Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles Chapter 08 Chapter 8: Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Understanding The Business Costly excess capacity reduces profits. Insufficient capacity results in lost sales. How much is enough? The optimal level of investment in long-lived assets is often difficult to determine. Insufficient investment results in inadequate capacity to meet consumer demand. Excess investment results in unused capacity, wasted resources, and excessive expenses.

Classifying Long-Lived Assets Actively Used in Operations Expected to Benefit Future Periods Tangible Physical Substance Intangible No Physical Substance Long-lived assets are assets that are used actively in the operations of the business, and that are expected to benefit the operations into the future. There are two major categories of long-lived assets. Tangible assets are long-lived assets that have physical substance. Intangible assets are long-lived assets without physical substance.

Classifying Long-Lived Assets Land Assets subject to depreciation Buildings and equipment Furniture and fixtures Natural resource assets subject to depletion Mineral deposits and timber Definite life Patents Copyrights Franchises Indefinite life Trademarks Goodwill Tangible Physical Substance Intangible No Physical Substance There are three major categories of tangible assets. The first is land which is not depreciated. Next are assets that are subject to depreciation such as building, equipment, furniture and fixtures. Depreciation allocates the cost of a long-lived asset over the periods benefited by its use. We will study depreciation in detail later in the chapter. The third category is natural resources that are acquired for extraction of valuable raw materials that will be used in the business. Examples include oil reserves, timber, and other minerals. Natural resources are subject to depletion, a process similar to depreciation. We will review the accounting issues related to all three of these categories in this chapter. Intangible assets are noncurrent assets without physical substance. They have value represented by rights that produce benefits. Patents, copyrights, trademarks, franchises and goodwill are examples of intangible assets. We will take a look at each of these later in the chapter. Intangibles with a definite life, such as patents and copyrights, are subject to amortization. Intangibles with an indefinite life, such as goodwill and trademarks, are not amortized. Amortization, similar to depreciation, is a process of allocating cost over an asset’s useful life.

Net Sales Revenue Average Net Fixed Assets Fixed Asset Turnover Fixed Asset Turnover Net Sales Revenue Average Net Fixed Assets = This ratio measures a company’s ability to generate sales given an investment in fixed assets. During 2009, Southwest Airlines had $10,350 of revenue. End-of-year fixed assets were $10,634 and beginning-of-year fixed assets were $11,040. (All numbers in millions.) The fixed-asset turnover ratio measures how effectively a company manages its fixed assets to generate revenue. The ratio is computed by dividing net sales by average net fixed assets. Fixed assets include land, buildings, equipment, and natural resources. Net fixed assets are fixed assets less accumulated depreciation or depletion. Consider the following example for Southwest Airlines. Southwest Airlines had $10,350,000,000 of revenue. End-of-year net fixed assets are $11,040,000,000 and beginning-of-year net fixed assets are $10,634,000,000. Let’s calculate fixed asset turnover for Southwest Airlines. Southwest’s fixed asset turnover is 0.96, meaning that Southwest generates 96 cents of revenue for each dollar invested in fixed assets. By comparison, you can see that two other airline companies, Delta and United, have higher fixed asset turnover ratios than Southwest. Fixed Asset Turnover $10,350 ($10,634 + $11,040) ÷ 2 = = 0.96

Measuring and Recording Acquisition Cost Acquisition cost includes the purchase price and all expenditures needed to prepare the asset for its intended use. Acquisition cost does not include financing charges and cash discounts. Buildings Purchase price Renovation and repair costs Legal and realty fees Title fees Acquisition cost of an asset includes the purchase price as well as all costs necessary to get the asset in place and ready for its intended use. We record the purchase price net of any cash discounts taken. Finance charges are not included in the cost of an asset. If we elect to finance the purchase over a period of time, the interest cost is charged as an expense when incurred. Recording acquisition costs as assets is referred to as capitalizing the costs. In addition to the purchase price of a building, the acquisition cost includes legal fees, realty fees, title fees, and renovation and repair costs necessary to get the building ready for its intended use.

