©2009 the mcgraw-hill companies, inc. chapter 7 long-term assets
TRANSCRIPT
©2009 The McGraw-Hill Companies, Inc.
Chapter 7
Long-Term Assets
7-2
Categories of Long-Term Assets
Property, Plant and Equipment
Intangible Assets
Land, land improvements, buildings, equipment, and natural resources
Patents, trademarks, copyrights, franchises, and
goodwill
Physical substance Lacks physical substance
©2009 The McGraw-Hill Companies, Inc.
Part A
Acquisition and Improvements
7-4
LO1 Property, Plant and Equipment
Record a long-term asset at
Cost +All expenditures necessary to
get the asset ready for use
7-5
Land and Land Improvements
We capitalize to land all expenditures necessary to get the land ready for its intended use.
Capitalized costs include the purchase price of the land plus: closing costs such as attorney fees real estate commissions title title search recording fees clearing, filling, and draining the land removing old buildings to prepare the land for its intended use
Land represents property a company is using in its operations
Any additional amount spent to improve the land by adding a parking lot, paving, temporary landscaping, lighting systems, fences, sprinkler systems etc. are recorded separately as land improvements, which are subject to depreciation.
7-6
Buildings
The cost of acquiring a building usually includes: the purchase price realtor commissions legal fees other costs incurred to remodel the building
The cost of constructing a building usually includes: architect fees material costs construction labor officer supervision overhead (costs indirectly related to the construction) and
“capitalized interest” (refers to interest costs we add to the asset account rather than recording them as interest expense.)
Buildings include offices, retail stores, storage warehouses, and manufacturing facilities a company is using in its operations.
7-7
Equipment
The cost of equipment includes: actual purchase price sales tax shipping delivery insurance assembly, installation and testing legal fees incurred to establish title.
Rather than including recurring costs, such as insurance and property taxes, as part of the cost of the equipment, we expense them as we incur them in order to properly match them with revenues.
Includes machinery used in manufacturing, computers and other office equipment, vehicles, furniture, and fixtures.
7-8
Natural Resources
We can physically use up, or deplete, natural resources.
For example, Exxon Mobil’s oil reserves are a natural resource that decreases as the firm extracts oil.
Oil, Natural Gas, and Timber
7-9
LO2 Intangible Assets
Purchase intangible assets like patents, copyrights, trademarks, or franchise rights from other entities.
Record purchased intangible assets at their original cost plus all other costs, such as legal and filing fees, necessary to get the asset ready for use.
Create intangible assets internally through research and development or advertising.
Rather than recording these as an intangible asset on the balance sheet, expense most of the costs for internally developed intangible assets to the income statement as they are incurred.
For example, research and development costs, advertising costs.
Companies can either purchase or create intangible assets internally.
7-10
Patents
The cost of a patent includes:
When it is purchased purchase price legal and filing fees to secure the patent any attorney fees and other costs of successfully defending
the patent in court
When it is internally developed research and development costs (expensed as incurred) legal and filing fees to secure the patent (recorded in the
patent asset account)
An exclusive right to manufacture a product or to use a process (normally granted for a period of 20 years).
7-11
Copyrights
Protected by law Gives the creator (and his or her heirs) the exclusive
right to reproduce and sell the work for the life of the creator plus 70 years
Accounting for the costs of copyrights is virtually identical to that of patents
An exclusive right of protection given to the creator of a published work such as a song, film, painting, photograph,
book, or computer software.
7-12
Trademarks
Can be registered for a period of 10 years. Registration can be renewed for an indefinite number of 10-year periods (useful life can be indefinite).
Firms often acquire trademarks through acquisition. When a firm develops a trademark internally through advertising,
it records the advertising costs as expenses in the income statement.
The firm can record attorney fees, registration fees, design costs, successful legal defense, and other costs directly related to securing the trademark as an intangible asset in the trademark asset account.
A word, slogan, or symbol that distinctively identifies a company, product, or service.
7-13
Franchises
Many franchisors provide other benefits to the franchisee, such as participating in the construction of the retail outlet, training employees, and purchasing national advertising.
The franchisee records the initial fee as an intangible asset and then expenses it over the life of the franchise agreement.
Additional periodic payments by the franchisee usually are for services the franchisor provides on a continuing basis. These are expensed by the franchisee as incurred.
Local outlets that pay for the exclusive right to use the franchisor company’s name and to sell its products within
a specified geographical area.
7-14
Goodwill
Recorded as an intangible asset in the balance sheet only when purchased as part of the acquisition of another company.
Goodwill is equal to the purchase price minus the fair value of the net assets acquired.
Represents the value of a company as a whole, over and above the value of its identifiable net assets.
