Property, Plant, and Equipment, Natural Resources, Chapter 8 Operating Assets: Property, Plant, and Equipment, Natural Resources, and Intangibles Financial Accounting 4e by Porter and Norton

Johnson Controls, Inc. Property, Plant, and Equipment Book Value At Cost Buildings and improvement $ 1,242.9 Machinery and equipment 3,191.1 Construction in progress 310.7 $ 4,744.7 Land 223.8 $ 4,968.5 Less accumulated depreciation (2,588.7) Property, plant, and equipment (net) $ 2,379.8

Acquisition Cost of P,P&E All costs necessary to acquire asset and prepare for intended use Transportation Charges Purchase Price + Taxes Installation Costs

Group Asset Purchases Allocate cost of lump-sum purchase based on fair market values $75,000 $25,000 Allocated Cost Land = $30,000 Building = $90,000 Fair Market Value 75% 25% % of Market Value Cost $100,000

Capitalization of Interest Interest can be included as part of the cost of an asset if: company constructs asset over time, and borrows money to finance construction

via Depreciation of P,P & E Match cost of with periods assets benefited via Straight-Line Accelerated Methods Units of Production

Straight-Line Method Allocates cost of asset evenly over its useful life $9,000 3-year life $3,000 Year 1 Year 2 Year 3

Units-of-Production Method Allocate asset cost based on number of units produced over its useful life depreciation = per unit

Double-Declining-Balance Method Double the straight-line rate on a declining balance (book value) Accelerated method - higher amount of depreciation in early years Straight-line Rate

Depreciation Example On January 1, Kemp Company purchases a machine for $20,000. The life of the machine is estimated at five years, after which it is expected to be sold for $2,000.

$20,000 cost - $2,000 residual value = $18,000 to be depreciated Depreciation Example Calculate Kemp's depreciation of the machine for years 1 - 5 using the straight-line, units-of-production and double-declining-balance depreciation methods. $20,000 cost - $2,000 residual value = $18,000 to be depreciated

Straight-Line Depreciation Depreciation = Cost - Residual Value Life = $20,000 - $2,000 5 years = $3,600 $18,000 5-year life $3,600 Year 1 $3,600 Year 2 $3,600 Year 3 $3,600 Year 4 $3,600 Year 5

Units-of-Production Depreciation Kemp’s estimated machine production: Yr. 1 3,600 units Yr. 2 3,600 units Yr. 3 3,600 units Yr. 4 3,600 units Yr. 5 3,600 units Total 18,000 units

Units-of-Production Depreciation Depreciation = Cost - Residual Value per unit Life in Units = $20,000 - $2,000 18,000 = $ 1.00

Units-of-Production Depreciation Kemp’s depreciation in 2004: 4,000 units x $1/unit = $ 4,000

Double-Declining-Balance Depreciation DDB rate = (100% / useful life) x 2 = (100% / 5 years) x 2 = 40% .40 Initially ignore residual value

Double-Declining-Balance Depreciation Year 1 Depreciation = Beginning book value x rate = $20,000 x 40% = $8,000 Beginning Ending Year Rate Book Value Depreciation Book Value 1 40% $20,000 $8,000 $12,000

Double-Declining-Balance Depreciation Year 2 Depreciation = Beginning book value x rate = $12,000 x 40% = $4,800 Beginning Ending Year Rate Book Value Depreciation Book Value 1 40% $20,000 $8,000 $12,000 2 40% $12,000 4,800 7,200

Double declining-balance Depreciation Beginning Ending Year Rate Book Value Depreciation Book Value 1 40% $20,000 $8,000 $12,000 2 40% 12,000 4,800 7,200 3 40% 7,200 2,880 4,320 4 40% 4,320 1,728 2,592 5 40% 2,592 592 2,000 $18,000 Final year’s depreciation = amount needed to equate book value with salvage value = Residual Value

Straight-line vs. DDB Depreciation

Reasons for Choosing Straight-Line Depreciation Simplicity Reporting to stockholders Comparability Bonus plans

Reasons for Choosing Accelerated Methods Technological rate of change and competitiveness Minimize taxable income Comparability Income Taxes

Changes in Depreciation Estimates Recompute depreciation schedule using new estimates Record prospectively (i.e. change should affect current and future years only) Useful life is 7 years vs. 5?

