Long-Term Assets 11

Management Issues Related to Long-Term Assets OBJECTIVE 1: Define long-term assets, and explain the management issues related to them.

Key Ratio Free cash flow

Figure 1: Long-Term Assets as a Percentage of Total Assets for Selected Industries

Figure 2: Classification of Long-Term Assets and Methods of Accounting for Them

Figure 3: Carrying Value of Long-Term Assets on the Balance Sheet

Table 1: Illustration of an Acquisition Decision

Figure 4: Issues in Accounting for Long- Term Assets

Management Issues Related to Long-Term Assets Long-term assets have three characteristics in common: –They have a useful life of more than one year. –They are used in the operation of a business. –They are not intended for resale to customers.

Management Issues Related to Long-Term Assets Tangible assets consist of property, plant, equipment, and natural resources. Intangible assets consist of patents, copyrights, goodwill, and the like.

Management Issues Related to Long-Term Assets The major accounting problem is the allocation of cost (as expenses) to accounting periods. –Property (not land, however), plant, and equipment are subject to depreciation. –Natural resources are subject to depletion. –Intangible assets are subject to amortization.

Management Issues Related to Long-Term Assets Carrying value (book value) equals cost less accumulated depreciation. All long-term assets are subject to an asset impairment evaluation.

Management Issues Related to Long-Term Assets A standard measure of a company's capacity to finance long-term assets is free cash flow (Net cash flows from operating activities less dividends and purchases of plant assets plus sales of plant assets).

Management Issues Related to Long-Term Assets Before investing in plant assets, cash inflows and outflows are analyzed. Accounting for long-term assets requires proper application of the matching rule by resolving two issues: –How much of the total cost to allocate to expense in the current accounting period –How much to retain on the balance sheet as an asset to benefit future periods

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Acquisition Cost of Property, Plant, and Equipment OBJECTIVE 2: Distinguish between capital expenditures and revenue expenditures, and account for the cost of property, plant, and equipment.

Acquisition Cost of Property, Plant, and Equipment An expenditure (a payment or incurrence of a liability) is one of two types. –A capital expenditure benefits more than one period and is recorded as an asset. –A revenue expenditure benefits only the current period and is expensed.

Acquisition Cost of Property, Plant, and Equipment Additions and betterments (improvements) are capital expenditures and are debited to an asset account. Extraordinary repairs increase an asset’s residual value or useful life. These capital expenditures are debited to accumulated depreciation.

Acquisition Cost of Property, Plant, and Equipment Errors in properly classifying expenditures result in misstatements in assets and net income of the current and future periods.

Acquisition Cost of Property, Plant, and Equipment The cost of a long-term asset includes the purchase cost, freight, installation, insurance while in transit, and any other costs required prior to operation. –The cost of land includes real estate commissions, lawyers’ fees, accrued taxes paid by the buyer, razing a building, draining, clearing, grading, assessments, and landscaping. –Land improvements include driveways, parking lots, fences, and signs.

Acquisition Cost of Property, Plant, and Equipment The cost of a long-term asset includes the purchase cost, freight, installation, insurance while in transit, and any other costs required prior to operation.(cont.) –The cost of buildings purchased includes the purchase price and repairs to make the building usable. –The cost of an asset constructed includes materials, labor, overhead, architects’ and lawyers’ fees, insurance during construction, and interest on a construction loan.

Acquisition Cost of Property, Plant, and Equipment The cost of a long-term asset includes the purchase cost, freight, installation, insurance while in transit, and any other costs required prior to operation.(cont.) –The cost of equipment includes the invoice price less cash discounts, freight, insurance, taxes, tariffs, buying expenses, installation costs, and test runs. –Interest on a loan to purchase an asset is expensed. Interest on a construction loan is capitalized.

Acquisition Cost of Property, Plant, and Equipment The cost of a long-term asset includes the purchase cost, freight, installation, insurance while in transit, and any other costs required prior to operation.(cont.) –All plant assets except land (i.e., land improvements, buildings, equipment) are depreciated.

Acquisition Cost of Property, Plant, and Equipment Leasehold improvements are amortized over the remaining term of the lease or the useful life of the improvement, whichever is shorter. When a lump-sum purchase is made, the cost is allocated based on the assets’ relative fair market values.

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Depreciation OBJECTIVE 3: Compute depreciation under the straight-line, production, and declining- balance methods.

