Cornerstones of Financial Accounting, 3e

Chapter 7: Operating Assets Cornerstones of Financial Accounting, 3e

Understanding Operating Assets Operating assets are the long-lived assets that are used by the company in the normal course of operations. Unlike inventory, operating assets are not sold to customers. Instead, operating assets are used by a company in the normal course of operations to generate revenue. LO-1

Understanding Operating Assets (cont.) Operating assets are divided into three categories: Property, plant, and equipment also known as fixed assets or plant assets. They include land, buildings, machines, and automobiles. Intangible assets do not have physical substance. They include patents, copyrights, trademarks, licenses, and goodwill. Natural resources are naturally occurring materials. They include timberlands and deposits such as coal, oil, and gravel. LO-1

Understanding Operating Assets (cont.) Operating assets represent future economic benefits, or service potential, that will be used in the normal course of operations. At acquisition, an operating asset is recorded at its cost, including the cost of acquiring the asset and the cost of preparing the asset for use (historical cost principle). These costs are said to be capitalized. LO-1 5

Understanding Operating Assets (cont.) As the service potential of an operating asset declines, the cost of the asset is allocated as an expense among the accounting periods in which the asset is used and benefits are received (the matching principle). This allocation is called depreciation for property, plant, and equipment assets, amortization for intangible assets, and depletion for natural resources. LO-1 6

Acquisition of Property, Plant, and Equipment Property, plant, and equipment are the tangible operating assets and include: Land: The site of a manufacturing facility or office building used in operations Land Improvements: Structural additions or improvements to land (such as driveways, parking lots, fences, landscaping, lighting) LO-2 7

Acquisition of Property, Plant, and Equipment (cont.) Buildings: Structures used in operations (factory, office, warehouse) Equipment: Assets used in operations (machinery, furniture, automobiles) It is important to note that land, unlike other assets, has an unlimited life and service potential and is not subject to depreciation. LO-2 8

Measuring the Cost of a Fixed Asset The cost of a fixed asset is an expenditure necessary to acquire the asset and to prepare the asset for use. Expenditures that are included as part of the cost of the asset are said to be capitalized. Expenditures that are not included as part of the cost of the asset are expensed immediately. LO-2 9

Typical Costs of Acquiring Property, Plant, and Equipment LO-2

Recording the Cost of a Fixed Asset The historical cost principle requires that a company record its fixed assets at the exchange price at the time the asset is purchased. When cash is paid in exchange for an asset, the amount of cash given, plus any other expenditure necessary to prepare the asset for use, becomes part of the historical cost of the acquired asset. LO-2

Recording the Cost of a Fixed Asset (cont.) Fixed assets can also be purchased by issuing debt. In this situation, the asset is valued at the fair value of the liability on the date the asset is acquired. When noncash consideration, such as land or other noncash assets, is given in exchange for an asset, the purchase price of the acquired asset is the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable. LO-2

Depreciation Depreciation is the process of allocating, in a systematic and rational manner, the cost of a tangible fixed asset (other than land) to expense over the asset’s useful life. The matching principle provides the conceptual basis for measuring and recognizing depreciation. LO-3

Capitalized Cost – Accumulated Depreciation = Book Value Depreciation (cont.) The amount of depreciation recorded each period, depreciation expense, is reported on the income statement. Accumulated depreciation, which represents the total amount of depreciation expense that has been recorded for an asset since the asset was acquired, is reported on the balance sheet as a contra-asset. Capitalized Cost – Accumulated Depreciation = Book Value LO-3

Information Required for Measuring Depreciation The following information is necessary in order to measure depreciation: cost of the fixed asset useful life (or expected life) of the fixed asset Residual value (salvage value) of the fixed asset Cost of the fixed asset is any expenditure necessary to acquire the asset and to prepare the asset for use. LO-3

Information Required for Measuring Depreciation (cont.) The useful life of an asset is the period of time over which the company anticipates deriving benefit from the use of the asset. The residual value (also called salvage value) is the amount of cash or trade-in consideration that the company expects to receive when an asset is retired from service. LO-3

