Ch.8 Operating Assets: Plant Assets, Natural Resources, and Intangible Assets

 Plant Assets, Natural Resources (FYI only) Intangible Assets (FYI only)

Part I: Plant Assets 1. Acquisition of plant assets 2. Use and depreciation of plant assets 3. Repair and maintenance – post acquisition expenditures 4. Disposal of plant assets

(in millions) Land $ Buildings Machinery and equipment 1,608.6 Leasehold improvements Construction in process 60.4 $ 3,132.3 Less accumulated depreciation 1,545.4 Property, plant, and equipment (net)$ 1,586.9 Nike, Inc. Property, Plant, and Equipment LO1

1. Acquisition Cost of Property, Plant, and Equipment  All of the costs necessary to acquire the asset and prepare it for its intended use Purchase price + Taxes Installation costs Transportation charges LO2

Group Purchase Allocate cost of lump-sum purchase based on fair market values Cost $100,000 $75,000 $25,000 Allocated Cost Land = $30,000 Building = $90,000 Fair Market Value 75% 25% % of Market Value LO3

Capitalization of Interest  Interest can be included as part of the cost of an asset if the company: Constructs the asset over time and Borrows money to finance construction LO 4

2. Depreciation of Property, Plant, and Equipment Match cost of assets with periods benefited Straight Line Units of Production Double Declining Balance via LO5

Straight-Line Method  Allocates the cost of the asset evenly over its useful life

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

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

Depreciation Example On January 1, ExerCo purchases a machine for $20,000. The life of the machine is estimated at 5 years, after which it is expected to be sold for $2,000.

Depreciation Example Calculate ExerCo’s depreciation of the machine for years 1 through 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  ExerCo’s estimated machine production: Year 1 3,600 units Year 2 3,600 units Year 3 3,600 units Year 4 3,600 units Year 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 per unit

 ExerCo’s Depreciation in 2007: 4,000 Units × $1 per Unit = $ 4,000 Units-of-Production Depreciation

Double-Declining-Balance Depreciation DDB Rate = (100%/Useful Life) × 2 = (100%/5 Years) × 2 = 40%.40 Initially ignore residual value

Double-Declining-Balance Depreciation 2007 Depreciation= Beginning Book Value × Rate = $20,000 × 40% = $8,000 Book Value at Book Value at Year Rate Beginning of Year Depreciation End of Year %$20,000 $8,000 $12,000

Double-Declining-Balance Depreciation 2008 Depreciation = Beginning Book Value × Rate = $12,000 × 40% = $4,800 Book Value at Book Value at Year Rate Beginning of Year Depreciation End of Year %$20,000 $8,000 $12, ,000 4,8007,200

Double-Declining-Balance Depreciation Book Value at Book Value at Year Rate Beginning of Year Depreciation End of Year % $20,000 $ 8,000 $12, ,000 4,800 7, ,200 2,880 4, ,320 1,728 2, , ,000 $18,000 Final year’s depreciation = amount needed to equate book value with salvage value = Residual Value

Straight-Line vs. Double-Declining- Balance Depreciation

Reasons for Choosing the Straight- Line Method  Simplicity  Reporting to stockholders  Comparability  Bonus plans

Reasons for Choosing Accelerated Methods  Result in better matching of revenue and expenses for some assets, particularly those becoming obsolete quickly.  Minimize taxable income (but companies usually use one method for tax purpose and another for financial reporting purpose.

Part III: Repair and maintenance – post acquisition expenditures  Such expenditures are charged to the period incurred (referred to as revenue expenditure) unless they significant benefit future periods (referred to as capital expenditure).

Revenue expenditures  Recorded as an expense when incurred:  Dr. repair/maintenance expense100  Cr. Cash100

Capital expenditures  Such expenditures benefit future periods Improve efficiency/productivity Extend useful life  They are added to the cost of the assets and depreciated over the remaining life of the assets Dr. Plant asset/Accu. Depreciation5,000 Cr. Cash 5,000

Capital vs. Revenue Expenditures CategoryExampleAsset or Expense Normal maintenanceRepaintingExpense Minor repairReplace spark plugsExpense Major repairReplace a vehicle’s engineAsset* AdditionAdd a wing to a buildingAsset *if life or productivity is enhanced

4. Disposal of Property, Plant, and Equipment  Record depreciation up to date of disposal  Compute gain or loss on disposal Selling Price > Book Value = Gain Selling Price < Book Value = Loss LO8

Disposal of Property, Plant, and Equipment  Sell machine (cost $20,000; accumulated depreciation $9,000) for $12,400 Asset cost$20,000 Less: Accumulated depreciation9,000 Book value$11,000 Sale price12,400 Gain on sale of asset$ 1,400 Example:

Part II: Natural Resources (FYI)  Acquisition of natural resources is recorded at cost  When the natural resources are extracted, a depletion expense is recorded

(in millions) Weyerhauser Company Partial Balance Sheet Property and equipment, net 11,843 Construction in progress 269 Investments in and advances to equity affiliates 489 Goodwill 3, Timber and timberlands at cost, less depletion charged to disposals4,212 Natural Resources

 When a natural resource is used or consumed, it should be treated as an expense  Recording the expense is referred to as depletion  Depletion method is similar to the units-of- production method

Part III: Intangible Assets

Patents Intangible Assets  Legal rights/privileges  Long-term in nature  Used in operation  No physical properties Goodwill Trademarks Copyrights LO9

Acquisition of Intangible Assets  Acquisition of intangible assets is recorded at cost  Externally acquired: recorded at cost  Internally developed  Only legal fees/registration fees are recorded as cost  R&D costs are expensed when incurred

Amortization of Intangibles  Normally recorded using the straight-line method  Reported net of accumulated amortization  Amortized over the legal or useful life, whichever is shorter LO10

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

Amortization of Intangibles Nike’s annual amortization: Patent approval costs $10,000 Divided by: Lesser of legal or useful life 5 years Annual amortization$ 2,000 Journal entry: Patent Amortization Expense 2,000 Accumulated Amortization—Patent 2,000 To record amortization of patent for one year.