Accounting, Fifth Edition 9 REPORTING AND ANALYZING LONG-LIVED ASSETS Accounting, Fifth Edition

Learning Objectives After studying this chapter, you should be able to: Describe how the historical cost principle applies to plant assets. Explain the concept of depreciation. Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods. Explain how to account for the disposal of plant assets. Describe methods for evaluating the use of plant assets. Identify the basic issues related to reporting intangible assets. Indicate how long-lived assets are reported in the financial statements. * Self-study

Plant Assets Plant assets are resources that have physical substance (a definite size and shape), Are actively used in the operations of a business, are not intended for sale to customers, are expected to provide service to the company for a number of years, except for land. Referred to as property, plant, and equipment; plant and equipment; and fixed assets. LO 1 Describe how the historical cost principle applies to plant assets.

Plant Assets Plant assets are critical to a company’s success Illustration 9-1 LO 1 Describe how the historical cost principle applies to plant assets.

Determining the Cost of Plant Assets Historical Cost Principle - requires that companies record plant assets at cost. Cost consists of all expenditures necessary to acquire an asset and make it ready for its intended use. LO 1 Describe how the historical cost principle applies to plant assets.

Determining the Cost of Plant Assets Cost - cash paid in a cash transaction or the cash equivalent price paid. Cash equivalent price is the fair value of the asset given up or fair value of the asset received, whichever is more clearly determinable. International Note IFRS is flexible regarding asset valuation. Companies revalue to fair value when they believe this information is more relevant. LO 1 Describe how the historical cost principle applies to plant assets.

Determining the Cost of Plant Assets All necessary costs incurred in making land ready for its intended use increase (debit) the Land account. Land Costs typically include: cash purchase price, closing costs such as title and attorney’s fees, real estate brokers’ commissions, and accrued property taxes and other liens on the land assumed by the purchaser. LO 1 Describe how the historical cost principle applies to plant assets.

Determining the Cost of Plant Assets Illustration: Assume that Hayes Manufacturing Company acquires real estate at a cash cost of $100,000. The property contains an old warehouse that is razed at a net cost of $6,000 ($7,500 in costs less $1,500 proceeds from salvaged materials). Additional expenditures are the attorney’s fee, $1,000, and the real estate broker’s commission, $8,000. Required: Determine the amount to be reported as the cost of the land. LO 1 Describe how the historical cost principle applies to plant assets.

Determining the Cost of Plant Assets Land Improvements Includes all expenditures necessary to make the improvements ready for their intended use. Examples: driveways, parking lots, fences, landscaping, and underground sprinklers. Limited useful lives. Expense (depreciate) the cost of land improvements over their useful lives. LO 1 Describe how the historical cost principle applies to plant assets.

Determining the Cost of Plant Assets Includes all costs related directly to purchase or construction. Buildings Purchase costs: Purchase price, closing costs (attorney’s fees, title insurance, etc.) and real estate broker’s commission. Remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing. Construction costs: Contract price plus payments for architects‘fees, building permits, and excavation costs. LO 1 Describe how the historical cost principle applies to plant assets.

Determining the Cost of Plant Assets Equipment Include all costs incurred in acquiring the equipment and preparing it for use. Costs typically include: Cash purchase price. Sales taxes. Freight charges. Insurance during transit paid by the purchaser. Expenditures required in assembling, installing, and testing the unit. LO 1 Describe how the historical cost principle applies to plant assets.

Determining the Cost of Plant Assets Illustration: Lenard Company purchases a delivery truck at a cash price of $22,000. Related expenditures are sales taxes $1,320, painting and lettering $500, motor vehicle license $80, and a three-year accident insurance policy $1,600. Compute the cost of the delivery truck. LO 1 Describe how the historical cost principle applies to plant assets.

Determining the Cost of Plant Assets Illustration: Lenard Company purchases a delivery truck at a cash price of $22,000. Related expenditures are sales taxes $1,320, painting and lettering $500, motor vehicle license $80, and a three-year accident insurance policy $1,600. Prepare the journal entry to record these costs. LO 1 Describe how the historical cost principle applies to plant assets.

Determining the Cost of Plant Assets To Buy or Lease? A lease is a contractual agreement in which the owner of an asset (lessor) allows another party (lessee) to use the asset for a period of time at an agreed price. Some advantages of leasing Reduced risk of obsolescence. Little or no down payment. Shared tax advantages. Assets and liabilities not reported. Capital lease - lessees show the asset and liability on the balance sheet. LO 1 Describe how the historical cost principle applies to plant assets.

