1 Chapter 9: Long-lived Assets and Cost Allocation

2 Long-lived Assets and Cost Allocation A. Property, Plant, and Equipment - Depreciation B. Intangible Assets - Amortization

3 A. Overview of Accounting for Property, Plant, and Equipment 1. What costs to capitalize? Acquisition 2. Depreciation 3.Postacquisition expenditures 4. Retirement or Sale UseDisposal

4 1. Acquisition - What Costs to Capitalize? General Rule: – Capitalize (add to an asset account) the costs to acquire the asset and to prepare it for its intended use. Note: For all acquisitions, part of the cost is the purchase price, specifically the “cash equivalent” purchase price (the amount we would pay if we paid cash). This excludes any cost of financing the purchase (interest expense).7

5 1. What Costs to Capitalize? Land – purchase price, clearing costs, survey costs, back taxes, closing costs, some landscaping (if permanent in nature). Land improvements – purchase price, for some landscaping (temporary), parking lots, sidewalks, etc.

6 1. What Costs to Capitalize? Machinery and equipment – purchase price, freight, installation, assembly, trial runs, testing and inspection during set up. Buildings – purchase price (or cost to construct), closing costs, attorney’s fees, building permits, etc.

7 1. What Costs to Capitalize Self-constructed assets – include cost of materials, labor, and overhead. – may also include interest cost during construction. The interest costs are calculated under specific rules, based on the length of time of the construction period, and the borrowing rates of the company.

8 Class Exercise: Exercise 9-3 Land (a) Land Improvement Building Purch. tract Raze whse. Sold scrap Construct bldg. Drive & park. lot Landscaping Totals * Since permanent (like trees), add to land; if not permanent (like annual plants), add to land improvement so that it may be depreciated.

9 Class Exercise: Exercise 9-3 (b) Depreciation expense, first year: Land - none; land is not depreciated. Land Improvements: Building:

10 2. Depreciation Depreciation is a method of cost allocation. – it is used to allocate the capitalized cost of PP&E over the years benefited (matching) – Note: depreciation will decrease the carrying value of the asset, but it is not a valuation technique (i.e., book value is not market value)

11 2. Depreciation Depreciation methods – (1) Activity (units-of-production) – (2) Straight-line – (3) Double-declining balance – (4) 150 percent declining balance – (5) Sum-of-the-years digits – (6) MACRS (income tax depreciation)

12 Class Example Given the following information regarding an automobile purchased by the company on January 2, 2005: Cost to acquire = $10,000 Estimated life = 4 years Estimated miles = 100,000 miles Salvage value = $2,000 Calculate depreciation expense for the first two years under each of the following methods.

13 (1) Units-of-Production (Activity) Assume that the car was driven 20,000 miles in the year 2005, and 30,000 miles in Annual depreciation = Cost - Salvage Value x Current Activity Total expected activity For 2005= 10, ,000 x 20,000 = $1, ,000 miles For 2006 = 10, ,000 x 30,000 = $2, ,000 miles

14 (2) Straight-Line = $10,000 - $2,000 = $2,000 per year 4 years Cost - Salvage Estimated Life Annual depreciation =

15 (3)Double-Declining Balance DDB is an accelerated depreciation technique. It generates more expense in the early years and less in the later years. Annual depreciation = % (Cost - A/D) where A/D is the accumulated depreciation for all prior years, and the percentage is double the straight line rate, or 2 x 1/Estimate life. In the example, the % = 2 x 1/4 = 2/4 = 50%. Depreciation expense (D.E.)for: 2005 = 50% x (10, ) = $5, = 50% x(10,000-5,000) = $2,500

16 (4)150% Declining Balance 150%DB is another accelerated depreciation technique. It also generates more expense in the early years and less in the later years. Annual depreciation = % (Cost - A/D) where A/D is the accumulated depreciation for all prior years, and the percentage is 1.5 times the straight line rate, or 1.5 x 1/Estimate life. In the example, the % = 1.5 x 1/4 = 37.5%. Depreciation expense (D.E.)for: 2005 = 37.5% x (10, ) = $3, = 37.5% x(10,000-3,750) = $2,344

