Chapter 07 Long-Term Assets McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc.

Participation Questions – Chapter 7  Nike was used as an example for the intangible asset of Trademarks. True or False  What company committed fraud by capitalizing $11 billion of costs instead of properly expensing them? Target, WorldCom, JC Penney, Albright Mobile Communications  Name a type of intangible asset. Equipment, Building, Land, Goodwill  Tangible property is depreciated each year in order to comply with the matching principle. True or False  The double declining balance method of calculating depreciation expense forces companies to pay higher income taxes in the earlier years of the assets life. True or False

Announcements  Assignments – Due 10/30/16 Chapter 7 Homework (Connect) – unlimited attempts Participation questions for Chapter 7 (Webcourses) – 1 attempt Learn Smart Extra Credit for Block 2 (All 4 100%)  Exam 2: 10/31 – 11/2 Study Session for Exam #2 – Friday 10/28 – 11:30 AM – 1:15 PM Exam Review Power Points in the Exam Review module page in Webcourses  College of Business Accounting Tutoring Lab - BA 1 – Room 355 Monday 2:00 PM - 6:00 PM Tuesday 8:00 AM – 6:00 PM Wednesday 8:00 AM – 1:00 PM; 1:30 PM - 6:00 PM Thursday 9:00 AM - 9:00 PM  Review of Exam Study Guide at the end of class

Questions to be Answered Chapter 7 – How does the 1.) purchase, 2.) use, or 3.) sale of long-term assets impact period earnings and the balance sheet? Purchase Equipment $100,000 with a useful life of 24 months Capitalize – record an expenditure as an asset. Depreciate the cost over time based on the matching principle.

WorldCom – WorldCom did not record expenses for costs associated with lines and cabling; instead they ‘parked’ the cost on the balance sheet to be expensed at a later time. Found through a routine internal audit. If the amount = $11 Billion – what is the result to the financial statements? Led to $100 Billion in losses to shareholders Capitalize – record an expenditure as an asset.

Chapter 7 – Long-term Assets (LTA) What is it? Calculate costs 1.) Purchase 2.) Use: Cost allocation - Spread costs to the periods when revenue is earned 3.) Sale: Sell or retire asset Tangible Asset Intangible Asset

Categories of Long-Term Assets Tangible Assets- Property, Plant and Equipment Intangible Assets Land, land improvements, buildings, and equipment Patents, trademarks, copyrights, franchises, and goodwill Physical substanceLacks physical substance 7-8

Part 1 Acquisition (Purchase) 7-9

Purchase of Long-term Assets - Measuring the Cost of a Plant Asset 10 Copyright ©2010 Pearson Education Inc. Publishing as Prentice Hall. Record a long-term asset at Cost + All expenditures necessary to get the asset ready for use

11 AssetCosts included LandPurchase price, commissions, survey & legal fees, and back property taxes paid; grading and removing unwanted buildings Land ImprovementsFencing, paving, security systems & lighting Building – Constructed Architectural fees, contractors’ charges, materials, labor, and overhead; interest on funds borrowed Building – Purchased Purchase price, broker’s commission, taxes paid and all costs to repair and renovate building EquipmentPurchase price, transportation, insurance in transit, sales tax, installation and testing Examples of Long-term Asset Accounts

Cash Purchase of Land and Related costs 12 Add up all of the costs associated with ‘Land’ and debit these costs to the Land account.

Definition - The allocation of the cost when more than one asset category (account) is purchased for one lump sum price. You must compare market value and cost. Two different Situations that occur in Basket Purchases: 1.) Market Value and Cost are equal:  Cost - Purchase Land and Building for $450,000 cash.  Market Value Appraisal shows the land value at $100,000 Appraisal shows the buildings value at $350,000 2.) Market Value and Cost are not equal:  Cost - Purchase Land and Building for $450,000 cash.  Market Value Appraisal shows the land value at $100,000 Appraisal shows the buildings value at $400,000 Lump-sum (Basket) Purchases FYI - Market Value: value assessed by third party based on current market conditions - appraisal

