accrual accounting and financial statements_8
TRANSCRIPT
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2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e
Long-Lived Assets
and Depreciation
CHAPTER
8
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2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e
Learning Objectives (LO)
After studying this chapter, you should be able to
1. Distinguish a companys expenses fromexpenditures that it should capitalize
2. Measure the acquisition cost of tangible assets suchas land, buildings, and equipment
3. Compute depreciation for buildings and equipmentusing various depreciation methods
4. Recalculate depreciation in response to a change in
estimated useful life or residual value5. Differentiate financial statement depreciation from
income tax depreciation
6. Explain the effect of depreciation on cash flow
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Learning Objectives (LO)
After studying this chapter, you should be able to7. Account for expenditures after acquisition
8. Compute gains and losses on disposal of fixedassets and consider the impact of these gains and
losses on the statement of cash flows
9. Determine the balance sheet valuation of tangibleassets for companies who use the revaluationmethod allowed under IFRS
10. Account for the impairment of tangible assets
11. Account for intangible assets, including impairment
12. Explain the reporting for goodwill
13. Interpret depletion of natural resources
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Overview of Long-lived Assets
Long-lived assets (LLA)
Used over a period longer than an operating cycle
As a percentage of total assets, vary considerably
depending on the industry Divisible into tangible and intangible categories
Tangible assets - physical (can see and touch)
Land Natural resources
Buildings
Equipment
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Overview of Long-lived Assets
Intangible assets Lack physical substance
Contractual or legal rights or economic benefits
Patents
Trademarks Copyrights
Amortizespreading the LLAs cost over theperiods it contributes to the production of
revenue
Depreciate buildings, equipment (but not land)
Deplete natural resources
Amortize intangible assets5 of 40
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LO 1 Contrasting Long-lived AssetExpenditures with Expenses
Expenditures what is paid for an item
Expensed Within an operating cycle or year
Not consumed - current asset
Consumed - deducted as an expense (expensed)
Capitalize Beyond an operating cycle oryear, expenditure is placed on the balance sheet
(capitalized) Cost is then amortized over its useful life
Exceptions Land and other items where cost-benefitconsiderations suggest expensing is justified
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LO 1 Contrasting Long-lived AssetExpenditures with Expenses
Capitalize or Expense? judgment required
Expensing all this year lowers this years net income
(and has no affect on future years net income)
Capitalizing this year then amortizing some of its costlowers this years expenses (in comparison toexpensing) thus improving this years net income. In
future years, more expenses means lower net income
In the long-run, same end results are achieved What is in the best interests of stakeholders
(management, investors)
WorldCom example in text What did they do?
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LO 2 - Tangible Assets Acquisition Cost
LLA asset costs that are capitalized include(besides the purchase price itself$100 ) allnecessary costs to get the asset into a usablecondition
Land survey, legal/title fees, taxes, demolition
Buildings legal/title fees, taxes
Equipment - taxes ($5), transportation ($3),installation ($4), testing ($1), essential repairs ($2) toget it into an operating condition
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ASSET 115CASH 115
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LO 2 - Tangible Assets Acquisition Cost
Nonmonetary exchange Fair market value
Fair market value = what could sell/buy the asses forfrom an independent third party
Fair market value of the consideration given up orreceived, whichever is more clearly determinable
Basket Purchase more than one asset for asingle price. E.g. For $1M, can buy Land($480,000) and building ($720,000) (appraisedvalue)
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Building 600,000 (480/1200) x $1m)Land 400,000 (720/1200 x $1m)
Cash 1,000,000
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LO 2 - Tangible Assets Acquisition Cost
Subsequent to Acquisition - The market value:
Declines
Write the value of the asset down (impairment if
considered permanent), or Leave at historical cost less depreciation, i.e.,Book Value
U.S. required and IFRS permitted
Increases
Revalue to fair market value (IFRS permitted)
Precluded by U.S. GAAP
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LO 3 Building/Equipment Depreciation
Matching recording expenses in the period inwhich they help produce revenue
Buildings and Equipment
Typically last many years
Thus contributing to revenue for many years
Thus their cost is capitalized when purchased
And amortized over many years Accumulated Depreciation = the cumulative
amount of Depreciation Expense recorded overthe life of the asset
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LO 3 Building/Equipment Depreciation
Information needed to determine depreciation
Acquisition (capitalized) cost what was debited tothe asset account
Salvage (terminal, residual) value what is expectedto be received at the time the asset is disposed of
Depreciable value = amount to be allocated to eachyear of usage
Useful life = shorter of the assets Physical life expected time it will wear out
Economic life when it is no longer economicallyfeasible to operate
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LO 3 Building/Equipment Depreciation
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Symbols Amounts for Illustration
C = total acquisition cost December 31, 20X2 $41,000
R = estimated residual value $1,000n = estimated useful life (in years or miles) 4 years
200,000 milesD = amount of depreciation Various
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LO 3 Building/Equipment Depreciation
Straight-line depreciation
Spreads the depreciable value evenly over the usefullife of an asset
Most popular method for financial reporting purposes
Depreciation Expense 10,000
Accumulated Depreciation 10,000
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Depreciation expense = (C R) / n= ($41,000 1,000) / 4 = $10,000 per year
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LO 3 Building/Equipment Depreciation
Units of Production
- If physical wear and tear determines the useful life,depreciation may be based on units of service (e.g.