Accounting for Plant Assets Depreciation Process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. Process of cost allocation, not asset valuation. Applies to land improvements, buildings, and equipment, not land. Depreciable, because the revenue-producing ability of asset will decline over the asset’s useful life. Helpful Hints Land does not depreciate because it does not wear out. Depreciation expense is reported on the income statement. Accumulated depreciation is reported on the balance sheet. LO 2 Explain the concept of depreciation.

Accounting for Plant Assets Decline in asset value over its useful life Acquisition 1. Compute cost. Disposal 4. Record disposal. Use 2. Allocate cost to periods benefited (Depreciation). 3. Account for subsequent expenditures (Betterments) Depreciation fulfills the Matching Principle by aligning revenues with expenses When we acquire a plant asset, it is recorded at its historical cost. The cost of a plant asset includes the purchase price as well as all costs necessary to get the asset in place and ready for its intended use. We record the purchase price net of any cash discounts available. Finance charges are not included in the cost of an asset. If we elect to finance the purchase over a period of time, the interest cost is charged as an expense when incurred. Once the asset is placed in service, we will allocate a portion of the asset’s cost to depreciation expense as the asset becomes older. Finally, at the end of the asset’s useful life, we will dispose of it and remove it from our books and records. The accounting for plant assets usually covers several accounting periods. 8-16

Computing Depreciation Factors in Computing Depreciation Illustration 9-6 1) Cost 2) Useful Life 3) Salvage Value LO 2 Explain the concept of depreciation.

Accounting for Plant Assets Depreciation Methods Management selects the method it believes best measures an asset’s contribution to revenue over its useful life. Examples include: Straight-line method – easiest, but least accurate. Declining-balance method – moderately complicated, moderately accurate. Units-of-activity method – most complicated, but most accurate. Illustration 9-7 Use of depreciation methods in major U.S. companies LO 3

Depreciation Illustration: Bill’s Pizzas purchased a small delivery truck on January 1, 2012. Cost $13,000 Expected salvage value $1,000 Estimated useful life (in years) 5 Estimated useful life (in miles) 100,000 Required: Compute depreciation using the following. (a) Straight-Line. (b) Units-of-Activity. (c) Declining-Balance. LO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods.

Straight-Line Method Straight-Line Expense is same amount for each year. Depreciable cost = Cost less salvage value. Illustration 9-8 LO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods.

Straight Line Method Illustration: (Straight-Line Method) 2014 $ 12,000 20% $ 2,400 $ 2,400 $ 10,600 2015 12,000 20 2,400 4,800 8,200 2016 12,000 20 2,400 7,200 5,800 2017 12,000 20 2,400 9,600 3,400 2018 12,000 20 2,400 12,000 1,000 2014 Journal Entry Depreciation expense 2,400 Accumulated depreciation (contra asset) 2,400 LO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods.

Time-Based so Pro-Rate for a midyear purchase Partial Year Straight Line Method Time-Based so Pro-Rate for a midyear purchase Assume the delivery truck was purchased on April 1, 2014. LO 3

P9-8B, Straight Line Depreciation Straight Line Depreciation Practice Problem P9-8B, Straight Line Depreciation Identify the three depreciation factors needed: Cost Useful Life Salvage Value Calculate depreciation for 2014.

Time-Based so Pro-Rate for a midyear purchase Declining Balance Method Time-Based so Pro-Rate for a midyear purchase Depreciation Repair Expense Early Years High Low Later Years Accelerated method. Decreasing annual depreciation expense over the asset’s useful life. Double declining-balance rate is double the straight-line rate. Rate applied to book value. One of the reasons to consider the declining-balance method is that it is an attempt to match depreciation expense and repairs expense to focus on the overall cost of ownership. In the early years of the asset’s life, depreciation under the declining-balance method is high and generally repair expenses are low. Conversely, in the later years of an asset’s life, we take less depreciation expense but repairs expense is usually higher. So, over the life of the asset we attempt to smooth the total cost of ownership. 8-24

