9–19–1 Copyright © Cengage Learning. All rights reserved. Chapter 9 Long-Term Assets Useful life of more than one year Used in the operation of a business

9–1Copyright © Cengage Learning. All rights reserved.

Chapter 9Long-Term Assets

Useful life of more than one yearUsed in the operation of a business Not intended for resale

Long-term assets might include: Equipment Vehicles Property Trademarks


Carrying Value

The unexpired cost of an asset (also called book value)

Unexpired Cost = Cost – Accumulated Depreciation

On the Balance Sheet:


Classification of Long-Term Assets and Methods of Accounting for Them


Asset Impairment

When is an asset deemed impaired?

When a long-term asset loses some or all

of its potential to generate revenue

before the end of its useful life

Asset Impairment

The carrying value of a long-term asset exceeds

its fair value

Gail Mestas

insert figure 3, chpater 10, FA, 8/e, titled "Carrying value of long-term assets on the balance sheet"


Acquiring Long-Term Assets

How do companies make the decision to acquire long-term assets?

Capital Budgeting Method of Evaluation

Net Present Value Method

Evaluates the purchase based on the net present

value of acquisition cost, net annual savings in cash

flows, and disposal price

© Royalty-Free/Corbis


Net Present Value Method Illustrated

Apple Computer is considering the purchase of a $100,000 customer relations software package. Management estimates that the company will save $40,000 in net cash flows per year for four years, the usual life of the software. The software should be worth $20,000 at the end of that period. The interest rate is 10 percent compounded annually.

20x5 20x6 20x7 20x8 Acquisition cost ($100,000) Net annual savings in cash flows $40,000 $40,000 $40,000 $40,000 Disposal price 20,000 Net cash flows ($60,000) $40,000 $40,000 $60,000

Cash flows related to the purchase of the computer would be as follows:

Present value Tables 1 and 2 can now be used to place the cash flows on a comparable basis.


Example of Net Present Value Method (hwk E4)

20x5 20x6 20x7 20x8 Acquisition cost ($100,000) Net annual savings in cash flows $40,000 $40,000 $40,000 $40,000 Disposal price 20,000 Net cash flows ($60,000) $40,000 $40,000 $60,000

Acquisition Cost Present Value Factor = 1.0 ($100,000)

Net Annual Savings Present Value Factor = 3.17 $126,800 Cash Flows Table 2: 4 Periods, 10% 3.170 X $40,000 Disposal Price Present Value Factor = 0.683 $13,660 Table 1: 4 Periods, 10% 0.683 X $20,000

Net Present Value $39,600

As long as the net present value is positive, Apple will earn a return of at least 10 percent.

As long as the net present value is positive, Apple will earn a return of at least 10 percent.

The return is greater than 10 percent on the investment. Based on this analysis, Apple should purchase the software.

The return is greater than 10 percent on the investment. Based on this analysis, Apple should purchase the software.


Financing Long-Term Assets

• Financing alternatives:Use cash flow from

operationsIssue common stockIssue long-term notesIssue bonds

Investors may investigate whether a company has

free cash flow to finance long-term assets.

Free cash flow is cash that remains after deducting funds committed to operations at current levels

© Royalty Free PhotoDisc Collection/ Getty Images


The Matching Rule and Long-Term Assets

When a company purchases an asset, it may choose to capitalize it, thus deferring an expense to a later period

Favorably impacts profitability for that current period

Management must use ethical judgments when resolving two issues:

1. How much of the total cost of a long-term asset should be allocated to expense in the current period?

2. How much should be retained on the balance sheet as an asset that will benefit future periods?


Long-Term Asset Accounting Policies

Each company must determine how it will treat long-term assets:

1. How is the cost of the long-term asset determined?

2. How should the expired portion of the cost of the long-term asset be allocated against revenues over time?

3. How should subsequent expenditures, such as repairs and additions, be treated?

4. How should disposal of the long-term asset be recorded?


Acquisition Cost of Property, Plant, and Equipment



What Are Expenditures?(hwk E6)

