Reporting and Interpreting Property, Plant and Equipment; Natural Resources; and Intangibles Chapter 8 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Tangible Physical Substance Intangible No Physical Substance Expected to Benefit Future Periods Actively Used in Operations 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 Examples Value represented by rights that produce benefits Definite life Patents Copyrights Franchises Indefinite life Trademarks Goodwill Examples

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. 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 Buildings Purchase price Renovation and repair costs Legal and realty fees Title fees

Measuring and Recording Acquisition Cost Equipment Purchase price Installation costs Modification to building necessary to install equipment Transportation costs 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 Land Purchase price Real estate commissions Title insurance premiums Delinquent taxes Surveying fees Title search and transfer fees Land is not depreciable.

On January 1, Southwest Air Lines purchased aircraft for $70,000,000 cash. Measuring and Recording Acquisition Cost Acquisition for Cash On January 14, Southwest Air Lines purchased aircraft for $1,000,000 cash and a $69,000,000 note payable. Acquisition for Debt

Repairs, Maintenance, and Additions

To solve this problem, many companies have policies regarding the expensing of all expenditures below a certain amount according to the materiality constraint.

Depreciation is a cost allocation process that systematically and rationally matches acquisition costs of operational assets with periods benefited by their use. Cost Allocation (Unused) Balance Sheet (Used) Income Statement Expense Depreciation Concepts Acquisition Cost 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. 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 Alternative depreciation methods:  Straight-line  Units-of-production  Accelerated Method: Declining balance

Straight-Line Method Cost - Residual Value Life in Years Depreciation Expense per Year 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 = Depreciation Expense per Year = $20,000 $62,500 - $2,500 3 years

Residual Value SL More companies use the straight-line method of depreciation in their financial reports than all other methods combined. Straight-Line Method

Units-of-Production Method Depreciation Rate = Cost - Residual Value Life in Units of Production Step 1: Step 2: Depreciation Expense = Depreciation 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?

Units-of-Production Method $62,500 - $2, ,000 miles = $.60 per mile Depreciation Rate = Step 1: Step 2: $.60 per mile × 30,000 miles = $18,000 Depreciation Expense = Residual Value

Accelerated Depreciation Depreciation Repair Expense Early Years High Low Later Years Low High 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.

Declining-Balance Method Annual Depreciation expense Net Book Value () Useful Life in Years 2 = × Cost – Accumulated Depreciation Declining balance rate of 2 is double-declining- balance (DDB) rate. Annual computation ignores residual value. 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.

Annual Depreciation expense Net Book Value () Useful Life in Years 2 = × () $62,500 × 3 years 2 = $41,667 () ($62,500 – $41,667) × 3 years 2 = $13,889 Declining-Balance Method Year 1 Depreciation: Year 2 Depreciation:

() ($62,500 – $55,556) × 3 years 2 = $4,629 Below residual value Declining-Balance Method

Depreciation expense is limited to the amount that reduces book value to the estimated residual value. Declining-Balance Method

Work on E8-4 and E8-7