DOUBLE Declining Balance Method Step 2: DOUBLE-declining- balance rate = 2 × Straight-line rate = 2 × 20% = 40% Step 1: Straight-line rate = 100 % ÷ Useful life = 100% ÷ 5 = 20% Step 3: Depreciation expense Double-declining- balance rate × Beginning period BOOK value 40% × $13,000 = $5,200 for 2014 Calculating depreciation expense under the double-declining-balance method is a three-step process. The first step is the calculate the straight-line depreciation rate. Recall that we do this by dividing one hundred percent by the asset’s useful life. In our specific case we divide one hundred percent by the five-year useful life to get a straight-line rate of twenty percent. The second step is to calculate the double-declining-balance rate. We do this by multiplying the straight-line rate times two. In our case that would be twenty percent times two, or forty percent. The third, and final step is to determine depreciation expense. We multiply the double-declining rate times the book value of the asset at the beginning of the period. Under the double-declining-balance method we ignore estimated salvage value. The beginning book value (cost less accumulated depreciation), is fifty thousand dollars. Depreciation expense for 2009 is twenty thousand dollars, forty percent times fifty thousand dollars. Don’t forget that salvage value is not used in the double-declining-balance method. 8-25

Declining Balance Method – Year 2 2014 Depreciation: 40% × $13,000 = $5,200 2015 Depreciation: 40% × ($13,000 - $5,200) = $3,120 At the start of the second year the book value of the asset was thirty thousand dollars (cost of fifty thousand dollars less accumulated depreciation of twenty thousand dollars). To determine depreciation expense, we multiply the book value of thirty thousand dollars times our rate of forty percent to yield twelve thousand dollars. Let’s look at a depreciation table for our asset. 8-26

Declining Balance Method 2014 13,000 40% $ 5,200 $ 7,800 2015 7,800 40 3,120 8,320 4,680 2016 1,872 10,192 2,808 2017 1,123 11,315 1,685 2018 685* 12,000 1,000 Illustration 9A-2 2014 Journal Entry Depreciation expense 5,200 Accumulated depreciation (contra asset) 5,200 * Computation of $674 ($1,685 x 40%) is adjusted to $685. LO 3

Appendix 9A Illustration: (Declining-Balance Method) Partial Year Purchased on 4/1/14 Appendix 9A Illustration: (Declining-Balance Method) LO 9 Compute periodic depreciation using the declining- balance method and the units-of-activity method.

P9-8B (Double Declining Balance), p 494 Double Declining Depreciation Practice Problem P9-8B (Double Declining Balance), p 494 Identify the three depreciation factors needed: Cost Useful Life Salvage Value Calculate the straight line rate, double it. Calculate depreciation for all five years.

NOT Time-Based so no Pro-Rating for a midyear purchase Units of Activity NOT Time-Based so no Pro-Rating for a midyear purchase Companies estimate total units of activity to calculate depreciation cost per unit. Expense varies based on units of activity. Depreciable cost is cost less salvage value. Illustration 9A-3 LO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods.

Units of Activity Illustration 9A-4 2014 15,000 $ 0.12 $ 1,800 $ 11,200 2015 30,000 0.12 3,600 5,400 7,600 2016 20,000 2,400 7,800 5,200 2017 25,000 3,000 10,800 2,200 2018 10,000 1,200 12,000 1,000 Depreciation expense 1,800 Accumulated depreciation 1,800 2014 Journal Entry LO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods.

Identify the three depreciation factors needed: Cost Units of Activity Depreciation Practice Problem E9-18, p 489 Identify the three depreciation factors needed: Cost Useful Life (defined by units) Salvage Value Calculate the depreciation rate per unit. Calculate depreciation for 2014 through 2017.

Comparing Depreciation Methods Illustration 9-12 Illustration 9-13 Each method is acceptable because each recognizes the decline in service potential of the asset in a rational and systematic manner. LO 3

Depreciation Disclosure in the Notes Illustration 9-14 LO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods.

Capital vs Revenue Expenditures If the amounts involved are not material, most companies expense the item. After a plant asset is purchased, the company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, upgrading the asset, and similar expenditures. One way to handle these types of expenditures is to treat them as a Capital Expenditure and charge the amount to a balance sheet account like the asset or accumulated depreciation. In some cases, the expenditures may be treated as Revenue Expenditures and charged to current period income as an expense. For each expenditure subsequent to acquisition of a plant asset we must decide if the expenditure is to be treated as a Capital or Revenue expenditure. 8-35

Capital vs Revenue Expenditures Generally, subsequent expenditures for ordinary repairs are treated as revenue expenditures and charged to current period income as an expense. Subsequent expenditures that are for betterments are classified as extraordinary repairs. These should be treated as capital expenditures and charged to the asset account. Let’s look at the proper accounting for the disposal of plant assets. 8-36

Accounting for Plant Assets Impairments Permanent decline in the fair value of an asset. So as not to overstate the asset on the books, the company writes the asset down to its new fair value during the year in which the decline in value occurs. LO 4 Describe the procedure for revising periodic depreciation.