Measuring and Recording Acquisition Cost Equipment Purchase price Installation costs Modification to building necessary to install equipment Transportation costs Land Purchase price Real estate commissions Title insurance premiums Delinquent taxes Surveying fees Title search and transfer fees Equipment is recorded at its purchase price less any available cash discounts. In addition to the purchase price, the cost of equipment includes sales taxes, delivery charges, installation costs, and any building modification costs necessary to accommodate the equipment. When purchasing land, the cost includes the purchase price, legal fees, surveying fees, broker’s commissions, and other costs generally incurred in connection with the purchase such as taxes and recording fees. As noted earlier, land is not a depreciable asset. Land is not depreciated

Measuring and Recording Acquisition Cost On January 1, Southwest Air Lines purchased aircraft for $75,000,000 cash. Acquisition for Cash On January 14, Southwest Air Lines purchased aircraft for $1,000,000 cash and a $74,000,000 note payable. Acquisition for Debt Let’s see how to record the purchase of an asset. Our first example will be a purchase for cash. On January 1, Southwest Air Lines purchased aircraft for $75,000,000 cash. Let’s prepare the journal entry to record the transaction. We debit flight equipment and credit cash for $75,000,000. Now, let’s look at an example where Southwest purchased aircraft by issuing a note. On January 14, Southwest Air Lines purchased aircraft for $75,000,000, paying $1,000,000 in cash and issuing a note payable for the remaining $74,000,000. Let’s prepare the journal entry to record the transaction. We debit flight equipment for $75,000,000, credit cash for $1,000,000, and credit notes payable for $74,000,000.

Acquisition for Noncash Consideration Record at the current market value of the consideration given, or the current market value of the asset acquired, whichever is more clearly evident. On July 7, Southwest gave Boeing 1,000,000 shares of $1.00 par value common stock with a market value of $50 per share plus $25,000,000 in cash for aircraft. Companies sometimes acquire assets without paying cash. In any noncash acquisition, the components of the transaction should be recorded at their fair values. The first indication of fair value is the fair value of the consideration given to acquire the asset. Sometimes the fair value of the asset received is used when that fair value is more clearly evident than the fair value of the consideration given. Let’s look at an example. On July 7, Southwest gave Boeing 1,000,000 shares of $1.00 par value common stock with a market value of $50 per share plus $25,000,000 in cash for aircraft. Let’s prepare the journal entry to record the transaction. The fair value of the stock given by Southwest is known since the shares trade on the New York Stock Exchange daily. Southwest gave shares of stock worth $50,000,000 and $25,000,000 in cash for the aircraft. To record the transaction, we debit flight equipment for $75,000,000, the sum of $50,000,000 and $25,000,000. We credit common stock for its total par value of $1,000,000, and additional paid-in capital for $49,000,000, the difference between the $50,000,000 market value of the 1,000,000 shares and the par value of $1,000,000. Then we credit cash for $25,000,000.

Acquisition by Construction Asset cost includes: All materials and labor traceable to the construction. A reasonable amount of overhead. Interest on debt incurred during the construction. If we construct a tangible asset, such as a building, the cost will include all the necessary construction costs, material and labor, plus a reasonable amount of overhead, and any interest costs on money borrowed to finance the construction.

Repairs, Maintenance, and Additions After a tangible long-lived asset is purchased, a company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, and upgrades or additions. Generally, subsequent expenditures for ordinary repairs and maintenance are expensed in the period incurred. These amounts are called revenue expenditures. Subsequent expenditures that are for betterments like overhauls that extend the life of the asset, and additions are capitalized instead of expensed. These amounts are called capital expenditures.

Repairs, Maintenance, and Additions The decision to capitalize an expenditure results in higher current income and higher current taxes. A revenue expenditure charges the amount to expenses in the current period resulting in lower current income and lower current taxes. In many cases there is no clear line distinguishing between revenue and capital expenditures. To solve this problem, many companies have policies regarding the expensing of all expenditures below a certain amount according to the materiality constraint. To solve this problem, many companies have policies regarding the expensing of all expenditures below a certain amount according to the materiality constraint.

