reporting and interpreting property, plant, and equipment ... · depreciation is a cost allocation...

Chapter 8

Reporting and Interpreting

Property, Plant and Equipment;

Natural Resources; and Intangibles

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin

Understanding The Business

How much

is enough?

Insufficient

capacity results

in lost sales.

Costly excess

capacity reduces

profits.

McGraw-Hill/Irwin

Understanding The Business

Insufficient

capacity results

in lost sales.

Costly excess

capacity reduces

profits.

McGraw-Hill/Irwin

Tangible

Physical Substance

Intangible

No Physical Substance

Expected to Benefit Future Periods

Actively Used in Operations

Classifying Long-Lived Assets

Land

Assets subject to depreciation

Buildings and equipment

Furniture and fixtures

Natural resource assets subject to depletion

Mineral deposits and timber

Examples

McGraw-Hill/Irwin Slide 5

Tangible

Physical Substance

Intangible

No Physical Substance

Expected to Benefit Future Periods

Actively Used in Operations

Classifying Long-Lived Assets

Value represented by rights that produce benefits

•Definite life

Patents

Copyrights

Franchises

•Indefinite life

Trademarks

Goodwill

Examples

McGraw-Hill/Irwin

Fixed Asset Turnover Fixed

Asset

Turnover

Net Sales Revenue

Average Net Fixed Assets =

This ratio measures a company’s ability to generate sales

given an investment in fixed assets.

Southwest Airlines had $9,861 of revenue. End-of-year fixed

assets were $10,874 and beginning-of-year fixed assets were

$10,094. (All numbers in millions.)

Fixed

Asset

Turnover

$9,861

($10,094 + $10,874) ÷ 2 = = 0.94

Delta Southwest United

1.26 0.94 1.68

2006 Fixed Asset Turnover Comparisons

McGraw-Hill/Irwin

Measuring and Recording Acquisition Cost

Acquisition cost includes the purchase price and all expenditures needed to prepare the asset for its intended use.

Acquisition cost does not include financing charges and cash discounts.

Buildings

• Purchase price

• Renovation and repair costs

• Legal and realty fees

• Title fees



Construction cost includes the costs needed to prepare the asset for its intended use.

Buildings The cost of constructing a building includes:

Architectural fees

Building permits

Contractors’ charges

Payments for material

Labor

Overhead

McGraw-Hill/Irwin

Acquisition by Construction

Asset cost includes:

All materials and

labor traceable to

the construction.

A reasonable

amount of

overhead.

Interest on debt

incurred during

the construction.

McGraw-Hill/Irwin


Equipment

• Purchase price

• Installation costs

• Modification to building necessary to install equipment

• Transportation costs

McGraw-Hill/Irwin


Land

• Purchase price

• Real estate

commissions

• Title insurance

premiums

• Delinquent taxes

• Surveying fees

• Title search and

transfer fees

• “Tear downs”

Land is not depreciable.

McGraw-Hill/Irwin

So Why No More Drive-Thru Service?

For years the fact that the business was a drive-thru that sold beer

and wine kind of made the Beer Depot a landmark. When we took

over in 2005, we were no longer ALLOWED to keep the drive thru

because Michigan law prevented it. Oddly, it's okay in Michigan to

sell beer and wine in a drive-thru, but not if your liquor license allows

you to also sell distilled spirits. The building is also an Ann Arbor

Historic Building, so there are limitations on remodeling and

restoration, so the building you see today is dictated by those

guidelines.

http://www.flickr.com/photos/swthomas/3265693296/

http://www.flickr.com/photos/70251312@N00/2026739372/

McGraw-Hill/Irwin

Measuring and Recording

Acquisition Cost

On January 1, Southwest Air Lines purchased aircraft for $70,000,000 cash.

