Accrual Accounting and Financial Statements - 8

Long-Lived Assets and Depreciation
CHAPTER
2010 Pearson Education Inc. Publishing as Prentice Hall
Introduction to Financial Accounting, 10/e
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Learning Objectives (LO)

After studying this chapter, you should be able to
1. Distinguish a companys expenses from expenditures that it should capitalize 2. Measure the acquisition cost of tangible assets such as land, buildings, and equipment 3. Compute depreciation for buildings and equipment using various depreciation methods 4. Recalculate depreciation in response to a change in estimated useful life or residual value 5. Differentiate financial statement depreciation from income tax depreciation 6. Explain the effect of depreciation on cash flow
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Learning Objectives (LO)

After studying this chapter, you should be able to
7. Account for expenditures after acquisition 8. Compute gains and losses on disposal of fixed assets and consider the impact of these gains and losses on the statement of cash flows 9. Determine the balance sheet valuation of tangible assets for companies who use the revaluation method allowed under IFRS 10. Account for the impairment of tangible assets 11. Account for intangible assets, including impairment 12. Explain the reporting for goodwill 13. Interpret depletion of natural resources
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Overview of Long-lived Assets

Long-lived assets (LLA)
Used over a period longer than an operating cycle As a percentage of total assets, vary considerably depending on the industry Divisible into tangible and intangible categories
Tangible assets - physical (can see and touch)

Land Natural resources Buildings Equipment
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Overview of Long-lived Assets

Intangible assets Lack physical substance
Contractual or legal rights or economic benefits Patents Trademarks Copyrights
Amortize spreading the LLAs cost over the periods it contributes to the production of revenue
Depreciate buildings, equipment (but not land) Deplete natural resources Amortize intangible assets
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LO 1 Contrasting Long-lived Asset Expenditures with Expenses

Expenditures what is paid for an item Expensed Within an operating cycle or year
Not consumed - current asset Consumed - deducted as an expense (expensed)
Capitalize Beyond an operating cycle or year, expenditure is placed on the balance sheet (capitalized)
Cost is then amortized over its useful life Exceptions Land and other items where cost-benefit considerations suggest expensing is justified
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LO 1 Contrasting Long-lived Asset Expenditures with Expenses

Capitalize or Expense? judgment required
Expensing all this year lowers this years net income (and has no affect on future years net income) Capitalizing this year then amortizing some of its cost lowers this years expenses (in comparison to expensing) thus improving this years net income. In future years, more expenses means lower net income In the long-run, same end results are achieved What is in the best interests of stakeholders (management, investors)
WorldCom example in text What did they do?

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LO 2 - Tangible Assets Acquisition Cost

LLA asset costs that are capitalized include (besides the purchase price itself $100 ) all necessary costs to get the asset into a usable condition
Land survey, legal/title fees, taxes, demolition Buildings legal/title fees, taxes Equipment - taxes ($5), transportation ($3), installation ($4), testing ($1), essential repairs ($2) to get it into an operating condition ASSET CASH 115
115
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Nonmonetary exchange Fair market value
Fair market value = what could sell/buy the asses for from an independent third party Fair market value of the consideration given up or received, whichever is more clearly determinable
Basket Purchase more than one asset for a single price. E.g. For $1M, can buy Land ($480,000) and building ($720,000) (appraised value)
Building Land Cash
600,000 (480/1200) x $1m) 400,000 (720/1200 x $1m) 1,000,000

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Subsequent to Acquisition - The market value:
Declines Write the value of the asset down (impairment if considered permanent), or Leave at historical cost less depreciation, i.e., Book Value U.S. required and IFRS permitted Increases Revalue to fair market value (IFRS permitted) Precluded by U.S. GAAP
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LO 3 Building/Equipment Depreciation
Matching recording expenses in the period in which they help produce revenue
Buildings and Equipment
Typically last many years Thus contributing to revenue for many years Thus their cost is capitalized when purchased And amortized over many years
Accumulated Depreciation = the cumulative amount of Depreciation Expense recorded over the life of the asset
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Information needed to determine depreciation
Acquisition (capitalized) cost what was debited to the asset account Salvage (terminal, residual) value what is expected to be received at the time the asset is disposed of Depreciable value = amount to be allocated to each year of usage Useful life = shorter of the assets Physical life expected time it will wear out Economic life when it is no longer economically feasible to operate
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Symbols
Amounts for Illustration
C = total acquisition cost December 31, 20X2 $41,000 R = estimated residual value $1,000 n = estimated useful life (in years or miles) 4 years 200,000 miles D = amount of depreciation Various
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Straight-line depreciation
Spreads the depreciable value evenly over the useful life of an asset Most popular method for financial reporting purposes
Depreciation expense = (C R) / n = ($41,000 1,000) / 4 = $10,000 per year
Depreciation Expense 10,000 Accumulated Depreciation 10,000
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Units of Production
- If physical wear and tear determines the useful life, depreciation may be based on units of service (e.g. miles) or units of production
Depreciation expense = (C R) / n = ($41,000 1,000) / 200,000 = $.20/mile
= 65,000 miles (yr 1) x $.20 = $13,000
Depreciation Expense 13,000 Accumulated Depreciation 13,000
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Double-declining-balance (DDB) method is an accelerated method
Straight line rate of depreciation = year = 25% per year Double the straight line rate = 25% x 2 = 50% Book value at the begin. of the year = Acquisition cost less Accumulated Depreciation Year
2 .50 ($41,000 $20,500)
Depreciation Expense
= $20,500 > $10,000 = $10,250
1 .50 ($41,000 zero Accum. Depr.)
3 .50 ($42,000 $20,500 $10,250)
= $5,125
4 .50 ($41,000 $20,500 $10,250 $5,125) = $2,563 < $10,000 $38,438
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Note that the $41,000 asset is only depreciated to $38,438 in this example, Thus to fully depreciate this asset, a plug number is needed to increase accumulated depreciation to $40,000. Never depreciate an asset below its salvage value.
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In comparison to straight line depreciation expense, DDB records more in the earlier years; less in the later years Over the assets life, the same amount is depreciated, regardless of method
Depreciable asset is never depreciated below its estimated salvage (terminal, residual) value
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LO 4 - Changes in Estimated Useful Life or Residual Value

