©2009 the mcgraw-hill companies, inc. chapter 7 long-term assets

©2009 The McGraw-Hill Companies, Inc.

Chapter 7

Long-Term Assets

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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

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LO1 Property, Plant and Equipment

Record a long-term asset at

Cost +All expenditures necessary to

get the asset ready for use

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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.

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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.

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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.

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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

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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.

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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).

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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.

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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.

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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.

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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.

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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

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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

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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.

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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

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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

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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)

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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

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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.

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Depreciation of Tangible Assets

Depreciation No Depreciation

Land Improvements

Buildings

EquipmentLand

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Depreciation Methods

Depreciation Methods

Straight-line Declining-balance

Activity-based

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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

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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

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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

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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.

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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

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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.

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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)

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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

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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

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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

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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)

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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)

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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)

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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

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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