Chapter 9Reporting and Interpreting Long-Lived Tangible and Intangible Assets
Learning Objectives1. Define, classify, and explain the nature of long-lived assets.2. Apply the cost principle to the acquisition of long-lived assets.3. Apply various depreciation methods as economic benefits are used up over time.4. Explain the effect of asset impairment on the financial statements.5. Analyze the disposal of long-lived tangible assets.6. Analyze the acquisition, use, and disposal of long-lived intangible assets.7. Interpret the fixed asset turnover ratio.8. Describe factors to consider when comparing companies’ long-lived assets.
Definition and Classification Actively Used in Operations Value represented by rights that produce benefits. Will not be used up within the next year Intangibles with a limited life, such as patents and copyrights, are subject to Examples amortization. Land Tangible Intangible Intangibles with an Assets subject to depreciation unlimited (or indefinite) Buildings and equipment Physical No Physical life, such as goodwill andFurniture and fixtures Substance are not trademarks, Substance amortized.
Long-term Tangible Assets Use Acquisition 2. Allocate cost to periods Disposal1. Compute cost. benefited. 4. Record disposal. 3. Account for subsequent expenditures.
Acquisition of Tangible Assets Acquisition cost includes: 1. purchase price; and 2. all necessary expenditures needed to prepare the asset for its intended use. Recording costs as assets is called capitalizing the costs. Principle Historical cost: Cash equivalent cost given up is the basis for the initial recording of elements.
Cash Purchase Cedar Fair purchased a new ride for $26,000,000 less a $1,000,000 discount. Cedar Fair paid $125,000 for transportation and $625,000 for installation of the ride.Prepare the journal entry for the acquisition assuming Cedar Fair paid cash for the new ride.1 Analyze2 Record
Credit Purchase Instead of paying cash, assume that Cedar Fair issued a note for the new ride, but paid cash for the transportation and installation of the ride. Prepare the journal entry for the acquisition.1 Analyze2 Record
Acquisition Cost of RealtyMartin Co. purchased land as a factory site for$400,000. The process of tearing down an oldbuilding on the site and constructing the factoryrequired 6 months. The company paid $42,000 toraze the old building and $1,850 for legal fees. Italso paid $68,000 for drawing the factory plan. Theconstruction of factory costs Martin $28,000,000. Land value to be capitalized Land purchase price 400,000 Land preparation 42,000 Legal fees 1,850 Total Land value 443,850 Building value to be capitalized Construction costs 28,000,000 Architectural fees 68,000 Total Building value 28,068,000
Acquisition Cost of Realty Total Land value = $443,850 Total Building value = $28,068,000 Accounts Debit CreditLand (+A) 443,850Building (+A) 28,068,000 Cash (-A) 28,511,850
Quick check1. Starbucks paid 1) $150,000 cash to acquire land for a retail store. 2) This land had an old service garage that was removed at a cost of $15,000, and salvaged materials were sold for $2,000. 3) Additional closing cost (brokerage fee and transfer fee) total $10,000.Calculate the cost of this land to Starbucks.2. S Co. purchased a machine for $32,000 with terms 2/15, n/60, and paid $400 in shipping charges. Experts were hired to install the machine at a cost of $1,000; In moving the machine, paid $500 in damages occurred. Once the machine was installed several test runs were made to calibrate the settings – material and labor associated with the testing totaled $600. Assuming the firm paid within the discount period, what cost should be recorded for the machine?
Acquisition Cost - Basket Purchase On January 1, Jones purchased land and building for $400,000 cash. The appraised values are building, $325,000, and land, $175,000.How much of the $400,000 purchase price will be charged to the building and land accounts? The total cost of a combined purchase of land and building is allocated in proportion to their relative market values.
