1 Chapter 7 Plant Assets, Intangible Assets, and Related Expenses

2 Learning Objective 1 Determine the cost of a plant asset.

3 Types of Assets Long-lived assets used in operations –Plant Assets (a.k.a. known in practice as “Property, Plant, and Equipment”) –Intangible Assets

4 Plant Assets: Terminology for Expensing of Plant and Intangible Assets Plant Assets - Depreciation Natural Resources - Depletion Intangibles - Amortization

5 What is Included in the Cost Basis of Plant Assets and Intangibles? All ordinary and necessary costs incurred to bring the asset to its useable state are included in the cost basis Following are examples of this principle [slide no. 6, etc.]

6 Determining the Cost of Land A business signs a $300,000 note payable to purchase land for a new store site. It pays: –$10,000 in back property tax –$8,000 in transfer taxes –$5,000 for removal of an old building –$1,000 survey fee –$260,000 to pave the parking lot.

7 What is the Cost of the Land? Purchase price of land$300,000 Add related costs: Back property taxes$10,000 Transfer taxes8,000 Removal of existing buildings 5,000 Survey fees 1,000 24,000 Total cost of land$324,000 Note that cost of paving the parking lot is not included in above.

8 Why are Parking Lot Costs not Included in the Cost Basis of the Land? The land has an indefinite life and is not depreciated, unless there has been an impairment in value, though that is rare However, the parking lot ($260,000 cost) will have a finite life, and therefore depreciated over its estimated useful life [till it has to be replaced] Thus, land improvements would be accounted for in a separate “Land Improvements “ plant asset account These land improvement costs would be depreciated over their useful lives

9 Land Improvements Account Would Include Cost of fencing Paving Security systems Lighting in parking lot Sprinkler systems

10 Determining the Cost of Buildings: Self Constructed by the Entity Architectural fees Building permits Contractor’s charges Materials Direct Labor on this project An allocation of Overhead Cost of construction loan interest

11 Determining the Cost of Buildings: Purchased by the Entity Purchase price Brokerage commissions Sales and other taxes Repairing or renovating building for its intended purpose

12 Determining the Cost of Machinery and Equipment Purchase price less discounts, if any Transportation charges Insurance in transit Sales and other taxes pursuant to the transaction Purchase commission Installation costs Expenditures to test the asset Special platforms or other modifications

13 Determining the Cost of Land and Leasehold Improvements Land improvements –Paving –Fences –Sprinkler systems –Lights in parking lot

14 Lump-Sum (or Basket) Purchases of Assets Xerox Corporation paid $2,800,000 for a combined purchase of land and a building. The land is appraised at $300,000 and the building at $2,700,000. The purchase price ($2,800,000) is allocated to land and building based upon proportionate appraisal (fair) values

15 Lump-Sum (or Basket) Purchases of Assets Total appraised value = $3,000,000 Land: $300,000 ÷ $3,000,000 = 10% $2,800,000 × 10% = $280,000 Building: $2,700,000 ÷ $3,000,000 = 90% $2,800,000 × 90% = $2,520,000

16 YES Capital Expenditure versus Period Expense NO YES NO

17 Learning Objective 2 Accounting for depreciation of plant assets

18 What Depreciation is (and isn’t) The allocation of the cost of a plant asset as expense to future periods benefited by the use of the fixed asset Depreciation is not intended to be a valuation technique, i.e… It would be sheer coincidence if the fair market value of an asset at any time was the same as its book value (asset cost minus accumulated depreciation to date)

19 Straight-line (SL) Units-of-production (UOP) Double-declining balance (DDB) Depreciation Methods

20 Depreciation Methods Data ItemsAmount Cost of truck$41,000 Estimated residual value( 1,000) Depreciable cost$40,000 Estimated useful life 5 years Est’d units of production 100,000 miles