Change in Estimate Example: $20,000 machine originally expected to be depreciated over 5 years. After 2 years, useful life is increased to 7 years. planned $3,600 $3,600 $3,600 Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 revise estimate Depreciation

Change in Estimate Example: $12,800 remaining book value allocated prospectively over remaining life $3,600 $2,160 $2,160 $2,160 Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 Yr. 6 Yr. 7 revise estimate Depreciation

Capital vs. Revenue Expenditures Balance Sheet Capital Expenditure Treat as asset addition to be depreciated over a period of time Income Statement Revenue Expenditure Expense immediately

Capital vs. Revenue Expenditures General Guidelines: Increase asset life Increase asset productivity Normal maintenance Material expenditures Capitalize Expense

Capital Expenditures Example: $20,000 machine originally expected to be depreciated over 5 years. After 2 years, overhaul machine at cost of $3,000. Machine life is increased by 3 years. planned $3,600 $3,600 $3,600 Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 replace engine

Capital Expenditures Example: $12,800 remaining book value + $3,000 capital expenditure depreciated prospectively over remaining life $3,600 $2,300 $2,300 $2,300 Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 Yr. 6 Yr. 7 replace engine

Disposal of Operating Assets Record depreciation up to date of disposal Compute gain or loss on disposal Proceeds > Book Value = Gain Proceeds < Book Value = Loss

Disposal of Operating Assets Example: Sell truck (cost $20,000; accumulated depreciation $9,000) for $12,400 Sale price $ 12,400 Less book value: Asset cost $20,000 Less: accumulated depreciation 9,000 11,000 = Gain on sale $ 1,400

Boise Cascade Corporation Partial Balance Sheet (in thousands) Property and Equipment: Land and land improvements $ 68,482 Buildings and improvements 675,905 Machinery and equipment 4,606,102 Less: accumulated depreciation (2,742,650) 2,607,839 Timber, timberlands, and timber deposits 322,132 $2,929,971 Natural Resources

Natural Resources Resource consumed as it is used Expense called depletion vs. depreciation Depletion method similar to units of production

AOL Time Warner, Inc. Partial Balance Sheet (in millions) Operating Assets: Property, plant and equipment, net $ 12,684 Music catalogues and copyrights 2,927 Film library 3,363 Cable television and sports franchises 27,109 Brands, trademarks, and other 10,684 Goodwill and other intangibles 128,338 Intangible Assets

Intangible Assets Long-term assets with no physical properties Trademarks Patents Goodwill Copyrights

(i.e. legal fees, registration fees, etc.) Intangible Assets Includes cost to acquire and prepare for intended use Purchase Price Acquisition Costs (i.e. legal fees, registration fees, etc.) +

Research & Development Must be expensed in period incurred Difficult to identify future benefits

Amortization of Intangibles Normally recorded using straight-line method Reported net of accumulated amortization Amortized over legal or useful life, whichever is shorter

Amortization of Intangibles Example: ML Company developed a patent for $10,000. The patent’s legal life is 20 years, but its anticipated useful life is 5 years.

Amortization of Intangibles ML Company’s annual amortization: Patent approval costs $10,000 Divide by: Lesser of legal or useful life 5 years Annual amortization $ 2,000

Amortization of Intangibles ML Company’s Balance Sheet Presentation: Upon End of acquisition Yr. 1 Yr. 5 Long-term Assets: Intangible assets, net of accum. amortization $10,000 $8,000 $ 0

Analyzing Long-term Assets Average Life = Property, Plant & Equipment Depreciation Expense What is the average depreciable period (or life) of the company’s assets?

Analyzing Long-term Assets Average Age = Accumulated Depreciation Depreciation Expense Are assets old or new?

Analyzing Long-term Assets Asset Turnover = Net Sales Average Total Assets How productive are the company’s assets?

Long-term Assets and the Statement of Cash Flows Operating Activities Net income xxx Depreciation and amortization + Gain on sale of asset - Loss on sale of asset + Investing Activities Purchase of asset - Sale of asset + Financing Activities

End of Chapter 8