resources include their acquisition, exploration costs, development and restoration costs.

Acquisition / Valuation of Long-Lived Assets

Intangible
Intangible assets are recorded at their acquisition price plus any other costs necessary to make them ready for use. These would include the purchase price, legal fees to acquire and protect the intangible assets, and other incidental expenses to acquire the asset. Internally created intangible assets are generally expensed as incurred because of the difficulty in determining their market values and the uncertainty over their future benefits and economic lives.

Acquisition / Valuation of Long-Lived Assets

Intangible
The most frequently reported intangible asset is goodwill. The only way to report goodwill as an asset is to purchase another business. Goodwill represents the difference between the acquisition price and the fair market value of an acquired firms identifiable net assets (assets liabilities). If a company acquires another company for a price that exceeds the fair market value of all of its identifiable net assets (including current and fixed assets plus any identifiable intangible assets such as patents, copyrights, licenses and trademarks), the excess is assumed to be for goodwill.

Accounting at Acquisition
Revenue expenditure (expense) or Capital expenditure (capitalize)?
To qualify as an asset, the resource must be expected to provide future benefits. If future benefit is uncertain, the resource must be expensed. Most assets require expenditures during their lives to maintain or enhance their productive capacity. Accountants need to determine whether these expenditures are revenue expenditures (expense) or capital expenditures (capitalize).

Accounting at Acquisition
How about if a company constructs an asset for its own use instead of buying from a manufacturer? How about expenditures after acquisition?

Expenditures after Acquisition

The general treatment for asset expenditures incurred after the point of acquisition depends on whether
the nature (and usability) of the asset has changed, and/or its original useful life has been extended because of the expenditure.

Revenue expenditures refer to outlays that merely maintain the productive capacity of the asset. These expenditures are recurring in nature and do not alter the nature or useful life of the asset, and are charged as an expense of the period. Capital expenditures that alter the nature of the asset are capitalized and added to the cost of the asset. Extraordinary repairs that prolong the life of the asset are also capitalized.

Expenditures after Acquisition

Type of Capital or Expenditure Revenue Identifying Characteristics

Ordinary Revenue 1. Maintains normal operating condition repairs and 2. Does not increase productivity maintenance 3. Does not extend life beyond original estimate Extraordinary repairs Additions Capital 1. Major overhauls or partial replacements 2. Extends life beyond original estimate 1. Increases productivity 2. May extend useful life 3. Improvements or expansions

Capital

Expenditures after Acquisition

Financial Statement Effect Treatment Capital Expenditure Statement Balance sheet account debited Expense Deferred Current Current Income Taxes Higher Higher Lower

Revenue Income statement Currently Expenditure account debited recognized Lower

To solve this problem, many companies have policies regarding the expensing of all expenditures below a certain amount according to the materiality constraint.

Improper Capitalization of Expenditures

Accounting for expenses as capital expenditures increases current income because it spreads a single periods operating expenses over many future periods as depreciation expense, and it increases cash flows from operations by moving cash outflows from the operating section to the investing section of the cash flow statement. WorldCom inflated its income and cash flow from operations by billions of dollar by capitalizing expenditures that should have been recorded as current period expense. Sulcus Computer Corp. was found by the SEC to have capitalized operating expenses as part of the costs of acquisitions.

Accounting Over the Useful Life

Depreciation is a systematic process of allocating the cost of a long-lived fixed asset over the periods that it provides benefits. The same process as applied to natural resources is called depletion and as applied to intangible assets is referred to as amortization. Depreciation/ depletion/amortization is not a revaluation process; it is merely a cost allocation procedure.

Accounting Over the Useful Life

Unlike PPE and natural resources, intangible assets are classified according to whether they have definite or indefinite lives. Intangible assets that have definite (limited) lives are amortized over their useful lives. Examples include patents and copyrights. Intangible assets that have indefinite lives are not amortized because they are considered to have a potentially unlimited life. Instead, they are subject to a regular annual review for impairment (involving an asset write-down of value). Examples of indefinite life intangible assets include goodwill and trademarks.

Depreciation Concepts Definitions Service or useful life

the length of time over which the company expects to use the asset, which may or may not be equal to the asset's actual operating life.

Salvage value or residual value

estimated realizable value of the asset at the end of its service life.

Book or carrying value

Cost less accumulated depreciation

Depreciation Concepts
The calculation of depreciation requires three amounts for each asset: Acquisition cost. Estimated useful life. Estimated residual value. Alternative depreciation methods: Straight-line Units-of-production Accelerated Method: Declining balance

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

At the beginning of the year, Southwest purchased ground equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500.

