1. Chapter 9 Long-Term Assets Skyline College Lecture Notes

2. 9–29–2 Copyright © Houghton Mifflin Company. All rights reserved. Long-Term Assets Useful life of more than one year Used in the operation of a business Not intended for resale Long-term assets might include:  Equipment  Vehicles  Property  Trademarks

3. 9–39–3 Copyright © Houghton Mifflin Company. All rights reserved. Carrying Value The unexpired cost of an asset (also called book value) Unexpired Cost = Cost – Accumulated Depreciation On the Balance Sheet:

4. 9–49–4 Copyright © Houghton Mifflin Company. All rights reserved. Classification of Long-Term Assets and Methods of Accounting for Them

5. 9–59–5 Copyright © Houghton Mifflin Company. All rights reserved. Asset Impairment When is an asset deemed impaired? When a long-term asset loses some or all of its potential to generate revenue before the end of its useful life Asset Impairment The carrying value of a long-term asset exceeds its fair value

6. 9–69–6 Copyright © Houghton Mifflin Company. All rights reserved. Acquiring Long-Term Assets How do companies make the decision to acquire long-term assets? Capital Budgeting Method of Evaluation Net Present Value Method Evaluates the purchase based on the net present value of acquisition cost, net annual savings in cash flows, and disposal price

7. 9–79–7 Copyright © Houghton Mifflin Company. All rights reserved. Apple Computer is considering the purchase of a $50,000 customer relations software package. Management estimates that the company will save $20,000 in net cash flows per year for four years, the usual life of the software. The software should be worth $10,000 at the end of that period. The interest rate is 10 percent compounded annually. Cash flows related to the purchase of the computer would be as follows: Net Present Value Method Present value Tables 3 and 4 can now be used to place the cash flows on a comparable basis.

8. 9–89–8 Copyright © Houghton Mifflin Company. All rights reserved. As long as the net present value is positive, Apple will earn a return of at least 10 percent. The return is greater than 10 percent on the investment. Based on this analysis, Apple should purchase the software. Example of Net Present Value Method (cont’d)

9. 9–99–9 Copyright © Houghton Mifflin Company. All rights reserved. Financing Long-Term Assets Financing alternatives: Use cash flow from operations Issue common stock Issue long-term notes Issue bonds Investors may investigate whether a company has free cash flow to finance long-term assets. Free cash flow is cash that remains after deducting funds committed to operations at current levels

10. 9–10 Copyright © Houghton Mifflin Company. All rights reserved. The Matching Rule and Long-Term Assets When a company purchases an asset, it may choose to capitalize it, thus deferring an expense to a later period Favorably impacts profitability for that current period Management uses ethical judgments in resolving two issues: 1.How much of the cost of a long-term asset should be allocated to expense in the current period? 2.How much should be retained on the balance sheet as an asset that will benefit future periods?

11. 9–11 Copyright © Houghton Mifflin Company. All rights reserved. Long-Term Asset Accounting Policies Each company must determine how it will treat long-term assets: 1.What is the cost of the long-term asset? 2.How should the expired portion of the cost of the asset be allocated against revenues over time? 3.How should subsequent expenditures, such as repairs and additions, be treated? 4.How should disposal of the long-term asset be recorded?

12. 9–12 Copyright © Houghton Mifflin Company. All rights reserved. Discussion: Ethics on the Job Brattman Company purchases a building and the land on which it is located for a lump sum. The accountant must allocate the purchase price between the building and the land. The accountant decides to allocate a larger portion of the price to the land since this will improve net income. (If he allocated more of the price to the building, depreciation expense would be higher, thus decreasing net income.) Q.Is this decision ethical? What must the accountant base his decision on?

13. 9–13 Copyright © Houghton Mifflin Company. All rights reserved. What Are Expenditures? Payments or obligations to make a future payment for an asset or for a service Capital Expenditure Revenue Expenditure Expenditure for the purchase or expansion of a long- term asset Expenditure for the repair, maintenance, and operation of a long-term asset

14. 9–14 Copyright © Houghton Mifflin Company. All rights reserved. Capital Expenditures Outlays for plant assets, natural resources, and intangible assets Additions, which are enlargements to the physical layout of a plant asset Betterments, which are improvements to a plant asset but that do not add to the plant’s physical layout Extraordinary repairs, which are repairs that significantly enhance a plant asset’s estimated useful life or residual value

15. 9–15 Copyright © Houghton Mifflin Company. All rights reserved. Acquisition Costs Includes all expenditures reasonable and necessary to get an asset in place and ready for use Installation costs Freight Insurance while in transit Testing and setup Are these items considered acquisition costs? Repair costs Interest charges on purchase No

16. 9–16 Copyright © Houghton Mifflin Company. All rights reserved. Acquiring Land Costs that should be debited to the Land account include: Purchase price Agent commissions Legal fees Accrued taxes paid by purchaser Grading Land preparation fees Assessments for local improvements Landscaping Sample Improvements to real estate like fences, driveways, or parking lots have a limited life. They should be recorded in an account called Land Improvements, not the Land account.