Step 1.) Calculate the % each asset account is of the total Market Value of the asset bundle purchased (third-party appraisal). Step 2.) Multiply each asset accounts % by the Total Cost of the asset bundle. 14 AssetMarket value Total market value % of total market valueTotal cost Cost of each asset Land$100,000$500,00020%$450,000$90,000 Building$400,000$500,00080%$450,000$360,000 $500,000100%$450,000 = = Lump-sum (Basket) Purchases (Cont.) Step 1 Step 2

Basket Purchase Example On 1/1/16, a used truck and fork lift are purchased for $50,000 cash. The Fair Market Value (FMV) on the truck is $30,000 and the FMV for the fork lift is $30,000. Journalize the purchases. Check-in #1: The cost of training employees on new equipment is considered part of the asset acquisition cost. True or False

Part 2 Use: Cost Allocation 7-16

Plant Asset Terminology – Cost Allocation Asset Account (Balance Sheet) Related Expense Account (Income Statement) Plant assets (aka fixed, capital) LandNone Buildings, Machinery & Equipment Depreciation Furniture & FixturesDepreciation Land ImprovementsDepreciation IntangiblesAmortization 17

18 Southwest Airlines

Depreciation Terminology  Residual value (or salvage value) is the amount the company expects to receive from selling the asset at the end of its service life. (Residual value is never depreciated)  Depreciable cost – total purchase cost less residual value.  Service life (or useful life) is how long the company expects to receive benefits from the asset before disposing of it; can be measured in units of time or in units of activity.  Accumulated depreciation is a contra-asset account representing the total depreciation taken to date (cumulative).  Book value is equal to the original cost of the asset minus the current balance in accumulated depreciation

LO4 Calculate Depreciation Expense Dictionary definition = Decrease in value. Accounting definition = Allocation of an asset’s cost $Cost $Benefit Time Periods Depreciation = Allocation of a portion of the asset’s cost to an expense over all periods benefited. Cost incurred to purchase an asset (future benefit) 7-20 Depreciation Calculation Methods are used to determine the annual depreciation expenses.

Depreciation Calculation Methods Depreciation Methods – selection of depreciation calculation method is based on time, how the asset is used, or if the company is seeking tax savings 1.) Straight- line 2.) Activity Based 3.) Declining- balance 7-21

1.) Straight-Line Depreciation Method Definition - Allocates an equal amount of the depreciable cost based on time to each year (month) of the asset’s service life. Asset cost - Estimated residual value Straight-Line Depreciation = Asset’s service life (Years or Months) 7-22

Truck purchase for $41,000; residual value = $1,000; useful life = 5 years. What is Annual Depreciation Expense? Journalize. 23

Straight-line Depreciation – Balance Sheet 24 Partial balance sheet Partial Income Statement

2.) Activity-Based Depreciation Method Definition - Allocate an asset’s cost based on use rather than time Step 1 Compute the average depreciation rate per unit of use Depreciable Cost (Cost – Salvage Value) Total units expected to be produced/used Step 2Multiply the average depreciation rate per unit by the number of units consumed each period 7-25 Step 3 Journal entry recording a debit to depreciation expense and a credit to accumulated depreciation.

Activity Based Depreciation – Example Truck purchase $41,000, 5 year useful life, $1,000 residual value, 100,000 miles expected use. UseMiles Year ,000 Year ,000 Year ,000 Year ,000 Year , ,000 26

Activity Based Depreciation – Example Truck purchase $41,000, 5 year useful life, $1,000 residual value, 100,000 expected use. 27

3.) Declining-Balance Depreciation  An accelerated depreciation method Depreciates a larger portion of the asset in the first years of the useful life.  Will be higher than straight-line depreciation in earlier years, but lower in later years  Double-declining-balance (DDB) depreciation computes annual depreciation by multiplying the asset’s declining book value by a constant percentage, which is two times the straight-line depreciation rate (hence – double).  Does not consider residual value until last year. 7-28

