Financial Accounting Chapter 8 Financial Accounting Chapter 8. Property, Plant and Equipment and Intangibles

Objectives Long-lived assets: tangible and intangible assets Acquisition of assets Maintenance of assets Depreciation Sales of assets

Overview of Long-lived Assets Most business hold such major long-lived assets as land, buildings, equipment, natural resources, and patents. These long-lived assets help produce revenues over many periods by facilitating the production and sale of goods or services to customers. Because these assets are necessary in a company'’ day-to-day operations, companies do not sell them in ordinary course of business.

Types of Long-lived Assets Tangible assets (also called fixed assets) are physical items that can be seen and touched. includes land, natural resources, buildings, and equipment A popular account name for these tangible assets is ’Property, plant, and equipment’ (PPE). Tangible assets are depreciated. Also, for natural resources, depreciation is called depletion. Land is unique in that it does not wear out or become obsolete and, therefore, doesn’t get depreciated for financial reporting purposes. Intangible assets are rights or economic benefits that are not physical in nature. includes franchises, patents, trademarks, copyrights, and goodwill Systematic value reduction for these intangible assets is called amortization.

Acquisition of tangible assets The acquisition cost of all long-lived assets is their cash-equivalent purchase price, including costs required to complete the purchase, to transport the asset, and to prepare it for use (set-up cost). For example, the acquisition cost of land includes charges to the purchaser for the cost of land surveys, legal fees, title fees, realtors’ commissions, transfer taxes, and even the demolition costs of unsuitable old structure to get the land ready for its intended use. These acquisition costs are capitalized (meaning added to the purchase price of the land) to calculate the cost of the land. Historical cost: Assets are measured and recorded as its cash-equivalent cost of what was given to buy (or produce) the assets. Under this convention, long-lived assets are carried indefinitely at their original costs, which are likely to be far below their current market values.

Maintenance Costs Ordinary repair and maintenance costs which incur in the course of normal operation and do not increase the economic value of the firm are called revenue expenditure and treated as maintenance expense. However, the expenditures that increase the life, efficiency, or capacity of the assets are called capital expenditure and the costs of those expenditures are added to the assets. (=capitalized).

Depreciation Depreciation is the key factor distinguishing accrual accounting from cash-based accounting. Accrual basis accounting allocates the cost of assets in use in the form of depreciation over the periods. Depreciation allocates the depreciable value to the income statement during the useful life of the assets. The depreciable value is the difference between the total acquisition cost and the predicted residual value (or called salvage value or scrap value). The useful life of an asset is expected service period of the asset.

1) Straight-line depreciation Straight-line depreciation spreads the depreciable value evenly over the useful life of an asset. It creates constant depreciation expense each year. It is by far the most popular method. Depreciation expense = [ Cost – residual value ] / useful life. Depreciation expense is a constant amount Net book value decreases by the same amount

2) Accelerated Depreciation This method uses multiple rates to determine the depreciation expenses, usually results in greater depreciation expense in early years and smaller expense in later years. Double-Declining Balance method DDB rate = (100% / useful life) x 2 Depreciation expense=(cost-Accumulated depreciation)*(2/useful life)

3) Unit depreciation When physical wear and tear is the dominant influence on the useful life of the asset (e.g., mining equipment), depreciation based on units of service or production is used, which is called unit depreciation. Unit depreciation = [cost – residual value] / estimated lifetime output Depreciation expense = this year output x unit depreciation

Gains and losses on sales of tangible assets Assets can be retired by either voluntary sale (including a trade–in) or involuntary loss due to casualty (fire, flood, or accidents). Upon disposal, the asset account and its accumulated depreciation account are eliminated at the same time. If there is any discrepancy between net book value and actual sale price after the sale, the amount is recorded as gain/loss. The gains (or losses) are included in the Other revenue/expense category in income statement. (It is investing activity to `purchase/sell LTA.)