1 chapter 10: long-lived assets learning objectives 1.what measurement base is used for long- lived...
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Chapter 10: Long-lived assets
Learning Objectives1. What measurement base is used for long-
lived assets?
2. What kinds of costs are capitalized and how joint costs are allocated among assets?
3. What does asset “impairment” mean and how is it recorded?
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Learning Objectives (contd.)
4. How analysts can adjust for different depreciation assumptions and improve comparisons across companies?
5. How GAAP measurement rules complicate ROA trend analysis and comparisons across companies?
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Asset
• An asset is something that generates future economic benefits and is under the exclusive control of a single entity.
• Examples: Cash, Accounts receivables, investments, inventories, property, plant and equipment, intangible assets.
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Assets Actively Used in OperationsAssets Actively Used in Operations
Tangible ( Fixed) Assets
Property, Plant, Equipment ( PPE)& Natural Resources
Tangible ( Fixed) Assets
Property, Plant, Equipment ( PPE)& Natural Resources
Intangible Assets
No PhysicalSubstance
Intangible Assets
No PhysicalSubstance
Long-Lived Assets
Expected to Benefit Future PeriodsExpected to Benefit Future Periods
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Property, Plane and Equipment PPE are acquired for use in
continuing operations over the life of the asset to generate revenue.
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PPE (contd.) PPE are classified into two categories:
Land (the cost is NOT subject to depreciation)
Depreciable assets: buildings, equipment, motor vehicles, land improvement. Matching principle is applied for the
periodical allocation of the cost of PPE to expenses ( this process is referred to as depreciation).
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Control Over PPE A fixed asset ledger card should be prepared
and maintained for each individual PPE asset purchased. Include all the pertinent information relating to
the asset and its use. These data enable the management to
establish and maintain control over each individual asset.
It also assists in accounting for all transaction relating to PPE assets.
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1. What costs to capitalize?
Overview of Accounting for PPE
Acquisition
2. Depreciation
3. Post acquisition expenditures
4. Retirement
Use Disposal
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Costs include in the initial cost
Identify the various costs included in the initial cost of property, plant, and equipment.
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Costs to be CapitalizedGeneral Rule
The initial cost of an operational asset includes the purchase price and all
expenditures necessary to bring the asset to its desired condition and location for use.
General RuleThe initial cost of an operational asset
includes the purchase price and all expenditures necessary to bring the asset to
its desired condition and location for use.
•PPE are acquired either by cash purchase or by incurring a liability. •If a liability is incurred, the interest charges cannot be included in the cost of the asset except for self-constructed assets.•
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Net purchase price Taxes Transportation costs Installation costs Modification to building necessary to
install equipment Testing and trial runs
Net purchase price Taxes Transportation costs Installation costs Modification to building necessary to
install equipment Testing and trial runs
Costs to be Capitalized- Equipment
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Land: Purchase price Commissions Legal fees Closing fees Clearing fees Title search &
transfer fees Net razing cost of
an old building
Land: Purchase price Commissions Legal fees Closing fees Clearing fees Title search &
transfer fees Net razing cost of
an old building
Costs to be Capitalized – Land and Land Improvements
Land Improvements (depreciable):
DrivewaysParking lotsFencingLandscapingPrivate roads
Land Improvements (depreciable):
DrivewaysParking lotsFencingLandscapingPrivate roads
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Building Purchase price or
contract priceCost of remodelingArchitectural feeBuilding permitsSurveying cost before constructionInterest capitalized7 excavation cost before construction
Building Purchase price or
contract priceCost of remodelingArchitectural feeBuilding permitsSurveying cost before constructionInterest capitalized7 excavation cost before construction
Costs to be Capitalized- Building and Nature Resources
Natural Resources Purchase price,
exploration and development costs of: Timber Mineral deposits Oil and gas reserves
Natural Resources Purchase price,
exploration and development costs of: Timber Mineral deposits Oil and gas reserves
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Capitalization example:Initial costs
All costs are capitalized.
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Lump-Sum Purchases
Cost allocation for Lump-Sum Purchases.
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Several assets are acquired for a single, lump-sum price that may be lower than the
sum of the individual asset prices.
Several assets are acquired for a single, lump-sum price that may be lower than the
sum of the individual asset prices.
Lump-Sum Purchases
Asset 2Asset 1 Asset 3
Allocation of the lump-sumprice is based on relative
market value of the individual assets.
