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Chapter 9:

Long-­‐Lived Assets

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Long – Lived Assets Land

Has indefinite life and therefore is not depreciated Historical Cost includes:

Purchase price, Closing costs, Cost to get ready for intended use (Note: Sale of salvaged materials reduces cost)

Land Improvements Have definite life and therefore are depreciated Fences, walls, parking lots, driveways

Long – Lived Assets Buildings

Have definite life and therefore are depreciated Proportionate share of purchase price, or construction cost, Closing Cost, Architect & Attorney fees

Machinery, Equipment, Furniture & Fixtures Purchase price (net of cash discounts), Freight & handling, Insurance while in transit, Installation

Intangible assets Rights, privileges, and benefits of possession No physical existence Includes cost and the cost to defend them Amortized over useful life (if indefinite life, no amortization)

The Relative Size of Long-­‐Lived Assets

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Figure 9-­1 Property, plant, and equipment plusIntangible as a percentage of total assets

Capitalize vs. Expense Revenue Expenditures

Merely maintain a given level of services Should be Expensed

Capital Expenditures Provide future benefits (useful life > 1 year) Matching principle Should be Capitalized

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Debit Expense

Debit Asset

Financial Statement Effects

7Figure 9-­2 (Partial) The effects of depreciation period on the financial statements: Rudman Manufacturing

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Overview of Accounting for Property, Plant, and Equipment

Figure 9-­4 Accounting for long-­lived assets

Acquisition: What Costs to Capitalize? General Rule:

Capitalize (add to an asset account) the costs to acquire the asset and bring it to its serviceable or usable condition and location. Dr. Asset (purchase price, sales tax,

delivery, installation, etc) Cr. Cash, Notes Payable, etc

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• Direct Materials• Labor• Overhead• Interest During Construction

Postacquisition Expenditures: Betterments or Maintenance? • Maintain current level of productivity• Repairs and maintenance• Expensed as incurred

• Betterments – one of the following must apply• Increase useful life beyond the initial estimate• Improve quality of output• Increase quantity of output• Reduce costs of operating the asset

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Cost Allocation: Amortizing Capitalized Costs The costs are to be matched against the benefits produced by the asset Estimate the Useful Life – based on physical obsolescence

Estimate a Salvage Value – based on amount that can be recovered on the asset

Choose a cost allocation (depreciation) method.

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Cost Allocation: Amortizing Capitalized Costs

• Technical Obsolescence is another challenge that must be overcome in estimating useful life and salvage value.

• Changes in estimates related to depreciation are treated prospectively – determine current book value and recalculate depreciation going forward.

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Remaining Book Value -­ New Est. SalvageRemaining Estimated Life

Cost Allocation (Depreciation) Methods There are a variety of depreciation methods utilized. The more

common methods are covered in this text.

The Straight-­Line Method of Amortization (Depreciation) (Cost – Salvage Value)/Useful Life

Double Declining Balance Method (2XBook Value)/Useful Life

The Activity (Units-­of-­Production) MethodCost -­ Salvage Value x Current Activity Total expected activity

Natural Resource DepletionCost -­ Salvage Value x Current Activity Total expected activity 14

Class ExampleGiven the following information regarding an automobile purchased by the company on January 2, 2014:

Cost to acquire = $10,000Estimated life = 4 yearsEstimated miles = 100,000 milesSalvage value = $2,000

Calculate depreciation expense for the first two years under each of the following methods.

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Units-­‐of-­‐Production (Activity)Assume that the car was driven 20,000 miles in the year 2013, and 30,000 miles in 2014.

Annual depreciation =Cost -­ Salvage Value x Current Activity Total expected activity

For 2013= 10,000 -­ 2,000 x 20,000 = $1,600 100,000 miles

For 2014 = 10,000 -­ 2,000 x 30,000 = $2,400100,000 miles

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Straight-­‐Line

= $10,000 -­ $2,000 = $2,000 per year4 years

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Cost -­ SalvageEstimated Life

Annual depreciation =

Double-­‐Declining BalanceDDB is an accelerated depreciation technique. It generates more expense in the early years and less in the later years. Annual depreciation = (2 X Book Value)/ Useful LifeDepreciation expense (D.E.)for:2013 = (2 x 10,000)/4 = $5,0002014 = 2 x(10,000-­5,000)/4 = $2,500

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How does Management Choose and Acceptable Cost Allocation MethodEffect on the Financial StatementsEffect on Income Taxes

Management may use a different depreciation method for financial statements and income taxes

IRS tax rules effect allowable depreciation methodologies

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Class Problem: Problem 9-­‐7(a) Book Value at 1/1/14:First: annual depr. expense = (180,000-­30,000)/10 = 15,000/yr.