21 (Cost – Residual value) ÷ Years of useful life ($41,000 – $1,000) ÷ 5 = $8,000 Year 1 depreciation:$ 8,000 Year 2 depreciation:8,000 Year 3 depreciation:8,000 Year 4 depreciation:8,000 Year 5 depreciation: 8,000 Total depreciation:$40,000 Straight-Line Method

22 ($41,000 – $1,000) ÷ 100,000 = $.40/mile Year 1: 20,000 miles × $.40 =$ 8,000 Year 2: 30,000 miles × $.40 = 12,000 Year 3: 25,000 miles × $.40 = 10,000 Year 4: 15,000 miles × $.40 = 6,000 Year 5: 10,000 miles × $.40 = 4,000 $40,000 Units-of-Production Method

23 Double-Declining-Balance Method Straight-line rate per year: 100% ÷ 5 = 20% Multiply the straight-line rate times 2, e.g.: 20% x 2 = 40% Multiply 40% times book value at beginning of each period, ignoring residual (salvage) value In last year, depreciation is amount needed to reduce book value to salvage value

24 Double-Declining-Balance Method Book value of truck at the end of the first year: $41,000 × 40% = $16,400 $41,000 – $16,400 = $24,600 (40% is multiplied by $24,600 for depreciation in next period, etc.)

25 Comparing Depreciation Methods Year Total SL $ 8,000 8,000 $40,000 UOP $ 8,000 12,000 10,000 6,000 4,000 $40,000 DDB $16,400 9,840 5,904 3,542 4,314 $40,000 Amount of Depreciation per Year

26 Depreciation Methods Used by 600 Public Companies 84% Straight-line 5% Units-of-production 10% Accelerated 1% Other

27 Learning Objective 3 Select the best depreciation method.

Relationship Between Depreciation and Taxes Cash revenues$400,000$400,000 Cash operating expenses 300, ,000 Cash provided by operations before tax$100,000$100,000 Depreciation expense 8,000 16,400 Income before income tax$ 92,000$ 83,600 Income tax expense (30%) 27,600 25,080 Net income$ 64,400$ 58,520 Straight-lineAccelerated ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Relationship Between Depreciation and Taxes Cash-flow analysis$100,000$100,000 Income tax expense 27,600 25,080 Cash provided by operations before taxes$ 72,400$ 74,920 Extra cash available for investment if DDB is used ($74,920 – $72,400)$ 2,520 Straight-lineAccelerated ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

30 Companies Can Use Differing Methods for Book and Tax Depreciation St. line depreciation can be used for book (reporting) purposes While using DDB for tax purposes, reducing taxes This is an acceptable practice, but creates a difference between book and tax income, causing deferred income tax liabilities Accounting majors will learn about this in ACCT 3312

31 Modified Accelerated Cost Recovery System (MACRS) Assets are grouped into one of eight classes identified by asset life: 3 yr. lives, 5 yr. lives, 7 yr. lives…39 yr. lives. This framework can only be used for tax purposes

32 Depreciation for Partial Years Suppose a calendar-year closing business purchases a building on April 1 for $500,000 with an estimated life of 20 years and an estimated residual value of $80,000. What is the current year’s depreciation using the straight-line method?

33 Partial-year depreciation: $21,000 × 9/12 = $15,750 Depreciation for Partial Years Full-year depreciation: ($500,000 – $80,000) ÷ 20 = $21,000

34 Assume an asset cost of $50,000, an ten-year useful life with no residual value, and the straight-line method. $50,000 ÷ 10 = $5,000 depreciation per year Changing the Useful Life of a Depreciable Asset What is the book value after four years? $50,000 – $20,000 = $30,000

35 Changing the Useful Life of a Depreciable Asset Management determines that the asset will be useful for an additional ten years. How much depreciation expense would be recognized each year starting in year five? $30,000 / 10 years = $3,000

36 Learning Objective 4 Analyze the effect of a plant asset disposal.

Accounting for Disposal of Plant Assets: Example Fixtures cost:$4,000 Accumulated depreciation:$3,000 Book value $1,000 Accumulated Depreciation3,000 Loss of Disposal of Asset1,000 Store Fixtures4,000 To dispose of store fixtures Accumulated Depreciation3,000 Loss of Disposal of Asset1,000 Store Fixtures4,000 To dispose of store fixtures ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

38 Selling a Plant Asset: Example Equipment which cost $10,000 on 1/1/2002 is sold on 9/30/2005 for $5,000. It has been depreciated on a straight-line basis over its 10 years’ estimated useful life. There is no residual value.