Plant Asset Disposals Companies dispose of plant assets in three ways —Retirement, Sale, or Exchange (appendix). Illustration 9-16 Record depreciation up to the date of disposal. Eliminate asset by (1) debiting Accumulated Depreciation, and (2) crediting the asset account. LO 5 Explain how to account for the disposal of a plant asset.

Plant Asset Disposals Sale of Plant Assets Compare the book value of the asset with the proceeds received from the sale. If proceeds exceed the book value, a gain on disposal occurs. If proceeds are less than the book value, a loss on disposal occurs. If Cash > BV, record a gain (credit). If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss. LO 5 Explain how to account for the disposal of a plant asset.

Plant Asset Disposals – Update Depreciation Illustration: On July 1, 2014, Wright Company sells office furniture for $16,000 cash. The office furniture originally cost $60,000. As of January 1, 2014, it had accumulated depreciation of $41,000. Depreciation for the first six months of 2014 is $8,000. Prepare the journal entry to record depreciation expense up to the date of sale. July 1 Depreciation expense 8,000 Accumulated depreciation 8,000 LO 5 Explain how to account for the disposal of a plant asset.

Plant Asset Disposals Illustration 9-17 Computation of gain on disposal Illustration: Wright records the sale as follows. July 1 Cash 16,000 Accumulated depreciation 49,000 Equipment 60,000 Gain on disposal of plant assets 5,000 LO 5 Explain how to account for the disposal of a plant asset.

Plant Asset Disposals Illustration: Assume that instead of selling the office furniture for $16,000, Wright sells it for $9,000. Illustration 9-18 Computation of loss on disposal July 1 Cash 9,000 Accumulated depreciation 49,000 Loss on disposal of plant assets 2,000 Equipment 60,000 LO 5 Explain how to account for the disposal of a plant asset.

Plant Asset Disposals Retirement of Plant Assets No cash is received. Decrease (debit) Accumulated Depreciation for the full amount of depreciation taken over the life of the asset. Decrease (credit) the asset account for the original cost of the asset. LO 5 Explain how to account for the disposal of a plant asset.

Plant Asset Disposals Illustration: Assume that Hobart Enterprises retires its computer printers, which cost $32,000. The accumulated depreciation on these printers is $32,000. The journal entry to record this retirement is? Accumulated depreciation 32,000 Printing equipment 32,000 Question: What happens if a fully depreciated plant asset is still useful to the company? LO 5 Explain how to account for the disposal of a plant asset.

Plant Asset Disposals Practice Problem Ex 9-7, p 486 Create T-accounts for Equipment & Accumulated Depreciation. Properly indicate + and – sides. Input opening balances for those two accounts. Create journal entries to record disposal: Is cash involved? If yes, create and record in a T- account. Zero out the Equipment & Accumulated Depreciation T-accounts. If the journal entry doesn’t balance, create a balanced journal entry using a Gain or Loss on the Sale/Disposal.

Analyzing Plant Assets Return on Asset indicates the amount of net income generated by each dollar of assets. Illustration 9-19 LO 6 Describe methods for evaluating the use of plant assets.

Analyzing Plant Assets Asset Turnover indicates how efficiently a company uses its assets to generate sales. Illustration 9-20 LO 6 Describe methods for evaluating the use of plant assets.

Intangible Assets Intangible assets are rights, privileges, and competitive advantages that result from ownership of long-lived assets that do NOT possess physical substance. Limited life or an indefinite life. Common types of intangibles: Patents Copyrights Franchises (not amortized) or licenses Trademarks (not amortized) Trade names Goodwill (not amortized) LO 7 Identify the basic issues related to reporting intangible assets.