Depreciation Concepts Depreciation is a cost allocation process that systematically and rationally matches acquisition costs of operational assets with periods benefited by their use. Balance Sheet Income Statement Acquisition Cost Cost Allocation Expense (Unused) (Used) Depreciation is a process of cost allocation. We allocate the cost of the asset to expense over its useful life in some rational and systematic manner. Do not confuse cost allocation with asset valuation, an economic concept. The unused portion of the asset’s cost appears on the balance sheet. We allocate a portion of the cost to expense on the income statement each accounting period. The current year’s depreciation is an expense on the income statement. Accumulated depreciation represents the depreciation taken on the asset since its purchase, and is deducted from the asset’s cost on the balance sheet. Depreciation Expense Income Statement Balance Sheet Accumulated Depreciation Depreciation for the current year Total of depreciation to date on an asset

Depreciation Concepts The calculation of depreciation requires three amounts for each asset: Acquisition cost. Estimated useful life. Estimated residual value. Alternative depreciation methods: Straight-line Units-of-production Accelerated Method: Declining balance Regardless of the method used to calculate depreciation expense, we must know three amounts for the asset: (1) the asset’s acquisition cost; (2) the estimated useful life of the asset, and (3) the estimated residual (salvage) value we expect to receive at the end of its useful life. Once these three amounts are known, we select the depreciation method that we will use to calculate depreciation expense. There are three popular methods of calculating depreciation expense. The easiest and most widely used method is called straight-line depreciation. In special circumstances, we may wish to use the units-of-productions method. We would elect this method if the life of the asset is generally measured in terms of units of production. For example, airplanes keep highly detailed records of engine operating hours. The unit of production may be operating hours run for an aircraft engine. The third method is called the declining-balance method. Under this method, we take more depreciation expense in the early years of the asset’s life and lower amounts of depreciation in later years. Several income tax depreciation calculations are based on the declining balance method.

Cost - Residual Value Useful Life in Years Straight-Line Method Cost - Residual Value Useful Life in Years Depreciation Expense per Year = At the beginning of the year, Southwest purchased ground equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500. Depreciation Expense per Year = $20,000 $62,500 - $2,500 3 years Depreciation expense for any given period is determined by taking the asset’s cost less its estimated residual value and dividing this amount by the asset’s estimated useful life in years. Let’s look at an example. At the beginning of the year, Southwest purchased ground equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500. Calculate depreciation expense for the year. This calculation was relatively easy. Did you get the annual depreciation of $20,000? Now let’s look at depreciation for this asset for its three-year life.

Straight-Line Method Residual Value Notice that depreciation expense is the same amount in each of the three years. If we plot this amount on a graph, it would be a straight-line. That is how this method got its name. Accumulated depreciation increases by $20,000 each year. The cost of the asset ($62,500) less accumulated depreciation at the end of any year is called book value. Book value decreases by $20,000 each year. The book value is equal to the estimated residual value at the end of the asset’s useful life. We want this to be true regardless of the method we use. About 95 percent of companies responding to a recent survey reported using the straight-line method for some or all of their assets disclosed in financial reports. Now let’s move on to the units-of-production method. Residual Value SL More companies use the straight-line method of depreciation in their financial reports than all other methods combined.

Units-of-Production Method Step 1: Depreciation Rate = Cost - Residual Value Life in Units of Production Step 2: Depreciation Expense = Rate × Number of Units Produced for the Year At the beginning of the year, Southwest purchased ground equipment for $62,500 cash. The equipment has a 100,000 mile useful life and an estimated residual value of $2,500. If the equipment is used 30,000 miles in the first year, what is the amount of depreciation expense? Using the units of production method, the first step is to calculate the depreciation rate per unit of production. To do this, we divide the asset’s cost less its residual value by the total estimated number of units that will be produced by the asset during its life. Once we complete the first step, we may calculate depreciation expense for the period by multiplying the depreciation rate per unit that we determined in step one times the number of units produced in the current period. Let’s look at a specific example. At the beginning of the year, Southwest purchased ground equipment for $62,500 cash. The equipment has a 100,000 mile useful life and an estimated residual value of $2,500. If the equipment is used 30,000 miles in the first year, what is the amount of depreciation expense? Let’s follow our two-step method of calculating depreciation expense for the year.