GENERAL JOURNAL Page 8

Date Description Debit Credit

Jan. 1 Flight equipment (+A) 70,000,000

Cash (-A) 70,000,000

Acquisition

for Cash

On January 14, Southwest Air Lines purchased aircraft

for $1,000,000 cash and a $69,000,000 note payable. Acquisition

for Debt



Jan. 14 Flight equipment (+A) 70,000,000

Cash (-A) 1,000,000

Note payable (+L) 69,000,000

http://www.photovault.com/Link/Technology/Aviation/FlightCommercial/show.asp?tg=TAFVolume36/TAFV36P05_19B

McGraw-Hill/Irwin

Acquisition for

Noncash Consideration Record at the current market value of the consideration

given, or the current market value of the asset acquired,

whichever is more clearly evident.

On July 7, Southwest gave Boeing 9,000,000 shares of

$1.00 par value common stock with a market value of

$5.00 per share plus $25,000,000 in cash for aircraft.



July 7 Flight equipment (+A) 70,000,000

Cash (-A) 25,000,000

Common stock (+SE) 9,000,000

Additional paid-in capital (+SE) 36,000,000


McGraw-Hill/Irwin

Repairs, Maintenance, and Additions

Type of Capital or

Expenditure Revenue Identifying Characteristics

Ordinary Revenue 1. Maintains normal operating condition

repairs and 2. Does not increase productivity

maintenance 3. Does not extend life beyond original

estimate

Extraordinary Capital 1. Major overhauls or partial

repairs replacements

2. Extends life beyond original estimate

Additions Capital 1. Increases productivity

2. May extend useful life

3. Improvements or expansions


Ordinary repairs and maintenance

Extraordinary repairs

May extend useful life

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McGraw-Hill/Irwin

Financial Statement Effect

Current Current

Treatment Statement Expense Income Taxes

Capital Balance sheet

Expenditure account debited Deferred Higher Higher

Revenue Income statement Currently

Expenditure account debited recognized Lower Lower

Repairs, Maintenance, and Additions

To solve this problem, many companies have policies

regarding the expensing of all expenditures below a

certain amount according to the materiality constraint.

McGraw-Hill/Irwin

Materiality and Capitalization

Movable Asset Capitalization Policy – Movable assets

include vehicles, furniture, software, and equipment that are

not part of a building. Effective July 1, 2007 expenditures

for movable assets are capitalized at the invoiced cost (plus

any applicable transportation and installation charges) if

they meet the following criteria:

1. Have capitalized value of $5,000 or more;

2. Are durable (an economic estimated useful life of

more than one year);

3. Are freestanding and movable (not permanently

affixed to a building or structure).

University of Notre Dame

Capital Asset Accounting Policies

Last revision August 10, 2009

McGraw-Hill/Irwin

Depreciation is a cost allocation process that systematically and rationally matches acquisition costs

of operational assets with periods benefited by their use.

Cost

Allocation (Unused)

Balance Sheet

(Used)

Income Statement

Expense

Depreciation Concepts

Acquisition

Cost

Depreciation

Expense

Income

Statement

Balance

Sheet Accumulated

Depreciation

Depreciation for

the current year

Total of depreciation

to date on an asset

McGraw-Hill/Irwin

Depreciation Concepts The calculation of depreciation requires

three amounts for each asset:

Acquisition cost.

Estimated useful life.

Estimated residual value.

Alternative depreciation methods:

Straight-line

Units-of-production

Accelerated Method: Declining balance


© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and

Horngren 7-

21

The estimated useful life of

this donut is pretty short !!

McGraw-Hill/Irwin

Straight-Line Method Cost - Residual Value

Life in Years

Depreciation

Expense per Year =

At the beginning of the year, Southwest purchased ground

equipment for $62,500 cash. The equipment has an estimated

useful life of 3 years and an estimated residual value of $2,500.

