Fixed Assets LECTURE 5 Issah Hamdu Faculty of Business Management and Globalization Tel : (Ext 8403) BACCT1201 Financial Accounting

BACCT1201Financial Accounting2 Objectives At the end of the lecture, students should be able to: Explain with examples what is fixed assets /plant assets/long-term assets. Define, explain and demonstrate how to compute depreciation expense using various methods of depreciation.

Objectives.... Explain the impact of various depreciation methods on income statement. To let students realized that depreciation is a discretionary management policies. Explain why the Inland Revenue Dept. does not recognize depreciation but only gives recognition to their prescribed capital allowance rates. BACCT1201Financial Accounting3

BACCT1201Financial Accounting4 Acquisition and Use of Long-Term Operational Assets

BACCT1201Financial Accounting5 Classification of Operational Assets Operational assets are used by a business to generate revenue. Tangible operational assets have physical substance.  Land, buildings, fixtures, and equipment Learning Objective 1

BACCT1201Financial Accounting6 Long-term Operational Assets Long-term assets will be used more than one year. Tangible operational assets are reported on the balance sheet in a classification called: Property, Plant, and Equipment.

BACCT1201Financial Accounting7 Classification of Operational Assets Intangible operational assets lack physical substance and confer specific use rights on the owner. p Patents p Copyrights p Franchises p Licenses p Trademarks

BACCT1201Financial Accounting8 Measuring and Recording Acquisition Cost Purchased operational assets are recorded at cost, an amount that includes all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use.  Invoice price  Sales taxes  Transportation costs  Installation costs  Renovation and repair cost incurred prior to use.

BACCT1201Financial Accounting9 Measuring Acquisition Cost Acquisition cost is the net cash equivalent amount paid for the asset. Financing charges are excluded from the acquisition cost but should be reported as interest expense.

BACCT1201Financial Accounting10 Measuring Acquisition Cost The cost of land includes:  Acquisition price  Real estate commissions  Attorneys’ fees  Preparing the land for use  Tearing down existing structures Land is not depreciated.

BACCT1201Financial Accounting11 Basket Purchase of Acquisitions When land and building are purchased together, the land cost and the building cost are placed in separate accounts. The total cost of the purchase is separated on the basis of relative market values.

BACCT1201Financial Accounting12 Basket Purchase of Acquisitions Example: Suppose a company purchased land and a building for RM100,000 cash. The appraised value of the building was RM90,000, and the land was appraised at RM30,000. How much of the RM100,000 purchase price will be allocated to each account?

BACCT1201Financial Accounting13 Fair Market Values: BuildingRM 90,000 LandRM 30,000 Total market valueRM120,000 Allocation of cost: Building90,000/120,000 = 3/4 Land30,000/120,000 = 1/4 Basket Purchase of Acquisitions

BACCT1201Financial Accounting14 Fair Market Values: BuildingRM 90,000 LandRM 30,000 Total market valueRM120,000 Allocation of cost: Building3/4 X RM100,000 = RM75,000 Land1/4 X RM100,000 = RM25,000 Basket Purchase of Acquisitions

BACCT1201Financial Accounting15 Cost of asset on Balance Sheet...as the asset is used..... is used..... Expense on Income Statement CapitalizeExpense The matching principle requires that part of the acquisition cost be expensed in periods when the future revenues are earned. Learning Objective 2 Depreciation, Depletion, and Amortization

BACCT1201Financial Accounting16 Terminology: Write-off….amortize franchise Depletion: Depletion: –Natural resources The most general term for writing off an asset is amortization. However, specific terms are used for certain assets: Amortization: Intangible assets Depreciation: Property, plant, equipment

BACCT1201Financial Accounting17 Cost - Residual Value Life in Years Depreciation Depreciation Expense per Year = Straight-line Straight-line Units of production method Units of production method (Double) Declining balance (Double) Declining balance Depreciation Methods

BACCT1201Financial Accounting18 Straight-Line Method: Example On January 1, 2003, a juice machine was purchased for RM11,500 cash. The equipment has an estimated useful life of 6 years and an estimated residual value of $500. Delivery and installation costs are RM1,000. What is the annual straight-line depreciation expense?