Double Declining Balance (DDB) - STEPS 1.Straight line Depreciation as a % - Compute straight-line deprec. in the form of a percentage. For example, 4 year useful life = 25% of the value each year (1 / useful life) 2.DDB Percentage Rate - Multiply the straight-line percentage rate by 2 (hence, the title of ‘double’ declining balance) to compute the DDB percentage rate. 3.First Year Depreciation Expense - Multiply the DDB % rate by the period’s beginning asset book value ***Under the DDB method, ignore the residual value of the asset in computing depreciation, except during the last year. *** 4.Record Depreciation Expense - Record and post the calculated depreciation expense (debit depreciation expense and credit accumulated depreciation) 5.Next Years Depreciation Expense - Multiply the DDB % rate by the period’s beginning asset book value (cost less accumulated depreciation). 6. Determine the final year’s depreciation amount—that is, the amount needed to reduce asset book value to its residual value. The residual value should not be depreciated but should remain on the books until the asset is disposed. 29

Double Declining Balance (DDB) – Example #1 30 Step 1 Step 2 DDB Percentage Rate

DDB – Example #2 – Using Depreciation Schedule - Truck purchase for $41,000; residual value = $1,000; useful life = 5 years. What is Annual Depreciation Expense? Journalize year 1. 31

DDB Example and Differences  First-year depreciation is based on asset’s full cost (NOT the depreciable cost)  Final year depreciation is a “plug” amount needed to reduce book value to residual value 32

Comparing Depreciation Methods  Straight line Best for assets that generate revenue evenly - TIME  Units of production Best for assets that wear out based on USAGE  Double declining balance Best for assets that generate most revenues early in their life Tax Advantage in the early years  Matching best achieved considering these scenarios

Depreciation for Tax Purposes 34 Tax savings increase cashflow and cash can be reinvested in business Tax deductions decrease tax payments Accelerated deprecation provides fastest tax deductions

Comparison of Dep. Methods 35 Check-in #2: If the bicycle trading company purchased an air pump on 1/1/16 for $10,000 with a useful life of 10 years and an estimated usage of 20,000 hours. If they used 1,500 hours in year 1, what is book value on 12/31/16 based on the straight line depreciation method? A.) $9,250; B.) $9,000; C.) $1,000; D.) $750

Exercise 36

Straight-line Depreciation – Bought van for $19,000 on year useful life (36,000) miles Residual value = $2,800  What is book value at the end of year 2?

Straight Line – Journal Entry DateAccountDebitCredit 12/31/2013Depreciation Expense 4,050 Accumulated Depreciation 4,050 (Annual depreciation expense) 12/31/2014Depreciation Expense 4,050 Accumulated Depreciation 4,050 (Annual depreciation expense) 12/31/2015Depreciation Expense 4,050 Accumulated Depreciation 4,050 (Annual depreciation expense) 12/31/2016Depreciation Expense 4,050 Accumulated Depreciation 4,050 (Annual depreciation expense)

Activity Based Depreciation Bought van on for $19,000 on ; 4 year useful life (36,000) miles; Residual value = $2,800 Actual usage: Year 1 = 11,000 miles; Year 2 = 13,000 miles; Year 3 = 5,000 miles; Year 4 = 7,000 miles  What is book value at the end of year 2?

Activity Based – Journal Entries DateAccountDebitCredit 12/31/2013Depreciation Expense 4,950 Accumulated Depreciation 4,950 (Annual depreciation expense) 12/31/2014Depreciation Expense 5,850 Accumulated Depreciation 5,850 (Annual depreciation expense) 12/31/2015Depreciation Expense 2,250 Accumulated Depreciation 2,250 (Annual depreciation expense) 12/31/2016Depreciation Expense 3,150 Accumulated Depreciation 3,150 (Annual depreciation expense)

41 Double-declining-balance Bought van on year useful life (36,000) miles Residual value = $2,800  Step 1  Step 2

Exercise 42 DDB rate 1/Life in years * 2 1/4 *2 50% Double-declining- balance DepreciationAccumulatedEnding DateAsset CostDDB RateBook ValueExpenseDepreciationBook Value 1/1/ ,000 12/31/ ,000 9,500 12/31/ ,500 4,750 14,250 4,750 12/31/ ,750 1,950 16,200 2,800*** 12/31/ , ,200 2,800