Depreciation

Expense per Year =

Depreciation

Expense per Year = $20,000

$62,500 - $2,500

3 years


McGraw-Hill/Irwin

Depreciation Accumulated Accumulated Undepreciated

Expense Depreciation Depreciation Balance

Year (debit) (credit) Balance (book value)

62,500$

1 20,000$ 20,000$ 20,000$ 42,500

2 20,000 20,000 40,000 22,500

3 20,000 20,000 60,000 2,500

60,000$ 60,000$

Residual Value

SL More companies use the straight-line method of depreciation in their financial

reports than all other methods combined.

Straight-Line Method


McGraw-Hill/Irwin

McGraw-Hill/Irwin

Units-of-Production Method

Depreciation

Rate = Cost - Residual Value

Life in Units of Production

Step 1:

Step 2:

Depreciation

Expense =

Depreciation

Rate ×

Number of

Units Produced

for the Year

At the beginning of the year, Southwest purchased ground

equipment for $62,500 cash. The equipment has a 100,000

mile useful life and an estimated residual value of $2,500.

If the equipment is used 30,000 miles in the first year, what is

the amount of depreciation expense?

McGraw-Hill/Irwin

Units-of-Production Method

$62,500 - $2,500

100,000 miles = $.60 per mile

Depreciation

Rate =

Step 1:

Step 2:

$.60 per mile × 30,000 miles = $18,000 Depreciation

Expense =

Accumulated Undepreciated

Depreciation Depreciation Balance

Year Miles Expense Balance (book value)

62,500$

1 30,000 18,000$ 18,000$ 44,500

2 50,000 30,000 48,000 14,500

3 20,000 12,000 60,000 2,500

100,000 60,000$ Residual Value


McGraw-Hill/Irwin

Accelerated Depreciation

Depreciation Repair

Expense Expense

Early Years High Low

Later Years Low High

Accelerated depreciation matches higher

depreciation expense with higher revenues

in the early years of an asset’s useful life

when the asset is more efficient.

McGraw-Hill/Irwin

Declining-Balance Method

Annual

Depreciation

expense

Net

Book

Value ( ) Useful Life in Years

2 = ×

Cost – Accumulated Depreciation

Declining balance rate

of 2 is double-declining-

balance (DDB) rate.

Annual computation ignores residual value.

At the beginning of the year, Southwest purchased equipment

for $62,500 cash. The equipment has an estimated useful

life of 3 years and an estimated residual value of $2,500.

Calculate the depreciation expense for the first two years.

McGraw-Hill/Irwin

Annual

Depreciation

expense

Net

Book

Value ( ) Useful Life in Years

2 = ×

( ) $62,500 × 3 years

2 = $41,667

( ) ($62,500 – $41,667) × 3 years

2 = $13,889


Year 1 Depreciation:

Year 2 Depreciation:

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McGraw-Hill/Irwin

Depreciation Accumulated Undepreciated

Expense Depreciation Balance

Year (debit) Balance (book value)

62,500$

1 41,667$ 41,667$ 20,833

2 13,889 55,556 6,944

3 4,629 60,185 2,315

60,185$

( ) ($62,500 – $55,556) × 3 years

2 = $4,629

Below residual value


McGraw-Hill/Irwin

Depreciation expense is limited to the amount that

reduces book value to the estimated residual value.

Depreciation Accumulated Undepreciated

Expense Depreciation Balance

Year (debit) Balance (book value)

62,500$

1 41,667$ 41,667$ 20,833

2 13,889 55,556 6,944

3 4,444 60,000 2,500

60,000$


McGraw-Hill/Irwin

Measuring Asset Impairment Impairment is the loss of a significant portion

of the utility of an asset through . . .

• Casualty.

• Obsolescence.

• Lack of demand for the asset’s services.

Recognize a

loss when

an asset

suffers a

permanent

impairment.

Disposal of Property, Plant and Equipment Voluntary disposals:

• Sale

• Trade-in

• Retirement

Involuntary disposals:

• Fire

• Accident

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McGraw-Hill/Irwin

Disposal of Property, Plant, and

Equipment

Journalize disposal by:

Writing off accumulated

depreciation (debit).

