Fixed Assets LECTURE 5 Issah Hamdu Faculty of Business Management and Globalization Tel : 603 8317 8833 (Ext 8403) Email: [email protected] BACCT1201

Fixed Assets

LECTURE 5

Issah HamduFaculty of Business Management and Globalization

Tel : 603 8317 8833 (Ext 8403)Email: [email protected]

BACCT1201 • Financial Accounting

BACCT1201 Financial Accounting 2

Objectives

• At the end of the lecture, students should be able to:

• Explain with examples what is fixed assets /plant assets/long-term assets.

• Define, explain and demonstrate how to compute depreciation expense using various methods of depreciation.

Objectives....

• Explain the impact of various depreciation methods on income statement. To let students realized that depreciation is a discretionary management policies.

• Explain why the Inland Revenue Dept. does not recognize depreciation but only gives recognition to their prescribed capital allowance rates.



Acquisition and Use of Long-Term Acquisition and Use of Long-Term Operational AssetsOperational Assets


Classification of Operational

Assets

Operational assets are used by a Operational assets are used by a business to generate revenue.business to generate revenue.

Tangible operational assets Tangible operational assets have physical substance.have physical substance.

Land, buildings, Land, buildings, fixtures, and equipmentfixtures, and equipment

LearningLearningObjective 1Objective 1


Long-term Operational

Assets

Long-term assets will be used Long-term assets will be used more than one year.more than one year.

Tangible operational assets are Tangible operational assets are reported on the balance sheet in a reported on the balance sheet in a classification called: classification called: Property, Plant, and Equipment.Property, Plant, and Equipment.


Classification of Operational

Assets

Intangible operational assets Intangible operational assets lack physical substance and lack physical substance and confer specific use rights on confer specific use rights on the owner.the owner.

PatentsPatents CopyrightsCopyrights FranchisesFranchises LicensesLicenses TrademarksTrademarks


Measuring and Recording

Acquisition Cost

Purchased operational assets are recorded at Purchased operational assets are recorded at cost, an amount that includes all normal and cost, an amount that includes all normal and reasonable expenditures necessary to get the reasonable expenditures necessary to get the asset in place and ready for its intended use.asset in place and ready for its intended use.

Invoice priceInvoice price

Sales taxes Sales taxes

Transportation costsTransportation costs

Installation costsInstallation costs

Renovation and repair cost incurred prior to use.Renovation and repair cost incurred prior to use.


Measuring Acquisition Cost

Acquisition cost is the net cash Acquisition cost is the net cash equivalent amount paid for the asset.equivalent amount paid for the asset.

Financing charges are Financing charges are excluded from the excluded from the acquisition cost but acquisition cost but should be reported as should be reported as interest expense.interest expense.


Basket Purchase of Acquisitions

When land and building are purchased When land and building are purchased together, the land cost and the building cost together, the land cost and the building cost are placed in are placed in separateseparate accounts. accounts.

The total cost of the purchase is separated on The total cost of the purchase is separated on the basis of relative market values.the basis of relative market values.


Basket Purchase of

Acquisitions

Example: Suppose a company purchased Example: Suppose a company purchased land and a building for RM100,000 cash. The land and a building for RM100,000 cash. The appraised value of the building was appraised value of the building was RM90,000, and the land was appraised at RM90,000, and the land was appraised at RM30,000. How much of the RM100,000 RM30,000. How much of the RM100,000 purchase price will be allocated to each purchase price will be allocated to each account?account?


Fair Market Values:Fair Market Values:

BuildingBuilding RM 90,000RM 90,000LandLand RM 30,000RM 30,000

Total market valueTotal market value RM120,000RM120,000

Allocation of cost:Allocation of cost:

BuildingBuilding 90,000/120,000 = 3/490,000/120,000 = 3/4LandLand 30,000/120,000 = 1/430,000/120,000 = 1/4

Basket Purchase of

Acquisitions


Fair Market Values:Fair Market Values:

BuildingBuilding RM 90,000RM 90,000LandLand RM 30,000RM 30,000

Total market valueTotal market value RM120,000RM120,000

Allocation of cost:Allocation of cost:

BuildingBuilding 3/4 X RM100,000 = RM75,0003/4 X RM100,000 = RM75,000

LandLand 1/4 X RM100,000 = RM25,0001/4 X RM100,000 = RM25,000

Basket Purchase of

Acquisitions


Cost of asset Cost of asset on Balance on Balance SheetSheet

...as the asset...as the asset is used.....is used.....