Double Declining Balance – JE’s DateAccountDebitCredit 12/31/2011Depreciation Expense 9,500 Accumulated Depreciation 9,500 (Annual depreciation expense) 12/31/2012Depreciation Expense 4,750 Accumulated Depreciation 4,750 (Annual depreciation expense) 12/31/2013Depreciation Expense 1,950 Accumulated Depreciation 1,950 (Annual depreciation expense) 12/31/2014Depreciation Expense - Accumulated Depreciation - (Annual depreciation expense)

Partial Year Depreciation Expense Calculation 44 Annual depreciation Months from date of purchase to end of year 12 Step 1 – calculate the annual depreciation expense. Step 2 – multiple the annual depreciation expense by time (fraction of months).

Partial Year Depreciation Example Cost = $500,000; Residual Value = $80,000; Useful Life = 20 years – bought April 1 st. 45 Step 1 – Calculate Annual Amount Step 2 – Multiply by Time

Part 3 Asset Disposition THE FOOD STORE 7-46

LO6 Disposal of Long-Term Assets Disposal of Long-Term Assets Sale Retirement Can result in either a gain or a loss Occurs when a long- term asset is no longer useful but cannot be sold 7-47

Calculate Gain or Loss on Sale/Retirement 1. Bring accumulated depreciation up-to-date to: 1. Record depreciation expense up to date of disposal 2. Calculate sale amount based on one of 2 scenarios 1. Sale Price - Equals cash received (sale) 2. Retirement, $0.00 is received. 3. Subtract current book value (Updated after Step 1). 1. If result is positive, record gain (credit); if negative, record loss (debit). Journal Entry – close out asset and accumulated depreciation 1. Debit Cash if sale (if retirement, no cash is received) 2. Debit accumulated depreciation (to close out account) 3. Credit tangible asset account (to close out account) 4. Record gain (credit) or loss (debit) on disposal (New accounts – Gain with a normal Credit Balance and Loss with a normal Debit Balance) Disposal of Long-Term Assets - STEPS

Selling a Plant Asset 49 If cash received is greater than book value GAIN (Credit) GAIN (Credit) If cash received is less than book value LOSS (Debit) LOSS (Debit)

Recording Long-Term Asset Disposals Little King Sandwiches purchased a new delivery truck. Here are the specific details: Cost of the new truck$40,000 Estimated residual value$5,000 Estimated service life5 years 7-50 Assume a sale at the end of 3 years for 22,000 cash & SL Depreciation

Sale If we assume that Little King sells the delivery truck at the end of year 3 for $22,000, we can calculate the gain as $3,000. Note that both the delivery truck and the related accumulated depreciation account are removed. The entry to record the gain on sale is: Cash22,000 Accumulated Depreciation21,000 Delivery Truck40,000 Gain on sale3,000 (Record gain on sale) Sale amount$22,000 Less: Cost of the new truck$40,000 Less: Accumulated depreciation (3 years x $7,000/year)(21,000) Book value at the end of year 319,000 Gain on sale$3, STEP 2 STEP 3 STEP 4

Retirement If we assume that the delivery truck is totaled in an accident at the end of year 3, we have a $19,000 loss on retirement. 7-52

Retirement - If we assume that the delivery truck is totaled in an accident at the end of year 3, we have a $19,000 loss on retirement. Sale amount$0 Less: Cost of the new truck$40,000 Less: Accumulated depreciation (3 years x $7,000/year)(21,000) Book value at the end of year 319,000 Loss on retirement($19,000) The entry to record the loss on retirement is: Accumulated Depreciation21,000 Loss on Retirement19,000 Delivery Truck40,000 (Record loss on retirement) 7-53 STEP 2 STEP 3 STEP 4 Check-in #3: If we assume that there is a positive book value in an asset retirement, the resulting journal entry will always include a A.) Gain; B.) Loss; C.) Not enough information to determine

INTANGIBLE ASSETS – Purchase or Create oPurchase intangible assets like patents, copyrights, trademarks, or franchise rights from other entities. oRecord purchased intangible assets at their original cost plus all other costs, such as legal and filing fees, necessary to get the asset ready for use. o Create intangible assets internally through research and development or advertising. o Most of the costs for internally developed intangible assets are expensed to the income statement as they are incurred Purchase - Definition - long-term assets that lack physical substance, and whose existence is often based on a legal contract.

