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Chapter 12Investments

inOperating Assets

2Financial Accounting, 7e Stice/Stice, 2006 © Thomson

Financial Statement Items Covered

Balance SheetIncome

StatementStatement of Cash Flows

Long-term AssetsProperty, Plant, &

EquipmentAccumulated

DepreciationIntangible Assets

Depreciation ExpenseAmortization ExpenseLoss on Impairment

OperatingAsset depreciation

(indirect method)Financing

Cash paid (received) to purchase (from sale of) long-term assets

Cash paid to acquire another company

What are Long-TermOperating Assets?


Long-Term Operating Assets

Long-term operating assets are– not held for resale to customers– are used by a business to generate

revenuesLong-term operating assets include

– Property, plant, and equipment– Intangible assets


Property, Plant, and Equipment

“PP&E”– Tangible, long-lived assets– Acquired for use in business operations

•Land•Buildings•Machinery•Equipment•Furniture


Long-lived assets– Used to facilitate the operation of a

business– Do not have physical substance

•Patents•Trademarks•Licenses•Franchises•Goodwill

Intangible Assets


Long-Term Asset Issues

Evaluate AcquireEstimate

andRecognize

Monitor Dispose

possible acquisition of

long-term operating

assets

long-term operating assets

periodic depreciation

asset value for possible decline

of the asset

Deciding Whether toAcquire a Long-Term

Operating Asset


Capital Budgeting

The process of evaluating a long-term project that may include purchasing property, plant, and equipmentCommon capital budgeting models:

– Payback period– Accounting rate of return– Net present value


Payback Period

The time it takes for a company to recover its original investment in cash Initial InvestmentPayback Period =

Annual Cash Inflow


Accounting Rate of Return

Projects are approved if their rate of return exceeds some predetermined rate

Annual Accounting IncomeAccounting Rate = of Return Initial Investment


Net Present Value

Utilizes the concept of the time value of moneyA project is undertaken only if the present value of the cash inflows from the project exceeds the present value of the cash outflow

Acquisition of Plant,Property, & Equipment


Acquisition of PP&E

The cost of PP&E includes any costs necessary to bring the asset to the condition and location for its intended use


Items Included in PP&EAcquisition Cost

Land Purchase price, commissions, legal fees, escrow fees, surveying fees, clearing and grading costs

Land Improvements (e.g., landscaping, paving, fencing)

Cost of improvements, including expenditures for materials, labor and overhead

Buildings Purchase price, commissions, reconditioning costs

Equipment Purchase price, taxes, freight, insurance, installation, and any expenditures incurred in preparing the asset for its intended use


Acquisition for CashPurchase price $15,000Discount* (300)Net Price $14,7006% sales tax on purchase price $900Freight charges 850Installation costs 150 1,900Total Acquisition Cost $16,600

*terms 2/10, n/30; payment made within discount period


Subsequent Expenditures

Normal repairs and maintenance are expensed in the current periodExpenditures which extend the useful life or increase the productive capacity are capitalized

– Asset book value is increased– Annual depreciation is revised


Acquisition Through Leasing

A lease is a contract whereby• one party (lessee)• is granted the right to use

property• owned by another party (lessor)• for a specified period of time for

a specified cost


Lease Types

Operating lease - equivalent to a rental– Lease payments charged to expense

Capital lease – equivalent to a purchase– The asset acquired is recorded in property,

plant and equipment The leased asset is depreciated over the

lease period– A lease liability is shown in the liability

section of the balance sheet


Acquisition by Exchange

The acquisition price of the asset is equal to fair market value of noncash consideration plus any cash given

To record the purchase of land in exchange for 10,000 shares of stock when market price of the stock was $78 per share

Land 780,000 Capital Stock 780,000


Acquisition Through Donation

The asset is recorded at its fair market value at time it is received

To record the receipt of land through donation.

Land 500,000 Gain - Donated Asset 500,000


Acquisition With a Basket Purchase

Fixed assets purchased for a lump sum need to be recorded separatelyThe total purchase price must be allocated among individual assets received in proportion to their appraised values


Example:Acquisition With a Basket

PurchaseFair Value of Assets:

Land300,000

Building900,000

Price Paid

$1,000,000

Appraised Value

Relative Percentage Allocation

Land 300,000 25.0% 250,000 Building 900,000 75.0% 750,000

1,200,000 100.0% 1,000,000


Acquisition of an Entire Company

All acquired assets are recorded on the books of the acquiring company at their fair values as of the acquisition dateThe excess of the purchase price over the fair value of the identifiable assets represents goodwill


Self-constructed assets are recorded at cost, including all expenditures necessary to build the asset and make it ready for its intended use

Acquisition ThroughSelf-Construction


Acquisition ThroughSelf-Construction

Costs include:– Materials and labor used directly in

construction– A reasonable share of general overhead– If interest is included it is called capitalized

interestInterest should be included equal to the amount that could have been saved if the money used on the construction had instead been used to repay loans

Acquisition ofIntangible Assets


Intangible Assets• Long-term• Nonmonetary• Generate revenues

– Grant a right to use of a product, process, name, image, customer list, or business practice

• Uncertainty about future benefits greater than that of tangible assets

• Specifically identifiable– Except goodwill

Patent

An exclusive right to use, manufacture, process, or sell a product granted by the U.S. Patent Office. Patents have a legal life of 17 years, but their economic life may be shorter

Copyright

The exclusive right of the creator or heirs to reproduce and/or sell an artistic or published work. Granted by the U.S. government for a period of 50 years after the death of the creator. Amortized over the shorter of its economic life or legal life.