Allocation of the lump-sumprice is based on relative
market value of the individual assets.
Must separate costs because many assets have different depreciable lives, and some (land) are not depreciated.
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For financial reporting and tax purposes, the allocation is guided by their relative market value.
Tax versus financial reporting incentives The allocation of costs between land and buildings affects
the amount of income that will be reported in future periods.
$100
$500
• Higher depreciation
• Lower net income
• Lower taxes
Land Building
Allocation 1:
$500
$100
• Lower depreciation
• Higher net income
• Higher taxesLand Building
Allocation 2:
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On May 13, we purchase land and building for $200,000 cash. The appraised value of
the building is $162,500, and the land is appraised at $87,500.
How much of the $200,000 purchase price will be charged to the building account?
On May 13, we purchase land and building for $200,000 cash. The appraised value of
the building is $162,500, and the land is appraised at $87,500.
How much of the $200,000 purchase price will be charged to the building account?
Lump-Sum Purchases
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Appraised % of Purchase AssignedAsset Value Value Price Cost
(a) (b)* (c) (b × c)Land 87,500$ 35% 200,000$ 70,000$ Building 162,500 65% 200,000 130,000 Total 250,000$ 200,000$
* $87,500÷$250,000 = 35%
The building will be apportioned $130,000of the total purchase price of $200,000.
The building will be apportioned $130,000of the total purchase price of $200,000.
Lump-Sum Purchases
Prepare the journal entry to record the purchase.Prepare the journal entry to record the purchase.
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Lump-Sum Purchases
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Exercise – Joint costsTotal cost of $260,000 ($10,000 cash, $250,000
credit). Individual fair value is determined as if purchased separately.
Asset (Fair value / Total FV) x Total Cost = CostBldg. (100,000 / 325,000) x 260,000 = $ 80,000Equip. (185,000 / 325,000) x 260,000 = 148,000Land ( 40,000 / 325,000) x 260,000 = 32,000Total 325,000 $260,000Journal entry:
Building 80,000Equipment 148,000Land 32,000
Cash 10,000Mort. Payable 250,000
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Self-Constructed Asset
Identify the items included in the cost of a self-constructed asset and determine the amount of
capitalized interest.
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Self-Constructed Assets Costs
Cost of self-constructed assets includes:1. direct materials,
2. direct labor,
3. factory overhead (variable overhead and fixed overhead).
When self-constructing an asset, two accounting issues must be addressed:
Overhead allocation to the self-constructed asset.
Proper treatment of interest incurred during construction.
Cost of self-constructed assets includes:1. direct materials,
2. direct labor,
3. factory overhead (variable overhead and fixed overhead).
When self-constructing an asset, two accounting issues must be addressed:
Overhead allocation to the self-constructed asset.
Proper treatment of interest incurred during construction.
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Under certain conditions, avoidable interest incurred on qualifying assets is
capitalized.
Under certain conditions, avoidable interest incurred on qualifying assets is
capitalized.
Interest that could have been avoided if the asset
were not constructed and the money used to
retire debt.
Interest that could have been avoided if the asset
were not constructed and the money used to
retire debt.
An asset constructed:
For a company’s own use.
As a discrete project for sale or lease.
An asset constructed:
For a company’s own use.
As a discrete project for sale or lease.
Interest Capitalization
GAAP limits the amount of interest capitalized to the lower of (1) Actual Interest or (2) Avoidable interest.
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Capitalization of interest begins when construction begins interest is incurred, and qualifying expenditures for assets
consturtion are incurred.
Capitalization ends when . . . The asset is substantially complete and
ready for its intended use, or when interest costs no longer are being
incurred.
Capitalization of interest begins when construction begins interest is incurred, and qualifying expenditures for assets
consturtion are incurred.
Capitalization ends when . . . The asset is substantially complete and
ready for its intended use, or when interest costs no longer are being
incurred.
Interest Capitalization
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Interest is capitalized based on Weighted Average Accumulated Expenditures
(WAAE).
Interest is capitalized based on Weighted Average Accumulated Expenditures
(WAAE).
Qualifying expenditures include labor, material
and overhead incurred on the construction project
during accounting period.
Qualifying expenditures include labor, material
and overhead incurred on the construction project
during accounting period.
Qualifying expenditures
weighted for the number of months outstanding during
the current accounting period.
Qualifying expenditures
weighted for the number of months outstanding during
the current accounting period.