Payments or obligations to make a future payment for an asset or for a service

Capital Expenditure

Revenue Expenditure

Expenditure for the purchase or

expansion of a long-term asset

Expenditure for the repair, maintenance, and operation of a long-term asset


Capital Expenditures

Outlays for plant assets, natural resources, and intangible assets

Additions, which are enlargements to the physical layout of a plant asset

Betterments, which are improvements to a plant asset but that do not add to the plant’s physical layout

Extraordinary repairs, which are repairs that significantly enhance a plant asset’s estimated useful life or residual value


Acquisition Costs

Includes all expenditures reasonable and necessary to get an asset in place and ready for use

Installation costs Freight Insurance while in transit Testing and setup

Are these items considered acquisition costs?

Repair costsInterest charges on purchase

No No

© Royalty Free/ Corbis


Acquiring Land

Costs that should be debited to the Land account include:

Purchase price Agent commissionsLegal feesAccrued taxes paid by

purchaserGradingLand preparation feesAssessments for local

improvements Landscaping

SampleAcquisition of Land

Net purchase price $340,000Brokerage fees 12,000Legal fees 4,000Tearing down old building $10,000Less salvage 8,000 12,000Grading 2,000Total cost $370,000

Improvements to real estate like fences, driveways, or parking lots have a limited life. They should be recorded in an account called Land Improvements, not the Land account.


Acquiring Buildings

Acquisition costs include: Purchase priceRepairs and other

expenditures required to put it in usable condition

Buildings are subject to depreciation because they have a limited useful life



Building Construction Costs

Materials and laborOverhead and other

indirect costsArchitects’ fees Insurance during

construction Interest on construction

loansLawyers’ feesBuilding permitsOutside contractors



Leasehold Improvements

Improvements to leased property that become the property of the lessor at the end of the lease

Classified as tangible assets in the property, plant, and equipment section of the balance sheet

Costs of leasehold improvements are depreciated or amortized over the remaining term of the lease or the useful life of the improvement, whichever is shorter.

© Royalty Free/ Getty Images


Acquiring Equipment

• Acquisition costs include:Purchase price (less cash discounts)All expenditures connected with purchasing the

equipment and preparing it for use• Freight• Insurance in transit• Excise taxes and tariffs• Buying expenses• Installation costs• Cost of test runs

Equipment is subject to depreciation because it has a

limited useful life


Group Purchases(example SE 4 hwk E 8)

Land and other assets may sometimes be purchased for a lump sum

Because buildings are depreciable and land is not, the purchase price

must be allocated to each asset

Appraisal Percentage Apportionment Land $ 20,000 10 % ($20,000 ÷ $200,000) $ 17,000 ($170,000 x 10%) Building 180,000 90 ($180,000 ÷ $200,000) 153,000 ($170,000 x 90%) Totals $200,000 100 % $170,000

ABC Co. buys a building and the land on which it is situated for a lump sum of $170,000. Assume that appraisals yield estimates of $20,000 for the land and $180,000 for the building if purchased separately. Allocate as follows:


What Is Depreciation?

The periodic allocation of the cost of a tangible asset (other than land and natural resources) over the asset’s estimated useful life

All tangible assets except land have a limited useful life (physical deterioration and obsolescence limit useful life)

Depreciation refers to the allocation of the cost of a plant asset to the periods that benefit from the asset, not to the asset’s physical deterioration or decrease in market value

Depreciation is not a process of valuation; it is a process of allocation


Four Factors That Affect the Computation of Depreciation

1. Cost Net purchase price of an asset plus all reasonable and necessary expenditures to get it in place and ready for use

2. Residual value

The portion of an asset’s acquisition cost that a company expects to recover when it disposes of the asset

3. Depreciable cost

Cost less residual value

4. Estimated useful life

Total number of service units expected from a long-term asset


Depreciation Expense, Asset Name xxx Accumulated Depreciation, Asset Name xxx To record depreciation for the period