Trademark andTrade Names

A symbol or name that allows the holder to use it to identify or name a specific product or service. A legal registration system allows for an indefinite number of 20-year renewals

Franchise

An exclusive right to use a formula, design, technique, or territory.

Goodwill

The ability of a company to earn above-normal income. Recorded goodwill is the excess amount paid to acquire a company, over and above the fair market value of the company’s identifiable assets.


Accounting for Goodwill

A business combination occurs when one company buys all of the assets of another companyThe combination is accounted for using the purchase method (as if one company is buying the other)


The identifiable assets and liabilities are recorded at their fair values

– The excess of the purchase price over the fair value of the identifiable net assets is recorded as goodwill• Goodwill represents the company’s

reputation, superior business practices, and market position

• Goodwill is only recorded when it is purchased

Purchase Method


Determining Goodwill

Purchase price paid 1,300,000 Net assets, book value (750,000)

550,000 Adjust net assets to fair value:

Inventory 50,000 Plant, Property, & Equip 150,000 Patent 100,000 300,000

Goodwill 250,000

Book Value Fair Value DifferenceAssets:

Cash 50,000 50,000 - Accounts Receivable 250,000 250,000 - Inventory 400,000 450,000 50,000 Plant, Property, & Equip 350,000 500,000 150,000 Patent - 100,000 100,000

LiabilitiesAccounts Payable (100,000) (100,000) - Long-term debt (200,000) (200,000) -

Net Assets 750,000 1,050,000

Depreciation andAmortization


Depreciation:What it Is ... and Isn’t

IS NOT• Accumulation of

a cash fund for asset replacement

• A determination of an asset’s current value

IS• The systematic

allocation of an asset’s cost to the periods of benefit


DepreciationCauses of depreciation:

– Physical deterioration•Due to use, passage of time, and

exposure to the elements– Obsolescence

•Outdated, outmoded, or inadequate


Residual value (salvage value)– An estimate of the asset’s worth at

the time of its disposalDepreciable cost

– The original cost minus the residual value

Estimated useful life– A measure of the service potential

in terms of years or units produced

Depreciation Factors


Depreciation Methods

Straight-line– Allocates an equal amount of asset

cost per yearUnits-of-production

– Allocates cost based on the productive output of the asset

Declining balance– An accelerated method which

allocates more cost to depreciation in the early years than the later years


Depreciation Methods Illustrated

Assume the following information:Equipment purchase date January 1, 2006Acquisition cost $40,000Estimated residual value $4,000Depreciable cost $36,000Estimated useful life 5 years


Straight-Line Depreciation Cost - Residual Value

= Annual DepreciationUseful Life

$40,000 - $4,000 = $7,200

5 years

Year Depreciation Accum Dep Book Value2006 7,200 7,200 32,800 2007 7,200 14,400 25,600 2008 7,200 21,600 18,400 2009 7,200 28,800 11,200 2010 7,200 36,000 4,000


Straight-Line Method

An equal amount of depreciation expense is allocated to each period

Straight-line Depreciation

$0$5,000

$10,000$15,000$20,000$25,000$30,000$35,000

1 2 3 4 5

Year

Annual Depreciation End of Year Book Value


Declining-Balance Method

Annual depreciation is determined by applying a fixed percentage to the remaining book value at the beginning of each year

1 rate = percentage ratelife

1 2 = 40%5

‘rate’ is the multiple of straight-line(double is 2 times the straight-line rate)


Declining-Balance Method40% remaining book value40% (cost - accum dep)Year 1: 40% ($40,000 - 0) = $16,000Year 2: 40% ($40,000 - $16,000) = $9,600

YearBeginning

Book Value Depreciation Accum Dep

Ending Book Value

2006 40,000 16,000 16,000 24,000 2007 24,000 9,600 25,600 14,400 2008 14,400 5,760 31,360 8,640 2009 8,640 3,456 34,816 5,184 2010 5,184 1,184 36,000 4,000

2010’s expense is adjusted so that ending book value is not less than established residual value


Declining-Balance MethodDouble Declining-Balance

Depreciation

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

1 2 3 4 5

Year

Annual Depreciation End of Year Book Value

Accelerated methods allocate a greater portion of cost to the earlier years of the asset’s life