39 Selling a Plant Asset: Example What is the accumulated depreciation on September 30, 2005? $10,000 ÷ 10 = $1,000/year $1,000 × 3 years = $3,000 $1,000 × 9/12 = $750 $3,000 + $750 = $3,750

Selling a Plant Asset: Example Sep 30Cash5,000 Accumulated Depreciation3,750 Loss of Sale of Equipment1,250 Equipment10,000 To record sale of equipment. ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

41 Exchanging Plant Assets Assume than an old delivery car with a cost of $9,000 and accumulated depreciation of $8,000 (book value of $1,000) is exchanged for a new car. Cash payment is $10,000. What is the cost of the new car? $10,000 + $1,000 = $11,000

Exchanging Plant Assets Delivery Auto (new)11,000 Accumulated Depreciation (old)8,000 Delivery Auto (old)9,000 Cash10,000 To record exchange of auto. ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

43 Learning Objective 5 Account for natural resources and depletion.

44 Natural gas and oil Precious metals and gems Timber, coal, and iron ore (Cost – Residual value) ÷ Estimated units of natural resource = Depletion per unit Accounting for Natural Resources and Depletion

45 Accounting for Natural Resources and Depletion Assume an oil lease cost $100,000 and contains an estimated 10,000 barrels of oil. If 3,000 barrels are extracted during the year,depletion expense is $30,000. Accumulated Depletion is a contra account similar to Accumulated Depreciation Depletion rate: $100,000 ÷ 10,000 = $10 per barrel.

46 Learning Objective 6 Account for intangible assets and amortization

47 Intangible Assets Have no physical form –Patents –Copyrights –Trademarks –Franchises –Leaseholds –Goodwill

48 Intangible Assets Amortization expense - can be written off directly as credits against the intangible asset account That is, no “accumulated amortization” is ordinarily recorded Assets with an indefinite useful life are not amortized. All intangible assets are subject to impairment

49 Intangible Assets: Patents Federal government grants giving holder the right to produce and sell an invention. Suppose a company pays $170,000 to acquire a patent on January 1. The company believes that its expected useful life is 5 years.

Intangible Assets: Patets Jan 1Patents170,000 Cash170,000 To record acquisition of patent. Dec 31Amortization Expense34,000 Patents34,000 To amortize cost of patent ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

51 Literary compositions (novels) Musical compositions Films (movies) Software Other works of art Extend 50 years beyond author’s life. Intangible Assets: Copyrights

52 Trademarks, Trade Names, or Brand Names - assets that represent distinctive identifications of a product or service Intangible Assets: Trademarks

53 Intangible Assets: Franchises Privileges granted by private business or government to sell a product or service

54 Intangible Assets: Goodwill An intangible asset created by purchasing a business and paying more than the fair value of the net assets (assets minus liabilities) acquired This excess of purchase price over fair value is for factors causing unusual earnings power, e.g. market or locational competitive advantages, reputation Goodwill is not amortized, unless there has been an impairment in its value

55 Purchase price paid for Mexana Company$10 million Assets at fair market value$9 million Less: Mexana’s liabilities$1 million Market value of Mexana’s net assets 8 million Goodwill$ 2 million Intangible Assets: Goodwill

56 Research and Development Ordinarily expensed (in the U.S.) as it is incurred, for reasons of financial statement comparability Only capitalized as an asset if a contract guarantees that the R&D costs incurred will be recovered from a customer who has requested the research and development activity

57 End of Chapter 7