copyright 2003 prentice hall publishing1 chapter 5 acquisitions: purchase and use of business assets

Copyright 2003 Prentice Hall Publishing

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Chapter 5 Chapter 5

Acquisitions: Purchase and Use Acquisitions: Purchase and Use of Business Assetsof Business Assets


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Classification of Operational AssetsClassification of Operational Assets

Operational assets are used by a business to generate revenue.

Tangible operational assets have physical substance. Land, buildings, fixtures,

and equipment Natural resources


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Long-term Operational Assets...Long-term Operational Assets...

Long-term assets will be used more than one year.

Tangible operational assets are reported on the balance sheet in a classification called Property, Plant, and Equipment.


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Classification of Operational AssetsClassification of Operational Assets

Intangible operational assets lack physical substance and confer specific use rights on the owner. Patents Copyrights Franchises Licenses Trademarks


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Purchased operational assets are recorded at cost, an amount that includes all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use.

Invoice price Sales taxes Transportation costs Installation costs Renovation and repair cost incurred prior to use.

Measuring and Recording Measuring and Recording Acquisition CostAcquisition Cost


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Acquisition cost is the net cash equivalent amount paid for the asset.

Financing charges are excluded from the acquisition cost but should be reported as interest expense.

Measuring Acquisition CostMeasuring Acquisition Cost


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When land and building are purchased together, the land cost and the building cost are placed in separate accounts.

The total cost of the purchase is separated on the basis of relative market values.

Basket Purchase of AcquisitionsBasket Purchase of Acquisitions


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Example: On March 1, Arco Co. purchasedland and building for $200,000 cash. The appraised value of the building was $172,500, and the land was appraised at $57,500. How much of the $200,000 purchase price will be allocated to each account?



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Fair Market Values:

Building $ 172,500Land $ 57,500

Total market value $ 230,000

Allocation of cost:

Building * $200,000 =Land * $200,000 =



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Fair Market Values:

Building $ 172,500Land $ 57,500


Allocation of cost:

Building 172,500/230,000 * $200,000 =Land 57,500/230,000 * $200,000 =



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Fair Market Values:

Building $ 172,500Land $ 57,500


Allocation of cost:

Building .75 * $200,000 = 150,000 Land .25 * $200,000 = 50,000



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Nature of Depreciation, Depletion, Nature of Depreciation, Depletion, and Amortizationand Amortization

The matching principle requires that part of the acquisition cost be expensed in periods when the future revenues are earned.

Cost of asset on Balance Sheet

...as the asset is used..... Expense on

Income Statement

[capitalize] [expense]


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Terminology: Write-off….amortizeTerminology: Write-off….amortize

Amortization: Intangible assets

Depreciation: Property, plant,

equipment

franchise

Depletion:–Natural resources

The most general term for writing off an asset isamortizationamortization. However, specific terms are used for certain assets:


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Depreciation MethodsDepreciation Methods

Straight-line

Production method

(Double) Declining balance


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Cost - Residual Value

Life in Years

Depreciation

Expense per Year=

Straight-Line MethodStraight-Line Method


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On January 1, 2003, equipment was purchased for $55,000 cash. The equipment has an estimated useful life of 5 years and an estimated residual value of $10,000.

What is the annual straight-line depreciation expense?

Straight-Line Method: ExampleStraight-Line Method: Example


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Depreciation

Expense per Year=

Depreciation

Expense per Year=


Life in Years

Depreciation

Expense per Year=



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Depreciation

Expense per Year=

Depreciation

Expense per Year=


Life in Years

Depreciation

Expense per Year=

55,000 - 10,000

5



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Depreciation

Expense per Year=

Depreciation

Expense per Year=


Life in Years

Depreciation

Expense per Year=

55,000 - 10,000

5

9,000



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Calculate depreciation expense for the fourth year of the asset’s life.

$9000

Depreciation expense is the same amount each year of the asset’s life

using the straight-line method.



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Units-of-Production MethodUnits-of-Production Method

Step 1:

DepreciationDepreciation RateRate

== Cost - Residual Value Cost - Residual Value Estimated units of useful lifeEstimated units of useful life


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Units-of-Production MethodUnits-of-Production Method


== Cost - Residual Value Cost - Residual Value Estimated units of useful lifeEstimated units of useful life

Step 1:

Step 2:

Depreciation Expense =

Depreciation Rate

×Number of

Units Producedfor the Year


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Given the same information [asset cost $55,000, a residual value of $10,000, and a useful life of five years] plus the asset is estimated to have a total productive capacity of 100,000 units during the useful life:

If 22,000 units were produced this year, what is the amount of depreciation expense?

Units of Production Method: Units of Production Method: ExampleExample


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Step 1:

Step 2:

Depreciation Expense =


==

=Cost - salvage value

Productive output

45,000

100,000

Production Method: ExampleProduction Method: Example


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Step 1:

Step 2:

Depreciation Expense = $ .45/unit * 22,000 = 9,900


==

=Cost - salvage value

Productive output

45,000

100,000

Dep. rate * units produced



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If 15,000 units are produced during the second year of the asset’s life, what is the amount of depreciation expense?

.45 * 675015000 =



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Accelerated depreciation methods result in more depreciation expense in the early years of an asset’s useful life and less depreciation expense in later years of the an asset’s useful life.

Accelerated DepreciationAccelerated Depreciation


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Double-Declining Balance MethodDouble-Declining Balance Method

Declining-balance depreciation is based on the straight-line rate multiplied by an acceleration factor. For example, when the acceleration

factor is 200 percent, the method is referred to as double-declining balance depreciation.