BACCT1201Financial Accounting19 Depreciation Depreciation Expense per Year = Depreciation Depreciation Expense per Year = Cost - Residual Value Life in Years Depreciation Expense per Year = Straight-Line Method: Example Cost = all costs to prepare machine for use. Acquisition plus delivery and installation costs. RM12,500 – RM2,000

BACCT1201Financial Accounting20 RM2000 The Accumulated depreciation account balance at the end of the second year is: Straight-Line Method: Example RM4,000. Accumulated depreciation amounts are identical to the amount of depreciation expensed each year. However, the accumulated depreciation account will increase each year by:

BACCT1201Financial Accounting21 Units-of-Production Method Step 1: Depreciation Rate Rate= Acquisition Cost - Salvage Value Acquisition Cost - Salvage Value Estimated units of useful life Step 2: Depreciation Expense Expense=Depreciation Rate Rate× Number of Units Produced for the Year

BACCT1201Financial Accounting22 We will use the same information from the previous example [a juice machine was purchased for $11,500 cash. The equipment has an estimated useful life of 6 years and an estimated residual value of $500. Delivery and installation costs are $1,000]. It is estimated that the machine will squeeze 240,000 glasses of juice over its useful life. What is the depreciation rate per glass? It is estimated that the machine will squeeze 240,000 glasses of juice over its useful life. What is the depreciation rate per glass? If 36,000 glasses were squeezed the first year, what is the amount of the depreciation expense for the year? Units-of-Production Method

BACCT1201Financial Accounting23 Step 1: Calculate the per glass rate. Step 2: Calculate the annual depreciation expense. Depreciation Expense Expense = $ 0.05/glass* 36,000 glasses = $1,800 $ 0.05/glass* 36,000 glasses = $1,800 Depreciation Rate Rate = = Cost - salvage value Total Productive output 12, ,000 glasses Dep. rate X units produced this year Dep. rate X units produced this year Production Method: Example =$0.05

BACCT1201Financial Accounting24 Accelerated Depreciation Accelerated depreciation methods result in more depreciation expense in the early years of an asset’s useful life and less depreciation expense in later years of the an asset’s useful life.

BACCT1201Financial Accounting25 Double-Declining Balance Method Declining-balance depreciation is based on the straight-line rate multiplied by an acceleration factor. For example, when the acceleration factor is 200 percent, the method is referred to as double-declining balance depreciation. Declining-balance depreciation computations ignore residual value, although the asset can’t be depreciated below the residual value.

BACCT1201Financial Accounting26 The annual depreciation amount is calculated with the following formula: First, calculate a rate by multiplying the book value by [2 divided by the number of years of useful life]. = Double-Declining Balance Method Yearly depreciation expense () Book Value × Useful Life in Years 2

BACCT1201Financial Accounting27 We will use the same information from the previous example [a juice machine was purchased for $11,500 cash. The equipment has an estimated useful life of 6 years and an estimated residual value of $500. Delivery and installation costs are $1,000]. Calculate the depreciation expense for the first two years of the asset’s life. Double-Declining-Balance Example

BACCT1201Financial Accounting28 Double-Declining-Balance Example First year’s depreciation: Second year’s depreciation: $12,500 X 1/3 = $4,167 $8,333 X 1/3 = $2,778 (rounded) Rate = 2/6 = 1/3 year Rate = 2/6 = 1/3 year Cost - previous year’s depreciation expense: $12,500 - $4,167 = $8,333

BACCT1201Financial Accounting29 Comparison of Methods The total amount of depreciation recorded over the useful life of an asset is the same regardless of the method used. Depreciation expense recorded in any one period will vary according to method used. The straight-line method is used by about 95 percent of companies because it is easy to use and to explain.

BACCT1201Financial Accounting30 A depletion rate is calculated using the units-of-production method. Depletion Cost Per Unit Is Calculated As Follows: Total Cost of Natural Resource Estimated Number of Available Units of Natural Resource Natural Resources

BACCT1201Financial Accounting31 Natural Resources Total cost of the asset is the cost of acquisition, exploration and development. Total cost is apportioned by means of depletion over periods in which resulting revenues are earned.

BACCT1201Financial Accounting32 Natural Resources Assets supplied by nature Examples: gold, oil, and coal Examples: gold, oil, and coal Presented on balance sheet as non-current assets at cost less depletion to date. Presented on balance sheet as non-current assets at cost less depletion to date. Depletion is just like “units of production” depreciation. Depletion is just like “units of production” depreciation.

BACCT1201Financial Accounting33 Intangible Assets Learning Objective 3 Noncurrent assets without physical substance that confer certain rights and privileges on the owner of the asset. Examples: patents, copyrights, franchises and licenses, leaseholds, leasehold improvements, trademarks, and goodwill. Purchased intangible assets are recorded at cost.