7-15
LO3 Expenditures after Acquisition
Expenditures
after Acquisition
Repairs and maintenance, additions, improvements, or litigation costs
Capitalize as an asset if it
increases future benefits
Expense if it benefits only the current period
7-16
Repairs and Maintenance
Expensed if repairs maintain a given level of
benefits in the period incurred
Capitalize as assets more extensive repairs that
increase future benefits
EXPENSE
Cost of an engine tune-up or the repair of an engine part
CAPITALIZE
Cost of a new transmission or an engine overhaul
For a delivery truck
7-17
Additions
Occurs when we add a new major component to an existing asset
CAPITALIZE
the cost of additions because they increase, rather than
maintain, the future benefits from the expenditure
DEPRECIATE
the capitalized cost over the remaining useful life of the
original asset or the addition, whichever is shorter.
7-18
Improvements
The cost of replacing a major component of an asset.
A new component with the same
characteristics as the old component
A new component with enhanced
operating capabilities
CAPITALIZE
Replace an existing refrigeration unit in a delivery truck
With a new and improved
refrigeration unit
With a new but similar unit
7-19
Legal Defense of Intangible assets
The cost of legally defending the right that gives the asset its value.
If the defense of an intangible right is
Successful Unsuccessful
CAPITALIZE
litigation costs and amortize them over the remaining useful life of
the related intangible
EXPENSE
the litigation costs as incurred because they provide no future
benefit
©2009 The McGraw-Hill Companies, Inc.
Part B
Cost Allocation
7-21
LO4 Depreciation of Tangible Assets
Dictionary definition = Decrease in value.Accounting definition = Allocation of an asset’s cost
$Cost
$Benefit $Benefit $Benefit $Benefit
Time Periods
Depreciation = Allocation of a portion of the asset’s cost to an expense over all periods benefited.
Cost incurred to purchasean asset (future benefit)
7-22
Depreciation Example
Starbucks pays $1,200 for a computer expected to have value for four years and allocates the cost equally over the years in that period. The entry to record annual depreciation is:
Depreciation Expense 300
Accumulated Depreciation 300
(To record depreciation = $1,200 / 4 years)
Rather than credit the equipment account directly, we instead credit its contra account i.e. Accumulated Depreciation which is then offset against the equipment account in the balance sheet.
After one year, we haveEquipment (cost) $1,200Less: Accumulated depreciation ($300 x 1 year) (300) = Book value $ 900
7-23
Depreciation Terminology
Accumulated depreciation is a contra-asset account representing the total depreciation taken to date.
Book value is equal to the original cost of the asset minus the current balance in accumulated depreciation.
Service life (or useful life) is how long the company expects to receive benefits from the asset before disposing of it; can be measured in units of time or in units of activity.
Residual value (or salvage value) is the amount the company expects to receive from selling the asset at the end of its service life.
7-24
Depreciation of Tangible Assets
Depreciation No Depreciation
Land Improvements
Buildings
EquipmentLand
7-25
Depreciation Methods
Depreciation Methods
Straight-line Declining-balance
Activity-based
7-26
Straight-Line Depreciation
Allocates an equal amount of the allocation base to each year of the asset’s service life
Asset cost - Estimated residual value Straight-Line Depreciation
=Asset’s service life
7-27
Declining-Balance Depreciation
An accelerated depreciation method Will be higher than straight-line depreciation in
earlier years, but lower in later years Both declining-balance and straight-line will result
in the same total depreciation over the asset’s service life
The most common declining-balance rate is 200%, which we refer to as the double-declining-balance method since the rate is double the straight-line rate
7-28
Activity-Based Depreciation
Allocate an asset’s cost based on use rather than time
Step 1
Compute the average depreciation rate per unit
Asset cost - residual value
Units expected to be produced
Step 2
Multiply the average depreciation rate per unit by the number of units each period
7-29
Tax Depreciation
An accelerated method that reduces taxable income more in the earlier years of an asset’s life than straight-line.
Most companies use the straight-line method for financial reporting and an accelerated method called MACRS for tax reporting.
Thus, companies record higher net income using straight-line depreciation and lower taxable income using MACRS depreciation.
7-30
LO5 Amortization of Intangible Assets
Allocation of the cost of intangible assets
Intangible assets subject to amortization
Intangible assets not subject to amortization
Assets having a finite useful life that we can
estimate
Assets having indefinite useful lives
Goodwill, TrademarksPatents, Copyrights, Franchises
7-31
Amortization of Intangible Assets
Estimate the intangible asset’s service life (usually is limited by legal, regulatory, or contractual provisions)
Estimate its residual value (for most intangible assets, it is zero)
Allocate the asset’s cost less any estimated residual value to periods in which we expect the intangible asset to contribute to the company’s revenue-generating activities.