17. 9–17 Copyright © Houghton Mifflin Company. All rights reserved. Acquiring Buildings Acquisition costs include: Purchase price Repairs and other expenditures required to put it in usable condition Buildings are subject to depreciation because they have a limited useful life

18. 9–18 Copyright © Houghton Mifflin Company. All rights reserved. Leasehold Improvements Improvements to leased property that become the property of the lessor at the end of the lease Classified as tangible assets in property, plant, and equipment section of the balance sheet Costs of leasehold improvements are depreciated or amortized over the remaining term of the lease or the useful life of the improvement, whichever is shorter.

19. 9–19 Copyright © Houghton Mifflin Company. All rights reserved. Acquiring Equipment Acquisition costs include: Purchase price (less cash discounts) All expenditures connected with purchasing the equipment and preparing it for use Freight Insurance in transit Excise taxes and tariffs Buying expenses Installation costs Cost of test runs Equipment is subject to depreciation because it has a limited useful life

20. 9–20 Copyright © Houghton Mifflin Company. All rights reserved. Group Purchases Land and other assets may sometimes be purchased for a lump sum Because buildings are depreciable and land is not, the purchase price must be allocated to each asset ABC Co. buys a building and the land on which it is situated for a lump sum of $85,000. Assume that appraisals yield estimates of $10,000 for the land and $90,000 for the building if purchased separately. Allocate as follows:

21. 9–21 Copyright © Houghton Mifflin Company. All rights reserved. What Is Depreciation? The periodic allocation of the cost of a tangible asset (other than land and natural resources) over the asset’s estimated useful life All tangible assets except land have a limited useful life (physical deterioration and obsolescence limit useful life) Depreciation refers to the allocation of the cost of a plant asset to the periods that benefit from the asset, not to the asset’s physical deterioration or decrease in market value Depreciation is not a process of valuation; it is a process of allocation

22. 9–22 Copyright © Houghton Mifflin Company. All rights reserved. Four Factors That Affect the Computation of Depreciation 1. Cost Net purchase price of an asset plus all reasonable and necessary expenditures to get it in place and ready for use 2. Residual value Estimated scrap, salvage, or trade-in value on the estimated date of its disposal 3. Depreciable cost Cost less residual value 4. Estimated useful life Total number of service units expected from a long-term asset

23. 9–23 Copyright © Houghton Mifflin Company. All rights reserved. Accounting for Depreciation Depreciation is recorded at the end of the accounting period by an adjusting entry

24. 9–24 Copyright © Houghton Mifflin Company. All rights reserved. Methods of Accounting for Depreciation Accelerated method of depreciation that results in larger amounts of depreciation in earlier years of the asset’s life and smaller amounts in later years Spreads the depreciable cost evenly over the estimated useful life of the asset Based on the assumption that depreciation is solely the result of use and that passage of time plays no role in the depreciation process Declining-balance method Straight-line method Production method

25. 9–25 Copyright © Houghton Mifflin Company. All rights reserved. A delivery truck costs $10,000 and has an estimated residual value of $1,000 at the end of its estimated useful life of 5 years. Straight-Line Method Illustrated

26. 9–26 Copyright © Houghton Mifflin Company. All rights reserved. The amount of depreciation is the same each year Accumulated depreciation increases uniformly The carrying value decreases uniformly until it reaches the estimated residual value Depreciation Schedule, Straight-Line Method

27. 9–27 Copyright © Houghton Mifflin Company. All rights reserved. A delivery truck costs $10,000 and has an estimated residual value of $1,000 at the end of its estimated useful life of five years. Assume the truck was driven 20,000 miles during year 1; 30,000 miles during year 2; 10,000 miles during year 3; 20,000 miles during year 4; and 10,000 miles during year 5. The unit of output or use should be appropriate for that asset Production Method