Acquisition Cost - Basket Purchase Appraised % of Purchase ApportionedAsset Value Value Price Cost a b* c b × cLand $ 175,000 35% × $ 400,000 = $ 140,000Building 325,000 65% × 400,000 = 260,000 Total $ 500,000 100% $ 400,000* $175,000 ÷ $500,000 = 35% $325,000 ÷ $500,000 = 65%
Additional Expenditures After a company acquires a plant asset and puts it into service, it often makes additional expenditures for that asset’s operation: General maintenance Repair Upgrade and improvement Capitalize them or Expense them? Capitalize: charge the amount to an asset account Expense: charged to current period income as an expense
Additional Expenditures Type of AccountingExpenditure Identifying Characteristics Treatment Ordinary 1. Maintains normal operating condition Expenserepairs and 2. Does not increase productivitymaintenance 3. Does not extend life beyond original estimateExtraordinary 1. Major overhauls or partial Capitalize repairs replacements 2. Extends life beyond original estimate Additions 1. Increases productivity Capitalize 2. May extend useful life 3. Improvements or expansions
Additional Expenditures Financial Statement Effect Current CurrentTreatment Statement Expense Income TaxesCapitalize Balance sheet account debited Deferred Higher HigherExpense Income statement Currently account debited recognized Lower Lower If the amounts involved are not material, most companies expense the item.
Additional Expenditures Kelly Co. owns machine that has net book value of 30,000. In Mar. 2007, Kelly paid $13,000 to rearrange and reinstall machinery, which will enhance productivity of the machine. In Apr. 2007, it paid $200 for regular maintenance of the machine. Prepare journal entries for the above transactions. Dr. Cr.Machine (+A) 13,000 Cash (-A) 13,000Maintenance Expense (+E,-SE) 200 Cash (-A) 200
DepreciationDepreciation is the process of allocating thecost of a plant asset to expense in theaccounting periods benefiting from its use. Balance Sheet Income Statement Acquisition Cost Expense Cost Allocation (Unused) (Used)
Rules of the Game As depreciation is recognized it is charged to income as depreciation expense and aggregated as the contra asset account “accumulated depreciation” The book value (or net book value) of a depreciable asset equals the historical cost minus the accumulated depreciation The depreciation method selected determines the periodic expense amount.
Depreciation on Delta’s2000 Balance SheetProperty and Equipment: Flight equipment $ 27,000 Less: Accumulated depreciation 5,000 $ 22,000 Ground property and equipment 4,500 Less: Accumulated depreciation $ 2,300 2,200 Total property and equipment, net $ 24,200 Book Values / Book value = Market value
Factors in Computing Depreciation The calculation of depreciation requires three amounts for each asset: Cost Salvage Value Do we know these with Useful Life absolute certainty?
Alternative Depreciation Methods Straight-line Units-of-production Accelerated Method: Double-Declining balance
Depreciation Methods Straight-line Units-of-production Declining balance We will use the following information to illustrate the three methods of depreciation: At the beginning of the year, Cedar Fair purchased a new Go-Cart Ride for $62,500 cash. The ride has an estimated useful life of 3 years and an estimated residual value of $2,500.
Units-of-Production Method The ride has a 100,000-mile estimated useful life. If the ride is used 30,000 miles in the first year, what is the amount of depreciation expense? ($62,500 - $2,500) × 30,000 = $18,000 100,000
Declining-Balance Method The declining-balance method matches higher depreciation expense with higher revenuesin the early years of an asset’s useful life when the asset is more efficient. Depreciation Expense Early Years High Later Years Low
Double-Declining-Balance Method Declining balance rate of 2 is double-declining-balance (DDB) rate. Annual Net 2Depreciation = Expense Book Value × ( Useful Life in Years ) Cost – Accumulated Depreciation Annual computation ignores residual value.
Double-Declining-Balance MethodAt the beginning of the year, Cedar Fairpurchased a new Go-Cart Ride for $62,500 cash. The ride 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.
Double-Declining-Balance Method Annual Net 2 Depreciation = Book expense Value × ( Useful Life in Years )Year 1 Depreciation: 2 $62,500 × ( 3 years ) = $41,667Year 2 Depreciation: 2 ($62,500 – $41,667) × ( 3 years ) = $13,889
Double-Declining-Balance Method 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 We usually must force depreciation expense in the last year so that book value equals salvage value. Depreciation expense is limited to the amount that reduces book value to the estimated residual value.