Components of Depreciation Expense LO-3

Straight-Line Method Straight-line depreciation method allocates an equal amount of an asset’s cost to depreciation expense for each year of the asset’s useful life. It is appropriate to apply this method to those assets for which an equal amount of service potential is considered to be used each period. LO-4

Straight-Line Method Calculation The computation of straight-line depreciation expense is based on an asset’s depreciable cost, which is the excess of the asset’s cost over its residual value. Straight-line depreciation expense for each period is calculated as follows: Straight-Line Depreciation = (Cost – Residual Value) / Expected Useful Life LO-4

Declining Balance Method The declining balance depreciation method is an accelerated depreciation method that produces a declining amount of depreciation expense each period by multiplying the declining book value of an asset by a constant depreciation rate. It results in a larger amount of depreciation expense in the early years of an asset’s life relative to the straight-line method. LO-4

Declining Balance Method The declining balance depreciation rate is some multiple (m) times the straight-line rate: Declining Balance Rate = (m) X Straight-Line Rate LO-4

Declining Balance Method (Cont.) Depreciation expense for each period of an asset’s useful life equals the declining balance rate times the asset’s book value (cost less accumulated depreciation) at the beginning of the period as shown: Declining Balance Depreciation Expense = Declining Balance Rate X Book Value LO-4

Units-of-Production Method When the decline in an asset’s service potential is proportional to the usage of the asset and asset usage can be measured, depreciation expense can be computed using the units-of-production method. Usage is typically gauged by a measure of productive capacity such as miles or hours. LO-4

Units-of-Production Method (cont.) To compute depreciation expense under the units-of-production method, the depreciation cost per unit is determined as shown in the following equation: Depreciation Cost per Unit = (Cost – Residual Value) / Expected Usage of the Asset LO-4

Units-of-Production Method (cont.) Next, the depreciation cost per unit is multiplied by the actual usage of the asset: Units-of-Production Depreciation Expense = Depreciation Cost per Unit X Actual Usage of the Asset LO-4

Expenditures after Acquisition In addition to expenditures made when property, plant, and equipment is purchased, companies incur costs over the life of the asset that range from ordinary repairs and maintenance to major overhauls, additions, and improvements. Companies must decide whether these expenditures should be capitalized (added to an asset account) or expensed (reported in total on the income statement). LO-5

Revenue Expenditures Expenditures that do not increase the future economic benefits of the asset are called revenue expenditures and are expensed in the same period the expenditure is made. These expenditures maintain the level of benefits provided by the asset, relate only to the current period, occur frequently, and typically involve relatively small dollar amounts. An example of a revenue expenditure is the ordinary repair and maintenance of an asset. LO-5

Capital Expenditures Expenditures that extend the life of the asset, expand the productive capacity, increase efficiency, or improve the quality of the product, are called capital expenditures. Because these expenditures provide benefits to the company in both current and future periods, capital expenditures are added to an asset account and are subject to depreciation. LO-5

Capital Expenditures (cont.) These expenditures typically involve relatively large dollar amounts. Examples of capital expenditures include extraordinary or major repairs, additions, remodeling of buildings, and improvements (sometimes called betterments). LO-5

Types of Expenditures LO-5

Revision of Depreciation Depreciation expense is based on estimates of useful life and residual value. As new or additional information becomes available, a company will often find it necessary to revise its estimates of useful life, residual value, or both. LO-6

Revision of Depreciation (cont.) To revise depreciation expense, the following steps are performed: Step 1: Obtain the book value of the asset at the date of the revision of depreciation. Step 2: Compute depreciation expense using the revised amounts for book value, useful life, and/or residual value. LO-6

Impairments Because depreciation is a cost allocation process and does not attempt to measure the fair value of the asset, the book value of an asset and the fair value of an asset may be quite different. When the fair value of the asset falls significantly below the book value of the asset, the asset may be impaired. LO-6