Then Accumulated Depr. to 1/1/14:15,000 x 5 yrs = $75,000

So BV = 180,000 -­ 75,000 = 105,000

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Class Problem: Problem 9-­‐7(b) Estimate for 2014, assuming revised useful life:

BV -­ SV = 105,000 -­ 30,000 = $9,375 per yr.Remaining life (10 – 5) +3

Journal entry:Depreciation Expense 9,375

Accum. Depreciation 9,375

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Disposal: Retirement, Sale and Trade-­‐Ins

Retirement : Dr. Loss (if not fully depreciated)Dr. Acc Dep

Cr. Asset Sale:Dr. Cash Dr. Acc Dep

Cr. Asset Dr. Loss if BV > Cash or Cr. Gain if BV < Cash

Trade-­ins (for dissimilar assets): asset received should be valued at The fair market value of assets given up, or The fair market value of the asset received,

Whichever is more evident and objectively determined 22

Disposals (cont’d)Using earlier example (cost = $10,000, salvage = $2,000). After 4 years straight-­line, $8,000 would be in A/D.

1. Assume the asset is retired (no cash received)Loss on retirement 2,000Accumulated Depr. 8,000

Automobiles 10,000

2. Assume the asset is sold for $3,000:Cash 3,000Accumulated Depr. 8,000

Automobiles 10,000Gain on sale 1,000

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Class Exercise: Exercise 9-­‐15 First calculate depreciation:DDB % = (2xBV)/Useful Life

Depr. BookDate Calculation Expense Value1/1/12 25,00012/31/12 (2x25,000)/5 = 10,000 15,00012/31/13 (2x15,000)/5 = 6,000 9,00012/31/14 (2x9,000) / 5 = 3,600 5,40012/31/15 400* 5,000=SV12/31/16 -­‐0-­‐ 5,000*formula will exceed salvage value limit in 2015; just depreciate $400, to salvage of $5,000.

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Exercise 9-­‐15 (cont’d)(a) JE to scrap after 3 years, at 12/31/14, assumes that no cash is received:

Dr. Loss on Disposal 5,400Dr. Acc Dep 19,600

Cr. Equipment 25,000

(b) JE to scrap after 5 years, assumes that no cash is received:

Dr. Loss on Disposal 5,000 Dr. Acc Dep 20,000

Cr. Equipment 25,00025

Exercise 9-­‐15 (cont’d)(c) JE to sell for $8,000 after 3 years:

Dr. Cash 8,000Dr. Acc Dep 19,600

Cr. Equipment 25,000Cr. Gain 2,600

(d) JE if, after 5 years, the equipment and $28,000 traded for a dissimilar asset with a fair market value of $30,000:

Dr. Asset (new) 30,000Dr. Acc Dep 20,000Dr. Loss 3,000

Cr. Equipment (old) 25,000Cr. Cash 28,000

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Intangible Assets Intangible assets are characterized by

Lack of physical substance, and Higher uncertainty about future benefits.

Cost is amortized over useful life (or legal life, if less). Straight line amortization is common. Goodwill is not amortized – indefinite life Some other assets have an indefinite life and are not amortized (permanent franchise rights)

Under IFRS, revaluing intangibles is an option, but not a requirement. Under US GAAP, revaluation is not an option.

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Patents (20 year legal life) A company may capitalize the following

The cost of acquiring an externally developed patent.

Filing fees for internally or externally developed patents.

The legal fees for acquiring and successfullydefending a patent (internal or external).

A company cannot capitalize the following: Legal fees for unsuccessfully defending a patent.Most research and development costs for an internally developed patent.

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Other Intangible Assets Copyrights

Granted for the life of the creator plus 70 years. Capitalization rules similar to patents: costs of internally developed copyright material cannot be capitalized.

Trademarks and Trade Names Granted for 10 year periods, but indefinite renewals. Some of design costs may be capitalized.

Organization Costs Costs related to the creation of a company including underwriting fees, legal and accounting, licenses, titles, etc.

Treatment similar to R&D costs;; even though there may be some future benefit, costs are expensed in the period incurred.

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Other Intangible Assets (cont’d) Software Development Costs (SFAS 86)

Capitalize the costs of developing software for sale or lease. Expense software development costs if for internal use.

Goodwill (also discussed in Chapter 8) Recognized when one company purchases another company. Causes include reputation, good customer relations, superior product development, etc.

To calculate:Purchase price paid for the company versus the fair market value of the net assets acquired= Goodwill (the excess amount paid)

No longer amortized, instead subjected to an impairment test

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IFRS vs. US GAAP: Revaluations to Fair Market Value

One very important way in which IFRS differs from US GAAP involves the use of fair market value as a basis for valuation on the balance sheet. Under US GAAP, long-­lived assets must be accounted for at original cost less accumulated depreciation.

Under IFRS, companies can either follow the US GAAP method or they can periodically revalue their long-­lived assets to fair market value.

In essence, US GAAP tends to follow a conservative “lower-­of-­cost-­or-­market” valuation principle, whereas IFRS allows managers the option to more closely follow a pure market valuation principle.

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