Partial-Year Depreciation When a plant asset is acquired during the year, depreciation is calculated for the fraction of the year the asset is owned. Calculate the straight-line depreciation on December 31, 2007, for equipment purchased on June 30, 2007. The equipment cost $75,000, has a useful life of 10 years, and an estimated salvage value of $5,000. (Straight-Line method)Depreciation = ($75,000 - $5,000) ÷ 10 = $7,000 for all 2007Depreciation = $7,000 × 6/12 = $3,500
Summary of Depreciation Methods
Tax Depreciation For tax purposes, most corporations use the Modified Accelerated Cost Recovery System (MACRS). MACRS depreciation provides for rapid write-off of an asset’s cost in order to stimulate new investment.
Asset Impairment LossesImpairment is the loss of a significant portion of the utility of anasset through . . . Casualty. Obsolescence. Lack of demand for the asset’s services.A loss should be recognized when an asset suffers a permanentimpairment. Cedar Fair recorded a write-down of $3,200,000 on equipment. 1 Analyze 2 Record
Accounting for Asset Disposals1. Recognize any unrecorded depreciation expense2. Remove the historical cost of the asset and the accumulated depreciation associated with the asset from books3. Record the cash receipts (or payment)4. Recognize any difference between value of asset received and book value of asset given up as a gain or loss
Disposal of Tangible Assets Update depreciation If Cash > BV, record a gain (credit). to the date of disposal. If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss. Recording a gain (credit) or loss (debit).BV is equal to cost less accumulated depreciation.
Disposal of Tangible AssetsOn December 31, 2007, Evans Company sells a machinethat originally cost $100,000 for $60,000 cash. Themachine was placed in service on January 1, 2004. Itwas depreciated using the straight-line method with anestimated salvage value of $20,000 and a useful life of10 years. Annual Depreciation: ($100,000 - $20,000) ÷ 10 Yrs. = $8,000
Update Depreciation to Date of Disposal Dr. Cr.Dec. 31 Depreciation expense 8,000 Accumulated Depreciation - Machine 8,000 To update depreciation to date of disposal Cost $ 100,000 Accumulated Depreciation: 4 yrs. × $8,000 = 32,000 Book Value $ 68,000
Determine Gain or Loss on Disposal If Cash > BV, record a gain (credit). If Cash < BV, record a loss (debit). If Cash = BV, no gain or loss. Cost $ 100,000 Accumulated depreciation 32,000 Book Value 68,000 Cash Received 60,000 Loss on disposal $ (8,000)
Record the Disposal in the Journal Dr. Cr. Dec. 31 Cash 60,000 Loss on Disposal of Asset 8,000 BV Accumulated Depreciation - Machine 32,000 Machine 100,000 To record disposal of equipmentQuestion: what if the company sells the machine for $80,000 Dr. Cr. Dec. 31 Cash 80,000 Accumulated Depreciation - Machine 32,000 BV Machine 100,000 Gain on Disposal of Asset 12,000 To record disposal of equipment
Classifying Long-Lived Assets Actively Used in Operations Examples Value represented by rights Expected to Benefit Future Periods that produce benefits Patents Copyrights Trademarks Tangible Franchises Intangible Goodwill Physical No Physical Substance Subject to amortization Substance
Intangible AssetsNoncurrent assets Often providewithout physical exclusive rightssubstance. or privileges. Intangible AssetsUseful life is Usually acquiredoften difficult for operationalto determine. use.
Cost Determination and Amortization Record at current cash Patents equivalent cost, including Copyrights purchase price, Franchises legal fees, and Trademarks filing fees. Goodwill
Trademarks and Copyrights A trademark is a symbol, design, or logo associated with a business.Internally developedtrademarks have no Purchased trademarks are recorded at cost.recorded asset cost. A copyright is an exclusive right granted by the federal government to protect artistic or intellectual properties. Legal life is Amortize cost life of creator over the period plus 70 years. benefited.
Patents and Licensing Rights A patent is an exclusive right granted by the federal government to sell or manufacture an invention.Cost is purchase Amortize costprice plus legal over the shorter of cost to defend. useful life or 20 years. Licensing rights grant limited permission 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.