Assets useful life and residual value estimated when acquired
If material changes to those estimates become known, must use the new estimate to revise the depreciation schedule Revisions are applied to the period in which they are determined and future periods, i.e., not applied retroactively
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LO 4 - Changes in Estimated Useful Life or Residual Value

Example
Cost = $41,000 Residual value = $1000 Life = 4 years Beginning of year 4, life changes to 2 full years Revised Depreciation Expense for next 2 years $41,000 ($10,000 x 3 years) = $11,000 $11,000 $1000 residual value = $10,000 to be depreciated $10,000 / 2 years = $5000 each for next 2 years
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LO 5 - Contrasting Income Tax and Shareholder Reporting

Tax reporting - prepared according to IRS rules
Assets divided into property classes Each class has prescribed lives and permissible depreciation methods Modified Accelerated Cost Recovery System (MACRS) prescribes zero salvage value and allows use of DDB (more deprecation/lower taxable income) Financial reporting prepared per FASB/SEC rules
Straight-line depreciation is the most used method Matches portions of the assets cost to the periods of revenue generation
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LO 6 - Depreciation and Cash Flow

Cash Flow
Operating repairs Investing - acquired, sold, or bettered
Depreciation expense
Allocates investing expenditures to periods
Operating cash flows - Statement of Cash Flows

Indirect method explains why net income is different than operating cash flows. Since depreciation expense was deducted from net income but is not a cash flow, it is removed by adding it back to net income, causing some to believe it increases cash from operations.
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LO 7 - Expenditures After Acquisition

Definitions
Maintenance - Sustain LLA original performance level Repairs Restore LLA to original performance level Improvements (betterments) improve LLAs life, quantity/quality of output or reduce operating costs
U.S. GAAP
Maintenance and repair expenditures - expensed Improvements If immaterial or cost/benefit applies expensed If material capitalize (revise depreciation schedules)
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LO 8 Sales of Tangible Assets

Example
Original cost - $41,000 Accumulated Depreciation at time of sale $20,000 Book Value at time of Sale - $21,000
Sale at book value (all are Asset accounts)

Cash Accumulated Depreciation Equipment 21,000 20,000 41,000
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Sale for more than its book value (41,000 20,000 = 21,000)
Cash Accumulated Depreciation Equipment Gain 25,000 20,000 41,000 4,000
Sale for less than its book value

Cash Accumulated Depreciation Loss Equipment 14,000 20,000 7,000
(41,000 20,000 = 21,000)
41,000
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Companies include gains and losses in a variety of locations on the income statement
Some companies list other income with sales revenue at the top of the income statement, thus combining usual and frequent inflows with unusual and/or infrequent inflows Other companies report it after operating income viewing it as not being a part of usual and frequent (central) operations
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LLA sales and the Cash Flow Statement
Investing activities if sold for cash Disclose in notes if for other than cash and considered significant Indirect method of presenting operating cash flows Net income includes investing gains and losses To remove them from net income Subtract gains Add losses Direct method - ignore since they are investing flows
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LO 9 Revaluation Method under IFRS

Revaluation
Prohibited by U.S. GAAP Optional under IFRS Revalued assets are not depreciated Once started, must continue to do so Must be done for all assets in the same class
Concept-Report assets at fair market value (FMV)

Amount the asset could be exchanged between willing knowledgeable parties in an arms length transaction Determined usually from appraisals
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LO 9 Revaluation Method under IFRS