17 (5) Sum-of-the-years Digits SYD is another accelerated technique that calculates more expense in early years and less in later years. Annual depreciation = Fraction x (Cost-Salvage) where the fraction is calculated as follows: Numerator = declining years (highest first) Denominator = sum of the years digits In the class example, the denominator is = 10 D.E. for 2005 =4/10(10,000-2,000) = $3,200 D.E. for 2006 = 3/10(10,000-2,000) = $2,400

18 (6) MACRS MACRS (modified accelerated cost recovery system) is a technique developed by the IRS for tax reporting. It utilizes combinations of DDB, 150%DB, and SL to calculate a table of percentages that can be applied to any depreciable asset. Additionally, the IRS assumes no salvage value, and a half year in the first and last year of depreciation (some limitations on fourth quarter purchases).

19 (6) MACRS continued Example of MACRS for a 5 year category. Assume an asset purchased for $1,000 sometime during The IRS uses DDB for the first 3 years (remember, no salvage and 1/2 year in the first year), then switches to SL for later years (see next page)to stretch it out to 5 full years. DDB % = 2 x 1/5 = 2/5 = 40%. DE 2005 =40%(1, ) x1/2 = $200 (20%) DE 2006 = 40%(1, ) = $320 (32%) DE 2007 = 40%(1, ) = $192 (19.2%) (Now A/D = 712, and BV =1, = 288) DE 2008 = 288/2.5 yrs = $ (11.52%) DE 2009 = = $ (11.52%) DE 2010 = (1/2)x = $57.60 (5.76 %)

20 (6) MACRS continued Note that the switch is made in This is the point where the straight line depreciation for the year is greater than or equal to the accelerated depreciation. If you calculate the depreciation expense using DDB for 2007, you would get: 40%(1, ) = This is the point where straight line and DDB cross. After this point, DDB will be less than SL for the remaining years. This is the point where the IRS, in its schedules, switches to straight line, to “stretch” the depreciation out to the total years of life.

21 (6) MACRS - continued Using the previous calculations, the IRS developed a comprehensive set of percentages for all companies to use for depreciation expense for tax purposes. The categories are predefined by the IRS, and all the company must do is figure out which category each asset fits into. For example, automobiles fit into the five year category. The company would take the cost of the automobile (ignoring salvage), and multiply it by the indicated percentage to get the depreciation expense for the year (for calculation of income tax payable). The tables on the next page are excerpted from the IRS tables.

22 MACRS Tables - selected years Yr.3 years5 years7 years10 years %20.00%14.29%10.00%

23 Depreciation - change in estimate Because depreciation is an estimate, and two of the three components are subject to variability, sometimes we need to make a change in estimate (either in the estimated life or the estimated salvage). The change in estimate affects only the current and future years; we do not go back and change the previous years that have already been posted.

24 Change in Estimate - continued To calculate the new depreciation expense, first find out how much depreciation has been posted (the Accumulated Depreciation to date). Then use the following formula (to modify the straight-line depreciation rate): Remaining Book Value - New Est. Salvage Remaining Estimated Life

25 Class Problem: Problem 9-7 (a)Book Value at 1/1/05:

26 Class Problem: Problem 9-7 (b) Estimate for 2005, assuming revised useful life:

27 3. Postacquisition Expenditures: Betterments or Maintenance? Betterments: – Increase asset’s useful life – Improve quality of asset’s output – Increase quantity of asset’s output – Reduce asset’s operating costs Maintenance – maintain existing productivity or useful life Accounting treatment – Betterments are capitalized – Maintenance expenditures are expensed

28 4. Disposal: Retirement, Sale or Trade-In Retirement - remove the asset and related A/D. If not fully depreciated, recognize loss. Sale - remove the asset and related A/D, then recognize cash received. The difference is a gain or loss. Trade-ins (for dissimilar assets): asset received should be valued at – the fair market value of assets given up, or – the fair market value of the asset received, – whichever is more evident and objectively determined.