Interest Capitalization= Average Accumulated Expenditures x interest rate
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If the qualifying asset is financed
through a specific new borrowing . . .
If the qualifying asset is financed
through a specific new borrowing . . .
. . . use the specific rate of the new
borrowing as the capitalization rate.
. . . use the specific rate of the new
borrowing as the capitalization rate.
If there is no specific new borrowing, and
the company has other debt . . .
If there is no specific new borrowing, and
the company has other debt . . .
. . . use the weighted average cost of other
debt as the capitalization rate.
. . . use the weighted average cost of other
debt as the capitalization rate.
Interest Rate used in Interest Capitalization
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Operational Assets: Acquisition 29
Example - Interest Capitalization for Self-Constructed Assets Capitalization period: 1/2/x2 to 6/30/x3
Specific construction debt: $1,500,000 at 11% annual int. rate. This debt was borrowed on 9/30/x1 to finance the project.
Other debt during the construction period:
1. $4,000,000 at 12% annual int. rate.
2. $8,000,000 at 15% annual int. rate.
These loans have been outstanding since 1/1/x2.
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Operational Assets: Acquisition 30
Example (contd.) Weighted Average Interest Rate (of other debt):
Total interest = 480,000 +1,200,000 = 14%Total Principle 12,000,000
or 12% x 4,000,000 +15% x 8,000,000 = 14% 12,000,000 12,000,000
Expenditures on the construction during 20x2 and 20x3 were as follows: 1/2/x2 $800,000 7/1/x2 $1,000,000
10/1/x2 $600,0003/1/x3 $900,0006/1/x3 $1,800,000
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Operational Assets: Acquisition 31
Example (contd.) The amount of interest to be capitalized for 20x2:
Computing the Weighted-Average Accumulated Expenditures (WAAE):
1/2/x2 $800,000 x 12/12 = $800,000 7/1/x2 1,000,000 x 6/12 = 500,00010/1/x2 600,000 x 3/12 = 150,000 2,400,000 $1,450,000
Capitalized Interest (Avoidable Interest) for 20x2:$1,450,000 x 11% x 12/12= $159,5001
1.$1,450,000 < $1,500,000 11% int. loan borrowed specifically to finance the project
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Operational Assets: Acquisition 32
Example (contd.) Actual interest incurred in 20x2:
$1,500,000 x11% + $4,000,000 x 12% + $8,000,000 x 15% = $1,845,000.
Interest exp. = actual int. - capitalized int.
= $1,845,000 - 159,500
= $1,685,500
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Operational Assets: Acquisition 33
Example (contd.)
Journal entry to record the construction costs and interest expense for 20x2:
Building 2,559,5001
Interest Expense 1,685,500
Cash 4,245,000
1.construction costs of 20x2 plus the capitalized interest of 20x2 (2,400,000+159,500=2,559,500).
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Operational Assets: Acquisition 34
Example (contd.) The amount of interest to be capitalized for 20x3:
WAAE of 20x3:
1/1/x3 $2,559,500 x 6/6 =$2,559,5003/1/x3 900,000 x 4/6 = 600,0006/1/x3 1,800,000 x 1/6 = 300,000
$3,459,500 Capitalized interest for 20x3:
WAAE Int. Rate $1,500,000 x 11% x 6/12= $ 82,500 1,959,5001 x 14% x 6/12= 137,165 219,6651. 3,459,500-1,500,000
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Operational Assets: Acquisition 35
Example (contd.) Actual interest incurred in 20x3:
Same as in x2 = $1,845,000.
Int. exp. Of x3 = 1,845,000-219,665= 1,625,335
Journal entry to record the construction costs and int. exp. for x3:
Building 2,919,6651
Interest Exp. 1,625,335
Cash 4,545,000
1.$900,000 + 1,800,000 + 219,665 = 2,919,665 (costs of 20x3 plus the capitalized interest)
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Operational Assets: Acquisition 36
Example (contd.) Reporting:
Income Statement (for the year ended 12/31/x2) Other Revenues & Expenses:
Interest Expenses $1,845,000 Less: Capitalized Int. (159,500)
$ 1,685,500 Notes:Accounting Policy Capitalized interest: during 20X2, total interest
expense was $1,845,000 of which $159,500 was capitalized and $1,685,500 was charged to expense.
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Interest capitalization can distort trends
The income decline becomes larger once the distortion is removed.
Income will be even lower without capitalizing interest.