Accounting for Depreciation

Depreciation is recorded at the end of the accounting period by an adjusting entry


Methods of Accounting for Depreciation

Accelerated method of depreciation that results in larger amounts of depreciation in earlier years of the asset’s life and smaller amounts in later years

Spreads the depreciable cost evenly over the estimated useful life of the asset

Based on the assumption that depreciation is solely the result of use and that passage of time plays no role in the depreciation process

Declining-balance method

Straight-line method

Production method


Life UsefulEstimated

Value Residual– Cost on DepreciatiYearly

yearper $3,600 years 5

$2,000– $20,000

A delivery truck costs $20,000 and has an estimated residual value of $2,000 at the end of its estimated useful life of 5 years.

Straight-Line Method Illustrated


Cost

Yearly Depreciation

Accumulated Depreciation

Carrying Value

Date of purchase $20,000 — — $20,000 End of first year 20,000 $3,600 $3,600 16,400 End of second year 20,000 3,600 7,200 12,800 End of third year 20,000 3,600 10,800 9,200 End of fourth year 20,000 3,600 14,400 5,600 End of fifth year 20,000 3,600 18,000 2,000

The amount of depreciation is the same each year

Accumulated depreciation increases uniformly

The carrying value decreases uniformly until it reaches the estimated residual value

Depreciation Schedule,Straight-Line Method


A delivery truck costs $20,000 and has an estimated residual value of $2,000 at the end of its estimated useful life of 90,000 miles. Assume the truck was driven 20,000 miles during year 1; 30,000 miles during year 2; 10,000 miles during year 3; 20,000 miles during year 4; and 10,000 miles during year 5.

Life Usefulof UnitsEstimated

Value Residual– Cost Cost on Depreciati

mileper $0.20 miles 90,000

$2,000– $20,000

The unit of output or use should be appropriate for

that asset

Production Method


Cost

Miles

Yearly Depreciation

Accumulated Depreciation

Carrying Value

Date of purchase $20,000 — — — $20,000 End of first year 20,000 20,000 $4,000 $4,000 16,000 End of second year 20,000 30,000 6,000 10,000 10,000 End of third year 20,000 10,000 2,000 12,000 8,000 End of fourth year 20,000 20,000 4,000 16,000 4,000 End of fifth year 20,000 10,000 2,000 18,000 2,000

There is a direct relation between the amount of depreciation each year and the units of output or use.

Accumulated depreciation increases each year in direct relation to units of output or use.

The carrying value decreases each year in direct relation to units of output or use until the estimated residual value is reached.

Depreciation Schedule,Production Method


Declining-Balance Method

Based on the passage of timeAssumes that many kinds of

plant assets are most efficient when new

Is consistent with the matching rule

Any fixed rate can be usedMost common rate is twice

the straight-line depreciation percentage (called double-declining-balance method)



Double-Declining-Balance Method Illustrated

A delivery truck costs $20,000 and has an estimated residual value of $2,000. Its estimated useful life is 5 years.

Under the straight-line method, the depreciation rate for each year is 20 percent:

percent 20 years 5 percent 100

Under the double-declining-balance method, the depreciation rate for each year is 40 percent:

percent 40 percent 20 2

This fixed rate is applied to the remaining carrying value at the end of each year.


Note that the fixed rate is always applied to the carrying value at the end of the previous year.

Depreciation is greatest in the first year and declines each year after that.

