Chapter 12 Investments in Operating Assets

2 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Financial Statement Items Covered Balance Sheet Income Statement Statement of Cash Flows Long-term Assets Property, Plant, & Equipment Accumulated Depreciation Intangible Assets Depreciation Expense Amortization Expense Loss on Impairment Operating Asset depreciation (indirect method) Financing Cash paid (received) to purchase (from sale of) long-term assets Cash paid to acquire another company

What are Long-Term Operating Assets?

4 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Long-Term Operating Assets Long-term operating assets are –not held for resale to customers –are used by a business to generate revenues Long-term operating assets include –Property, plant, and equipment –Intangible assets

5 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Property, Plant, and Equipment “PP&E” –Tangible, long-lived assets –Acquired for use in business operations Land Buildings Machinery Equipment Furniture

6 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Long-lived assets –Used to facilitate the operation of a business –Do not have physical substance Patents Trademarks Licenses Franchises Goodwill Intangible Assets

7 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Long-Term Asset Issues EvaluateAcquire Estimate and Recognize MonitorDispose possible acquisition of long-term operating assets long-term operating assets periodic depreciation asset value for possible decline of the asset

Deciding Whether to Acquire a Long-Term Operating Asset

9 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Capital Budgeting The process of evaluating a long-term project that may include purchasing property, plant, and equipment Common capital budgeting models: –Payback period –Accounting rate of return –Net present value

10 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Payback Period The time it takes for a company to recover its original investment in cash

11 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting Rate of Return Projects are approved if their rate of return exceeds some predetermined rate

12 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Net Present Value Utilizes the concept of the time value of money A project is undertaken only if the present value of the cash inflows from the project exceeds the present value of the cash outflow

Acquisition of Plant, Property, & Equipment

14 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Acquisition of PP&E The cost of PP&E includes any costs necessary to bring the asset to the condition and location for its intended use

15 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Items Included in PP&E Acquisition Cost LandPurchase price, commissions, legal fees, escrow fees, surveying fees, clearing and grading costs Land Improvements (e.g., landscaping, paving, fencing) Cost of improvements, including expenditures for materials, labor and overhead Buildings Purchase price, commissions, reconditioning costs EquipmentPurchase price, taxes, freight, insurance, installation, and any expenditures incurred in preparing the asset for its intended use

16 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Acquisition for Cash Purchase price$15,000 Discount* (300) Net Price$14,700 6% sales tax on purchase price$900 Freight charges850 Installation costs 150 1,900 Total Acquisition Cost$16,600 *terms 2/10, n/30; payment made within discount period

17 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Subsequent Expenditures Normal repairs and maintenance are expensed in the current period Expenditures which extend the useful life or increase the productive capacity are capitalized –Asset book value is increased –Annual depreciation is revised

18 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Acquisition Through Leasing A lease is a contract whereby one party ( lessee ) is granted the right to use property owned by another party ( lessor ) for a specified period of time for a specified cost

19 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Lease Types Operating lease - equivalent to a rental –Lease payments charged to expense Capital lease – equivalent to a purchase –The asset acquired is recorded in property, plant and equipment  The leased asset is depreciated over the lease period –A lease liability is shown in the liability section of the balance sheet

20 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Acquisition by Exchange The acquisition price of the asset is equal to fair market value of noncash consideration plus any cash given To record the purchase of land in exchange for 10,000 shares of stock when market price of the stock was $78 per share

21 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Acquisition Through Donation The asset is recorded at its fair market value at time it is received To record the receipt of land through donation.