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Depreciation Methods
Depreciation Methods:( a) Straight-line method
( b) Double-declining balance ( c) Sum-of-the-years’ digits
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Depreciation method recap:Basic concepts The costs of productive assets must be apportioned to
the periods in which they provide benefits (matching principle).
Depreciation is not intended to track the asset’s declining market value but to allocate the cost over its economic life.
Depreciation
Amortization
Depletion
• Buildings• Equipment
• Intangibles
• Mineral deposits• Wasting assets
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Depreciation method recap :(a) Straight-line method example
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Depreciation method recap : (b) Double-declining balance example
Switch to straight-line method
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Depreciation method recap : (c) Sum-of-the-years’ digits example
= n(n+1)/2
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Compare depreciation methods:Alternative patterns
Compare Alternative depreciation methods
(a)
(b)
(a) Annual depreciation charges
(b) Net book value (carrying value)
Total depreciation expenses will be the same
Ending book values will be the same
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Depreciation:Methods used in financial reports
Straight-line is the most popular depreciation method for financial reporting purposes.
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On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and estimated residual value of $5,000.
What is the annual straight-line depreciation?
On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated service life of 5 years and estimated residual value of $5,000.
What is the annual straight-line depreciation?
Straight-Line
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Straight-Line
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Accumulated Accumulated UndepreciatedDepreciation Depreciation Depreciation Balance
Year (debit) (credit) Balance (book value)50,000$
1 9,000$ 9,000$ 9,000$ 41,000 2 9,000 9,000 18,000 32,000 3 9,000 9,000 27,000 23,000 4 9,000 9,000 36,000 14,000 5 9,000 9,000 45,000 5,000
45,000$ 45,000$
Residual ValueResidual Value
Note that at the end of the asset’s useful life, BV = Residual Value
Note that at the end of the asset’s useful life, BV = Residual Value
Straight-Line
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2
SYD depreciation is computed as follows:
Accelerated Methods : Sum-of-the-Years’ Digits (SYD)
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On January 1, we purchased equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated
residual value of $5,000.
Using SYD to compute depreciation for the first two years.
On January 1, we purchased equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated
residual value of $5,000.
Using SYD to compute depreciation for the first two years.
Sum-of-the-Years’-Digits (SYD)
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50
2
Use this in your computation of SYD Depreciation for Years 1 & 2.
Use this in your computation of SYD Depreciation for Years 1 & 2.
Sum-of-the-Years’ Digits (SYD)
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Sum-of-the-Years’ Digits (SYD)
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Accumulated UndepreciatedDepreciation Depreciation Balance
Fraction (debit) Balance (book value)50,000$
5/15 15,000$ 15,000$ 35,000 4/15 12,000 27,000 23,000 3/15 9,000 36,000 14,000 2/15 6,000 42,000 8,000 1/15 3,000 45,000 5,000
45,000$
Accumulated UndepreciatedDepreciation Depreciation Balance
Fraction (debit) Balance (book value)50,000$
5/15 15,000$ 15,000$ 35,000 4/15 12,000 27,000 23,000 3/15 9,000 36,000 14,000 2/15 6,000 42,000 8,000 1/15 3,000 45,000 5,000
45,000$ Residual ValueResidual Value
Sum-of-the-Years’ Digits (SYD)
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Declining-Balance (DB) Methods
DB depreciation
Based on the straight-line rate multiplied by an acceleration factor.
Computations initially ignore residual value.
DB depreciation
Based on the straight-line rate multiplied by an acceleration factor.
Computations initially ignore residual value.
Stop depreciating when:
BV=Residual Value
Stop depreciating when:
BV=Residual Value
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DDB depreciation is computed as follows:
Note that the Book Value will get lower each time
depreciation is computed!
Note that the Book Value will get lower each time
depreciation is computed!
Double-Declining-Balance (DDB)
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On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated
residual value of $5,000.
What is depreciation forthe first two years using
double-declining-balance?
On January 1, we purchase equipment for $50,000 cash. The equipment has a service life of 5 years and an estimated
residual value of $5,000.
What is depreciation forthe first two years using
double-declining-balance?