miles) or units of production
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Depreciation expense = (C R) / n= ($41,000 1,000) / 200,000 = $.20/mile
Depreciation Expense 13,000Accumulated Depreciation 13,000
= 65,000 miles (yr 1) x $.20 = $13,000
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LO 3 Building/Equipment Depreciation
Double-declining-balance (DDB) method is anaccelerated method
Year Depreciation Expense
1 .50 ($41,000 zero Accum. Depr.) = $20,500 > $10,000
2 .50 ($41,000 $20,500) = $10,250
3 .50 ($42,000 $20,500 $10,250) = $5,125
4 .50 ($41,000 $20,500 $10,250 $5,125) = $2,563 < $10,000
$38,438
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Straight line rate of depreciation = year = 25% per yearDouble the straight line rate = 25% x 2 = 50%Book value at the begin. of the year = Acquisition cost less
Accumulated Depreciation
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LO 3 Building/Equipment Depreciation
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Note that the $41,000 asset is only depreciated to $38,438 in this example, Thus tofully depreciate this asset, a plug number is needed to increase accumulated
depreciation to $40,000. Never depreciate an asset below its salvage value.
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LO 3 Building/Equipment Depreciation
In comparison to straight line depreciationexpense, DDB records more in the earlier years;less in the later years
Over the assets life, the same amount isdepreciated, regardless of method
Depreciable asset is never depreciated below its
estimated salvage (terminal, residual) value
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LO 4 - Changes in Estimated Useful Lifeor Residual Value
Assets useful life and residual value estimated
when acquired
If material changes to those estimates become
known, must use the new estimate to revise thedepreciation schedule
Revisions are applied to the period in which they
are determined and future periods, i.e., notapplied retroactively
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LO 4 - Changes in Estimated Useful Lifeor Residual Value
Example
Cost = $41,000
Residual value = $1000
Life = 4 years Beginning of year 4, life changes to 2 full years
Revised Depreciation Expense for next 2 years
$41,000 ($10,000 x 3 years) = $11,000
$11,000 $1000 residual value = $10,000 to bedepreciated
$10,000 / 2 years = $5000 each for next 2 years
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LO 5 - Contrasting Income Tax andShareholder Reporting
Tax reporting - prepared according to IRS rules
Assets divided into propertyclasses Each class has prescribed lives and permissible
depreciation methods Modified Accelerated Cost Recovery System
(MACRS) prescribes zero salvage value and allowsuse of DDB (more deprecation/lower taxable income)
Financial reporting prepared per FASB/SEC rules Straight-line depreciation is the most used method
Matches portions of the assets cost to the periods of
revenue generation
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LO 6 - Depreciation and Cash Flow
Cash Flow
Operating repairs
Investing - acquired, sold, or bettered
Depreciation expense
Allocates investing expenditures to periods
Operating cash flows - Statement of Cash Flows
Indirect method explains why net income is different thanoperating cash flows.
Since depreciation expense was deducted from net income butis not a cash flow, it is removed by adding it back to net income,causing some to believe it increases cash from operations.