22 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Acquisition With a Basket Purchase Fixed assets purchased for a lump sum need to be recorded separately The total purchase price must be allocated among individual assets received in proportion to their appraised values

23 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Example: Acquisition With a Basket Purchase Fair Value of Assets: Land300,000 Building900,000 Price Paid$1,000,000

24 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Acquisition of an Entire Company All acquired assets are recorded on the books of the acquiring company at their fair values as of the acquisition date The excess of the purchase price over the fair value of the identifiable assets represents goodwill

25 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Self-constructed assets are recorded at cost, including all expenditures necessary to build the asset and make it ready for its intended use Acquisition Through Self-Construction

26 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Acquisition Through Self-Construction Costs include: –Materials and labor used directly in construction –A reasonable share of general overhead –If interest is included it is called capitalized interest Interest should be included equal to the amount that could have been saved if the money used on the construction had instead been used to repay loans

Acquisition of Intangible Assets

28 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Intangible Assets Long-term Nonmonetary Generate revenues –Grant a right to use of a product, process, name, image, customer list, or business practice Uncertainty about future benefits greater than that of tangible assets Specifically identifiable –Except goodwill

Patent An exclusive right to use, manufacture, process, or sell a product granted by the U.S. Patent Office. Patents have a legal life of 17 years, but their economic life may be shorter

Copyright The exclusive right of the creator or heirs to reproduce and/or sell an artistic or published work. Granted by the U.S. government for a period of 50 years after the death of the creator. Amortized over the shorter of its economic life or legal life.

Trademark and Trade Names A symbol or name that allows the holder to use it to identify or name a specific product or service. A legal registration system allows for an indefinite number of 20-year renewals

Franchise An exclusive right to use a formula, design, technique, or territory.

Goodwill The ability of a company to earn above-normal income. Recorded goodwill is the excess amount paid to acquire a company, over and above the fair market value of the company’s identifiable assets.

34 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Accounting for Goodwill A business combination occurs when one company buys all of the assets of another company The combination is accounted for using the purchase method (as if one company is buying the other)

35 Financial Accounting, 7e Stice/Stice, 2006 © Thomson The identifiable assets and liabilities are recorded at their fair values –The excess of the purchase price over the fair value of the identifiable net assets is recorded as goodwill Goodwill represents the company’s reputation, superior business practices, and market position Goodwill is only recorded when it is purchased Purchase Method

36 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Determining Goodwill

Depreciation and Amortization

38 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Depreciation: What it Is... and Isn’t IS NOT Accumulation of a cash fund for asset replacement A determination of an asset’s current value IS The systematic allocation of an asset’s cost to the periods of benefit

39 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Depreciation Causes of depreciation: – Physical deterioration Due to use, passage of time, and exposure to the elements – Obsolescence Outdated, outmoded, or inadequate

40 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Residual value (salvage value) –An estimate of the asset’s worth at the time of its disposal Depreciable cost –The original cost minus the residual value Estimated useful life –A measure of the service potential in terms of years or units produced Depreciation Factors

41 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Depreciation Methods Straight-line –Allocates an equal amount of asset cost per year Units-of-production –Allocates cost based on the productive output of the asset Declining balance –An accelerated method which allocates more cost to depreciation in the early years than the later years

42 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Depreciation Methods Illustrated Assume the following information: Equipment purchase dateJanuary 1, 2006 Acquisition cost$40,000 Estimated residual value $4,000 Depreciable cost$36,000 Estimated useful life 5 years

43 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Straight-Line Depreciation

44 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Straight-Line Method An equal amount of depreciation expense is allocated to each period

45 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Declining-Balance Method Annual depreciation is determined by applying a fixed percentage to the remaining book value at the beginning of each year ‘rate’ is the multiple of straight-line (double is 2 times the straight-line rate)

46 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Declining-Balance Method 2010’s expense is adjusted so that ending book value is not less than established residual value

47 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Declining-Balance Method Accelerated methods allocate a greater portion of cost to the earlier years of the asset’s life

48 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Both methods allocate a depreciable cost of $36,000 over a five- year period Comparison of Straight-line and Double-Declining Balance

49 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Selecting a Depreciation Method for Financial Reporting Purposes Management may choose any GAAP-based method for financial reporting Theoretically, best to use a method that reflects the pattern of the asset’s revenues or benefits –The straight-line method is appropriate for assets whose benefits diminish on a fairly uniform basis –The double-declining-balance method is appropriate for assets that give up a greater portion of their benefits in the early years Most companies use the straight-line method due to its simplicity

50 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Choosing a Depreciation Method for Tax Purposes IRS Code stipulates depreciation method and techniques –Method depends on the statutory “class life” category –Current recovery periods range from 3 to 20 years for personal property