Double-Declining-Balance (DDB)
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Double-Declining-Balance (DDB)
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Accumulated UndepreciatedDepreciation Depreciation Balance
Year (debit) Balance (book value)50,000$
1 20,000$ 20,000$ 30,000 2 12,000 32,000 18,000 3 7,200 39,200 10,800 4 4,320 43,520 6,480 5 1,480 45,000 5,000
45,000$
Accumulated UndepreciatedDepreciation Depreciation Balance
Year (debit) Balance (book value)50,000$
1 20,000$ 20,000$ 30,000 2 12,000 32,000 18,000 3 7,200 39,200 10,800 4 4,320 43,520 6,480 5 1,480 45,000 5,000
45,000$
Double-Declining-Balance (DDB)
We usually have to force depreciation in thelatter years to an amount that brings BV = Residual Value.
We usually have to force depreciation in thelatter years to an amount that brings BV = Residual Value.
2,592
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Reporting Fixed assets –Carrying value
Define and measure carrying value
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Measuring the carrying amount:Carrying value = Original Purchase Price – Accumulated Depreciation There are two ways that long-lived assets could be
measured on balance sheets:
Expected benefit approach:
$$• Discounted present
value
• Net realizable value
Estimated value in an output market where the asset is sold
Economic sacrifice approach:
$$• Historical cost
• Replacement cost
Estimated value in an input market where the asset is purchased
GAAP uses historical cost because the numbers are reliable and verifiable.
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Measuring the carrying amount Assume a truck originally costing $100,000, is two years old, has a remaining life of 8 years, is
being depreciated on a straight-line basis, and is expected to have no salvage value.
Historical cost less accumulated depreciation is the carrying value reported on balance sheets:
$100,000 – {(100,000/10) *2} = $80,000 ( Carrying amount)
Carrying value = Cost – Accumulated Depreciation
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Assets held for sale When firms actively try to sell assets they own, the
asset groups should be classified on the balance sheet as “held for sale”.
When assets are held for sale, they are reported at the lower of book value or fair market value minus costs to sell.
$2,500,000$2,350,000
$46,000
$2,304,000
Book value Fair value Expected cost to sell
So, these assets would be shown on the balance sheet at $2,304,000.
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International perspective
In the U.K., companies are permitted to revalue land and buildings.
Suppose a building that originally cost ₤20 million and has an accumulated depreciation balance of ₤10 million is appraised at ₤35 million. The entry to write-up the building is:
And the new book value becomes:
DR Building £15,000,000DR Accumulated depreciation 10,000,000 CR Revaluation reserve £ 25,000,000
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Post-acquisition Expenditures
Identify the post-acquisition expenditures need to be capitalized or expensed.
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Post-acquisition Expenditures: Capitalize or Expense? GAAP capitalizes costs (i.e., record the
cost in an asset account) incurred after the asset has been placed in use as long as the expenditure: Extends the asset’s useful life Increases its productive capacity
(e.g. attainable production units) Increases its production efficiency
(e.g., fewer raw materials) Increases the asset’s other economic
benefits
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Post-acquisition Expenditures: Capitalize or Expense?
If there is no increase in economic benefits (or future service potential), the expenditure is charged to income as an expense.
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Post-acquisition Expenditures: Subsequent costs In January 2008 (three years later), Winger spent an
additional $8,000 on the machine:
$2,000
$6,000
Ordinary repairs and maintenance
Install new component
Expense to income statement: record as repair expenses.
Capitalize to balance sheet : Adding values into the asset accounts.
Increases the economic benefit (future service potential) of the machine.
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Expenditures Subsequent to Acquisition
Maintenance and ordinary
repairs.
Maintenance and ordinary
repairs.
Additions.Additions.
Improvements (betterments),
replacements, and extraordinary repairs.
Improvements (betterments),
replacements, and extraordinary repairs.
Rearrangements and other
adjustments.
Rearrangements and other
adjustments.
Normally we debit an expense account for amounts spent on:
Normally we debit the asset account for amounts spent on:
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Case Study: Impact of WorldCom’s Misapplication of Asset Capitalization Rules
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Asset Impairment
What asset “impairment” means and how it is recorded.
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Operational Assets: Utilization and Disposition
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Asset Impairmentsa
Unlike inventory which is reported at LCM, PPE and Intangibles are reported at cost except for impairments.
An impairment occurs when the book value of an asset is not fully recoverable.
a. Based on SFAS No. 144: Accounting for the Impairment or Disposal of Long-Lived Assets and SFAS No. 142: Goodwill and Other Intangible Assets
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Impairment of Value
Accounting treatment differs.Accounting treatment differs.