Units-of-Production Method Step 1: $62,500 - $2,500 100,000 miles = $.60 per mile Depreciation Rate = Step 2: $.60 per mile × 30,000 miles = $18,000 Depreciation Expense = Residual Value First we calculate the depreciation rate per mile of use and find it to be 60 cents per mile. During the year Southwest recorded 30,000 miles of use on the ground equipment. So, we determine depreciation expense of $18,000 by multiplying 30,000 miles times 60 cents per mile. Let’s look at a table of depreciation expense for this equipment over its life. Remember that we need to know the miles of use in each year. In the second column we see the miles for each of the three years. Depreciation expense amounts for each year are determined by multiplying the miles for each year times the depreciation rate of 60 cents per mile. The accumulated depreciation balance is the sum of all depreciation expense including the current year. Book value is the acquisition cost of $62,500 dollars less the accumulated depreciation. Finally, notice that the book value at the end of the third year is equal to the estimated residual value of $2,500. Now let’s move on to the declining balance method.

Accelerated Depreciation Accelerated depreciation matches higher depreciation expense with higher revenues in the early years of an asset’s useful life when the asset is more efficient. Depreciation Repair Expense Early Years High Low Later Years One of the reasons to consider the declining-balance method is that it is an attempt to match depreciation expense and repair expenses to focus on the overall cost of ownership. In the early years of the asset’s life, depreciation under the declining balance method is high and, generally, repair expenses are low. Conversely, in the later years of an asset’s life, depreciation expense is less but repair expenses are usually higher. So, over the life of the asset we attempt to equalize the total cost of ownership each year.

Declining-Balance Method Declining balance rate of 2 is double-declining- balance (DDB) rate. Cost – Accumulated Depreciation Annual Depreciation expense Net Book Value ( ) Useful Life in Years 2 = × Annual computation ignores residual value. Calculating depreciation expense under the declining-balance method is a two step process. The first step is to calculate the double-declining-balance depreciation rate. We do this by dividing two by the useful life in years. We can convert this number to a percentage by multiplying by 100 percent. Next, we determine depreciation expense by multiplying the double-declining-balance rate times the asset’s beginning-of-the-period book value. The double-declining-balance method ignores estimated residual value. Let’s continue with our Southwest example. At the beginning of the year, Southwest purchased equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500. Calculate the depreciation expense for the first two years. Don’t forget that residual value is not used in the double-declining-balance method computations. At the beginning of the year, Southwest purchased equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500. Calculate the depreciation expense for the first two years.

Declining-Balance Method Annual Depreciation expense Net Book Value ( ) Useful Life in Years 2 = × Year 1 Depreciation: Year 2 Depreciation: ( ) $62,500 × 3 years 2 = $41,667 Here is our double-declining-balance method equation. Calculate the depreciation expense for the first year before advancing. At the start of the first year the book value of the asset is its acquisition cost of $62,500. For the first year, to determine depreciation expense, we multiply the book value of $62,500 times the double-declining-balance rate of two-thirds and find the depreciation expense of $41,667. At the start of the second year the book value of the asset is its acquisition cost of $62,500 minus the first year’s depreciation of $41,667. To determine depreciation expense, we multiply the book value times the double-declining-balance rate of two-thirds and find the depreciation expense of $13,889. Let’s look at a depreciation table for our asset. ( ) ($62,500 – $41,667) × 3 years 2 = $13,889

Declining-Balance Method While we always want the book value to be equal to estimated residual value at the end of the asset’s useful life, it just will not work properly using the double-declining- balance method. As you can see, the book value of the asset at the end of the third year is $2,315. It should be $2,500. The only way we can make this work is to force depreciation expense in the last year to be the amount needed to bring the book value down to the $2,500 estimated residual value. Let’s look at a corrected schedule. Below residual value ( ) ($62,500 – $55,556) × 3 years 2 = $4,629

Declining-Balance Method In the third year, depreciation expense is limited to the amount that will reduce the book value to the estimated residual value of $2,500. For the third year, we will record depreciation expense of $4,444. We determine this amount by subtracting the residual value of $2,500 from the book value at the end of the second year, $6,944. Depreciation expense is limited to the amount that reduces book value to the estimated residual value.