Intangible Assets Intangible Assets Noncurrent assets without physical substance. Often provide exclusive rights or privileges. Intangible Assets Now let’s turn to the last major subject we will cover in the presentations…intangible assets. Intangible assets lack physical substance and that makes it difficult to determine the asset’s useful life or any residual value. Many intangible assets involve exclusive rights or privileges. We will review the major types of intangible assets and related accounting on the remaining screens. Useful life is often difficult to determine. Usually acquired for operational use. 8-50

Intangible Assets Accounting for Intangibles Limited-Life Intangibles: Amortize to expense. Credit asset account or accumulated amortization. Indefinite-Life Intangibles (i.e goodwill, trademarks): No foreseeable limit on time the asset is expected to provide cash flows. No amortization. LO 7 Identify the basic issues related to reporting intangible assets.

Types of Intangible Assets - Patents Exclusive right to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. Capitalize costs of purchasing a patent and amortize over its 20-year life or its useful life, whichever is shorter. Expense any R&D costs in developing a patent. Legal fees incurred successfully defending a patent are capitalized to Patent account. LO 7 Identify the basic issues related to reporting intangible assets.

Patents Illustration: National Labs purchases a patent at a cost of $60,000 on June 30. National estimates the useful life of the patent to be eight years. Prepare the journal entry to record the amortization for the six-month period ended December 31. Cost $60,000 Useful life ÷ 8 Annual expense $ 7,500 6 months x 6/12 Amortization $ 3,750 Dec. 31 Amortization expense 3,750 Patent 3,750 LO 7

Types of Intangible Assets – R&D Costs Research and Development Costs Expenditures that may lead to patents, copyrights, new processes, and new products. All R & D costs are expensed when incurred. Helpful Hint Research and development costs are not intangible costs, but because these expenditures may lead to patents and copyrights, we discuss them in this section. LO 7 Identify the basic issues related to reporting intangible assets.

Types of Intangible Assets - Copyrights Give the owner the exclusive right to reproduce and sell an artistic or published work. Granted for the life of the creator plus 70 years. Capitalize costs of acquiring and defending it. Amortized to expense over useful life. LO 7 Identify the basic issues related to reporting intangible assets.

Types of Intangible Assets - Trademarks Trademarks and Trade Names Word, phrase, jingle, or symbol that identifies a particular enterprise or product. Wheaties, Monopoly, Sunkist, Kleenex, Coca-Cola, Big Mac, and Jeep. Legal protection for indefinite number of 20 year renewal periods. Capitalize acquisition costs. No amortization. LO 7 Identify the basic issues related to reporting intangible assets.

Types of Intangible Assets - Franchises Contractual arrangement between a franchisor and a franchisee. Toyota, Shell, Subway, and Marriott are franchises. Franchise (or license) with a limited life should be amortized to expense over the life of the franchise. Franchise with an indefinite life should be carried at cost and not amortized. LO 7 Identify the basic issues related to reporting intangible assets.

Types of Intangible Assets – Goodwill Includes exceptional management, desirable location, good customer relations, skilled employees, high-quality products, etc. Only recorded when an entire business is purchased. Goodwill is recorded as the excess of ... purchase price over the FMV of the identifiable net assets acquired. Internally created goodwill should not be capitalized. LO 7 Identify the basic issues related to reporting intangible assets.

Types of Intangible Assets – Goodwill Occurs when one company buys another company. Only purchased goodwill is an intangible asset. An intangible asset called goodwill can be created when one company buys another company. If the purchase price of the company is greater than the fair value of the net assets and liabilities acquired, we have goodwill associated with the transaction. Goodwill is not amortized. Each year we must test to see if there has been any impairment in the carrying value of the goodwill. If an impairment is determined to exist, we will reduce the goodwill account and recognize the loss in value. Goodwill is not amortized. It is tested each year to determine if there has been any impairment in carrying value. 8-59

Allocation Terminology Summary of LT Asset Cost Allocations Asset Type Allocation Terminology Calculation Methods Property, Plant & Equipment (except Land) Depreciation a) Straight Line b) Double-Declining Balance c) Units of Production Natural Resources (i.e. gold, oil, ore, etc.) Depletion Units of Production Intangible Assets (except Goodwill) Amortization Straight Line

Intangible Assets Practice Problem Identify what type of asset it is. Recognize the amortization methodology that should be used with this type of asset. Calculate the depreciation.

Financial Statement Presentation of Long-Lived Assets Illustration 9-23 LO 8 Indicate how long-lived assets are reported in the financial statements.