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LO 7 - Expenditures After Acquisition
Definitions
Maintenance - Sustain LLA original performance level
Repairs Restore LLA to original performance level
Improvements (betterments)improve LLAs life,quantity/quality of output or reduce operating costs
U.S. GAAP
Maintenance and repair expenditures - expensed Improvements
If immaterial or cost/benefit applies expensed
If material capitalize (revise depreciation schedules)
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LO 8 Sales of Tangible Assets
Example
Original cost - $41,000
Accumulated Depreciation at time of sale $20,000
Book Value at time of Sale - $21,000
Sale at book value (all are Asset accounts)
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Cash 21,000
Accumulated Depreciation 20,000Equipment 41,000
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LO 8 Sales of Tangible Assets
Sale for more than its book value (41,000 20,000 = 21,000)
Cash 25,000
Accumulated Depreciation 20,000
Equipment 41,000
Gain 4,000
Sale for less than its book value (41,000 20,000 = 21,000)
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Cash 14,000Accumulated Depreciation 20,000Loss 7,000
Equipment 41,000
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2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e
LO 8 Sales of Tangible Assets
Companies include gains and losses in a varietyof locations on the income statement
Some companies list other income with sales
revenue at the top of the income statement, thuscombining usual and frequent inflows with unusual
and/or infrequent inflows
Other companies report it after operating income
viewing it as not being a part of usual and frequent(central) operations
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LO 8 Sales of Tangible Assets
LLA sales and the Cash Flow Statement
Investing activities if sold for cash
Disclose in notes if for other than cash and
considered significant Indirect method of presenting operating cash flows
Net income includes investing gains and losses
To remove them from net income
Subtract gains
Add losses
Direct method - ignore since they are investing flows
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LO 9 Revaluation Method under IFRS
Revaluation Prohibited by U.S. GAAP
Optional under IFRS
Revalued assets are not depreciated
Once started, must continue to do so
Must be done for all assets in the same class
Concept-Report assets at fair market value
(FMV) Amount the asset could be exchanged between willing
knowledgeable parties in an arms length transaction
Determined usually from appraisals
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LO 9 Revaluation Method under IFRS
Concept continued
Original cost 10,000
+ Revaluation gain year 1* +1,000*
Fair market Value end of year 1 11,000 Revaluation loss year 2* 2,000*
Fair market Value end of year 2 9,000
* Gains and losses typically posted to single account
that is reported on the
Income statement (rarely volatility of net income)
Owners equity (part of Comprehensive Income)
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LO 10 - Impairment of Tangible Assets
Circumstances leading to Impairment whenany of the following become apparent (i.e., notautomatically on an annual basis)
Significant decline in assets fair market value Significant change in the way the asset is used
Change in legal/business environment
Obsolescence or physical damage
Forecast of continuing losses if usage continues
Other factors
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LO 10 - Impairment of Tangible Assets
Process of determining impairment
1. Recoverability testCompare undiscountedexpected cash flows from operations and sale to the
book value Cash flows > book value = no impairment
Cash flows < book value, go to step 2
2. Compute the impairment loss as
Active market: Book value fair market value
Inactive market: Book value discounted cashflows (see Appendix A to Chapter 9)
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LO 10 - Impairment of Tangible Assets
Recording the loss
Book value ($150,000) less FMV of asset ($105,000)
Reporting the loss
U.S. GAAP: part of Income from ContinuingOperations
Separate line if material
Combined with other items if immaterial
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Loss on Impairment 45,000 *Accumulated Depreciation 45,000
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LO 10 - Impairment of Tangible Assets
Assets held for resale can be written upfollowing an impairment loss only to the net bookvalue at the time of the impairment
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LO 11 - Intangible Assets (Other than Goodwill)
Intangible assets
Not physical in nature
Rights or claims to expected benefits that are oftenfrom contract rights Patents - exclusive right to produce/sell a product or
use a process for up to 20 years Copyrights exclusive rights to reproduce and sell a
book, musical composition, film, or similar creative itemfor the life of the creator plus 70 years
Accounting for intangible assets depends onwhether the asset
Was acquired externally or developed internally
Has a finite or infinite life
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LO 11 - Intangible Assets (Other than Goodwill)
Trademarks - distinctive identifications of amanufactured product or a service, taking the formof a name, sign, slogan, logo, or emblem
Franchises/licenses - legal contracts that grant
the buyer the right to sell a product or service inaccordance with specified conditions
Leasehold - right to use a fixed asset for aspecified period of time beyond one year
Leasehold improvements - lessee spends moneyto improve leased property
Improvements = become part of the leasedproperty and are classified as fixed assets
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LO 13 - Depletion of Natural Resources
Natural resources - LLA such as minerals, oil,and timber (wasting assets)
Depletion expense is the amount of the
acquisition cost of natural resources allocated tothis period
Depletion is measured on a units-of-production basis
Annual depletion may be recorded as A direct reduction of the asset (credit the asset)
Or by using an Accumulated Depletion (contra-asset) account