Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD Chapter 12 Capital Assets and Goodwill

In this chapter… Balance Sheet Current Assets Cash Chapter Current Liabilities Accounts Payable Chapter 5000 Accounts Receivable20000 Wages Payable25000 Notes Receivable15000 Utilities Payable2000 Marketable Securities25000Long-Term Debt Inventory Notes Payable20000 Capital Assets Bonds Payable Equipment Owner’s Equity Buildings Common Stock Goodwill Retained Earnings48000 Total Assets Total Liabilities + OE Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Capital Assets Capital Assets – assets used in the operations of a company and have a useful life of more than one accounting period –(Generally, we don’t use the term “Capital Assets” any more under the new IFRS rules) Generally divided into 2 groups –Tangible Assets – Property, Plant and Equipment –Intangible Assets – patents, copyrights, trademarks (excluding goodwill) The IFRS defines an intangible asset as an identifiable, non-monetary asset without physical substance that provides future economic benefit The three major accounting issues to examine are –The accounting for initial and subsequent costs –Allocating costs of capital assets against revenues –Recording the disposal of the capital assets Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Costs of Capital Assets Capital assets are recorded at cost, which includes normal and reasonable expenditures to get the asset to a place where it can be useful –Freight, packing and unpacking costs, installation costs, non- refundable taxes –These are known as capital expenditures Capital Expenditures are costs relating to capital assets that provide a benefit beyond the current period. –They are added to the capital assets line and depreciated along with the capital assets over time. Revenue Expenditures – costs that improve the asset but which do not increase its useful life or productive capabilities. –They are recorded as expenses and deducted in the current period. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Land Land is a special asset. It can’t be depreciated. –But stuff on the land, like buildings, parking lots, etc are depreciated. Cost of land will include its price, real estate commissions, insurance for titles, legal fees and accrued property taxes Costs relating to land preparation for building are also added to the cost of the land Costs relating to removing old unwanted buildings or scrap can also be added to the land. If those are sold for salvage, then the salvage amount is subtracted from the land costs Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Buildings Building costs include its purchase price, commissions, taxes, legal and title fees. These are all costs needed to make the building ready for use. Buildings are depreciated over a defined useful life Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Leasehold Improvements Leasehold Improvements – these are improvements made to land or buildings under lease by a lessee –Lease – the contract under which the property is rented –Lessor – the property owner renting the property –Lessee – the organization renting the property Long term leases often will look and feel as if the lessee actually owns the property. –This is why improvements to leased property need to be depreciated. –They are depreciated either over the useful life of the improvements or over the life of the lease. Leasehold improvements are amortized over the life of the lease or the life of the improvements – whichever is shorter Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Machinery and Equipment Machinery and Equipment costs include the purchase price, plus installation, transportation, non-refundable taxes, insurance, etc Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Amortization and Depreciation Capital Assets wear out over time or decline in usefulness Amortization (intangible assets) or depreciation (tangible assets) is the process of matching or allocating the cost of the capital assets over the time that the asset is used. –In effect, accounting is trying to use the matching principle to match the cost of the assets to the revenues they helped create. –You can think of the original purchase as the outlay of cash for the asset. However, the expensing of that asset is postponed until that portion of the asset is used to create a future portion of revenue Note that amortization is a process of cost allocation NOT asset valuation. –Amortization is not a measure of an assets declining market value Start recording asset depreciation once the asset is put into use Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Reporting Asset Depreciation As we have seen, –The cost and accumulated depreciation is reported on the balance sheet These can be shown as separate line items or as a Net amount –The depreciation expense for the period is shown on the income statement Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Calculating Depreciation Cost – the cost of the capital asset including all reasonable costs needed to acquire it and prepare it for use Salvage Value – aka Residual Value, is an estimate of the amount that the asset could be sold for at the end of its useful life Useful Life – aka Serviceable Life, the length of time over which the asset is productive –Different types of assets will have different useful lives Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Depreciation Methods 3 Depreciation Methods –Straight-line depreciation or amortization –Units of Production –Double declining balance Straight-line Method –Charges the same amount to Depreciation expense for each period of the assets useful life –Depreciation Expense = (Total Cost – Salvage Value)/No. useful periods DateAccount Titles and explanationPRDebitCredit Jan 31Depreciation Expense750 Acc. Dep.750 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Financial Accounting Dave Ludwick, P.Eng, MBA, PMP Depreciation Methods Straight-line Method, con’t –The Depreciation expense for the asset is always the same from period to period. –The accumulated Depreciation is the sum of this and all previous periods’ amortization expenses –When we draw a graph showing the book value of the asset, it is a straight line declining toward the salvage value