Concept continued
Original cost 10,000 + Revaluation gain year 1* +1,000* Fair market Value end of year 1 11,000 Revaluation loss year 2* 2,000* Fair market Value end of year 2 9,000 * Gains and losses typically posted to single account that is reported on the Income statement (rarely volatility of net income) Owners equity (part of Comprehensive Income)
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LO 10 - Impairment of Tangible Assets

Circumstances leading to Impairment when any of the following become apparent (i.e., not automatically on an annual basis)
Significant decline in assets fair market value Significant change in the way the asset is used Change in legal/business environment Obsolescence or physical damage Forecast of continuing losses if usage continues Other factors
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Process of determining impairment
1. Recoverability testCompare undiscounted expected cash flows from operations and sale to the book value Cash flows > book value = no impairment Cash flows < book value, go to step 2
2. Compute the impairment loss as Active market: Book value fair market value
Inactive market: Book value discounted cash flows (see Appendix A to Chapter 9)
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Recording the loss
Loss on Impairment Accumulated Depreciation 45,000 * 45,000
Book value ($150,000) less FMV of asset ($105,000)
Reporting the loss

U.S. GAAP: part of Income from Continuing Operations Separate line if material Combined with other items if immaterial
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Assets held for resale can be written up following an impairment loss only to the net book value at the time of the impairment
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LO 11 - Intangible Assets
Intangible assets

(Other than Goodwill)
Not physical in nature Rights or claims to expected benefits that are often from contract rights
Patents - exclusive right to produce/sell a product or use a process for up to 20 years Copyrights exclusive rights to reproduce and sell a book, musical composition, film, or similar creative item for the life of the creator plus 70 years
Accounting for intangible assets depends on whether the asset

Was acquired externally or developed internally Has a finite or infinite life
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LO 11 - Intangible Assets
(Other than Goodwill)
Trademarks - distinctive identifications of a manufactured product or a service, taking the form of a name, sign, slogan, logo, or emblem Franchises/licenses - legal contracts that grant the buyer the right to sell a product or service in accordance with specified conditions Leasehold - right to use a fixed asset for a specified period of time beyond one year Leasehold improvements - lessee spends money to improve leased property Improvements = become part of the leased property and are classified as fixed assets
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LO 13 - Depletion of Natural Resources

Natural resources - LLA such as minerals, oil, and timber (wasting assets)
Depletion expense is the amount of the acquisition cost of natural resources allocated to this period
Depletion is measured on a units-of-production basis Annual depletion may be recorded as A direct reduction of the asset (credit the asset) Or by using an Accumulated Depletion (contraasset) account
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Accrual Accounting and Financial Statements - 8

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Accrual Accounting and Financial Statements - 8

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Long-Lived Assets and Depreciation

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

Learning Objectives (LO)

Learning Objectives (LO)

Overview of Long-lived Assets

Tangible assets - physical (can see and touch)

2010 Pearson Education Inc. Publishing as Prentice Hall

Overview of Long-lived Assets

LO 1 Contrasting Long-lived Asset Expenditures with Expenses

LO 1 Contrasting Long-lived Asset Expenditures with Expenses

WorldCom example in text What did they do?

LO 2 - Tangible Assets Acquisition Cost

2010 Pearson Education Inc. Publishing as Prentice Hall

LO 2 - Tangible Assets Acquisition Cost

600,000 (480/1200) x $1m) 400,000 (720/1200 x $1m) 1,000,000

LO 2 - Tangible Assets Acquisition Cost

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

Amounts for Illustration

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

Depreciation Expense 10,000 Accumulated Depreciation 10,000

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

= 65,000 miles (yr 1) x $.20 = $13,000

Depreciation Expense 13,000 Accumulated Depreciation 13,000

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

1 .50 ($41,000 zero Accum. Depr.)

3 .50 ($42,000 $20,500 $10,250)

4 .50 ($41,000 $20,500 $10,250 $5,125) = $2,563 < $10,000 $38,438

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 4 - Changes in Estimated Useful Life or Residual Value

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 4 - Changes in Estimated Useful Life or Residual Value

2010 Pearson Education Inc. Publishing as Prentice Hall

LO 5 - Contrasting Income Tax and Shareholder Reporting

LO 6 - Depreciation and Cash Flow

Operating cash flows - Statement of Cash Flows

LO 7 - Expenditures After Acquisition

LO 8 Sales of Tangible Assets

Sale at book value (all are Asset accounts)

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 8 Sales of Tangible Assets

Sale for less than its book value

(41,000 20,000 = 21,000)

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 8 Sales of Tangible Assets

2010 Pearson Education Inc. Publishing as Prentice Hall

Introduction to Financial Accounting, 10/e

LO 8 Sales of Tangible Assets

LO 9 Revaluation Method under IFRS

Concept-Report assets at fair market value (FMV)

LO 9 Revaluation Method under IFRS

LO 10 - Impairment of Tangible Assets