FINANCIAL ACCOUNTING A USER PERSPECTIVE Hoskin • Fizzell • Davidson Second Canadian Edition

Capital Assets Chapter Eight

Capital Asset Recognition Capital assets Used to generate revenue over several periods in the future Used until replaced with a new asset Can have residual (or resale) value

Capital Asset Valuation Historical cost Original cost of the asset Expensed (amortized) over the period used

Capital Asset Valuation Gain or loss on sale Recognized only when sold Difference between proceeds of the sale and the net book value Net book value (or carrying value) Original cost less amortization

Capital Asset Valuation Market value Replacement cost Amount that would be needed to acquire an equivalent asset Net realizable value Amount that could be received by converting the asset to cash

Capital Asset Valuation Canadian practice Uses historical cost Amortized over the period of use Maximum of 40 years Market value changes generally not recognized

Capitalizable Costs Costs to acquire and prepare the asset for use Purchase price (less any discounts) Installation costs Transportation costs Legal costs Direct taxes

Basket Purchases Several assets acquires in one transaction Price paid is divided between the assets on the basis of their relative fair values at the time of acquisition

Basket Purchases Timberland Example

Interest Capitalization Companies often borrow money to finance a capital asset Interest paid on borrowed money Capitalized when it is included in the capital asset account rather than being expensed

Amortization (or Depreciation) Method for allocating the cost of capital assets to the periods in which the benefits from the assets are received (the useful life) Does not refer to the value of the asset Follows the matching concept

Amortization Methods Straight-line method Accelerated or diminishing balance method Decelerated method Unit of production method

Amortization Methods Asset Carrying Value Dol lars

Amortization Methods Amortization Expense Do l lars

Straight-Line Method Allocates the cost evenly over the life of the asset Estimates needed for Useful life Residual value

Straight-Line Method Assumptions: Original Cost $10,000 Estimated Residual Value $1,000 Useful Life 5 years

Straight-Line Method - = - = = Original Cost Residual Value Amortization Expense = Useful Life - $10,000 $1,000 = 5 years = $1,800 per year

Straight-Line Method Amortization Schedule

Accelerated Methods Amortization Carrying value decreases each year Multiply the carrying value of the asset by a fixed percentage Carrying value decreases each year Amortization expenses decreases each year

Accelerated Methods Percentage rates Double declining balance method Lower when asset has longer life Double declining balance method Percentage is double the straight-line rate Residual value Not used for computations Serves as a constraint

Double Declining Balance Method Assumptions: Original Cost $10,000 Estimated Residual Value $1,000 Useful Life 5 years 200% Declining Balance Method

Double Declining Balance Method Calculation: DB rate = DB% x SL rate = 200% x 1/n = 200% x 1/5 = 40%

Double Declining Balance Method Amortization Schedule

Production Method Assumptions Benefits derived are related to the output or use of an asset Requires that the useful life can be expressed as units of output

Production Method Assumptions: Original Cost $10,000 Estimated Residual Value $1,000 Estimated Usage

Production Method - = - = = Cost Residual Value Amortization Expense per Unit = Estimated Total Units of Output - $10,000 $1,000 = 20,000 units = $0.45 per unit

Production Methods Amortization Schedule

Recording Amortization Expense All amortization methods: SE-Amortization expense XX XA-Accumulated amortization XX

Corporate Income Taxes Revenue Canada Amortization expense is allowed to be deducted to calculate accounting income Capital cost allowance (CCA) instead must be used to calculate taxable income

Corporate Income Taxes May result in a temporary difference between Accounting income and taxable income Result is a future tax asset or liability (formerly referred to as deferred tax)

Capital Cost Allowance (CCA) Capital assets are grouped into classes and assigned a maximum rate Vehicles: Class 10: rate 30% Equipment: Class 8: rate 20%

Capital Cost Allowance (CCA) Companies may deduct any part of the undepreciated capital costs (UCC) in the class up to the stated maximum Exception: Year of acquisition: 50% of normal amount

Capital Cost Allowance (CCA) Central Corp. purchases new equipment (Class 8) at a cost of $20,000 CCA Year 1: 50% x $20,000 x 20% = $2,000 Year 2: 20% x ($20,000-$2,000)= $3,600 Year 3: 20% x ($20,000-$2,000-$3,600) = $2,880

Capital Cost Allowance (CCA) Journal entry: SE-Tax expense 11,460 A-Future tax asset* 90 L-Income taxes payable 11,550 *(Future tax liability if a credit balance)

Changes in Amortization Estimates and Methods Estimates of useful life and residual value may change over time Amortization may change as a result

Changes in Amortization Estimates and Methods Straight-Line Method Assumptions Original Cost $10,000 Residual Value $1,000 Useful Life 5 years Changes in Year 4 (Estimations) Remaining Useful Life 3 years Residual Value $ 400

Changes in Amortization Estimates and Methods Remaining Book Value - Residual Value Amortization Expense = Useful Life - $4,600 $400 = 3 years = $1,400 per year

Changes in Amortization Estimates and Methods Amortization Schedule

Sale of Capital Assets Original cost and accumulated amortization removed from accounts Gain or loss: difference between cash received and book value A-Cash 1,200 XA-Accumulated amortization 9,000 A-Property, plant and equipment 10,000 SE-Gain on sale of PP&E 200

Disposal of Capital Assets If assets are disposed of and no cash is received XA-Accumulated amortization 9,000 SE-Loss on disposal of PP&E 1,000 A-Property, plant and equipment 10,000

Writedown of Capital Assets If future recoverable amount of a capital asset declines below its carrying value SE-Loss due to damage to asset 1,000 XA-Accumulated amortization 1,000

Natural Resources Capitalizing the costs implies that they have future value Example: oil exploration Exploration costs choices Full costing method Successful efforts method

Intangible Assets Intangible assets have probable future value but no physical form Guidelines: If developed internally, expense as incurred If purchased, can be capitalized

Intangible Assets Estimate useful life and residual value (if any) Use straight-line method to amortize SE-Amortization expense XX A-Patents XX

Intangible Assets Advertising Patents, Trademarks, Copyrights Goodwill Generally expensed as incurred Patents, Trademarks, Copyrights Legal life is the maximum for amortizing Goodwill Capitalize and amortize if purchased

Return on Assets ROA Net income before interest = Average total assets Net income + [Interest expense x (1-Tax rate)] = Average total assets