International Perspective—IFRS Measurement Basis for Property, Plant and Equipment US GAAP and IFRS differ with respect to the measurement basis for property, plant and equipment on the balance sheet. Under GAAP, revaluation of property, plant, and equipment to fair value is prohibited. IFRS permit companies to value property, plant, and equipment at historical cost or to revalue them to their fair value as of the balance sheet date. One of the most important differences between U.S. GAAP and International Financial Reporting Standards (IFRS) relates to the measurement basis for property, plant, and equipment. IFRS permit companies to value property, plant, and equipment at historical cost or to revalue them to their fair value as of the balance sheet date. The primary argument in favor of revaluation is that the historical cost of an asset purchased 15 or 20 years ago is not meaningful because of the impact of inflation. However, revaluation to fair value is prohibited in the United States (under GAAP). A primary argument against revaluation property, plant, and equipment is the lack of objectivity involved in estimating an asset’s current cost.

Measuring Asset Impairment Impairment is the loss of a significant portion of the utility of an asset through . . . Casualty. Obsolescence. Lack of demand for the asset’s services. Recognize a loss when an asset suffers a permanent impairment. Disposal of Property, Plant and Equipment Voluntary disposals: Sale Trade-in Retirement Involuntary disposals: Fire Accident If an asset’s value decreases and cannot be recovered through future use or sale, the asset is considered to be impaired. An impairment can be the result of a casualty, obsolescence, or the lack of demand for the asset’s services. The impaired asset should be written down to its net realizable value resulting in a loss being recognized. A business may voluntarily dispose of an asset by selling it, trading it, or retiring it. A business may also dispose of an asset involuntarily as the result of a casualty such as a fire or accident.

Disposal of Property, Plant and Equipment Update depreciation to the date of disposal. Journalize disposal by: Recording cash received (debit) or paid (credit). Recording a gain (credit) or loss (debit). When we dispose of a plant asset, the first thing we do is update depreciation to the date of disposal. After completing the update we can record the disposal with a journal entry. We start the journal entry by recording a debit to the cash account, if cash was received, or credit the cash account, if cash was paid by the company. In addition, we must determine whether a gain or loss is associated with the disposal. A gain is recorded with a credit, just like revenue, and a loss is recorded with a debit, just like an expense account. We complete the entry by removing the plant asset’s cost from our books with a credit, and by removing related accumulated depreciation with a debit. Writing off accumulated depreciation (debit). Writing off the asset cost (credit).

Disposal of Property, Plant and Equipment If Cash > BV, record a gain (credit). If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss. Southwest Airlines sold flight equipment for $11,000,000 cash at the end of its 17th year of use. The flight equipment originally cost $30,000,000, and was depreciated using the straight-line method with zero residual value and a useful life of 25 years. Let’s answer the following questions. If the amount of cash received is greater than the book value of the asset (cost less accumulated depreciation), a gain is associated with the disposal. If the cash received is less than the book value of the asset, a loss will be recorded. When the amount of cash is exactly equal to the book value of the asset, there will be no gain or loss in connection with the disposal. Now let’s look at a specific example of a disposal of a plant asset. Southwest Airlines sold flight equipment for $11,000,000 cash at the end of its 17th year of use. The flight equipment originally cost $30,000,000, and was depreciated using the straight-line method with zero residual value and a useful life of 25 years. We will use this information with a series of multiple choice questions to give you some practice accounting for the disposal of a long-lived asset. Try to answer each question before advancing to the next slide.

Disposal of Property, Plant and Equipment The amount of depreciation expense recorded at the end of the 17th year to bring depreciation up to date is: a. $0. b. $1,200,000. c. $1,500,000. d. $2,000,000. Annual Depreciation: ($30,000,000 – $0) ÷ 25 Years. = $1,200,000 Part I. What is the amount of depreciation expense that should be recorded at the end of the 17th year of use to bring the depreciation up to the date of sale? Part II. The correct answer is choice b, $1,200,000. Annual depreciation expense is $1,200,000. Since depreciation expense for the 17th year of use has not been recorded, the amount should be recorded at the sale date.