Both methods allocate a depreciable cost of $36,000 over a five-year period

Comparison of Straight-line and Double-Declining

Balance

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

1 2 3 4 5

YearStraight-Line Method Declining Balance Method


Selecting a Depreciation Method for Financial Reporting Purposes

Management may choose any GAAP-based method for financial reportingTheoretically, best to use a method that reflects the pattern of the asset’s revenues or benefits

– The straight-line method is appropriate for assets whose benefits diminish on a fairly uniform basis

– The double-declining-balance method is appropriate for assets that give up a greater portion of their benefits in the early years

Most companies use the straight-line method due to its simplicity


Choosing a Depreciation Method for Tax PurposesIRS Code stipulates depreciation method and techniques

– Method depends on the statutory “class life” category

– Current recovery periods range from 3 to 20 years for personal property

IRS DepreciationRecovery Periods and Lives

Cost Recovery

Period (Yrs) Method

4 years or less 34 to < 10 years 510 to < 16 years 716 to < 20 years 1020 to < 25 years 1525 years or more 20

Real Propertyresidential rental 27.5nonresidential 39

Personal Property

200% DB

150% DB

straight-line


Choosing a Depreciation Method for Tax Purposes

Salvage value is ignored for tax purposesThe half-year convention is used

– Property is depreciated for half the taxable year in which it is placed in service, regardless of when use actually begins

Deferred tax liability arises– Accelerated depreciation for tax purpose vs straight-line depreciation for financial

purpose– Earlier years have higher tax deductions– Later years have higher taxable income


Depreciation and Cash Flow

Depreciation is not a source of cash; it is a noncash expenseDepreciation indirectly affects cash flow

– depreciation reduces taxable income– results in lower income taxes being

paid


Changes in Estimated Useful Lives

Later events may require changes in estimates of economic life and residual value

– A change in estimate is not an error correction

– A change in estimate is reflected by spreading the remaining depreciable cost over the remaining useful life of the asset


Amortization of Intangible Assets

Finite life intangibles:– Amortize over the economic useful

life or legal life, whichever is shorter– Not to exceed 40 years– Direct subtraction from the asset

accountIndefinite life intangibles:

– No amortization

Impairment ofAsset Value


Impairment of Asset Value

Occurs when an event happens after the purchase of an asset that reduces its value

– Recognized in the financial statements as a reduction in the value of the asset on the balance sheet and a loss on the income statement


Recording Decreasesin the Value of PP&E

A two-step process to identify impairments and record decreases in the value of PP&E

Identify: An impairment loss exists if the sum of estimated future cash flows from the asset is less than its book value Record: An impairment is measured as the difference between the book value of the asset and the fair value


Impairment of Intangible Assets

Intangibles must be evaluated to determine if

– Their estimated useful life has changed

– The intangible has become impaired


Recording Increasesin the Value of PP&E

U.S. GAAP– The principle of conservatism controls– Increases in the value of PP&E are not

allowed under current U.S. GAAP– Gains are recognized in income only

when assets are soldIAS GAAP

– Upward revaluation permitted

Disposal ofLong-Term Assets


Disposal of Long-Term Assets

Disposal of long-term assets can occur through retirement, sale, or trade-in of operating assetsIn each case, depreciation must be recorded up to the date of the disposal and any gain or loss recognized


Retirement

Occurs when an operating asset is removed from service and is disposed of without the company receiving any proceedsAn difference between the cost and balance in the accumulated depreciation account results in a loss on retirement


A gain occurs if the cash or other assets received are greater than the book value at the time of saleA loss occurs if the consideration received is less than the book value at the time of saleGains/Losses are reported in “Other” section of the Income Statement

Sale


Sale: Two Examples

Cash received 7,000 4,000 Book Value of Truck

Cost 35,000 35,000 Accum Dep 30,000 5,000 30,000 5,000

Gain (Loss) on Sale 2,000 (1,000)

Case 1 Case 2

When the disposal is recorded in the accounting records, both the original cost of the truck and the accumulated depreciation on the truck are removed from the books.


Trade-In

Trade-in allowance > book value of the asset given up

a gain is realizedTrade-in allowance < book value of the asset given up

a loss is realized

Measuring PP&EEfficiency


Used to evaluate the appropriateness of the level of a company’s PP&E

Fixed Asset (PPE)Turnover

SalesFixed Asset Turnover = Average PP&E

Can be interpreted as the number of dollars in sales generated by each dollar of fixed assets


The ratios for two companies in different industries cannot be compared

The reported amount of PP&E can be a poor indicator of fair value

Sales generated by leased assets are included in the numerator, but the leased assets are not included in the denominator; upward bias in the ratio

Fixed Asset Turnover Dangers


In Summary ...• Long-term assets provide the infrastructure for production

and distribution• Capital budgeting models include the payback period,

accounting rate of return, and net present value analysis• Patents, franchises, licenses, and goodwill are intangible

assets.• Straight-line and declining balance are common

depreciation methods• Recognizing impairment for PPE is a two-step process• Gain (loss) on asset disposal occurs if proceeds received are

greater (less) than the asset’s book value at date of sale

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