Expense onExpense onIncome Income StatementStatement

CapitalizeCapitalize ExpenseExpense

The matching principle requires that part of the The matching principle requires that part of the acquisition cost be expensed in periods when acquisition cost be expensed in periods when the future revenues are earned.the future revenues are earned.

LearningLearningObjective 2Objective 2 Depreciation, Depletion, and

Amortization


Terminology: Write-off….amortize

franchisefranchise Depletion:Depletion:

–Natural resourcesNatural resources

The most general term for writing off an asset is amortization. The most general term for writing off an asset is amortization. However, specific terms are used for certain assets:However, specific terms are used for certain assets:

Amortization: Amortization: Intangible assetsIntangible assets

Depreciation:Depreciation:Property, plant, Property, plant, equipmentequipment


Cost - Residual ValueCost - Residual Value

Life in YearsLife in Years DepreciationDepreciation

Expense per YearExpense per Year==

Straight-lineStraight-line

Units of production methodUnits of production method

(Double) Declining balance(Double) Declining balance

Depreciation Methods


Straight-Line Method:

Example

On January 1, 2003, a juice machine was purchased for On January 1, 2003, a juice machine was purchased for RM11,500 cash. The equipment has an estimated RM11,500 cash. The equipment has an estimated useful life of 6 years and an estimated residual value of useful life of 6 years and an estimated residual value of $500. Delivery and installation costs are RM1,000.$500. Delivery and installation costs are RM1,000.

What is the annual straight-line depreciation expense?What is the annual straight-line depreciation expense?


DepreciationDepreciation

Expense per YearExpense per Year ==


Expense per YearExpense per Year==

Cost - Residual ValueCost - Residual Value

Life in YearsLife in Years


Expense per YearExpense per Year ==

Straight-Line Method: Example

Cost = all costs to prepare machine for use. Cost = all costs to prepare machine for use. Acquisition plus delivery and installation costs.Acquisition plus delivery and installation costs.

RM12,500 – 500RM12,500 – 500

66

RM2,000RM2,000


RM2000RM2000

The Accumulated depreciation account The Accumulated depreciation account balance at the end of the second year is:balance at the end of the second year is:

Straight-Line Method: Example

RM4,000.RM4,000.

Accumulated depreciation amounts are identical Accumulated depreciation amounts are identical to the amount of depreciation expensed each to the amount of depreciation expensed each year. However, the accumulated depreciation year. However, the accumulated depreciation

account will increase each year by:account will increase each year by:


Units-of-Production

Method

Step 1:Step 1:

DepreciationDepreciation RateRate

== Acquisition Cost - Salvage Value Acquisition Cost - Salvage Value Estimated units of useful lifeEstimated units of useful life

Step 2:Step 2:

DepreciationDepreciation ExpenseExpense ==


××

Number of Number of Units ProducedUnits Produced

for the Yearfor the Year


We will use the same information from the We will use the same information from the previous example [a juice machine was purchased previous example [a juice machine was purchased for $11,500 cash. The equipment has an estimated for $11,500 cash. The equipment has an estimated useful life of 6 years and an estimated residual useful life of 6 years and an estimated residual value of $500. Delivery and installation costs are value of $500. Delivery and installation costs are $1,000].$1,000].

It is estimated that the machine will squeeze It is estimated that the machine will squeeze 240,000 glasses of juice over its useful life. 240,000 glasses of juice over its useful life. What is the depreciation rate per glass?What is the depreciation rate per glass?

If 36,000 glasses were squeezed the first year, If 36,000 glasses were squeezed the first year, what is the amount of the depreciation expense what is the amount of the depreciation expense for the year?for the year?

Units-of-Production Method


Step 1: Calculate the per glass rate.Step 1: Calculate the per glass rate.