Declining-balance depreciation computations ignore residual value, although the asset can’t be depreciated below the residual value.


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The annual depreciation amount is calculated with the following formula:

Book Value × (2 × Straight-Line Rate)

First, calculate a rate by dividing 2 by the numberof years of useful life.

=



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Annual depreciation expense is calculated with

the following formula:

( )Book Value × Useful Life in Years

2



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Using the same information from our earlier example [asset cost $55,000, residual value is $10,000, and useful life is 5 years]:

Calculate the depreciation expense for the first two years of the asset’s life.

Double-Declining-Balance ExampleDouble-Declining-Balance Example


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First year’s depreciation:

Second year’s depreciation:

Rate = 2/5 = 40%



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55,000 * .40 = 22,000

Rate = 2/5 = 40%


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Second year’s depreciation:

55,000 * .40 = 22,000

33,000 * .40 = 13,200

Rate = 2/5 = 40%


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The total amount of depreciation recorded over the useful life of an asset is the same regardless of the method used.

Depreciation expense recorded in any one period will vary according to method used.

The straight-line method is used by about 95 percent of companies because it is easy to use and to explain.

Comparison of MethodsComparison of Methods


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Most corporations use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes.

MACRS provides for rapidwrite-off of an asset’s cost inorder to stimulate investmentin modern facilities.

Depreciation andDepreciation andFederal Income TaxFederal Income Tax


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Revising Estimates of Salvage Revising Estimates of Salvage Value or of Useful LifeValue or of Useful Life

When an estimate is revised, no changes are made to amounts reported in the past.

The new estimates are incorporated into the present and future calculations only.

Depreciation amounts are revised using the book value and the estimated useful life and salvage value at beginning of the year of the revision.


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Continuing Expenditures Continuing Expenditures for Plant Assetsfor Plant Assets

Expenditures made to keep an asset in good working order are expensed in the period in which they are incurred.

Substantial costs spent to improve the quality or extend the life of an asset are capitalized.


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Extend the life? viewed as canceling

some of the previous depreciation

journal entry to reduce (debit) accumulated depreciation

new depreciation amount will be calculated

Improve the quality? viewed as an additional

cost of the equipment journal entry to increase

(debit) the cost of the asset

new depreciation amount will be calculated

Accounting for Capital ExpendituresAccounting for Capital Expenditures


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Voluntary disposal refers to situations where a business gives up ownership of an asset by: Sale Trade-in Retirement

Involuntary disposal results because of a casualty such as a fire or an accident.

Disposal of Operational AssetsDisposal of Operational Assets


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1. Update the depreciation on the asset tothe date of disposal.

2. Compare the book value of the asset to the cash proceeds from the disposal. If the proceeds > book value, there is a gain on the disposal. If the book value > proceeds, then there is a loss on the sale.

3. Gains and losses go on the income statement.

Disposal of Operational AssetsDisposal of Operational Assets


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Truck which was purchased for $10,000 and with accumulated depreciation of $8,000 was sold for $3,000.

Asset Disposal: ExampleAsset Disposal: Example


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Compare the Book Value (10,000-8,000) to the cash proceeds (3,000).

The difference is a gain or loss on the sale.

Here it is a gain:

Proceeds of $3,000 > BV of $2,000 Gain of $1,000 goes to the income

statement.


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Truck which was purchased for $10,000 and with accumulated depreciation of $8,000 was sold for $1,000.

Asset Disposal: ExampleAsset Disposal: Example


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Compare the Book Value (10,000-8,000) to the cash proceeds (1,000).

The difference is a gain or loss on the sale.

Here it is a loss:

Book value of $2,000 > Proceeds of $1,000

Loss on disposal of $1,000 goes to the income statement.


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Compare cash received for the asset with the asset’s book value (BV).

If cash greater than BV, record a gain. If cash less than BV, record a loss. If cash equals BV, no gain or loss.

asset for sale

Disposal of Operational Assets Disposal of Operational Assets


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Assets supplied by nature Examples: gold, oil, and coal

Presented on balance sheet as non-current assets at cost less depletion to date.

Depletion is just like “units of production” depreciation.

Natural ResourcesNatural Resources


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Total cost of the asset is the cost of acquisition, exploration and development.

Total cost is apportioned by means of depletion over periods in which resulting revenues are earned.



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A depletion rate is calculated usingthe units-of-production method.

Depletion Cost Per Unit Is Calculated As Follows:

Total Cost of Natural Resource

Estimated Number of Available Unitsof Natural Resource



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Noncurrent assets without physical substance that confer certain rights and privileges on the owner of the asset. Examples: patents, copyrights, franchises

and licenses, leaseholds, leasehold improvements, trademarks, and goodwill.

Purchased intangible assets are recorded at cost.

Intangible AssetsIntangible Assets


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Purchased intangible assets are amortized over the shorter of their economic life or legal life, subject to a maximum of 40 years.

Normally the straight-line method is used and the asset is reported in the balance sheet at book value without a related accumulatedamortization account.

Intangible AssetsIntangible Assets


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A patent is an exclusive right granted by federal government to sell or manufacture an invention.

A patent is amortized over the shorter of its useful life or 17-year legal life.

Intangible Assets: PatentsIntangible Assets: Patents

copyright 2003 prentice hall publishing1 chapter 5 acquisitions: purchase and use of business assets

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