Disposal of Property, Plant and Equipment Accumulated Depreciation = (17yrs. × $1,200,000) = $20,400,000 BV = Cost – Accumulated Depreciation BV = $30,000,000 – $20,400,000 = $9,600,000 After updating the depreciation, the equipment’s book value at the end of the 17th year is: a. $9,600,000. b. $20,400,000. c. $12,800,000. d. $6,600,000. Part I. After updating the depreciation, what is the equipment’s book value at the end of the 17th year of use? Part II. The correct answer is choice a, $9,600,000. Book value is calculated by subtracting the accumulated depreciation at the date of sale from the equipment’s acquisition cost. The balance in the accumulated depreciation account is $20,400,000, which is calculated by multiplying the depreciation of $1,200,000 per year times the 17 years the equipment was used before the sale. Book value is the $30,000,000 acquisition cost minus the $20,400,000 of accumulated depreciation. Once we determine the book value of the asset, we can calculate any gain or loss involved with the disposal.

Disposal of Property, Plant and Equipment The equipment’s sale resulted in: a. a gain of $1,400,000. b. a gain of $6,200,000. c. a gain of $3,800,000. d. a loss of $1,700,000. Gain = Cash Received – Book Value Gain = $11,000,000 – $9,600,000 = $1,400,000 Part I. Did the sale of the equipment result in a gain or a loss? Part II. The correct answer is choice a, a gain of $1,400,000. To determine a gain or loss, compare the cash received of $11,000,000 with the book value of $9,600,000. Since Southwest received more cash than the book value, there is a gain of $1,400,000.

Disposal of Property, Plant and Equipment Prepare the journal entry to record Southwest’s sale of the equipment at the end of the 17th year. Let’s prepare the journal entry to record the sale transaction now that we have all the necessary pieces of information. We record the disposal with debits to the cash account for $11,000,000 and to the accumulated depreciation account for $20,400,000. The debit to accumulated depreciation eliminates the account balance. Next we credit gain on sale for $1,400,000 and finally, we credit flight equipment for the original cost of $30,000,000. The credit to flight equipment removes the equipment from Southwest’s books.

Acquisition and Depletion of Natural Resources Extracted from the natural environment. A noncurrent asset presented at cost less accumulated depletion. Total cost of asset is the cost of acquisition, exploration, and development. Total cost is allocated over periods benefited by means of depletion. In general, natural resources can be thought of as anything extracted from our natural environment such as coal, oil, and iron ore. Natural resources are reported at their cost less accumulated depletion in the noncurrent assets portion of the balance sheet. Total cost, including exploration and development, is charged to depletion expense over the periods benefited. We use the units-of-production method to compute depletion expense. Depletion is like units-of-production depreciation. Examples: oil, coal, gold

Acquisition and Depletion of Natural Resources The unit depletion rate is calculated as follows: Estimated Recoverable Units Acquisition and Residual Development Cost Value – Depletion cost for a period is: UNIT DEPLETION RATE NUMBER OF UNITS EXTRACTED IN PERIOD × We begin the process of calculating depletion expense by determining the unit depletion rate for the natural resource. The numerator of the equation contains the resource cost less any estimated residual value. The denominator of the equation is our estimated total capacity of the natural resource we expected to extract. For oil we express the denominator in terms of barrels, for coal we use tons, for timber we use board feet, and similar measures for other natural resources. When accounting for the periodic depletion of a natural resource, it is important to understand that the company obtains inventory from its mining or harvesting of some type of raw material. Thus, the amount of the total depletion cost for a period is capitalized as inventory-- equal to the unit depletion rate times the number of units extracted during the period. Once in inventory, part of the depletion cost will be expensed during the current period through Cost of Goods Sold as sales are made. This expense is computed as the number of units sold multiplied by the unit depletion rate. The unsold part of the period depletion cost remains in inventory until sold in a later period. Depletion cost Inventory for sale Unsold Inventory Cost of goods sold

Acquisition and Amortization of Intangible Assets Noncurrent assets without physical substance. Often provide exclusive rights or privileges. Intangible Assets Usually acquired for operational use. Useful life is often difficult to determine. Intangible assets lack physical substance and that makes it difficult to determine the asset’s useful life or any residual value. Many intangible assets involve exclusive rights or privileges. We will review the major types of intangible assets and the related accounting procedures on the remaining screens. Intangible assets are normally recorded at the purchase price plus any legal or related fees. Goodwill, trademarks, patents, copyrights, franchises, licensing rights, and technology are examples of intangible assets. We will briefly discuss each of these intangible assets. Record at current cash equivalent cost, including purchase price, legal fees, and filing fees.