Operational assetsto be held and usedOperational assetsto be held and used
Operational assetsheld to be sold
Operational assetsheld to be sold
Tangible andintangible with finiteuseful lives
Tangible andintangible with finiteuseful lives
Intangiblewith
indefiniteuseful lives
Intangiblewith
indefiniteuseful lives
GoodwillGoodwill
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Operational Assets Held for Use – a. Tangible Assets and Finite-Life Intangibles SFAS No. 144 (effective 2002) requires
test for impairment only when events or changes in circumstances indicate that the book value of this asset (or asset group) may not recoverable.
For the purpose of this test, assets are grouped at the lowest level in which the cash flows of each group are independent.
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The Accounting Treatment for Impairment (for Held for Use Tangible and finite-Life Intangibles)
Steps:
1. Conduct the Recoverability Test.
2. Compute the Impaired Amount.
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Asset impairment:The impairment loss is the difference between the fair value of the asset and the carrying amount of the assetAccording to SFAS No. 144 Guidelines: Step 1: If the events or changes in circumstances
raised the possibility that certain long-lived assets may be impaired, go to step 2.
Step 2: Estimate the future undiscounted net cash flows expected from the use and disposal of the asset.
If the future undiscounted net cash flows are less than the carrying amount of the asset, the impaired asset must be written down.
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Operational Assets: Utilization and Disposition 75
Step 1: Conduct the Recoverability Test Compare the book value (BV) of the
asset with the undiscounted expected future cash flows (EFCF) of the asset (asset group).
If BV > Undiscounted EFCF, the impairment has occurred and the impaired amount should be written off.
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Step 2: Compute The Impaired Amount
Impaired amount
= Book value - fair value
(if the fair value is available) or
Impaired amount
= Book value – estimated fair value1
(if fair value is not available)1. discounted present value of the future cash flows of the asset can be the estimated fair value
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Asset impairment:SFAS No. 144 guidelines
• Market value, price of similar assets, or PV of future net cash inflows.
Recoverable value
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Asset impairment: An Example
Solomon Corporation manufactures a variety of consumer electronics products. The growing popularity of DVD players is expected to reduce the demand for Solomon’s videocassettes. The videocassettes are produced on an assembly line consisting of five special purpose assets with a carrying amount (net book value) of $2,000,000. Solomon’s management believes that this change in the business climate threatens the recoverability of these assets’ carrying amount. Assume the current fair value of the entire assembly line is $1,000,000.
Impairment possible?
Undiscounted net cash flows expected
Are cash flows lowerthan carrying amount?
Impairment loss
a.
b.
c.
d.
Yes!
$1,500,000
The difference between the fair vale of the asset and the carrying amount of the asset.
2,000,000-1,000,000=1,000,000
Yes!
Expected net operating cash flows:
2005 $800,0002006 400,0002007 200,000Expected salvage value 100,000
Total undiscounted cash flows $1,500,000
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Disposition or retirement of long-lived assets
Disposition or retirement of long-lived assets.
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Suppose the asset in Exhibit 10.9 is sold at the end year 2 for $5,000 when its book value is $3,780. The entry to record this disposition is:
Dispositions of individual assets take place frequently, so gains and losses do not qualify for extraordinary item treatment.
Both original cost and accumulated depreciation must be removed from the balance sheet.
Disposition or retirement of long-lived assets
DR Cash $5,000
DR Accumulated depreciation 6,720
CR Long-lived assets $10,500
CR Gain on sale of assets 1,220
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Obligations arising from retiring long-lived assets (SFAS No. 143)
Kali records the asset retirement obligation when the asset is placed into service:
This results in additional depreciation expense:
DR Drilling rig (asset retirement cost) $8,167,000
CR ARO liability $8,167,000
DR Depreciation expense $1,633,400
CR Accumulated depreciation-drilling rig $1,633,400
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Intangible Assets
Identify the various costs included in the initial cost of intangible assets.
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Intangible assets:Overview
Intangible assets convey future benefits to their owners.
Examples of Intangible assets: Patents, Copyrights, Trademarks, Franchises and goodwill.
Characteristics of Intangible assets: Lack physical substance. Future benefits less certain than tangible assets. Owner with exclusive rights.
TrademarkPatent
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Costs to be Capitalized Intangible Assets
The accounting for acquired intangible assets is straight-forward: The asset is first recorded at the arm’s length
transaction price. Then amortized (think “depreciation”) over its
expected useful life. Difficult financial reporting issues arise when
the intangible asset is developed internally instead of being purchased.