Writing off the

asset cost (credit).

Recording cash

received (debit)

or paid (credit).

Recording a

gain (credit)

or loss (debit).

Update depreciation

to the date of disposal.

McGraw-Hill/Irwin

If Cash > BV, record a gain (credit).

If Cash < BV, record a loss (debit).

If Cash = BV, no gain or loss.

Disposal of Property, Plant, and

Equipment

Southwest Airlines sold flight equipment

for $5,000,000 cash at the end of its

17th year of use. The flight equipment originally

cost $20,000,000, and was depreciated using the

straight-line method with zero residual value

and a useful life of 20 years.

Let’s answer the following questions.


The amount of depreciation expense

recorded at the end of the 17th year to

bring depreciation up to date is:

a. $0.

b. $1,000,000.

c. $2,000,000.

d. $4,000,000.

Annual Depreciation:

($20,000,000 - $0) ÷ 20 Years.

= $1,000,000

Disposal of Property, Plant, and Equipment


After updating the depreciation,

the equipment’s book value at the end of

the 17th year is:

a. $3,000,000.

b. $16,000,000.

c. $17,000,000.

d. $4,000,000.

Accumulated Depreciation =

(17yrs. × $1,000,000) = $17,000,000

BV = Cost - Accumulated Depreciation

BV = $20,000,000 - $17,000,000

= $3,000,000

Disposal of Property,

Plant, and Equipment



The equipment’s sale resulted in:

a. a gain of $2,000,000.

b. a gain of $3,000,000.

c. a gain of $4,000,000.

d. a loss of $2,000,000.

Gain = Cash Received - Book Value

Gain = $5,000,000 - $3,000,000 = $2,000,000





© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and

Horngren 7-

40

DISPOSAL OF PLANT ASSETS

McGraw-Hill/Irwin

Prepare the journal entry to record Southwest’s sale of the equipment at the end of the 17th year.





Cash (+A) 5,000,000

Accumulated Depreciation (+XA) 17,000,000

Gain on Sale (+Gain, +SE) 2,000,000

Flight Equipment (-A) 20,000,000


McGraw-Hill/Irwin

Acquisition and Depletion of Natural

Resources

Examples: oil, coal, gold

Extracted from

the natural

environment.

A noncurrent

asset presented

at cost less

accumulated

depletion.

Total cost of

asset is the cost

of acquisition,

exploration,

and development.

Total cost is

allocated over

periods benefited

by means of

depletion.

Depletion is like units-of-production depreciation.

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McGraw-Hill/Irwin

The unit depletion rate is calculated as follows:

Estimated Recoverable Units

Acquisition and Residual Development Cost Value –

Depletion

cost

Inventory

for sale Unsold

Inventory

Cost of

goods sold

Depletion cost for a period is:

UNIT DEPLETION

RATE

NUMBER OF UNITS

EXTRACTED IN PERIOD ×

Acquisition and Depletion of Natural

Resources

McGraw-Hill/Irwin

Acquisition and Amortization of Intangible

Assets

Noncurrent assets

without physical

substance.

Useful life is

often difficult

to determine.

Usually acquired

for operational

use.

Often provide

exclusive rights

or privileges. Intangible

Assets

Record at current cash equivalent cost, including

purchase price, legal fees, and filing fees.

McGraw-Hill/Irwin


Assets

Definite Life

• Amortize over shorter of economic life or legal life, subject to rules specified by GAAP.

• Use straight-line method.

Indefinite Life

• Not amortized.

• Tested at least annually for possible impairment, and book value is reduced to fair value if impaired.

Amortization is a cost allocation process similar to depreciation and depletion.

McGraw-Hill/Irwin

Occurs when one company buys

another company.

The amount by which the purchase price exceeds the fair market value of net assets acquired.

