1 PRINCIPLES OF ACCOUNTING Lecture 11 Reporting non-current assets

Lecture Outline Classification of Long lived assets –Tangible assets –Intangible assets Property, Plant and Equipment (PPE) –Acquisition cost –Depreciation –Disposal 2

Classification of long lived assets Tangible assets: have physical substance. –Land –Buildings, fixtures, and equipment –Natural Resources Intangible assets are long lived assets without physical substance that confer specific rights on their owner 3

Acquisition of PPE Plant assets are initially recorded at acquisition cost. Acquisition cost should include all of the costs that are normal and necessary to acquire the asset and prepare it for its intended use. –Items included in acquisition cost would generally include purchase price, taxes paid at time of purchase, incidental costs, renovation and repairs costs incurred prior to the asset’s use, transportation charges, installation costs. 4

Which costs to be included? A firm purchased a photocopier for $5,000 and incurred the following additional costs: –Freight on photocopier$100 –Insurance in transit $20 –Cost of installation & testing$100 –Cost of carpet shampoo in photocopier room prior to install $50 5

Acquisition cost Eg., Delta purchased a new 737 aircraft from Boeing for list price of $63m; was offered a discount of $4m, paid $0.2m delivery cost and $0.8m preparation costs. 6

Recording acquisition for cash Assuming Delta paid cash for the aircraft and related cost. The transaction is recorded as follows: Dr. Flight Equipment$60m Cr. Cash$60m 7

Recording acquisition for debt Assuming Delta signed a note payable for the new aircraft and paid cash for the transportation and preparation cost. The transaction is recorded as follows: Dr. Flight Equipment$60m Cr. Cash $1m Cr. Note payable$59m 8

Recording acquisition for Equity Assuming Delta gave Boeing 400,000 shares of its $3 par value common stock with market value of $85 per share and paid the balance in cash. Dr. Flight Equipment$60m Cr. Common stock$1.2m Cr. Additional paid in capital$32.8m Cr. Cash$26m 9

Recording acquisition by construction A company may construct an asset for its own use instead of buying from a producer The acquisition cost of that asset includes all the necessary costs associated with construction such as labor cost, materials and “ capitalised interest”. Capitalised interest represents interest expenditures included in the cost of a self- constructed asset 10

A lump-sum purchase of asset A lump-sum purchase: the purchase price should be allocated to different items on the basis of the proportion of the fair market value. 1 Jan, Payton purchased building and land for $100,000 –Estimated market value for land is $30,000 and for building is $90,000. Total is $120,000 –Allocation of purchase price : –Land: $100,000 * (30,000/120,000) = $25,000 –Building: $100,000 * (90,000/120,000) = $75,000 11

Capital versus revenue expenditure A capital expenditure is a cost that improves the asset and is added to the cost of the asset. A revenue expenditure is a cost that keeps an asset in its normal operating condition and is treated as an expense. If an expenditure increases the life of the asset or its productivity, it should be treated as a capital expenditure and added to the asset account. If an expenditure simply maintains the productive capacity of the asset during the current accounting period only, it should be treated as an expense. 12

Depreciation The allocation of the cost of the asset over its useful life Expense Non-cash item Process of allocation not valuation 13

Depreciation Factors contributing to decline in value of a non- current asset –Wear and tear through physical use of asset –Technical obsolescence –Commercial obsolescence Depreciation is made to ensure matching principle. 14

Depreciation 3 factors in calculating depreciation 15

Accumulated depreciation The amount of depreciation that has accumulated since the purchase of the asset. Contra asset account Increase by a credit Decrease by a debit Normal balance is credit balance 16

Net book value or carrying value This is the value of the asset after subtracting depreciation from the original cost of the asset. That is, cost less accumulated depreciation Represents the value of the asset in the accounting records. 17

Depreciation methods Straight-line method Reducing-balance Units of production 18

Lecture example Truck Purchase(cost):$100,000 Estimated Useful Life:5 years Residual Value:$ 10,000 Useful life in kilometres90,000 Year 120,000 kilometres Year 230,000 kilometres Year 310,000 kilometres Year 420,000 kilometres Year 510,000 kilometres 19

Straight line method Depreciation expense the same amount every year over the useful life of the asset. Formula Depreciation=Cost – Residual Value exp p.aEstimated Useful Life 20

Straight line method YearDepreciation Accumulated depreciationBook value ,000 21

Reducing balance method Applied at a particular rate –Double declining method: applied at double of the straight line rate. Calculated on last periods book value Accelerated method –Why? Because more of the depreciation cost is allocated to the earlier years of an asset’s life and less depreciation to the latter years. 22

Reducing balance method Reducing balance rate = double the straight-line rate. –What is the depreciation rate? What is the depreciation expense in each of the five years? What is the book value at the end of the fifth year? 23

24 Reducing balance method YearDepreciation Accumulated depreciationBook value ,000

Units of production This method assumes that depreciation is solely through the usage of the asset Allocates depreciation based on the units of output or use during each period of an assets useful life 25

26 Units of production YearDepreciation Accumulated depreciationBook value ,000

Comparison of depreciation method The choice of depreciation method can have a significant impact on firms’ financial statements. The method to be selected should be chosen on the basis of best satisfying the matching principle. The choice of depreciation method should be linked to the nature of asset being considered. A business may use both methods for different assets that have different revenue-earning patterns. 27

28 Choice of depreciation method FactorLikely choice SimplicityStraight line method Reporting to stockholdersStraight line method ComparabilitySame method with others in the same industry or line of business Management bonus planStraight line method Technological competitiveness Accelerated method Reporting for tax purposeAccelerated method

Disposal of PPE When an asset is disposed, all accounts related to it must be removed. The asset account and accumulated depreciation should be eliminated from the balance sheet. The gain or loss on sale of asset is recorded as Other income/ expense in the income statement. 29

Disposal of PPE Example: 1 Jan 20X7, a machine is purchased for $20,000 Estimated residual value: $2,000, estimated useful life:5 years Assume it is sold on 1 Jul 20X9. Accumulated depreciation up to 1 Jul 20X9 (2.5 years) = {(20,000 – 2,000)/5} * 2.5 = 9,000 30

Disposal of PPE Proceeds from sale of the machine is $12,400 Book value = Cost – Accumulated depreciation = 20,000 – 9,000 = 11,000 Gain on sale = 12,400 – 11,000 = 1,400 1 Jul 20X9 Dr Accumulated depreciation 9,000 Dr Cash12,400 Cr Machine20,000 Cr Gain on sale of asset 1,400 31

Disposal of PPE Proceeds from sale of the machine is $10,000 Book value = Cost – Accumulated depreciation = 20,000 – 9,000 = 11,000 Loss on sale = 11,000 – 10,000 = 1,000 1 Jul 20X9 Dr Accumulated depreciation 9,000 Dr Cash10,000 Dr Loss on sale of asset 1,000 Cr Machine 20,000 32

Intangibles Patents Copyrights Trademarks, brand names Franchises, licenses Goodwill 33

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