Table 2: Depreciation Schedule, Straight- Line Method

Table 3: Depreciation Schedule, Production Method

Table 4: Depreciation Schedule, Double- Declining-Balance Method

Figure 5: Graphic Comparison of Three Methods of Determining Depreciation

Figure 6: Depreciation Methods Used by 600 Large Companies for Financial Reporting

Depreciation Depreciation is the logical allocation of asset cost to the periods that benefit from the services of that asset. –Depreciable assets have limited useful lives because of physical deterioration and obsolescence.

Depreciation Several factors affect the computation of depreciation. –Cost –Residual (salvage) value –Depreciable cost –Estimated useful life (in time or in units)

Depreciation List the three most common methods of depreciation. –The straight-line method (based on the passage of time) The formula for the straight-line method:

Depreciation –The production method (based on units produced, miles driven, and the like) The formula for the production method:

Depreciation –The declining-balance method (an accelerated method) The double-declining-balance formula: –The production method is a good application of the matching principle, but it can be used only if output over useful life can be estimated with reasonable accuracy.

Depreciation List the three most common methods of depreciation. (cont.) –Residual value is ignored initially, but an asset may not be depreciated below its residual value. –Compare the three depreciation methods by referring to Figure 5 in the text.

Depreciation Special issues in depreciation –Group depreciation saves time by depreciating a group of similar assets as a whole.

Depreciation Special issues in depreciation (cont.) –When an asset is owned for less than a year, only a partial year’s depreciation should be taken. Under the half-year convention, one-half year’s depreciation is recorded in the year of purchase and one-half year’s depreciation is recorded in the year of disposition.

Depreciation Special issues in depreciation (cont.) –After an asset has been put into use, its estimated useful life or residual value may be revised. Leave the previously taken depreciation unchanged. Revise the useful life or residual value. Allocate the remaining depreciable cost over the remaining useful life.

Depreciation Special issues in depreciation (cont.) –Accelerated cost recovery allows companies to take rapid write-offs of plant assets for tax purposes. This method is usually not acceptable for financial reporting purposes.

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Disposal of Depreciable Assets OBJECTIVE 4: Account for the disposal of depreciable assets.

Disposal of Depreciable Assets An asset is disposed of when it is discarded, sold, or traded in. Record depreciation for the period preceding disposal.

Disposal of Depreciable Assets Journalize the disposal of an asset. –Debit Accumulated Depreciation and credit the asset account. –Debit any receipt of cash. –Debit or credit a loss or gain on disposal if cash received differs from the carrying value. –Credit asset for recorded cost.

Disposal of Depreciable Assets Account for the exchange of similar assets. –For financial accounting purposes, losses are recognized, but gains are not. –For tax purposes, neither gains nor losses are recognized. Account for the exchange of dissimilar assets. –Both gains and losses are recognized for both reporting and tax purposes.

Disposal of Depreciable Assets

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Natural Resources OBJECTIVE 5: Identify the issues related to accounting for natural resources, and compute depletion.

Natural Resources Depletion –The allocation of the cost of a natural resource over the periods benefited. –Compute depletion, using the depletion formula. –Units extracted but not sold are recorded as inventory.

Natural Resources Tangible assets used with natural resources should be depreciated over the shorter of the life of the tangible asset or the life of the natural resource.

Natural Resources There are two methods of accounting for oil and gas development and exploration costs. –Under successful efforts accounting, only the cost of productive wells is capitalized. –Under the full-costing method, the cost of all wells is capitalized.

Natural Resources

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Intangible Assets OBJECTIVE 6: Identify the issues related to accounting for intangible assets, including research and development costs and goodwill.

Table 5: Accounting for Intangible Assets

Figure 7: Intangible Assets Reported by 600 Large Companies

Intangible Assets Intangible assets (list examples) represent rights and privileges extended to their owner. Other than goodwill, intangible assets usually are capitalized and expensed over their useful lives (not to exceed 40 years) in accordance with the matching rule.

Intangible Assets Research and development costs are expensed. Computer software costs are expensed until a product has been proved to be technologically feasible, then they are capitalized.

Intangible Assets Goodwill is the excess of the purchase cost over the fair market value of the net assets purchased. –Goodwill usually is estimated based on superior past earnings. –For financial reporting purposes, goodwill is an asset to be reported as a separate line item on the balance sheet and is subject to an annual impairment review.

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