7-32
Amortization Example
In early January, Little King Sandwiches acquires franchise rights from University Hero for $800,000. The franchise agreement is for a period of 20 years. In addition, Little King purchases a patent for $72,000. The original legal life of the patent was 20 years; there are 12 years remaining. However, due to expected technological obsolescence, the company estimates that the useful life of the patent is only 8 more years. Little King uses straight-line amortization for all intangible assets. The company’s fiscal year-end is December 31. The amortization expense for the franchise and the patent is recorded as:
Amortization Expense 40,000
Franchise 40,000
(Amortization expense = $800,000 / 20 years)
Amortization Expense 9,000
Patent 9,000
(Amortization expense = $72,000 / 8 years)
7-33
Intangible Assets not subject to Amortization
Do not amortize intangible assets with indefinite useful lives. Goodwill is the most common intangible asset with an
indefinite useful life. Another example is trademarks. Review these assets for a potential write-down when events
or changes in circumstances indicate the amount recorded in the accounting records might not be recoverable.
©2009 The McGraw-Hill Companies, Inc.
Part C
Asset Disposition
THE FOOD STORE
7-35
LO6 Disposal of Long-Term Assets
Disposal of Long-Term Assets
Sale Retirement Exchange
Can result in either a gain or a loss
Occurs when a long-term asset is no longer useful but cannot be sold
Occurs when two companies trade
assets
7-36
Recording Long-Term Asset Disposals
Little King Sandwiches purchased a new delivery truck. Here are the specific details:
Cost of the new truck $40,000
Estimated residual value $5,000
Estimated service life 5 years
7-37
SaleIf we assume that Little King sells the delivery truck at the end of year 3 for $22,000, we can calculate the gain as $3,000. Note that both the delivery truck and the related accumulated depreciation account are removed.
Sale amount $22,000
Less:
Cost of the new truck $40,000
Less: Accumulated depreciation (3 years x $7,000/year)
(21,000)
Book value at the end of year 3 19,000
Gain on sale $3,000
The entry to record the gain on sale is:
Cash 22,000
Accumulated Depreciation 21,000
Delivery Truck 40,000
Gain on sale 3,000
(To record gain on sale)
7-38
Retirement
If we assume that the delivery truck is totaled in an accident at the end of year 3, we have a $19,000 loss on retirement.
Sale amount $0
Less:
Cost of the new truck $40,000
Less: Accumulated depreciation (3 years x $7,000/year)
(21,000)
Book value at the end of year 3 19,000
Loss on retirement ($19,000)
The entry to record the loss on retirement is:
Accumulated Depreciation 21,000
Loss on Retirement 19,000
Delivery Truck 40,000
(To record loss on retirement)
7-39
ExchangeAssume that Little King exchanges the delivery truck at the end of year 3 for a new truck valued at $45,000. The dealership gives Little King a trade-in allowance of $23,000 on the exchange, with the remaining $22,000 payable in cash. We have a $4,000 gain.
Trade-in allowance $23,000
Less:
Cost of the new truck $40,000
Less: Accumulated depreciation (3 years x $7,000/year) (21,000)
Book value at the end of year 3 19,000
Gain on exchange $4,000
The entry to record the gain on exchange is:
Delivery Truck (new) 45,000
Accumulated Depreciation 21,000
Cash 22,000
Delivery Truck (old) 40,000
Gain on Exchange 4,000
(To record gain on exchange)
7-40
LO7 Asset Analysis
Analyze the relation between Return on Assets, Profit Margin and Asset Turnover to analyze the profitability of a company’s assets.
Return on Assets = Profit Margin x Asset Turnover
Net Income
=
Net Income
x
Net Sales
Average Total Assets
Net SalesAverage Total
Assets
To maximize profitability, a company ideally strives to increase both net income per dollar of sales (profit margin) and sales per dollar of assets invested (asset turnover).
©2009 The McGraw-Hill Companies, Inc.
Appendix
Asset Impairment
7-42
Asset ImpairmentImpairment occurs when the future cash flows (future benefits) generated for a long-term asset is < its book value (cost minus accumulated depreciation)
Impairment loss = Asset’s book value - its fair value.
STEP 1:Test for Impairment
Are future cash flows less than book value?
Yes No
Asset ImpairedAsset Not Impaired
STEP 2:If Impaired, Record Loss
Record Loss (Loss equals book value of
asset in excess of fair value of
asset)
No Action Needed
©2009 The McGraw-Hill Companies, Inc.
End of chapter 7