IRS Depreciation Recovery Periods and Lives

52 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Choosing a Depreciation Method for Tax Purposes Salvage value is ignored for tax purposes The half-year convention is used –Property is depreciated for half the taxable year in which it is placed in service, regardless of when use actually begins Deferred tax liability arises –Accelerated depreciation for tax purpose vs straight-line depreciation for financial purpose –Earlier years have higher tax deductions –Later years have higher taxable income

53 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Depreciation and Cash Flow Depreciation is not a source of cash; it is a noncash expense Depreciation indirectly affects cash flow –depreciation reduces taxable income –results in lower income taxes being paid

54 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Changes in Estimated Useful Lives Later events may require changes in estimates of economic life and residual value –A change in estimate is not an error correction –A change in estimate is reflected by spreading the remaining depreciable cost over the remaining useful life of the asset

55 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Amortization of Intangible Assets Finite life intangibles: –Amortize over the economic useful life or legal life, whichever is shorter –Not to exceed 40 years –Direct subtraction from the asset account Indefinite life intangibles: –No amortization

Impairment of Asset Value

57 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Impairment of Asset Value Occurs when an event happens after the purchase of an asset that reduces its value –Recognized in the financial statements as a reduction in the value of the asset on the balance sheet and a loss on the income statement

58 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Recording Decreases in the Value of PP&E A two-step process to identify impairments and record decreases in the value of PP&E Identify: An impairment loss exists if the sum of estimated future cash flows from the asset is less than its book value Record: An impairment is measured as the difference between the book value of the asset and the fair value

59 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Impairment of Intangible Assets Intangibles must be evaluated to determine if –Their estimated useful life has changed –The intangible has become impaired

60 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Recording Increases in the Value of PP&E U.S. GAAP –The principle of conservatism controls –Increases in the value of PP&E are not allowed under current U.S. GAAP –Gains are recognized in income only when assets are sold IAS GAAP –Upward revaluation permitted

Disposal of Long-Term Assets

62 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Disposal of Long-Term Assets Disposal of long-term assets can occur through retirement, sale, or trade-in of operating assets In each case, depreciation must be recorded up to the date of the disposal and any gain or loss recognized

63 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Retirement Occurs when an operating asset is removed from service and is disposed of without the company receiving any proceeds An difference between the cost and balance in the accumulated depreciation account results in a loss on retirement

64 Financial Accounting, 7e Stice/Stice, 2006 © Thomson A gain occurs if the cash or other assets received are greater than the book value at the time of sale A loss occurs if the consideration received is less than the book value at the time of sale Gains/Losses are reported in “Other” section of the Income Statement Sale

65 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Sale: Two Examples When the disposal is recorded in the accounting records, both the original cost of the truck and the accumulated depreciation on the truck are removed from the books.

66 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Trade-In Trade-in allowance > book value of the asset given up a gain is realized Trade-in allowance < book value of the asset given up a loss is realized

Measuring PP&E Efficiency

68 Financial Accounting, 7e Stice/Stice, 2006 © Thomson Used to evaluate the appropriateness of the level of a company’s PP&E Fixed Asset (PPE)Turnover Can be interpreted as the number of dollars in sales generated by each dollar of fixed assets

69 Financial Accounting, 7e Stice/Stice, 2006 © Thomson  The ratios for two companies in different industries cannot be compared  The reported amount of PP&E can be a poor indicator of fair value  Sales generated by leased assets are included in the numerator, but the leased assets are not included in the denominator; upward bias in the ratio Fixed Asset Turnover Dangers

70 Financial Accounting, 7e Stice/Stice, 2006 © Thomson In Summary... Long-term assets provide the infrastructure for production and distribution Capital budgeting models include the payback period, accounting rate of return, and net present value analysis Patents, franchises, licenses, and goodwill are intangible assets. Straight-line and declining balance are common depreciation methods Recognizing impairment for PPE is a two-step process Gain (loss) on asset disposal occurs if proceeds received are greater (less) than the asset’s book value at date of sale