Depreciation Expense per Year Depreciation Expense per Year

$62,500 - $2,500 3 years

$20,000

Straight-Line Method
Depreciation Accumulated Expense Depreciation Year (debit) (credit) 1 2 3 $ 20,000 20,000 20,000 $ 60,000 $ 20,000 20,000 20,000 60,000 Accumulated Depreciation Balance $ 20,000 40,000 60,000 Undepreciated Balance (book value) $ 62,500 42,500 22,500 2,500

Residual Value More companies use the straight-line method of depreciation in their financial reports than all other methods combined.

SL

Units-of-Production Method
Step 1:

Depreciation = Rate
Step 2:

Cost - Residual Value Life in Units of Production

Number of Depreciation Depreciation Units Produced = Expense Rate for the Year
At the beginning of the year, Southwest purchased ground equipment for $62,500 cash. The equipment has a 100,000 mile useful life and an estimated residual value of $2,500. If the equipment is used 30,000 miles in the first year, what is the amount of depreciation expense?

Units-of-Production Method
Step 1:

Depreciation = $62,500 - $2,500 = $.60 per mile 100,000 miles Rate

Step 2:

Depreciation = $.60 per mile 30,000 miles = $18,000 Expense

Year 1 2 3 Miles 30,000 50,000 20,000 100,000 Depreciation Expense $ 18,000 30,000 12,000 60,000 Accumulated Depreciation Balance $ 18,000 48,000 60,000 Undepreciated Balance (book value) $ 62,500 44,500 14,500 2,500

Residual Value

Accelerated Depreciation
Accelerated depreciation matches higher depreciation expense with higher revenues in the early years of an assets useful life when the asset is more efficient.

Depreciation Expense Early Years High Later Years Low

Repair Expense Low High

Declining-Balance Method
Cost Accumulated Depreciation

Declining balance rate of 2 is double-decliningbalance (DDB) rate.

Annual Depreciation = expense

Net Book Value

2 Useful Life in Years

Annual computation ignores residual value.

At the beginning of the year, Southwest purchased equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500. Calculate the depreciation expense for the first two years.

Declining-Balance Method
Annual Depreciation expense
=

Net Book Value

2 Useful Life in Years

Year 1 Depreciation:
$62,500

2 3 years

) = $41,667 (
2 3 years

Year 2 Depreciation:
($62,500 $41,667)

) = $13,889

Declining-Balance Method
Depreciation Expense (debit) $ 41,667 13,889 4,629 60,185 Accumulated Depreciation Balance $ 41,667 55,556 60,185 Undepreciated Balance (book value) $ 62,500 20,833 6,944 2,315

Year 1 2 3

($62,500 $55,556)

2 3 years

Below residual value

) = $4,629

Declining-Balance Method
Depreciation Expense (debit) $ 41,667 13,889 4,444 60,000 Accumulated Depreciation Balance $ 41,667 55,556 60,000 Undepreciated Balance (book value) $ 62,500 20,833 6,944 2,500

Year 1 2 3

Depreciation expense is limited to the amount that reduces book value to the estimated residual value.

Changes in Estimates
If after using an asset for a few years, a company decides that the assets useful life or salvage value is different from its original estimates, a change in estimate may occur. The company needs to revise the amount of depreciation charged every year subsequent to the date of discovery (prospectively).

Changes in Estimates
Example: A fixed asset costing $10,000 with a useful life of 5 years and $2,000 salvage value is being depreciated under the straight-line method. On Year 3, the company extends the assets useful life to a total of 10 years with a salvage value of $1,000. Calculate depreciation expense for all years:

Accounting for Disposal

If an asset is disposed of at the end of its useful life, and the salvage value is exactly equal to its disposal value, then no gain or loss is recognized. Example: Asset originally costing $120,000 is retired at the end of its useful life. Assume that the salvage value of $15,000 is realized. Prepare the journal entry upon disposal.

Accounting for Disposal

If an asset is disposed of prior to the end of its useful life, and the disposal price is not equal to its book or carrying value (cost less accumulated depreciation), then a gain or loss is recognized for the difference. Example: Equipment costing $10,000 with accumulated depreciation of $4,000 was sold for $7,000. Prepare the journal entry.

Focus on Cash Flows

Fixed Asset Turnover

Fixed = Asset Turnover
Net Sales Revenue Average Net Fixed Assets

This ratio measures a companys ability to generate sales given an investment in fixed assets.
Southwest Airlines had $9,861 of revenue. End-of-year fixed assets were $10,874 and beginning-of-year fixed assets were $10,094. (All numbers in millions.)

Fixed = Asset Turnover

$9,861 ($10,094 + $10,874) 2

= 0.94

2006 Fixed Asset Turnover Comparisons Delta Southwest United 1.26 0.94 1.68