29 4.Disposal - continued Using earlier example (cost = $10,000, salvage = $2,000). After 4 years straight-line, $8,000 would be in A/D. 1.Assume the asset is retired (no cash received) Loss on retirement2,000 Accumulated Depr.8,000 Automobiles 10,000 2.Assume the asset is sold for $3,000: Cash3,000 Accumulated Depr.8,000 Automobiles 10,000 Gain on sale 1,000

30 Class Exercise: Exercise 9-15 First calculate depreciation: DDB % = 1/5 x 2 = 2/5 = 40% Depr. Book Date % Cost - A/D Expense Value 1/1/03 25,000 12/31/03 40% (25, ) = 10,00015,000 12/31/04 40% (25,000-10,000) = 6,000 9,000 12/31/05 40% (25,000-16,000) = 3,600 5,400 12/31/06 400* 5,000=SV 12/31/ ,000 *formula will exceed salvage value limit in 2006; just depreciate $400, to salvage of $5,000.

31 Exercise 9-15, continued (a) JE to scrap after 3 years, at 12/31/05, assumes that no cash is received:

32 Exercise 9-15, continued (b) JE to scrap after 5 years, assumes that no cash is received:

33 Exercise 9-15, continued (c) JE to sell for $8,000 after 3 years:

34 Exercise 9-15, continued (d) JE if, after 5 years, the equipment and $28,000 traded for a dissimilar asset with a fair market value of $30,000:

35 B. Intangible Assets Intangible assets characterized by (1) lack of physical evidence, and (2) high uncertainty about future benefits. Cost is amortized over useful life (or legal life, if less), but not to exceed 40 years. Intangibles include the following: (1) Patents (2) Copyrights (3) Trademarks (4) Organization Costs (5) Software Development Costs (6) Goodwill

36 (1) Patents (20 year legal life) A company may capitalize the following – the cost of acquiring an externally developed patent. – filing fees for internally or externally developed patents. – the legal fees for acquiring and successfully defending a patent (internal or external). A company cannot capitalize the following: – legal fees for unsuccessfully defending a patent. – Most research and development costs for an internally developed patent.

37 Class Exercise: Exercise 9-20, Part (a) (1) $50,000 capitalized in 2005 (none amortized in the year of acquisition), so balance at 12/31/05? (2)$200,000 incurred in 2006 to successfully defend patent. Amortization? Since defense is successful, add amount to cost of patent, and amortize: Balance at end of 2006? (3) Journal entry at 12/31/2006 for amortization:

38 Class Exercise: Exercise 9-20, Part (b) (1) $50,000 capitalized in 2005 (none amortized in the year of acquisition), so balance 12/31/05: (2)$200,000 incurred in 2006 in unsuccessful defense of patent. Since unsuccessful, expense legal fees. (3) Journal entry at 12/31/06 to write off patent:

39 Research and Development Costs (for internally developed patents) Prior to 1974, most companies capitalized research and development costs, then amortized the cost to future periods. The FASB stated in SFAS 2 that, because “future benefits” were uncertain, companies should expense all R&D costs, unless they were related to tangible assets (like buildings and equipment) that had multi-year lives. Companies complied with the standard, but for several years many companies actually reduced their R&D activities, because of concern for excess expense on the income statement.

40 Other Intangible Assets (2) Copyrights – granted for the life of the creator plus 70 years. – capitalization rules similar to patents: costs of internally developed copyright material cannot be capitalized. (3) Trademarks and Trade Names – granted for 10 year periods, but indefinite renewals. – some of design costs may be capitalized. (4) Organization Costs – costs related to the creation of a company – include underwriting fees, legal and accounting, licenses, titles, etc. – treatment similar to research and development costs; even though there may be some future benefit, costs are expensed in the period incurred.

41 Other Intangible Assets - continued (5) Software Development Costs – Capitalize the costs of developing software for sale or lease. – Expense software development costs if for internal use. (6) Goodwill (also discussed in Chapter 8) – The “unidentifiable” intangible – Causes include reputation, good customer relations, superior product development, etc. – Recognized when one company purchases another company. – To calculate: Purchase price paid for the company versus the fair market value of the net assets acquired = Goodwill (the excess amount paid)