The depreciation in the last year is limited to the amount necessary to reduce the carrying value to the residual value.($2,592 - $2,000 = $592

Cost

Yearly Depreciation Accumulated Depreciation

Carrying Value

Date of purchase $20,000 — $20,000 End of first year 20,000 (40% x $20,000) $8,000 $8,000 12,000 End of second year 20,000 (40% x $12,000) 4,800 12,800 7,200 End of third year 20,000 (40% x $7,200) 2,880 15,680 4,320 End of fourth year 20,000 (40% x $4,320) 1,728 17,408 2,592 End of fifth year 20,000 592 18,000 2,000

Depreciation Schedule,Double-Declining-Balance Method


Graphic Comparison of Three Methods of Determining Depreciation

(examples SE 5-7 hwk E10 P4)

Gail Mestas

Insert figure 5, chpater 10. FA, 8/e, titled "graphic comparison of three methods of determining depreciaiton"


Group Depreciation

Companies often group similar assets to calculate depreciation

Group depreciation is used in all fields of industry and business

Average length of time assets of the same type are expected to last © Royalty Free C Squared Studios/ Getty Images


Methods of Disposal

DiscardSell for cash Exchange for another asset

When plant assets are no

longer useful…

1. Record depreciation for the partial year up to the date of disposal

2. Remove the carrying value of the asset


Discarded Plant Assets

Plant assets rarely last as long as their estimated lives

Never depreciate past point at which carrying value equals residual value

Total accumulated depreciation should never exceed total depreciable cost © Royalty Free/ Corbis


KOT Company purchased a machine on January 2, 2009, for $13,000 and planned to depreciate it on a straight-line basis over its estimated useful life (8 years). Its residual value at the end of 8 years is estimated to be $600.

On December 31, 2015, the balances of the relevant accounts were:

Machinery Accumulated Depreciation, Machinery

13,000 9,300

On January 2, 2015, management disposed of the asset.

Disposal of a Depreciable Asset


Disposal of a Plant Asset

Remove the carrying value of the asset• Carrying value is computed by subtracting accumulated

depreciation from the acquisition cost of the asset• If the asset is fully depreciated, the carrying value is zero• If the asset is not fully depreciated, a loss is recorded

Jan. 2 Accumulated Depreciation, Machinery 9,300 Loss on Disposal of Machinery 3,700 Machinery 13,000 Discarded machine no longer

used in business

Accum. Depreciation, Machinery

9,300

Machinery

13,000 9,30013,000

Bal. -0- Bal. -0-

Gains and losses on disposal of plant assets are classified as other revenues and expenses on the income statement.


Selling a Plant Asset for Cash

In addition to removing the carrying value of the asset, you will also record the cash received

If cash received = carrying value, no gain or loss is recorded

If cash received < carrying value, loss is recorded

If cash received > carrying value, gain is recorded



Selling an Asset for CashCash Received = Carrying Value

Received $3,700 cash for sale of machinery.

Remove the carrying value of the asset and record receipt of cash:

Jan. 2 Cash 3,700 Accumulated Depreciation, Machinery 9,700 Machinery 13,00 Sale of machinery for carrying

value; no gain or loss


Selling an Asset for CashCash Received < Carrying Value


Jan. 2 Cash 2,000 Accumulated Depreciation, Machinery 9,300 Loss on Sale of Machinery 1,700 Machinery 13,000 Sale of machinery at less than carrying

value; loss of $1,700 recorded ($3,700 – $2,000)



Selling an Asset for CashCash Received > Carrying Value

(example SE 8 hwk E 13)


Jan. 2 Cash 4,000 Accumulated Depreciation, Machinery 9,300 Gain on Sale of Machinery 300 Machinery 13,000 Sale of machinery at more than carrying

value; gain of $300 recorded ($4,000 – $3,700)



What Are Natural Resources?

Assets that are converted to inventory by cutting, pumping, mining, or other extraction methods

Timberlands

Oil and Gas Reserves

Mineral Deposits

Record at acquisition cost and show on the

balance sheet as long-term assets


Available UnitsofNumber Estimated

Value Residual - Resource Natural ofCost per Unit Cost Depletion

Depletion of Natural Resources

(1) The exhaustion of a natural resource and

(2) The proportional allocation of the cost of a natural resource to the units extracted

Costs are allocated much like the

production method of depreciation

Costs are allocated much like the

production method of depreciation

© Royalty-Free/Corbis


Recording Depletion Expense

A mine that cost $3,600,000 has an estimated 3,000,000 tons of coal. The estimated residual value of the mine is $600,000. During the first year, 230,000 tons of coal are mined and sold.