28. 9–28 Copyright © Houghton Mifflin Company. All rights reserved. There is a direct relation between the amount of depreciation each year and the units of output or use. Accumulated depreciation increases each year in direct relation to units of output or use. The carrying value decreases each year in direct relation to units of output or use until the estimated residual value is reached. Depreciation Schedule, Production Method

29. 9–29 Copyright © Houghton Mifflin Company. All rights reserved. Declining-Balance Method Based on the passage of time Assumes that many kinds of plant assets are most efficient when new Is consistent with the matching rule Any fixed rate can be used Most common rate is twice the straight- line depreciation percentage (called double-declining-balance method)

30. 9–30 Copyright © Houghton Mifflin Company. All rights reserved. Double-Declining-Balance Method Illustrated A delivery truck costs $10,000 and has an estimated residual value of $1,000. Its estimated useful life is 5 years. Under the straight-line method, the depreciation rate for each year is 20 percent: Under the double-declining-balance method, the depreciation rate for each year is 40 percent: This fixed rate is applied to the remaining carrying value at the end of each year.

31. 9–31 Copyright © Houghton Mifflin Company. All rights reserved. Note that the fixed rate is always applied to the carrying value at the end of the previous year. Depreciation is greatest in the first year and declines each year after that. The depreciation in the last year is limited to the amount necessary to reduce the carrying value to the residual value. ($1,296 - $1,000 = $296) Depreciation Schedule, Double-Declining-Balance Method * * ($1,296 – $1,000 = $296)

32. 9–32 Copyright © Houghton Mifflin Company. All rights reserved. Graphic Comparison of Three Methods of Determining Depreciation

33. 9–33 Copyright © Houghton Mifflin Company. All rights reserved. Revising Depreciation Rates Sometimes a company must revise its estimate of an asset’s useful life or its residual value The periodic depreciation expense will increase or decrease depending on the adjustment The remaining depreciable cost of the asset should be spread over the remaining years of useful life

34. 9–34 Copyright © Houghton Mifflin Company. All rights reserved. Methods of Disposal Discard Sell for cash Exchange for another asset When plant assets are no longer usefu… 1.Record depreciation for the partial year up to the date of disposal 2.Remove the carrying value of the asset

35. 9–35 Copyright © Houghton Mifflin Company. All rights reserved. MGC Company purchased a machine on January 2, 20x2, for $6,500 and planned to depreciate it on a straight-line basis over its estimated useful life (8 years). Its residual value at the end of 8 years was estimated to be $500. On December 31, 20x7, the balances of the relevant accounts were: Machinery Accumulated Depreciation, Machinery 6,500 4,650 On January 2, 20x8, management disposed of the asset. Disposal of a Depreciable Asset

36. 9–36 Copyright © Houghton Mifflin Company. All rights reserved. Disposal of a Plant Asset Remove the carrying value of the asset Carrying value is computed by subtracting accumulated depreciation from the acquisition cost of the asset If the asset is fully depreciated, the carrying value is zero If the asset is not fully depreciated, a loss is recorded Accum. Depreciation, Machinery 4,650 Machinery 6,500 4,650 6,500 Bal. -0- Gains and losses on disposal of plant assets are classified as other revenues and expenses on the income statement.

37. 9–37 Copyright © Houghton Mifflin Company. All rights reserved. Selling a Plant Asset for Cash In addition to removing the carrying value of the asset, you will also record the cash received If cash received = carrying value, no gain or loss is recorded If cash received < carrying value, loss is recorded If cash received > carrying value, gain is recorded

38. 9–38 Copyright © Houghton Mifflin Company. All rights reserved. Selling an Asset for Cash Cash Received = Carrying Value Received $1,850 cash for sale of machinery. Remove the carrying value of the asset and record receipt of cash:

39. 9–39 Copyright © Houghton Mifflin Company. All rights reserved. Selling an Asset for Cash Cash Received < Carrying Value Received $1,000 cash for sale of machinery. Remove the carrying value of the asset and record receipt of cash:

40. 9–40 Copyright © Houghton Mifflin Company. All rights reserved. Selling an Asset for Cash Cash Received > Carrying Value Received $2,000 cash for sale of machinery. Remove the carrying value of the asset and record receipt of cash:

41. 9–41 Copyright © Houghton Mifflin Company. All rights reserved. Exchanges of Plant Assets May involve similar assets May involve dissimilar assets Old machine traded in for newer model Cement mixer traded in for truck Purchase price is reduced by the amount of the trade-in allowance  If trade allowance is greater than asset’s carrying value, gain realized.  If trade allowance is less than asset’s carrying value, loss realized.