Step 2: Calculate the annual depreciation expense.Step 2: Calculate the annual depreciation expense.

DepreciationDepreciation ExpenseExpense == $ 0.05/glass$ 0.05/glass * 36,000 glasses = $1,800* 36,000 glasses = $1,800


==

==Cost - salvage valueCost - salvage value

Total Productive outputTotal Productive output

12,00012,000

240,000 glasses240,000 glasses

Dep. rate X units produced this yearDep. rate X units produced this year

Production Method: Example

== $0.05$0.05


Accelerated Depreciation

Accelerated depreciation methods result Accelerated depreciation methods result in more depreciation expense in the early in more depreciation expense in the early years of an asset’s useful life and less years of an asset’s useful life and less depreciation expense in later years of the depreciation expense in later years of the an asset’s useful life.an asset’s useful life.


Double-Declining Balance

Method

Declining-balance depreciation is based Declining-balance depreciation is based on the straight-line rate multiplied by an on the straight-line rate multiplied by an acceleration factor. acceleration factor.

For example, when the acceleration For example, when the acceleration factor is 200 percent, the method is factor is 200 percent, the method is referred to as double-declining referred to as double-declining balance depreciation.balance depreciation.

Declining-balance depreciation Declining-balance depreciation computations ignore residual value, computations ignore residual value, although the asset can’t be depreciated although the asset can’t be depreciated below the residual value.below the residual value.


The annual depreciation amount is The annual depreciation amount is calculated with the following formula:calculated with the following formula:

First, calculate a rate by multiplying the book value First, calculate a rate by multiplying the book value by [2 divided by the number of years of useful life].by [2 divided by the number of years of useful life].

==

Double-Declining Balance Method

Yearly depreciation expenseYearly depreciation expense

(( ))Book Value ×Book Value × Useful Life in YearsUseful Life in Years 22


We will use the same information from the previous We will use the same information from the previous example [a juice machine was purchased for $11,500 example [a juice machine was purchased for $11,500 cash. The equipment has an estimated useful life of 6 cash. The equipment has an estimated useful life of 6 years and an estimated residual value of $500. years and an estimated residual value of $500. Delivery and installation costs are $1,000].Delivery and installation costs are $1,000].

Calculate the depreciation expenseCalculate the depreciation expense for the first two years of the asset’s life. for the first two years of the asset’s life.

Double-Declining-Balance

Example


Double-Declining-Balance

Example

First year’s depreciation:First year’s depreciation:

Second year’s depreciation:Second year’s depreciation:

$12,500 X 1/3 = $4,167$12,500 X 1/3 = $4,167

$8,333 X 1/3 = $2,778 (rounded)$8,333 X 1/3 = $2,778 (rounded)

Rate = 2/6 = 1/3 yearRate = 2/6 = 1/3 year

Cost - previous year’s depreciation expense: Cost - previous year’s depreciation expense: $12,500 - $4,167 = $8,333$12,500 - $4,167 = $8,333


Comparison of Methods

•The total amount of depreciation recorded over the useful life of an asset is the same regardless of the method used.

•Depreciation expense recorded in any one period will vary according to method used.

•The straight-line method is used by about 95 percent of companies because it is easy to use and to explain.


A depletion rate is calculated usingA depletion rate is calculated usingthe units-of-production method.the units-of-production method.

Depletion Cost Per Unit Is Calculated As Follows:Depletion Cost Per Unit Is Calculated As Follows:

Total Cost of Natural Resource Total Cost of Natural Resource

Estimated Number of Available UnitsEstimated Number of Available Unitsof Natural Resource of Natural Resource

Natural Resources


Natural Resources

Total cost of the asset is the cost of acquisition, exploration and development.

Total cost is apportioned by means of depletion over periods in which resulting revenues are earned.


Natural Resources

Assets supplied by natureAssets supplied by nature Examples: gold, oil, and coalExamples: gold, oil, and coal

Presented on balance sheet as Presented on balance sheet as non-current assets at cost less non-current assets at cost less depletion to date.depletion to date.

Depletion is just like “units of Depletion is just like “units of production” depreciation.production” depreciation.