Depreciation Methods Units of Production Method –This method charges a varying amount of expense for each period depending on the amount of usage –Two step Process Calculate the Depreciation on a per unit basis –Deprec. = (Total Cost – Salvage Value)/Total Estimated Production Units) Calculate Depreciation for the period, by multiplying the above unit based amortization rate by the number of units produced in the period –This method is preferred over the straight-line method, when the equipment is not used evenly from period to period. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Depreciation Methods Declining-balance Method –This is an accelerated depreciation method: It allocates comparatively more to depreciation expense in early years and smaller amounts in later years The rate of the acceleration can be different for each asset (but must be consistent over the life of that asset) The amount of depreciation expense applied is based on the book value in that period. –This methods attempts to more closely approximate the value of the asset over its life Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Depreciation Methods Declining-balance Method –Two Step Process Calculate the declining balance rate Calculate the depreciation expense by multiplying the rate by the asset’s beginning of period book value. –Look at Exhibits and In this case they are using Double-declining balance Step 1: Rate = 2/Estimated Useful Life Step 2: First year Deprec. Exp. = Rate * Beg. Period Book Value Step 3: –Next year Beg. Balance = Previous year beg balance – Deprec. Exp. Notice how the Beg. Period book value is the previous period’s end of period book value Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Depreciation Methods for Tax Purposes For tax purposes, companies must use a declining balance method for calculating the maximum allowable Capital Cost Allowance Capital Cost Allowance (CCA) – is depreciation for tax purposes There is a different CCA rate for various different asset classes. Different types of assets are assigned to a class which determines the CCA rate Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Partial-Year Depreciation Assets are not always acquired at the beginning of a period To account for this, there are 2 ways to calculate the first year’s depreciation expense Nearest Whole Month –If the asset is purchased in the first part of a month, that whole month and all months after it until the end of the period are considered the first year –Example: A machine is purchased for $10000 on April 8, with a fiscal year end of Dec 31 and salvage value of $1000 in 5 years –First Year Depreciation = [(Cost – Salvage Value)/Estimate useful life]* 9/12 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Partial-Year Depreciation Half-Year Rule –The materiality principal may allow a company to simply use the half year rule for the first year’s depreciation amount –The Half-Year Rule says the regardless of when the asset was purchased, only half of the depreciation is allocated in the first year. –The process is to calculate what normally would be the first year’s depreciation, then multiply it by half. This applies to all the depreciation calculation methods except Units of Production Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Net Book Value Net Book Value = Original Cost – Accumulated depreciation –Regardless of the method used to calculate depreciation expense, Net Book Value is always the original cost less the accumulated depreciation Things to remember –Depreciation expense is an income statement account that is the amount of depreciation taken just for that period –Accumulated depreciation is the sum total of all the depreciations ever taken for that asset. It is a balance sheet account –So, … Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Net Book Value The asset account never changes from when the asset was bought The Deprec. Expense account gets a new entry every period –Remember it gets cleared out at the end of the previous period by the Chapter 5 closing process The Accum. Deprec. account just keeps getting bigger until it equals the original asset cost BuildingAccumulated Depreciation Aug Dec ‘ Dec ’09 Depreciation Expense20000 Dec ’10 Dec ‘ Total Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD This goes on income statement This goes on balance sheet

Net Book Value Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD Balance SheetIncome Statement Current Assets Cash10000 Current Liabilities Accounts Payable5000Revenue AR20000 Wages Payable25000COGS(550000) Notes Receivable15000 Utilities Payable2000Gross Profit Marketable Sec.25000Long-Term DebtExpenses Inventory Notes Payable20000 Bad Debt10000 Capital Assets Bonds Payable Utilities5000 Equipment250000Owner’s Equity Wages Less: Acc. Depr.(20000) Common Stock Insurance15000 Buildings Retained Earnings28000 Depreciation20000 Less: Acc. Depr.(60000)440000Total Expenses Goodwill60000 Total Assets911000Total Liabilities + OE911000Net Income28000 Net Book Value

