Financial Accounting Lesson 7: Fixed and Intangible Assets Ben Trnka/Boz Bostrom www.benandboz.com

Fixed Assets are typically quite significant

Overview Understand accounting for Property, Plant, and Equipment starting with inception and through disposal Learn the three main methods of depreciation Understand how to deplete natural resources Understand broad accounting of intangibles

Acquiring Property, Plant, and Equipment What are some example of Property, Plant, and Equipment? Land, Office Buildings, Factories, Machinery, Vehicles, Computers How can companies acquire Property, Plant, and Equipment? Buy from another company Construct own assets

Acquiring Property, Plant, and Equipment Capitalizing vs. expensing When a purchase is capitalized, an asset is created Expense is recorded as the asset is used up When a purchase is expensed, there is an immediately decrease to net income If fixed assets are purchased, what is capitalized? Purchase Price, Sales Tax, Legal Fees, Transportation Costs, Setup Pretty much anything to get the asset ready for use If fixed assets are constructed, what is capitalized? All constructions costs – materials, labor Interest on a loan to finance the construction

Acquisition Journal Entry When an Asset is Purchased When an Asset is Constructed The Fixed Asset is debited Credit generally to cash or notes payable Dr Factory $1M Cr Notes Payable $1M Throughout Construction: Construction in Progress $400K Cash or Notes Payable $400K Construction in Progress $600K Cash or Notes Payable $600K Construction Completed: Factory $1M Construction in Progress $1M

During Use - Depreciation Depreciation allocates the cost of an asset over its useful life NOT a way to measure the value of an asset Need to know three pieces of information: 1. Cost 2. Estimated Useful Life 3. Estimated Salvage Value Three ways to measure depreciation: 1. Straight Line 2. Units of Production 3. Declining Balance

During Use – Depreciation – Straight Line Costco purchased a new forklift. Pertinent information: Cost - $100,000 Estimated Life – 5 years Salvage Value - $10,000 Depreciation per year = Cost- Salvage Value 100,000-10,000 = 18,000 Useful Life 5 What is the journal entry in year 1? What is the financial statement impact?

During Use – Depreciation – Straight Line Entries in Years 2-5

During Use – Depreciation – Units of Production Costco purchased a new forklift. Pertinent information: Cost - $100,000 Estimated Life – 15,000 Hours Salvage Value - $10,000 Depreciation rate = Cost- Salvage Value 100,000-10,000 = $6 per hour Useful Life (in units) 15,000 hours What is the journal entry in year 1 assuming the forklift was used for 4,000 hours? What is the financial statement impact?

During Use – Depreciation – Units of Production Year-by-Year Summary What if things don’t work out exactly as planned? Adjust the last year to meet expected salvage value

During Use – Depreciation – Declining Balance Costco purchased a new forklift. Pertinent information: Cost - $100,000 Estimated Life – 5 years Salvage Value - $10,000 Costco has elected to use the double declining balance method Depreciation Rate = __1___ X 2 1 X 2 = 40% - Depreciate 40% of Useful Life 5 Carrying Value each year - Carrying value is cost less accumulated depreciation What is the journal entry in year 1? What is the financial statement impact?

During Use – Depreciation – Declining Balance Year-by-Year Summary Adjust the last year to meet expected salvage value

During Use – Depreciation - Summary

Method choice and tax considerations A goal of financial accounting is to provide users with useful information Companies prefer to show higher net income and thus usually choose straight- line For tax purposes, different rules apply For tangible assets other than buildings/land, companies generally can deduct 100% of the cost of the asset in the year purchased Thus, some companies can show financial statement income but not pay tax

During Use – Repairs and Maintenance Vs. Additions and Improvements Repairs/maintenance Routine costs to keep assets in proper condition Don’t extend life of asset or increase its value Additions/improvement Often referred to as capital expenditures Significant expenditures which increase life and/or value of asset Not always clear / judgement often needed Management may have incentive to capitalize expenditures In 2001/2002 WorldCom capitalized $3.8 billion which should have been expensed

During Use – Repairs and Maintenance Vs. Additions and Improvements Normal Maintenance/repairs are expensed as incurred Dr. Maintenance Expense $1,000 Cr. Cash $1,000 Additions and improvements are capitalized Dr. Factory $1,000

Disposition of Fixed Assets Computation of gain/loss: Proceeds Less: Net Book Value (Cost less accumulated depreciation) Equals: Gain/(Loss) Proceeds: $25,000 Net book value: $30,000 ($100,000 - $70,000) Gain/(Loss): ($5,000) Dr. Cash 25,000 Dr. Accumulated Depreciation 70,000 Dr. Loss on Sale 5,000 Cr. Building 100,000 Example: A company sells a building with a cost of $100,000 and Accumulated Depreciation of $70,000. The company receives $25,000 cash. What is the gain/(loss) and journal entry?

Disposition of Fixed Assets Computation of gain/loss: Proceeds Less: Net Book Value (Cost less accumulated depreciation) Equals: Gain/(Loss) Proceeds: $45,000 Net book value: $30,000 ($100,000 - $70,000) Gain/(Loss): $15,000 Dr. Cash 45,000 Dr. Accumulated Depreciation 70,000 Cr. Gain on Sale 15,000 Cr. Building 100,000 Example: A company sells a building with a cost of $100,000 and Accumulated Depreciation of $70,000. The company receives $45,000 cash. What is the gain/(loss) and journal entry?

Natural Resources - Depletion When a company uses natural resources, they record depletion using the units of production method Example: A company purchased a tract of timber for $900,000, with an estimated 2,000,000 board feet included in the land. The land will be worth $50,000 after the timber is harvested. What is the first year journal entry if 100,000 board feet are harvested? Cost per board foot: Cost of Asset – Residual Value = $900,000-$50,000 = $0.425/Board foot Life in Units 2,000,000 Expense in year 1 = .425 * 100,000 = $42,500 Journal Entry Dr. Depletion Expense $42,500 Cr. Accumulated Depletion $42,500

Intangibles Any asset that is not physical in nature, no tangible substance. Two main groups: Indefinite Lived Intangibles Created when one company purchases either another company or its intangible assets Goodwill, Trademarks/Brands Check for impairment annually, do not amortize Definite Lived Intangibles Patents, Copyrights, Franchises, Licenses Record amortization to allocate the value of the asset over its useful life Amortize using straight line

Amortization Example A company developed a patent, which has a 20 year life. The patent was capitalized at a cost of $50,000. What is the amortization entry each year? $50,000/20 years = $2,500 Amortization Expense per year Dr. Amortization Expense $2,500 Cr. Patent $2,500

Thanks for tuning in! Key Takeaways In general, capitalize all costs needed to bring a long-lived asset to its intended use The three main depreciation methods are straight line, units of production, and declining balance Natural resources are depleted using a system similar to units of production Indefinite lived intangibles are tested for impairment annually Definite lived intangibles are amortized each year Thanks for tuning in!