Only purchased goodwill is an

intangible asset.

Goodwill


Assets

Goodwill is not amortized. Its value must be reviewed at least annually for possible impairment, and the

book value is reduced to fair value if impaired. Impairment if: Net BV > Estimate Future Cash Flows

McGraw-Hill/Irwin

Arpec Company paid $2,000,000 to purchase

all of Utek Company’s assets and assumed liabilities of $400,000.

The acquired assets were appraised at a fair value of $1,800,000.

What amount of goodwill should be

recorded on Arpec Company books?

a. $200,000

b. $400,000

c. $600,000

d. $800,000

FMV of Assets 1,800,000$

Debt Assumed 400,000

FMV of Net Assets 1,400,000

Purchase Price 2,000,000

Goodwill 600,000$


Assets

McGraw-Hill/Irwin


Assets

Trademarks

• A symbol, design, or

logo associated with

a business.

• An exclusive legal right

to use a name, image

or slogan.

• Purchased trademarks

are recorded at cost.

Copyrights

• The exclusive right to

publish, use, and sell a

literary, musical, or

artistic work.

• Legal life is life of

creator plus 70 years.

• Amortize cost over the

period benefited.

McGraw-Hill/Irwin


Assets

Patents

• Exclusive right granted by the federal government to sell or manufacture an

invention.

• Cost is purchase price plus legal cost to defend.

• Amortize cost over the shorter of useful life or 20 years.

• Research and development costs that might result in a patent are normally

expensed as incurred.

Technology

• A category of intangible assets that includes a company’s

website and any computer programs written by its employees.

McGraw-Hill/Irwin

Franchises

• Legally protected right

purchased by a

franchisee to sell

products or provide

services for a specified

period and purpose.

• Purchase price is an

intangible asset that is

amortized.


Assets

Licenses and Operating Rights

• Limited permissions to

use a product or service

according to specific

terms and conditions.

• You may be using

computer software that

is made available to you

through a campus

licensing agreement.

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McGraw-Hill/Irwin

What about R&D Costs?

Pharmaceuticals Software and Hardware Aviation and Space

Previous treatment:

Capitalize and the expense

Issues with this mechanism:

Timing of costs on income statement

Valuation of company

Current treatment:

Expense when incurred

IFRS treatment

Research costs: when incurred

Development costs: over expected useful life

McGraw-Hill/Irwin

Focus on Cash Flows

McGraw-Hill/Irwin

Chapter Supplement A – Changes in

Depreciation Estimates Depreciation Expense is based on . . .

ESTIMATED useful

life

ESTIMATED

residual value

If the estimates change, the book value less any

residual value at the date of change is depreciated

over the remaining useful life.

Southwest purchased an aircraft for $60,000,000. The aircraft is

depreciated using the straight-line method with a useful life of 20

years and an estimated residual value of $3,000,000. In year 5,

Southwest changed the estimated useful life to 25 years and

lowered the residual value to $2,400,000. Calculate depreciation

expense for the fifth year using the straight-line method.

McGraw-Hill/Irwin

Asset cost 60,000,000$

Accumulated depreciation

($2,850,000 per year × 4 years) 11,400,000

Remaining book value 48,600,000

Less estimated residual value 2,400,000

Depreciable base 46,200,000

Divide by remaining life ÷ 21

Revised annual depreciation 2,200,000$

Chapter Supplement A – Changes in

Depreciation Estimates

McGraw-Hill/Irwin

Partial Year Depreciation

Not all assets are acquired January 1st.

McGraw-Hill/Irwin

Partial Year Depreciation

Acquire asset on July 1, 2011.

Calendar year corporation.

Asset cost $16,000, S/L Depreciation, No residual value,

Estimated Useful life of Four Years. December 31, 2011 – Depreciation Expense - $2,000

December 31, 2012 – Depreciation Expense - $4,000





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