Acquisition and Amortization of Intangible Assets Definite Life Amortize over shorter of economic life or legal life, subject to rules specified by GAAP. Use straight-line method. Indefinite Life Not amortized. Tested at least annually for possible impairment, and book value is reduced to fair value if impaired. Intangible assets are normally recorded at the purchase price plus any legal or related fees. At purchase, we determine whether the individual intangibles have definite or indefinite lives. Intangible assets with definite lives are amortized, using the straight-line method, over the shorter of their economic life or legal life, subject to generally accepted accounting principles. Amortization is the same concept as depreciation only we call it a different name because it refers to intangible assets. Intangible assets with indefinite lives are not amortized. They must be tested at least annually for possible impairment of value, and if impaired, the book value is reduced to fair value. Amortization is a cost allocation process similar to depreciation and depletion.

Acquisition and Amortization of Intangible Assets Goodwill Occurs when one company buys another company. Only purchased goodwill is an intangible asset. The amount by which the purchase price exceeds the fair market value of net assets acquired. An intangible asset called goodwill can be created when one company buys another company. If the purchase price of the company is greater than the fair value of the net assets and liabilities acquired, goodwill is associated with the transaction. Unlike other intangible assets, goodwill can not be associated with any specific right. It does not exist separate from the company itself. It represents the value of a company as a whole over and above its identifiable net assets. Goodwill may be attributed to many factors, including good reputation, superior employees and management, good clientele, and good business location. Goodwill is not amortized. Each year we must test to see if there has been any impairment in the carrying value of the goodwill. If an impairment is determined to exist, we will reduce the goodwill account to its fair value and recognize a loss. Goodwill is not amortized. Its value must be reviewed at least annually for possible impairment, and the book value is reduced to fair value if impaired.

Acquisition and Amortization of Intangible Assets Arpec Company paid $2,000,000 to purchase all of Utek Company’s assets and assumed liabilities of $400,000. The acquired assets were appraised at a fair value of $1,800,000. What amount of goodwill should be recorded on Arpec Company books? a. $200,000 b. $400,000 c. $600,000 d. $800,000 Part I. Arpec Company paid $2,000,000 to purchase all of Utek Company’s assets and assumed liabilities of $400,000. The acquired assets were appraised at a fair value of $1,800,000. How much goodwill should Arpec Company record as a result of its purchase of Utek Company? Part II. The correct answer is choice c. Arpec Company paid $2,000,000 dollars for net assets with a fair value of $1,400,000. Since the purchase price exceeded the fair value of net assets by $600,000, Arpec Company will record $600,000 of goodwill.

Acquisition and Amortization of Intangible Assets Copyrights The exclusive right to publish, use, and sell a literary, musical, or artistic work. Legal life is life of creator plus 70 years. Amortize cost over the period benefited. Trademarks A symbol, design, or logo associated with a business. An exclusive legal right to use a name, image or slogan. Purchased trademarks are recorded at cost. A trademark or trade name is any symbol, name, phrase, or jingle that is identified with a company, product or service. No other party may use the trademark or trade name without the permission of the holder. Many trademarks are extremely valuable. Trademarks have unlimited (or indefinite) lives and are not amortized. A copyright grants to the holder the exclusive right to publish and sell musical, literary, or artistic work for the life of the creator plus seventy years. Most copyrights are amortized over a short period of time using the straight-line method.

Acquisition and Amortization of Intangible Assets Patents Exclusive right granted by the federal government to sell or manufacture an invention. Cost is purchase price plus legal cost to defend. Amortize cost over the shorter of useful life or 20 years. Research and development costs that might result in a patent are normally expensed as incurred. A patent gives the holder the exclusive right to manufacture and sell an item or process for twenty years. A patent is amortized using the straight-line method over its useful life, but never more than twenty years. Most companies amortize patents over a very short period of time. Research and development costs that might lead to a patent are normally expensed as incurred. Technology is a category of intangible assets that includes a company’s website and any computer programs written by its employees. This category of intangible assets is rapidly growing on corporate balance sheets. Technology A category of intangible assets that includes a company’s website and any computer programs written by its employees.

