CHAPTER 6 ACCOUNTING FOR AND PRESENTATION OF PROPERTY, PLANT, AND EQUIPMENT, AND OTHER NONCURRENT ASSETS McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 1.How are the costs of land, buildings, and equipment reported on the balance sheet? 2.How are the terms capitalize and expense used with respect to property, plant, and equipment? 3.What are the alternative methods of calculating depreciation for financial accounting purposes, and what are the relative effects of each on the income statement (depreciation expense) and the balance sheet (accumulated depreciation)? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 4.Why is depreciation for income tax purposes an important concern of tax- payers, and how does tax depreciation differ from financial accounting depreciation? 5.What is the accounting treatment of maintenance and repair expenditures? 6.What is the effect on the financial statements of the disposition of noncurrent assets either by abandonment or sale? 7.What is the difference between and operating lease and a capital lease? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 8.What are the similarities in the financial statement effects of buying an asset compared to using a capital lease to acquire the rights to an asset? 9.What are the meanings of various intangible assets, how are their values measured, and how are their costs reflected in the income statement? 10.What is the role of present value concepts in financial reporting, and what is their usefulness in decision making? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 1 How are the costs of land, buildings, and equipment reported on the balance sheet? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Land Shown on the balance sheet at its original cost Cost includes all ordinary and necessary items to get the land ready for its intended use Land acquired for investment or potential future use is classified as a noncurrent, nonoperating asset Land is not depreciated Gains and losses on the sale of land are recognized as the difference between the cost of the land and the amount received McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 2 How are the terms capitalize and expense used with respect to property, plant, and equipment? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Capitalization Expenditures should be capitalized if the item acquired will have an economic benefit beyond the current fiscal year Capitalized assets – except land – are depreciated Depreciation expense is recognized over the useful life of the asset Materiality concept is applied to capitalization Accounting judgment plays a role in determination of capitalization McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Expense Expenditures should be expensed if the item acquired will not have an economic benefit beyond the current fiscal year Expenditures for preventive maintenance are expensed Items are expensed if their costs are not material, even if they have a useful life of several years McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 1 How are the costs of land, buildings, and equipment reported on the balance sheet? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Buildings and Equipment Recorded at original cost Cost includes all ordinary and necessary costs to get the asset ready to use Interest costs associated with the loans used to finance construction are capitalized until the building is put in operation Installation costs and shake-down costs are capitalized Self-manufactured asset cost includes materials, labor, and overhead costs McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Basket Purchase Allocation When two or more items are purchased in a single transaction, the cost of each asset must be determined The allocation of the purchase price is made based on the relative appraisal values of each asset to the total See Exhibit 6-2 in text McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Depreciation for Financial Accounting Purposes An application of the matching concept since an asset is a prepaid cost A portion of the cost should be subtracted from the revenues that are generated through the use of the asset Depreciation is the allocation of the cost of an asset to the time periods benefited McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Recording Depreciation The expense “Depreciation Expense” is increased The contra asset account “Accumulated Depreciation” is increased The journal entry is as follows: Depreciation Expense XX Accumulated Depreciation XX McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Depreciation Details The balance in the Accumulated Depreciation account is the cumulative total of all depreciation expense recorded over the life of the asset Net book value is the cost of the asset less the accumulated depreciation Note: cash is not involved in the depreciation entry McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 3 What are the alternative methods of calculating depreciation for financial accounting purposes, and what are the relative effects of each on the income statement (depreciation expense) and the balance sheet (accumulated depreciation)? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Depreciation Methods Accelerated depreciation results in greater depreciation expense and lower net income during the early years of an asset’s life Straight-line depreciation results in even amounts of depreciation being taken over the life of the asset McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Depreciation Calculation Methods The specific depreciation calculation methods are: –Straight-line –Units of production –Sum-of-the-years’-digits –Declining balance McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Straight-Line Depreciation Annual amount of depreciation is calculated as follows: Cost – Estimated salvage value Estimated useful life The same amount of depreciation expense is taken each year McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Units-of-Production Depreciation The depreciation expense per unit produced is calculated as follows: Cost – Estimated salvage value Estimated total units to be made The depreciation expense for the period is calculated by multiplying the number of units produced that period times the depreciation expense per unit McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Sum-of-the-Years’ Digits Depreciation Annual depreciation expense is calculated as follows: (Cost – Estimated salvage value) x Remaining life in years Sum-of-the-years’ digits Results in greater depreciation expense earlier in the life of the asset McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Declining-Balance Depreciation Annual depreciation expense is calculated as follows: Double the Asset’s net book straight-line X value at beginning depreciation rate of year Greater depreciation expense is taken earlier in the life of the asset McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 4 Why is depreciation for income tax purposes an important concern of taxpayers, and how does tax depreciation differ from financial accounting depreciation? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Depreciation Expense for Income Tax Purposes Depreciation is a deductible expense for income tax purposes In 1981, ACRS was placed in use In 1986, MACRS lengthened the lives of the assets for depreciation purposes and additional categories were added Most firms do not use income tax depreciation methods for financial reporting purposes – tax rules are subject to frequent change McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 5 What is the accounting treatment of maintenance and repair expenditures? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Maintenance and Repair Expenditures Preventative maintenance expenditures and routine repair costs are expenses of the period in which they were incurred If a maintenance expenditure will extend the useful life or salvage value of an asset beyond that originally used in the depreciation expense calculation, the expenditure should be capitalized McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 6 What is the effect on the financial statements of the disposition of noncurrent assets either by abandonment or sale? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Disposal of Depreciable Assets When a depreciable asset is sold or scrapped, both the asset and the related accumulated depreciation account must be reduced by the appropriate amounts If net book value is greater than amount received, a loss will result If net book value is less than the amount received, a gain will result McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 7 What is the difference between and operating lease and a capital lease? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Assets Acquired by Capital Lease Operating lease – just the use of the asset; does not involve any attributes of ownership Capital lease (financing lease) – lessee (renter) assumes all of the risks and benefits of ownership McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Capital Lease Criteria A lease is categorized as a capital lease if any of the following apply: –The lease transfers ownership of the asset to the lessee –The lease permits the lessee to purchase the asset at a nominal price at the end of the lease –The lease term is at least 75% of the asset’s economic life –The present value of the lease payments is at least 90% of the fair value of the asset McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 8 What are the similarities in the financial statement effects of buying an asset compared to using a capital lease to acquire the rights to an asset? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Similarities of Buying and Leasing Before the FASB lease standard was issued in 1976, many capital leases were not reported in the financial statements Leases not appearing on financial statements is called off-balance-sheet financing Now both the asset and the related liability are reported on the balance sheet McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Lease Transactions A lease payment reduces cash, reduces the lease liability, and increases interest expense: Interest expense XX Capital lease liability XX Cash XX The leased asset is depreciated: Depreciation expense XX Accumulated depreciation XX McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 9 What are the meanings of various intangible assets, how are their values measured, and how are their costs reflected in the income statement? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Intangible Assets Long-lived assets that are represented by a contractual right or result from a purchase transaction Is not physically identifiable Are amortized – the process of allocating the cost of the intangible asset to expense over time McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Examples of Intangible Assets Leasehold improvements – modification expenses for leased spaces Patents – licenses granted by the government giving the control of the use or sale of an invention for a period of 17 years Trademarks – registered with the Federal Trade Commission for an unlimited life McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

More Examples of Intangible Assets Copyrights – protections granted to writers and artists to prevent unauthorized copying of a work. The protection is granted for the life of the artist or writer plus 50 years Goodwill – the result of a purchase of one firm by another for a price greater than the fair value of the net assets acquired McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Natural Resources Consist of coal deposits, crude oil reserves, timber, mineral deposits, etc. The using up of the natural resource is called depletion –The concept of depletion is similar to depreciation, only more complicated –Usually computed on a straight-line basis McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Other Noncurrent Assets Long-term investments Notes receivable that are due more than one year in the future Are reclassified as they become current (receivable within a year) McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 10 What is the role of present value concepts in financial reporting, and what is their usefulness in decision making? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Present Value An application of compound interest – the process of earning interest on interest Involves determining the present amount that is equivalent to an amount to be paid or received in the future Recognizes that money does have value over time The interest rate is called the discount rate McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Present Value Calculations Can use for events that consist of a single payment or a series of payments (called an annuity) Formulas and computer programs and calculators can calculate present value The appendix demonstrates how to calculate present value using tables containing present value factors McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002