Mid-Chapter Demonstration Problem Lets look at the Mid-Chapter Demo problem Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Disposal of Capital Assets Assets can be disposed of for many reasons, but generally the process for recording their disposal is as follows: –Up to the point of sale, calculate the Acc. Dep. and Depreciation Expense as normal –When the sale is made, you must clear out the Acc. Dep. and the asset – since it is now gone –Record the receipt of the cash –Record a Gain or Loss Note: If/When there is a Gain or Loss, the Gain or Loss is like Revenue or Expense type of account. A Gain or Loss is of type: “Other Income” or “Other Loss” On the income statement it is shown down below after all operating information Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Discarding a Capital Asset Discarding a capital asset means it is no longer used, and it has no market value If we are discarding an asset that still has some undepreciated cost, we complete the depreciation to the date of disposal then record a loss Example: Some equipment is discarded on July 1 that had Acc Dep to that point of 6500, but was bought for 8000 DateAccount Titles and explanationPRDebitCredit July 1Acc Dep.6500 Loss on Discarded Equipment1500 Equipment8000 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Selling a Capital Asset When selling the asset, the cash portion must also be considered. –The journal entry will take the cash, zero out both the Acc.Dep. and the asset’s cost and take the difference up as a gain or loss –Example: The equipment was sold for It was originally bought for and had Acc. Dep. of to date. –The Gain takes up the difference between the Debits and Credits DateAccount Titles and explanationPRDebitCredit July 1Cash7000 Acc. Dep. Equipment13000 Gain on sale of assets4000 Equipment16000 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Exchanging Capital Assets Exchanges or trade-ins are counted as a combination of a sale of the old asset and purchase of a new asset at the same time. Again, the process is similar to the previous: –Bring in the new asset, zero out the old asset’s account and Acc. Dep. –Bring in the cash and account for the difference as a Gain or Loss –Ex: Trade in a $30000 car for a $40000 trailer plus pay $21000 DateAccount Titles and explanationPRDebitCredit July 1Trailer40000 Acc. Dep. Car12000 Car30000 Cash21000 Gain on Trade of Car1000 Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Demonstration Problem Lets try the Demonstration problem –Assume the company uses straight-line depreciation Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Natural Resources Natural Resources are considered tangible assets. When they are still in their natural state they are considered capital assets They are initially recorded at cost and have an amortization and accumulated amortization just like other capital assets. The rate of the amortization is based on units extracted – similar to the Units of Production Method –Step 1: Depreciation per unit = (Cost – Salvage)/Total Units –Step 2: Depreciation Expense = Depr. Per unit * No. Units extracted in the period Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Natural Resources Once the material is extracted, it can either be sold or stored for future sale The portion sold is rolled into accumulated depreciation The portion unsold is saved on the Balance Sheet as a current asset. –Say we owned $1,000,000 of ore deposits, extracted $ worth and sold $80000 of it for $160000: –The cost side of this event is: DateAccount Titles and explanationPRDebitCredit Dec 31Unsold Ore Inventory20000 Depreciation Expense80000 Acc. Dep. - Ore Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Intangible Assets Intangible Assets are capital assets. Examples are –Rights, privileges, competitive advantages, trademarks, copyrights Goodwill is an intangible asset but not considered a capital asset –It is always shown separately on the balance sheet Accounting for intangible assets is just like that for tangible assets –They are recorded at cost. They are amortized over time in a systematic way (only the Straight-line Method is used) –When disposed, a Gain or Loss is recorded –Note: Usually no Acc.Amort. Is kept – we just credit directly to the intangible capital asset account. Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Goodwill Goodwill is an intangible asset. It is the amount by which the price paid for a company exceeds the fair market value of its net assets, if they were to be purchased separately –Goodwill represents the company's value beyond just its assets (Ex: Strong customer base, management skills, expected future cash flow) Goodwill is only generated from the purchase of a company. –A company cannot establish its own goodwill DateAccount Titles and explanationPRDebitCredit Jan 1Assets Purchased Goodwill60000 Liabilities acquired Cash Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD

Exercises Try Problems 12-3A, 12-10A and 12-13A Financial Accounting Dave Ludwick, P.Eng, MBA, PMP, PhD