Franchises A franchise provides legally protected rights to sell products or provide services purchased by a franchisee from the franchisor.
GoodwillPurchase Price > Fair Market Value of Net Assets Acquired Occurs when one Only purchased company buys goodwill is an another company. intangible asset. Is impairment Is not amortized. tested and may be written down.
Amortization of Limited Life IntangibleAsset Assume Cedar Fair purchased a patent for an uphill water-coaster for $800,000 and intends to use it for 20 years. Each year, the company would record $40,000 in Amortization Expense ($800,000 ÷ 20 years). 1 Analyze Assets = Liabilities + Stockholders Equity Patent (-A) $40,000 Amortization Expense (+E, -SE) -40,000 2 Record dr Amortization Expense (+E, -SE) 40,000 cr Patent (-A) 40,000
Summary of Accounting Rules for Long-Lived Assets Stage Subject Tangible Assets Intangible AssetsAcquisition Purchased Asset Capitalize all related costs Capitalize all related costsUse Repairs/maintenance Ordinary Expense related costs Not applicable Extraordinary Capitalize related costs Not applicable Depreciation/ amortization Limited life straight-line Typically use straight line only units-of-production declining-balance Unlimited life Do not depreciate land Do not amortize Impairment test Write-down if necessary Write-down if necessaryDisposal Report gain or (loss) when . . . Receive more (less) on Receive more (less) on disposal than book value disposal than book value
Turnover Analysis Fixed Net Sales Revenue Asset = Average Net Fixed Assets Turnover This ratio measures the sales dollars generated by each dollar invested in fixed assets. For the year 2008, Cedar Fair had $1,000,000 ofrevenue. End-of-year fixed assets were $1,800,000and beginning-of-year fixed assets were $1,940,000. (All numbers in millions.)
Turnover Analysis Fixed Asset Net Sales Revenue =Turnover Average Net Fixed Assets Fixed Asset $1,000,000 = = 0.53Turnover ($1,800,000 + $1,940,000) ÷ 2 2008 Fixed Asset Turnover Comparisons Yahoo! Six Flags Cedar Fair 5.68 0.64 0.53
Impact of Depreciation Differences Accelerated depreciation, in the early years of an asset’s useful life, results in higher depreciation expense, lowernet income, and lower book value than would result using straight-line depreciation. Selling an asset with a low book value, resulting from accelerated depreciation, might result in a gain. Selling the same asset with a higher book value,resulting from straight-line depreciation, might result in a loss.
In-class exercise problem #1 On January 1, Manning Co. purchases a new knitting machine costing $300,000, the shipping cost was 1,000 and installs it at a cost of $23,000. Estimates The useful life of the equipment is 5 years Salvage value of $24,000 at the end of 5 years Total production of 1,500,000 pairs of socks Actual production is as follows: Year 1 350,000 Year 2 320,000 Year 3 300,000 How much depreciation will be recognized in each year using (a) straight-line depreciation and (b) units of production depreciation
In-class exercise problem #2 City Corp. owns machinery that cost $20,000 when purchased on January 1, 2004. It sold the machinery on July 31, 2008 for $10,500 cash. On the day of sale, the updated accumulated depreciation for the machinery was $10,000. Determine gain (loss) from the sale and prepare a journal entry for the sale transaction.
In-class exercise problem #3On December 31, 2007, Travis Inc. had a machine with a book value of $940,000. The original cost and related accumulated depreciation at this date are as follows: 12/31/2007 Machine $1,300,000 Accumulated depreciation 360,000 Book Value $ 940,000The machine has expected useful life of 10 years and will have $100,000 salvage value at the end of its useful life. Travis has been depreciating the machine using a straight-line method.Required: Assume that Travis Inc. sold the machine for $920,000 on January 1, 2008. Determine Gain (Loss) from the sale of the machine and prepare journal entries to record the disposal transaction. Assume that Travis Inc. sold the machine on Dec 31, 2008 for $920,000. Determine Gain (Loss) from the sale of the machine and prepare journal entries to record the disposal transaction.