Available UnitsofNumber Estimated

Value Residual - Resource Natural ofCost per Unit Cost Depletion

per ton $1 tons3,000,000

$600,000 - $3,600,000

Dec. 31 Depletion Expense, Coal Deposits 230,000 Accumulated Depletion, Coal Deposits 230,000 To record depletion of coal mine: $1

per ton, 230,000 tons mined and sold

Natural resources that have been extracted but not sold are considered inventory and are not recorded as an expense until the year sold.


Depreciation of Closely Related Plant Assets

(example SE 9 hwk E 15)Closely related long-term assets are those assets necessary to extract the resource(Conveyors, drilling, and pumping devices)

If the life of the asset is longer than the life of the resource, depreciate on the same basis as the depletion is computed

If the life of the asset is shorter than the life of the resource, depreciate over the shorter life of the asset

© Royalty Free C Squared Studios/ Getty Images


What Is an Intangible Asset?

GoodwillTrademarks Brand namesCopyrightsPatentsLeaseholdsSoftwareCustomer lists

Long-term, nonphysical asset whose value comes from the rights or advantages afforded its owner



Importance of Intangibles

For some companies, intangible assets make up a substantial portion of total assets


Accounting for Intangible Assets

Intangibles developed by a firm for its own

benefit

Intangibles acquired from others

Record as expense Record as asset; amortize over the shorter of useful life or legal life (not to exceed 40 years)


Difficult Issues When Accounting for Intangibles

How to account for the initial carrying value? How to account for that amount under

normal business conditions (periodic write-off or amortization)?

How to account for the amount if the value declines substantially and permanently?

How to estimate an intangible asset’s value and useful life?


Intangible Assets Illustrated

Later Bottling Company purchases a patent on a unique bottle cap for $36,000. The patent will last for 20 years, but the product using the cap will be sold only for the next six years.

Patents 36,000 Cash 36,000 To record purchase of bottle cap

patent

Record the purchase of the patent:

Amortization Expense 6,000 Patents 6,000 To record amortization expense for

patent ($36,000 ÷ 6 years)

Record the annual amortization expense:

Notice that the Patents account is directly reduced by the amount of amortization expense, whereas depreciation or depletion is accumulated in separate contra accounts for other long-term assets.


Intangible Assets Illustrated (hwk E 17)

The patent becomes worthless after only 1 year. Record the write-off:

Loss on Patent 30,000 Patents 30,000 To record the write-off of a

worthless patent ($36,000 – $6,000)

If the patent becomes worthless before it is fully amortized, the remaining carrying value is written off as a loss by removing it from the Patents account.



Research and Development Costs

The FASB requires that all R&D costs be treated as revenue expenditures and charged to expense in the period in which they are incurred.

Why? Too difficult to trace specific costs to specific profitable

developments Costs of research and development are continuous and

necessary for the success of a business and so should be treated as current expenses

Studies show that 30 to 90 percent of all new product fail and 75 percent of new-product expenses go to unsuccessful products


Computer Software Costs

Costs incurred in developing computer software for sale or lease or for a firm’s internal use are research and development costs until the product has proved technologically feasible

Costs incurred before technologically feasible should be charged to expense as incurred

Once a working program is ready, all costs are recorded as assets

Amortize over the estimated economic life using the straight-line method


Goodwill

A company’s good reputationCustomer satisfactionGood managementManufacturing efficiencyGood location

Goodwill exists when a purchaser pays more for a business than the fair market value of the business’s net assets

Goodwill should not be recorded unless it is paid for in connection with the purchase of a whole business

Goodwill = Purchase price – FMV of identifiable net assets


Documents

9–19–1 Copyright © Cengage Learning. All rights reserved. Chapter 9 Long-Term Assets Useful life of more than one year Used in the operation of a business