Intangible AssetsLearningLearningObjective 3Objective 3

Noncurrent assets without physical substance Noncurrent assets without physical substance that confer certain rights and privileges on the that confer certain rights and privileges on the owner of the asset. owner of the asset.

Examples: patents, copyrights, franchises and Examples: patents, copyrights, franchises and licenses, leaseholds, leasehold improvements, licenses, leaseholds, leasehold improvements, trademarks, and goodwill.trademarks, and goodwill.

Purchased intangible assets are recorded at cost.Purchased intangible assets are recorded at cost.


Purchased intangible assets are amortized Purchased intangible assets are amortized over the shorter of their useful life or legal over the shorter of their useful life or legal life, whichever is longer.life, whichever is longer.

Normally the straight-line method is used Normally the straight-line method is used and the asset is reported in the balance and the asset is reported in the balance sheet at book value.sheet at book value. PatentPatent

Intangible Assets


Intangible Assets

Intangible assets such as Goodwill are subject to Intangible assets such as Goodwill are subject to Impairment: a permanent reduction in its market value.Impairment: a permanent reduction in its market value.

The asset will be evaluated for any permanent decline in The asset will be evaluated for any permanent decline in value. The asset value will be reduced by the amount of value. The asset value will be reduced by the amount of decline in value, and an expense will be recognized in the decline in value, and an expense will be recognized in the income statement.income statement.

Impairment may be due to: Impairment may be due to:

A downturn in the economyA downturn in the economy

A change in how the company uses the assetA change in how the company uses the asset

A change in the business climateA change in the business climate


Accounting for Capital

Expenditures


Extend the life?Extend the life?

viewed as canceling some viewed as canceling some of the previous depreciationof the previous depreciation

reduce accumulated reduce accumulated depreciationdepreciation

new depreciation new depreciation amount will be calculatedamount will be calculated

Improve the quality?Improve the quality?

viewed as an additional viewed as an additional cost of the equipmentcost of the equipment

Increases the cost of Increases the cost of the assetthe asset

new depreciation new depreciation amount will be calculatedamount will be calculated


Accounting for Capital Expenditures

Expenditures made to keep an Expenditures made to keep an asset in good working order are asset in good working order are expensed in the period in which expensed in the period in which they are incurred.they are incurred.

Substantial costs spent to Substantial costs spent to improve the quality or extend the improve the quality or extend the life of an asset are capitalized.life of an asset are capitalized.


Revising Estimates of Salvage Value or Useful Life

When an estimate is revised, no changes are made to When an estimate is revised, no changes are made to amounts reported in the past.amounts reported in the past.

The new estimates are incorporated into the present The new estimates are incorporated into the present and future calculations only.and future calculations only.

Depreciation amounts are revised using the book Depreciation amounts are revised using the book value and the estimated useful life and salvage value value and the estimated useful life and salvage value at beginning of the year of the revision.at beginning of the year of the revision.


Disposal of Operational

Assets


Voluntary disposal refers to Voluntary disposal refers to situations where a business gives up situations where a business gives up ownership of an asset by: ownership of an asset by:

SaleSale

Trade-inTrade-in

RetirementRetirement

Involuntary disposal results Involuntary disposal results because of a casualty such as a fire because of a casualty such as a fire or an accident.or an accident.


Disposal of Operational Assets

1. Update the depreciation on the asset tothe date of disposal.

2. Compare the book value of the asset to the cash proceeds from the disposal. If the

proceeds > book value, there is a gain on the disposal. If the book value > proceeds, then there is a loss on the sale.

3. Gains and losses go on the income statement.


asset for sale

asset for sale

Disposal of Operational Assets

Compare cash received for the asset Compare cash received for the asset with the asset’s book value (BV).with the asset’s book value (BV).

If cash greater than BV, record a gain.If cash greater than BV, record a gain.If cash less than BV, record a loss.If cash less than BV, record a loss.If cash equals BV, no gain or loss. If cash equals BV, no gain or loss.