BACCT1201Financial Accounting34 Purchased intangible assets are amortized over the shorter of their useful life or legal life, whichever is longer. Purchased intangible assets are amortized over the shorter of their useful life or legal life, whichever is longer. Normally the straight-line method is used and the asset is reported in the balance sheet at book value. Normally the straight-line method is used and the asset is reported in the balance sheet at book value. Patent Intangible Assets

BACCT1201Financial Accounting35 Intangible Assets Intangible assets such as Goodwill are subject to Impairment: a permanent reduction in its market value. The asset will be evaluated for any permanent decline in value. The asset value will be reduced by the amount of decline in value, and an expense will be recognized in the income statement. Impairment may be due to: Impairment may be due to: A downturn in the economy A downturn in the economy A change in how the company uses the asset A change in how the company uses the asset A change in the business climate A change in the business climate

BACCT1201Financial Accounting36 Accounting for Capital Expenditures Learning Objective 4 Extend the life? Extend the life?  viewed as canceling some of the previous depreciation  reduce accumulated depreciation  new depreciation amount will be calculated Improve the quality? Improve the quality?  viewed as an additional cost of the equipment  Increases the cost of the asset  new depreciation amount will be calculated

BACCT1201Financial Accounting37 Accounting for Capital Expenditures Expenditures made to keep an asset in good working order are expensed in the period in which they are incurred. Substantial costs spent to improve the quality or extend the life of an asset are capitalized.

BACCT1201Financial Accounting38 Revising Estimates of Salvage Value or Useful Life When an estimate is revised, no changes are made to amounts reported in the past. The new estimates are incorporated into the present and future calculations only. Depreciation amounts are revised using the book value and the estimated useful life and salvage value at beginning of the year of the revision.

BACCT1201Financial Accounting39 Disposal of Operational Assets Learning Objective 5 Voluntary disposal refers to situations where a business gives up ownership of an asset by:  Sale  Trade-in  Retirement Involuntary disposal results because of a casualty such as a fire or an accident. Involuntary disposal results because of a casualty such as a fire or an accident.

BACCT1201Financial Accounting40 Disposal of Operational Assets 1. Update the depreciation on the asset to the date of disposal. 2. Compare the book value of the asset to the cash proceeds from the disposal. If the proceeds > book value, there is a gain on the disposal. If the book value > proceeds, then there is a loss on the sale. 3. Gains and losses go on the income statement.

BACCT1201Financial Accounting41 asset for sale Disposal of Operational Assets Compare cash received for the asset with the asset’s book value (BV).  If cash greater than BV, record a gain.  If cash less than BV, record a loss.  If cash equals BV, no gain or loss.

BACCT1201Financial Accounting42 Asset Disposal: Example Suppose you decide to sell an asset for RM8,000 that was purchased 7 years ago for RM25,000 with accumulated depreciation of RM17,500.

BACCT1201Financial Accounting43 Asset Disposal: Example Compare the Book Value (RM7,500 = RM25, ,500) to the cash proceeds (RM8,000). The difference is a gain or loss on the sale. It is a gain because the proceeds of RM8,000 > BV of RM7,500 RM500 gain is reported on the income statement.

BACCT1201Financial Accounting44 Now suppose you sell the asset for $5,000. Compare the Book Value (RM7,500 = RM25,000 17,500) to the cash proceeds (RM5,000). 17,500) to the cash proceeds (RM5,000). The difference is a gain or loss on the sale. This is a loss: Book value of RM7500 > Proceeds of RM5,000 RM2500 loss is reported on the income statement. Asset Disposal: Example

BACCT1201Financial Accounting45 Presentation of Long-term Assets Long-term assets are shown on the balance sheet valued at amortized or depreciated cost which is the carrying value. Carrying value is the difference between the cost of the asset and its accumulated depreciation. Balance Sheet Learning Objective 6

BACCT1201Financial Accounting46 Presentation of Long-term Assets The use of Long-term assets is shown on the income statement with amortization or depreciation expense. Gains and losses on disposal of long-term assets are reported on the income statement, too. The statement of cash flows will show any cash expenditures for long-term assets or any cash collected from the sale of long-term assets. Income Statement Statement of Cash Flows

BACCT1201Financial Accounting47 Firms risk losing long-term assets due to theft especially for its smaller, mobile, fixed assets. Even large assets are at risk for damage due to vandalism, hurricanes, or terrorists’ activities. Learning Objective 8 1. Physical controls such as locks on a warehouse door, video cameras, security guards on duty, fences, and alarms. 2. Segregation of duties: People who are responsible for the record keeping should be different than those who have physical control of the assets to help assure complete and reliable record keeping. 3. Monitoring all controls to ensure that all controls are in place and operating properly. Controls that safeguard assets and minimize these risks: Business Risk, Control, and Ethics

BACCT1201Financial Accounting48 Depreciation and Federal Income Taxes The accounting information a company reports on its financial statements is not the same information it reports to the IRS on its federal income tax return. For depreciating fixed assets, corporations use a method called the Modified Accelerated Cost Recovery System (MACRS). MACRS is allowed for tax purposes but not GAAP. Learning Objective 8

BACCT1201Financial Accounting49 Depreciation and Federal Income Tax Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes. MACRS provides for rapid write-off of an asset’s cost in order to stimulate investment in modern facilities.

BACCT1201Financial Accounting50 End of Lecture 5 The End