Research & Development Costs  R&D costs are generally not capitalized.  Generally, all R&D costs are expensed when incurred  What makes sense is not always GAAP Research & development may lead to revenue producing intangible assets  Drug formula, special recipes, processes 55

LO5 Amortization of Intangible Assets Definition: Allocation of the cost of intangible assets to the periods it helped earn the revenue Intangible assets subject to amortization for useful life only Intangible assets not subject to amortization Assets having a FINITE useful life that we can estimate Assets having INDEFINITE useful lives Goodwill, Trademarks Patents, Copyrights, Franchises 7-56

Amortization of Intangible Assets (Cont.) Definition - Allocates an equal amount of the amortization cost to each year of the asset’s useful life. Asset cost Straight-Line Amortization = Lessor of Useful Life or Legal Life 7-57

Patents (example, patent with a useful life of 5 years is purchased for $100,000 cash).  Granted by federal government  Give holder exclusive right to produce & sell an invention  Granted for 20 years  Useful life may be less 58

Copyrights  Granted by the federal government  Give holder exclusive rights to reproduce & sell a book, musical composition, film or other work of art  Extend 70 years after creator’s life Useful life is usually very short 59 ©

Trademarks & Trade Names TM ®  Distinctive identification of a product or service Also include  Advertising slogans  Coloring/uniforms  Signage, mastheads, etc.  Useful life may be set by contract Or indefinite life 60

Franchises & Licenses  Granted by private business or government  Give purchaser right to sell a product or service with specified conditions  Include restaurant chains & sports organizations  May have indefinite life 61

Intangible with Finite life – Purchased Patent for $170,000 cash. Legally Enforceable for 20 years Estimated Useful life – 5 years Journal purchase and amortization 62

Intangible with Finite life – Purchased Patent for $170,000 Legally Enforceable for 20 years Estimated Useful life – 5 years 63

Goodwill  Only recorded when assets are acquired in a business combination Assets not individually identified  Reputation, corporate culture, market share  Defined as the excess of the purchase price of the company over the market value of its net assets  Represents future economic benefits (earning power of assets acquired in a business combination)  Not amortized – evaluate at least annually for impairment 64

Questions to be Answered How does the 1.) purchase, 2.) use, or 3.) sale of long-term assets impact period earnings and the balance sheet?

Bonus Questions – Chapter 7 Items 1 & 2 are Conceptual only and will not be on Exam 2 1.) The purchase and recording of the bicycle air pump for $10,000 in cash in Check-in #2 on 1/1/16 will impact which financial statement(s) on 1/1/16 (Slide 38 in Chapter 7 PPT’s) ? A.) Balance Sheet; B.) Income Statement; C.) Balance Sheet and Income Statement; D.) No impact 2.) The sale of an asset for cash that resulted in a gain will impact the financial statements as follows (See slide 53 in Chapter 7 PPT’s): A.) Increase in net profit and a decrease in assets B.) Increase in net profit and an increase in assets C.) Decrease in net profit and a decrease in assets D.) Decrease in net profit and an increase in assets UCF College of Engineering purchased a patent on 10/1/16 for $50,000. The remaining legal life of the patent is 5 years but the firm only expects to benefit from the patent for 2.5 years. No residual value is expected. Assuming the straight- line method is used, what is the amortization expense, if any, for 2016? A.) $20,000; B.) $10,000; C.) $5,000 UCF athletics purchased land for a new figure skating rink for 10,000 cash. They also incurred commissions of $1,000, fencing for $5,000, back property taxes of $2,000, and title insurance of $1,000. What is the total amount to be recorded in the land account as the cost of the land? A.) $14,000; B.) $19,000; C.) $10,000; D.) $17,000