Acquisition and Amortization of Intangible Assets Franchises Legally protected right purchased by a franchisee to sell products or provide services for a specified period and purpose. Purchase price is an intangible asset that is amortized. Licenses and Operating Rights Limited permissions to use a product or service according to specific terms and conditions. You may be using computer software that is made available to you through a campus licensing agreement. You probably can’t drive down any major street without finding a number of fast-food franchise operations. The holder of a franchise has the right to deliver a product or service under conditions granted by the franchisor. Any cost to acquire a franchise is amortized over the contract life of the franchise. Licenses and operating rights grant limited permission to use a product or service according to specific terms and conditions. For example, you may be using computer software that is made available to you through a campus licensing agreement.

International Perspective—IFRS Measurement Basis for Property, Plant and Equipment US GAAP and IFRS differ with respect to the treatment of development costs. Under GAAP, all research and development costs must be reported as an expense. IFRS require that research expenditures be reported as an expense, but development costs be capitalized as an asset after technical and commercial feasibility of the resulting product or service have been established. While all research and development costs must be reported as an expense under U.S. GAAP, International Financial Reporting Standards (IFRS) require that research expenditures be reported as an expense, but development costs be capitalized as an asset after technical and commercial feasibility of the resulting product or service have been established. The FASB is currently working on a new accounting standard aimed at eliminating this difference.

Focus on Cash Flows Several items relating to the accounting for investments are reported as adjustments to net income in the operating activities section of the statement of cash flows prepared using the indirect method. These adjustments to net income are: Depreciation, depletion, and amortization are added to net income. Gains on the sale of long-lived assets are subtracted from net income. Losses on the sale of long-lived assets are added to net income. Impairment losses are added to net income. Purchases of long-lived asset result in cash outflows. Sales of long-lived assets result in cash inflows. These two types of cash flows are reported in the investing activities section of the statement of cash flows.

Chapter Supplement A – Changes in Depreciation Estimates Depreciation Expense is based on . . . ESTIMATED useful life ESTIMATED residual value If the estimates change, the book value less any residual value at the date of change is depreciated over the remaining useful life. Chapter Supplement A: Changes in Depreciation Estimates. The useful life and the residual value used in depreciation computations are both estimates. Like all estimates, new information may come to light that will cause us to revise our previous estimates. If the estimates do change, the book value less any residual value at the date of change is depreciated over the remaining useful life. Let’s look at an example involving a change in both useful life and residual value. Southwest purchased an aircraft for $60,000,000. The aircraft is depreciated using the straight-line method with a useful life of 20 years and an estimated residual value of $3,000,000. In year 5, Southwest changed the estimated useful life to 25 years and lowered the residual value to $2,400,000. Let’s calculate the depreciation expense for the fifth year using the straight-line method with the new estimates. Southwest purchased an aircraft for $60,000,000. The aircraft is depreciated using the straight-line method with a useful life of 20 years and an estimated residual value of $3,000,000. In year 5, Southwest changed the estimated useful life to 25 years and lowered the residual value to $2,400,000. Calculate depreciation expense for the fifth year using the straight-line method.

Chapter Supplement A – Changes in Depreciation Estimates The depreciation expense for each of the first four years is $$2,850,000 ($60,000,000 cost minus $3,000,000 residual value, divided by the original estimated useful life of 20 years). The accumulated depreciation for the first four years totals $11,400,000, computed by multiplying the $2,850,000 of depreciation each year times four years. The undepreciated cost (book value) of the equipment on the date of change is $48,600,000, computed by subtracting $11,400,000 of accumulated depreciation from the $60,000,000 cost. The new depreciable base is the book value of $48,600,000 minus the new estimated residual value of $2,400,000. To calculate the amount of straight-line depreciation for each of the remaining 21 years of the equipment’s life, we divide the depreciable base of $46,200,000 by 21 years. The resulting straight-line depreciation is $2,200,000 per year.

End of Chapter 08 End of chapter 8.