Operating Assets: Property, Plant, and Equipment, and Intangibles Chapter 8 Operating Assets: Property, Plant, and Equipment, and Intangibles

Operating Assets Two categories of operating assets presented on the balance sheet: Property, Plant and Equipment Intangible Assets Presented at their acquisition cost (historical cost) Essential to a company’s long-term future Used to produce the goods or services the company sells to customers Constitute the major productive assets of many companies LO 1

Balance Sheet Presentation of Property, Plant, and Equipment Balance sheet uses one line item for property, plant, and equipment and presents the details in the notes

Acquisition of Property, Plant, and Equipment Initially recorded at acquisition cost or original cost Includes all cost normally necessary to acquire an asset and prepare it for its intended use Purchase price Taxes paid at time of purchase (for example, sales tax) Transportation charges Installation costs LO 2

Group Purchase Firm purchases several assets as a group and pays a lump-sum amount Acquisition cost of each asset is separately measured on the basis of the proportion of the fair market value of each LO 3

Example 8.1—Determining Cost When a Group of Assets Is Purchased Assume that on January 1, ExerCo purchased a building and the land on which it is situated for $100,000. The accountant established the assets’ fair market value on January 1 as follows: Based on the estimated market values, purchase price should be allocated as follows: To land $100,000 × $30,000/$120,000 = $25,000 To building $100,000 × $90,000/$120,000 = $75,000

Example 8.1—Determining Cost When a Group of Assets Is Purchased (continued) The effect of the transaction can be identified and analyzed as follows:

Capitalization of Interest The interest on borrowed money should be treated as an expense of the period If a company constructs an asset over a period of time and borrows money to finance the construction The interest incurred during the construction period is not treated as interest expense The interest must be included as part of the acquisition cost of the asset LO 4

Land Improvements The acquisition cost of land should be kept in a separate account because land has an unlimited life and is not subject to depreciation Costs associated with land should be recorded in an account such as Land Improvements Example: Costs of paving a parking lot and landscaping costs Have a limited life Should be depreciated over their useful lives

Use and Depreciation of Property, Plant, and Equipment Depreciation: allocation of the original cost of an asset to the periods benefited by its use An asset’s decline in usefulness is related to: Physical deterioration from usage or from the passage of time Obsolescence factors such as changes in technology The company’s repair and maintenance policies LO 5

Use and Depreciation of Property, Plant, and Equipment Methods of depreciation: Straight-line Units-of-production Accelerated depreciation The method chosen should be one that best matches the expense to the revenue generated by the asset

Straight-Line Method Allocates the cost of the asset evenly over time

Example 8.2—Computing Depreciation Using the Straight-Line Method Assume that on January 1, 2014, ExerCo, a manufacturer of exercise equipment, purchased a machine for $20,000. The machine’s estimated life would be five years, and its residual value at the end of 2018 would be $2,000. The annual depreciation should be calculated as follows: The book value at the end of 2014

Example 8.2—Computing Depreciation Using the Straight-Line Method (continued) The book value at the end of 2014

Units-of-Production Method Depreciation is determined as a function of the number of units the asset produces

Example 8.3—Computing Depreciation Using the Units-of-Production ExerCo has estimated that the total number of units that will be produced during the asset’s five-year life is 18,000. During 2014, ExerCo produced 4,000 units. The depreciation per unit for ExerCo’s machine can be calculated as follows: The book value at the end of 2014

Accelerated Depreciation Method Higher amount of depreciation is recorded in the early years than in later years Double-declining-balance method: recorded at twice the straight-line rate, but the balance is reduced each period

Example 8.4—Computing Depreciation Using the Double-Declining-Balance Method Assume that ExerCo wants to depreciate its asset using the double-declining-balance method. The first step is to calculate the straight-line rate as a percentage. The straight-line rate for the ExerCo asset with a five-year life is as follows: The second step is to double the straight-line rate, as follows: The amount of depreciation for 2014 The amount of depreciation for 2015

