accrual accounting and financial statements_8

7/30/2019 Accrual Accounting and Financial Statements_8

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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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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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7/36 2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e

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




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




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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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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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




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




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




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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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.




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




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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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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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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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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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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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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2010 Pearson Education Inc. Publishing as Prentice Hall Introduction to Financial Accounting, 10/e 35 of 40

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

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