Impairments (cont.) An impairment is a permanent decline in the future benefit or service potential of an asset. The impairment may be due to numerous factors, including too little depreciation expense being recorded in previous years or obsolescence of the asset. LO-6

Disposal of Fixed Assets Although companies usually dispose of fixed assets voluntarily, disposition may also be forced. Voluntary disposal occurs when the company determines that the asset is no longer useful. Involuntary disposal occurs when assets are lost or destroyed through theft, acts of nature, or by accident. LO-7

Analyzing Fixed Assets It is important to understand how efficiently a company is using its fixed assets because fixed assets are the productive assets. One measure of efficiency in the use of fixed assets is the fixed asset turnover ratio. It is calculated as: Fixed Asset Turnover Ratio = Net Sales / Average Fixed Assets LO-7

Analyzing Fixed Assets (cont.) (The more efficiently a company uses its fixed assets, the higher the ratio will be.) Investors are also concerned with the condition of a company’s fixed assets. Typically, older assets tend to be less efficient. An estimate of the average age of fixed assets can be computed as follows: Average Age of Fixed Assets = Accumulated Depreciation / Depreciation Expense LO-7

Intangible Assets Intangible operating assets, like tangible assets, represent future economic benefit to the company, but unlike tangible assets, they lack physical substance. Patents, copyrights, trademarks, leaseholds, organization costs, franchises, and goodwill are all examples of intangible assets. See Exhibit 7.12 LO-9

Intangible Assets (cont.) The economic benefits associated with most intangible assets are in the form of legal rights and privileges conferred on the owner of the asset. The economic value of a patent, for example, is the legal right to restrict, control, or charge for the use of the idea or process covered by the patent. LO-9

Intangible Assets (cont.) Accounting for Intangible Assets Intangible assets are recorded at cost, consistent with the historical cost principle. For internally developed intangible assets, the cost of developing the asset is expensed as incurred and normally recorded as research and development (R&D)expense. LO-9

Intangible Assets (cont.) Organizational Costs: costs related to legal fees, stock issuance, accounting fees, and promotional fees. Occur during the formation of a new company. Current accounting standards treat organizational costs as an expense in the period the cost is incurred. LO-9

Intangible Assets (cont.) The cost of an intangible asset with a finite life, like the cost of a tangible asset, is allocated to accounting periods over the life of the asset to reflect the decline in service potential. This process is referred to as amortization. LO-9

Natural Resources Natural resources, such as coal deposits, oil reserves, and mineral deposits, make up an important part of the operating assets for many companies. Like intangible assets, natural resources present difficult estimation and measurement problems. LO-10

Natural Resources (cont.) Natural resources differ from other operating assets in two important ways: Unlike fixed assets, natural resources are physically consumed as they are used by a company. Natural resources can generally be replaced or restored only by an act of nature. (Timberlands are renewed by replanting and growth, but coal deposits and most mineral deposits are not subject to renewal.) LO-10

Natural Resources (cont.) As a natural resource is removed from the earth, the cost of the natural resource is allocated to each unit of natural resource removed. This process of allocating the cost of the natural resource to each period in which the resource is used is called depletion. Depletion is computed by using a procedure similar to that for the units-of-production method of depreciation. LO-10

Natural Resources (cont.) First, a depletion rate is computed as follows: Depletion Rate = (Cost – Residual Value) / Recoverable Units Second, depletion is calculated by: Depletion = Depletion Rate X Units Recovered LO-10

Appendix 7A: Impairment of Property, Plant and Equipment An impairment is a permanent decline in the future benefit or service potential of an asset. Impairment may be due to numerous factors, including too little depreciation expense being recorded in previous years or obsolescence of the asset. A company is required to review an asset for impairment if events or circumstances lead the company to believe that an asset may be impaired. LO-11

Impairment of Property, Plant and Equipment (cont.) Consistent with the principle of conservatism, if a fixed asset is impaired, a company should reduce the asset’s book value to its fair value in the year the impairment occurs. LO-11