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An exclusive right recognized by law and granted by the US Patent Office for 20 years.
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 successfully defending a
patent (internal or external).
A company cannot capitalize the following legal fees for unsuccessfully defending a patent. R& D costs that lead to an
internally developed patentare expensed in the periodincurred.
An exclusive right recognized by law and granted by the US Patent Office for 20 years.
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 successfully defending a
patent (internal or external).
A company cannot capitalize the following legal fees for unsuccessfully defending a patent. R& D costs that lead to an
internally developed patentare expensed in the periodincurred.
Patents
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Genetech, Inc. has developed a new device. Research and development costs totaled
$30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal
registration fees.
What is Genetech’s patent cost?
Genetech, Inc. has developed a new device. Research and development costs totaled
$30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal
registration fees.
What is Genetech’s patent cost?
Torch’s cost for the new patent is $3,000. The $30,000 R & D cost is expensed as
incurred.
Torch’s cost for the new patent is $3,000. The $30,000 R & D cost is expensed as
incurred.
Patents
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A form of protection given by law to authors of literary, musical, artistic, and similar works.
Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work.
Generally, the legal life of a copyright is the life of the author plus 70 years.
A form of protection given by law to authors of literary, musical, artistic, and similar works.
Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work.
Generally, the legal life of a copyright is the life of the author plus 70 years.
Copyrights
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A symbol, design, or logo associated with a business.
If internally developed, trademarks have no recorded asset cost.
If purchased, a trademark is recorded at cost.
Registered with U.S. Patent Office and renewable indefinitely in 10-year periods.
A symbol, design, or logo associated with a business.
If internally developed, trademarks have no recorded asset cost.
If purchased, a trademark is recorded at cost.
Registered with U.S. Patent Office and renewable indefinitely in 10-year periods.
Trademarks
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A franchise is a contractual agreement under which the franchiser grants the franchisee the right to sell certain products or service or to use certain tradenames or trademarks
A license is a contractual agreement between a governmental body (i.e., city, state, etc.) and a private enterprise to use public prope
A franchise is a contractual agreement under which the franchiser grants the franchisee the right to sell certain products or service or to use certain tradenames or trademarks
A license is a contractual agreement between a governmental body (i.e., city, state, etc.) and a private enterprise to use public prope
Franchises and License
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Occurs when onecompany buys
another company.
The amount by which thepurchase price exceeds the fair
market value of net assets acquired.
Only purchased goodwill is an
intangible asset.
Goodwill
Goodwill
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Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000.
Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000.
Goodwill
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What amount of goodwill should be recorded on Eddy Company books?
a. $100,000
b. $200,000
c. $300,000
d. $400,000
What amount of goodwill should be recorded on Eddy Company books?
a. $100,000
b. $200,000
c. $300,000
d. $400,000
Goodwill
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Intangible assets:Research and development (R&D) Recoverability of R&D expenditures (i.e., the
future benefit) is highly uncertain at the start of a project.
So, SFAS No. 2 requires virtually all R&D expenditures to be expensed as incurred.
The FASB justified expensing all R&D for three reasons:1. The future benefits are highly uncertain and difficult to predict.
2. A causal relationship between current R&D and future revenue (the benefit) has not been demonstrated.
3. Whatever benefits may arise cannot be objectively measured.
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Research Planned search or critical investigation aimed at discovery of
new knowledge . . .Development
The translation of research findings or other knowledge into a plan or design . . .
Research Planned search or critical investigation aimed at discovery of
new knowledge . . .Development
The translation of research findings or other knowledge into a plan or design . . .
Research and Development (R&D)
Accounting Treatment for R&D costs: R&D costs incurred under contract for other
companies are expensed against revenue from the contract.
Operational assets used in R&D should be capitalized if they have alternative future uses.
Accounting Treatment for R&D costs: R&D costs incurred under contract for other
companies are expensed against revenue from the contract.
Operational assets used in R&D should be capitalized if they have alternative future uses.
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Intangible assets:Software development
SFAS No. 86 extends the accounting treatment for R&D to internal expenditures for software development.
Development expenditures $$
Development expenditures $$
Software project time line
Technological feasibility establishedExpensed as incurred
Capitalized and amortized
Befor After
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Intangible assets:Purchased in-process R&D
When one firm buys another firm, the total purchase price must be apportioned among the individual assets acquired.
Managers have a strong incentive to allocate a large portion of the purchase price to purchased in-process R&D.