Participation Questions – Chapter 7  Nike was used as an example for the intangible asset of Trademarks. True or False  What company committed fraud by capitalizing $11 billion of costs instead of properly expensing them? Target, WorldCom, JC Penney, Albright Mobile Communications  Name a type of intangible asset. Equipment, Building, Land, Goodwill  Tangible property is depreciated each year in order to comply with the matching principle. True or False  The double declining balance method of calculating depreciation expense forces companies to pay higher income taxes in the earlier years of the assets life. True or False

Exam #2 – Study Guide Overall Study Tips  Block 2 Definitions – if it is an account, make sure you know the definition, normal balance, main category (i.e. asset), and financial statement where it appears  How matching principle and revenue recognition principle relate to how we record transactions in these chapters.  Connect LearnSmart Learning Presentations for items that you need more help understanding Exam Practice Questions  Self-study questions at the end of each chapter related to the topics listed below.  Re-do practice problems from in class (original Excel document and solutions are posted on webcourses)  Keep in mind how each transaction (bank rec., AR allowances, inventory costing, and depreciation) affect the Inc. Stmt. and Balance Sheet accounts as well as the original transactions.

Remember Accounting Equation and understand transactions through it. Watch the dates… Write the Accounting Equation down on the scrap paper provided in Testing Lab as soon as you sit down. Use T Accounts during the exam starting from the original transaction! Tips for Taking Exam

 Learn Smart (Extra Credit)  Study Groups  Flash Cards for def., normal balance, financial statement.(Materia)  Tutor – if needed Review Session for Exam #2 with Graduate Assistants  October 28 th – 11:30 AM – 1:15 PM in BA1 #107 (Normal auditorium) Tools that are critical to success

For Exam, you must be able to place our typical accounts (see Block 1 Definitions) in the right location on the Accounting Equation, know the normal balance of the account, and which financial statement it appears on. Permanent Accounts Temporary Accounts

Exam #2 – Study Guide Chapter 4  Objective of internal controls  Framework for internal controls (Pyramid) – definitions and examples of each Control environment Risk assessment Control activities  Preventative  Detective Monitoring Information and communication  Bank statement reconciliation Adds and subtracts from bank/book Journal Entries for each type of activity that occurs during the bank statement reconciliation Error correction

Exam #2 – Study Guide Chapter 5  Definitions and Journal Entries - Sales discounts, allowances, & Returns (contra revenue accounts)  Recording an amount for uncollectible accounts receivable Two methods  Direct write off (not GAAP)  Allowance - GAAP estimated bad debts (contra asset account)  Techniques for calculating the allowance for uncollectible accounts  % of aging (only % of aging on the exam)  How to write off the actual A/R amount that becomes uncollectible months after the sale.  Net realizable value of accounts receivable amount - how to calculate – also just called Net A/R  Notes receivable – original transaction and accrue interest at year end only

Exam #2 – Study Guide Chapter 6  Components of the cost of inventory (Cost of net purchases) on the balance sheet  Cost of goods sold formula  Gross profit formula  Inventory costing methods LIFO, FIFO, Weighted Average  Effects of each inventory valuation method on COGS, Gross profit, & ending inventory  Order of current assets on balance sheet

Exam #2 – Study Guide Chapter 7  Measuring cost of plant assets Land and Land Improvements  Lump-sum purchases of assets (Basket)  Definitions and calculation - Accumulated depreciation (contra asset account), Depreciable Cost, Book value  Depreciation expense definition and how to record, when to use each calculation method, and how to calculate annual expense Straight line; Activity based and Double declining balance - (how to calculate for first two years only)  accelerated – reduces net income in the early years, company pays less in taxes, increases cash flow  Journal entry for recording depreciation expense  Intangible Assets Amortization expense – definition and to record JE  Patents, Copyrights, Franchises, Goodwill.  Research and Development – expense