Example 8.4—Computing Depreciation Using the Units-of-Production (continued) The complete depreciation schedule for ExerCo for all five years of the machine’s life would be as follows:

Exhibit 8.1—Comparison of Depreciation and Book Values of Straight-Line and Double-Declining-Balance Methods

Exhibit 8.2—Management’s Choice of Depreciation Method

Changes in Depreciation Estimate Change in the life of the asset or in its residual value Recorded prospectively The depreciation recorded in prior years is not corrected or restated The new estimate should affect the current and future years LO 6

Example 8.5—Calculating a Change in Depreciation Estimate $20,000 machine originally expected to be depreciated over 5 years. After 2 years, useful life is increased to 7 years $3,600 $3,600 2012 2013 2014 2015 2016 revise estimate Depreciation From 5 years to 7 years

Example 8.5—Calculating a Change in Depreciation Estimate (continued) $3,600 $3,600 $2,160 $2,160 $2,160 $2,160 $2,160 2012 2013 2014 2015 2016 2017 2018 revise estimate Depreciation

Example 8.5—Calculating a Change in Depreciation Estimate (continued) In Example 8-5, the effect of the transaction can be identified and analyzed as follows:

Capital vs. Revenue Expenditures Capital Expenditure Increases the life of the asset or its productivity Treated as an asset (Balance sheet) Revenue Expenditure Maintains an asset in its normal operating condition Treated as an expense (Income statement) LO 7

Capital vs. Revenue Expenditures

Example 8.6—Capitalizing Costs of a Major Repair At the beginning of 2016, ExerCo made a $3,000 overhaul to the machine, extending its life by three years. Because the expenditure qualifies as a capital expenditure, the cost of overhauling the machine should be added to the asset account. Beginning in 2016, the company should record depreciation of $2,300 per year, computed as follows:

Example 8.6—Capitalizing Costs of a Major Repair (continued) The effect of the transaction for the overhaul is as follows:

Example 8.6—Capitalizing Costs of a Major Repair (continued) The effect of the transaction to record depreciation for 2016 can be identified and analyzed as follows:

Disposal of Property, Plant, and Equipment Occurs when the asset is sold, traded, or discarded Update depreciation to the date of disposal and calculate gain or loss A gain occurs when the selling price of the asset exceeds its book value A loss occurs when the selling price of the asset is less than its book value Gain or loss is reported in the Other Income or Expense category of the income statement LO 8

Gain on Sale of an Asset On January 1,2014, ExerCo purchased a machine 2014, for $20,000, estimating its life to be five years and the residual value to be $2,000. ExerCo used the straight-line method of depreciation. ExerCo sold the machine on July 1, 2016. Depreciation for the six-month period from January 1 to July 1, 2016, is $1,800 ($3,600 per year × 1/2 year = 1,800). The effect of the transaction for depreciation can be identified and analyzed as follows:

Example 8.7—Calculating the Gain on Sale of an Asset Assume that ExerCo purchased a machine on January 1, 2014, for $20,000, estimating its life to be five years and the residual value to be $2,000. ExerCo used the straight-line method of depreciation. ExerCo sold the machine on July 1, 2016,for $12,400. The gain can be calculated as follows:

Example 8.7—Calculating the Gain on Sale of an Asset (continued) After the July 1 entry, the balance of the Accumulated Depreciation—Machine account is $9,000, which reflects depreciation for the 2½ years from the date of purchase to the date of sale. The effect of the transaction for the sale can be identified and analyzed as follows:

Example 8.8—Calculating the Loss on Sale of an Asset Assume that ExerCo purchased a machine on January 1, 2014, for $20,000, estimating its life to be five years and the residual value to be $2,000. ExerCo used the straight-line method of depreciation. ExerCo sold the machine on July 1, 2016,for $10,000. The loss is calculated as follows:

Example 8.8—Calculating the Loss on Sale of an asset (continued) The effect of the transaction for the sale can be identified and analyzed as follows:

IFRS and Property, Plant, and Equipment IFRS requires estimates of residual value and the life of the asset be reviewed at least annually FASB standards does not require the annual review The international standards also indicate that companies should determine the components of an asset and depreciate each component separately International Standards allow companies to revalue the assets to reflect their fair market values FASB does not allow the revaluing to fair market value

Operating Assets: Intangible Assets Assets with no physical properties Long-term assets and should be shown separately from property, plant, and equipment LO 9

Operating Assets: Intangible Assets Most common intangible assets: Patent: right to use, manufacture, or sell a product Copyright: right to reproduce or sell a published work Trademark: symbol or name that allows a product or service to be identified Goodwill: excess purchase price to acquire a business over the value of net assets acquired

Acquisition Cost of Intangible Assets Includes cost to acquire and prepare it for its intended use Acquisition Cost (i.e., legal fees, registration fees, etc.) Purchase Price +

Exhibit 8.4—The Nike, Inc., Consolidated Assets Section and Intangibles Notes

Research and Development Costs Costs incurred in the discovery of new knowledge According to FASB, all such expenditures must be treated as expenses in the period incurred Patent account should not include the costs of research and development of a new product

Amortization of Intangibles Intangibles with finite life must be amortized Recorded over the legal life or the useful life, whichever is shorter Mostly recorded using the straight-line method Intangibles with indefinite life are not amortized Example: trademark, goodwill, and broadcast license LO 10

Example 8.9—Calculating the Amortization of Intangibles Assume that Nike developed a patent for a new shoe product on January 1, 2014. The costs involved with patent approval were $10,000, and the company wants to record amortization on the straight-line basis over a five-year life with no residual value. In this case, the useful life of the patent is less than the legal life. Nike should record amortization over the useful life as $10,000/5 years = $2,000. The effect of the amortization for 2014 is as follows:

Example 8.9—Calculating the Amortization of Intangibles Some companies decrease (credit) the intangible asset account directly. In that case, the preceding transaction is recorded as follows:

Intangibles with Indefinite Life If an intangible asset has an indefinite life, amortization should not be recognized

Goodwill and Impairments As per the FASB, goodwill should be treated as an intangible asset with an indefinite life and that companies should not record amortization expense related to goodwill Each year, Assets with indefinite life should be checked for impairment If an impairment has occurred, a loss should be recognized

Goodwill and Impairments Assume that Nike learns on January 1, 2015, when accumulated amortization is $2,000 (or the book value of the patent is $8,000), that a competing company has developed a new product that renders Nike’s patent worthless. Nike has a loss of $8,000 and should record an entry to write off the asset as follows:

IFRS and Intangible Assets International standards are more flexible than the FASB standards in allowing the use of fair market values for intangible assets Active market must exist Fair value must be possible to determine Research and development costs FASB: all such costs should be treated as an expense IFRS: Research costs be treated as an expense and development costs can be capitalized as an asset

Exhibit 8.5—Long-Term Assets and the Statement of Cash Flows

Analyzing Long-term Assets—Average Life Ratios are used to determine the age, composition, and quality of the operating assets What is the average depreciable period (or life) of the company’s assets? Property, Plant, and Equipment Depreciation Expense Average Life = LO 12

Analyzing Long-term Assets—Average Age Are assets old or new? Accumulated Depreciation Depreciation Expense Average Age =

Analyzing Long-term Assets—Asset Turnover How productive are the company’s assets? Net Sales Average Total Assets Asset Turnover =

The Ratio Analysis Model What is the average life of the assets? What is the average age of the assets? How productive are the assets in producing revenue for the company? Gather the information about net sales and cost of goods sold Calculate the average life and average age Compare the ratio with prior years and with competitors Interpret the ratios

The Business Decision Model If you were a lender, would you be willing to lend money to Nike, Inc., and use the operating assets as collateral for the loan? Gather information from the financial statements and other sources Compare the ratios with industry averages and look at trends Lend money or find an alternative use for the money Monitor the investment periodically

End of Chapter 8