$500
$200
$250
In-process R&D (no alternative future use)
Other in-process R&D
Tangible assets
Immediately written off
Price paid for company
Allocation of purchase price
$950
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Software Development CostsSFAS No. 86
All costs incurred to establish the technological feasibility of a computer software product are treated as R&D and expensed as incurred.
Subsequent costs to obtain product masters are to be capitalized as an intangible asset.
All costs incurred to establish the technological feasibility of a computer software product are treated as R&D and expensed as incurred.
Subsequent costs to obtain product masters are to be capitalized as an intangible asset.
“Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed”
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Start ofR&D
Activity
TechnologicalFeasibility
Date ofProductRelease
Sale of Product
CostsExpensed
as R&DCosts
CapitalizedOperating
Costs
Software Development CostsSFAS No. 86
Software project time line
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Intangible assets:Accounting in the United Kingdom Marketing and advertising expenditures are
treated as period costs. R&D accounting also similar to U.S. GAAP.
However, UK accounting rules allow companies to write long-lived assets up to a new higher carrying value when market value exceeds historical cost.
One firm decided to put a balance sheet value of $1.2 billion on its 60 trademarks (called “brands” in the UK).
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Learning Objective
How analysts can adjust for different depreciation assumptions and improve
comparisons across companies
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Depreciation Disclosures Depreciation. Balances of major classes of depreciable
assets. Accumulated depreciation by asset or in
total. General description of
depreciation methods used.
Depreciation. Balances of major classes of depreciable
assets. Accumulated depreciation by asset or in
total. General description of
depreciation methods used.
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Financial analysis:Depreciation differences
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When a company uses straight-line depreciation, the ratio of average gross PP&E divided by depreciation expense is a rough approximation of estimated useful life:
Financial analysis:Finding average useful life
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Financial analysis:Average useful life at Wal-Mart and Costco
Using Costco’s estimated service life, Wal-mart’s depreciations expense would be:
$52.1
19 years$2.7 =
Compared to $3.1 billion reported depreciation expense
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Wal-Mart and Costco Example (contd.) Therefore, had Wal-Mart used Costco’s
deprecation life, its earnings will be reduced by $400 million.
This adjustment process relies on many assumptions (i.e., both companies assets are similar and have similar lives and residual value, etc.)
If the assumptions are incorrect, this method will not result in correct adjustment.
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Learning Objective
Learning ObjectiveLearning
How GAAP measurement rules complicate trend analysis and comparisons across companies
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Financial analysis and fixed assets:ROA distortion example
Assume: No new capital
expenditures. Prices rise at 3% per year -
operating CF increases.
0%
5%
10%
15%
20%
25%
2005 2006 2007 2008 2009
Return on assets
ROA chart shows improving performance.
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Financial analysis and fixed assetsWhy ROA appears to increase
Constant amount
each year
Increases 3% each year
Asset base declines
each year
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Financial analysis and fixed assets:Rizzo Corporation
Assume: Long-lived asset age of
4.5 years. Capital expenditures
replace 10% of long-lived assets each year.
Prices rise at 3% per year.
0%
5%
10%
15%
20%
25%
2005 2006 2007 2008 2009
Return on assets
Same as CHEN
ROA no longer increases over time.
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Financial analysis and fixed assetsWhy Rizzo’s ROA is flat
Capital expenditures
cause the increase
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ROA distortion Example (contd.) Therefore, firms whose assets are
continually being replaced (i.e., Rizzo) cannot be easily compared to firms with aging assets such as Chen.
However, most firms do regularly replace some assets.
Therefore, when assets are regularly replaced, the average age of long-lived assets remains fairly constant from year to year.
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ROA distortion Example (contd.) One of the reasons causing the distortion
on ROA analysis is the historical cost basis on depreciation of long-lived assets and the reporting of these assets on financial statements.
Within the same industry comparison of ROA is usually meaningful due to competition often leads firms to have similar investments and operating strategies (i.e., similar % increase in capital expenditures).
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Summary The need for reliable and verifiable numbers causes
long-lived assets to be measured using historical cost. The balance sheet amounts for intangible assets often
differ from their real value. Changes in the amount of capitalized interest from one
period to another can distort earnings trends. When comparing return on assets (ROA) ratios across
firms, remember that ROA drifts upward as assets age.
Depreciation differences can complicate comparisons across firms. Footnote details can be used to improve these comparisons.