42. 9–42 Copyright © Houghton Mifflin Company. All rights reserved. What Are Natural Resources? Assets that are converted to inventory by cutting, pumping, mining, or other extraction methods Timberlands Oil and Gas Reserves Mineral Deposits Record at acquisition cost and show on the balance sheet as long-term assets

43. 9–43 Copyright © Houghton Mifflin Company. All rights reserved. Depletion of Natural Resources (1)The exhaustion of a natural resource and (2) The proportional allocation of the cost of a natural resource to the units extracted Costs are allocated much like the production method of depreciation

44. 9–44 Copyright © Houghton Mifflin Company. All rights reserved. Recording Depletion Expense A mine that cost $1,800,000 has an estimated 1,500,000 tons of coal. The estimated residual value of the mine is $300,000. During the first year, 115,000 tons of coal are mined and sold. Natural resources that have been extracted but not sold are considered inventory and are not recorded as an expense until the year sold.

45. 9–45 Copyright © Houghton Mifflin Company. All rights reserved. Development and Exploration Costs in the Oil and Gas Industry Use one of these two accounting methods: Successful efforts method Cost recorded as an asset and depleted over the estimated life of the resource. For an unsuccessful effort, write off immediately as a loss. Full-costing method All costs, including costs of dry wells, are recorded as assets and depleted over the estimated life of the producing resources. Improves earnings performance in the early years.

46. 9–46 Copyright © Houghton Mifflin Company. All rights reserved. What Is an Intangible Asset? Goodwill Trademarks Brand names Copyrights Patents Leaseholds Software Customer Lists Long-term, nonphysical asset whose value comes from the rights or advantages afforded its owner

47. 9–47 Copyright © Houghton Mifflin Company. All rights reserved. Importance of Intangibles For some companies, intangible assets make up a substantial portion of total assets

48. 9–48 Copyright © Houghton Mifflin Company. All rights reserved. Accounting for Intangible Assets Intangibles developed by a firm for its own benefit Intangibles acquired from others Record as expenseRecord as asset; amortize over the shorter of useful life or legal life (not to exceed 40 years)

49. 9–49 Copyright © Houghton Mifflin Company. All rights reserved. Difficult Issues When Accounting for Intangibles  How to account for the initial carrying value?  How to account for that amount under normal business conditions (periodic write-off or amortization)?  How to account for the amount if the value declines substantially and permanently?  How to estimate an intangible asset’s value and useful life?

50. 9–50 Copyright © Houghton Mifflin Company. All rights reserved. Intangible Assets Illustrated Soda Bottling Company purchases a patent on a unique bottle cap for $18,000. The patent will last for 20 years, but the product using the cap will be sold only for the next six years. Record the purchase of the patent: Record the annual amortization expense: Notice that the Patents account is directly reduced by the amount of amortization expense, whereas depreciation or depletion is accumulated in separate contra accounts for other long-term assets.

51. 9–51 Copyright © Houghton Mifflin Company. All rights reserved. Intangible Assets Illustrated (cont’d) The patent becomes worthless after only 1 year. Record the write-off: If the patent becomes worthless before it is fully amortized, the remaining carrying value is written off as a loss by removing it from the Patents account. Loss on Patent 15,000 Patents 15,000 To record the write-off of a worthless patent ($18,000– $3,000)

52. 9–52 Copyright © Houghton Mifflin Company. All rights reserved. Research and Development Costs The FASB requires that all R&D costs be treated as revenue expenditures and charged to expense in the period in which they are incurred. Why? Too difficult to trace specific costs to specific profitable developments Costs of R&D are continuous and necessary for the success of a business and are treated as current expenses Studies show that 30 to 90 percent of all new products fail and 75 percent of new-product expenses are unsuccessful

53. 9–53 Copyright © Houghton Mifflin Company. All rights reserved. Computer Software Costs Costs incurred in developing computer software for sale or lease or for a firm’s internal use are research and development costs until the product has proved technologically feasible Costs incurred before technologically feasible should be charged to expense as incurred Once a working program is ready, all costs are recorded as assets Amortize over the estimated economic life using the straight-line method

54. 9–54 Copyright © Houghton Mifflin Company. All rights reserved. Goodwill A company’s good reputation Customer satisfaction Good management Manufacturing efficiency Good location Goodwill exists when a purchaser pays more for a business than the fair market value of the business’s net assets Goodwill should not be recorded unless it is paid for in connection with the purchase of a whole business Goodwill = Purchase price – FMV of identifiable net assets