Asset Disposal: Example

Suppose you decide to sell Suppose you decide to sell an asset for RM8,000 that an asset for RM8,000 that was purchased 7 years ago was purchased 7 years ago for RM25,000 with for RM25,000 with accumulated depreciation of accumulated depreciation of RM17,500.RM17,500.



Compare the Book Value (RM7,500 = RM25,000-Compare the Book Value (RM7,500 = RM25,000-17,500) to the cash proceeds (RM8,000).17,500) to the cash proceeds (RM8,000).

The difference is a gain or loss on the sale. The difference is a gain or loss on the sale.

It is a gain because the proceeds of RM8,000 > BV It is a gain because the proceeds of RM8,000 > BV of RM7,500of RM7,500 RM500 gain is reported on the income statement.RM500 gain is reported on the income statement.


Now suppose you sell the asset for $5,000. Now suppose you sell the asset for $5,000.

Compare the Book Value (RM7,500 = RM25,000Compare the Book Value (RM7,500 = RM25,000

17,500) to the cash proceeds (RM5,000).17,500) to the cash proceeds (RM5,000).

The difference is a gain or loss on the sale. The difference is a gain or loss on the sale.

This is a loss:This is a loss:

Book value of RM7500 > Proceeds of RM5,000Book value of RM7500 > Proceeds of RM5,000RM2500 loss is reported on the income statement.RM2500 loss is reported on the income statement.



Presentation of Long-term Assets

Long-term assets are shown on the Long-term assets are shown on the balance sheet valued at amortized or balance sheet valued at amortized or depreciated cost which is the carrying depreciated cost which is the carrying value value ..

Carrying value is the difference between Carrying value is the difference between the cost of the asset and its accumulated the cost of the asset and its accumulated depreciation.depreciation.

Balance SheetBalance Sheet



Presentation of Long-term Assets

The use of Long-term assets is shown on the The use of Long-term assets is shown on the income statement with amortization or income statement with amortization or depreciation expense. Gains and losses on depreciation expense. Gains and losses on disposal of long-term assets are reported on the disposal of long-term assets are reported on the income statement, too.income statement, too.

The statement of cash flows will show any cash The statement of cash flows will show any cash expenditures for long-term assets or any cash expenditures for long-term assets or any cash collected from the sale of long-term assets.collected from the sale of long-term assets.

Income StatementIncome Statement

Statement of Cash FlowsStatement of Cash Flows


Firms risk losing long-term assets due to theft Firms risk losing long-term assets due to theft especially for its smaller, mobile, fixed assets. especially for its smaller, mobile, fixed assets. Even large assets are at risk for damage due Even large assets are at risk for damage due to vandalism, hurricanes, or terrorists’ to vandalism, hurricanes, or terrorists’ activities. activities.


1. Physical controls such as locks on a 1. Physical controls such as locks on a warehouse door, video cameras, security warehouse door, video cameras, security guards on duty, fences, and alarms.guards on duty, fences, and alarms.2. Segregation of duties: People who are 2. Segregation of duties: People who are responsible for the record keeping should be responsible for the record keeping should be different than those who have physical control different than those who have physical control of the assets to help assure complete and of the assets to help assure complete and reliable record keeping. reliable record keeping. 3. Monitoring all controls to ensure that all 3. Monitoring all controls to ensure that all controls are in place and operating properly. controls are in place and operating properly.

Controls that safeguard assets and minimize these risks:Controls that safeguard assets and minimize these risks:

Business Risk, Control, and Ethics


Depreciation and Federal

Income Taxes

The accounting information a The accounting information a company reports on its company reports on its financial statements is not the financial statements is not the same information it reports to same information it reports to the IRS on its federal income the IRS on its federal income tax return. tax return.

For depreciating fixed assets, For depreciating fixed assets, corporations use a method corporations use a method called the Modified Accelerated called the Modified Accelerated Cost Recovery System Cost Recovery System (MACRS). MACRS is allowed (MACRS). MACRS is allowed for tax purposes but not GAAP.for tax purposes but not GAAP.



Depreciation and Federal Income

Tax

Most corporations use the Modified Most corporations use the Modified Accelerated Cost Recovery System Accelerated Cost Recovery System (MACRS) for tax purposes.(MACRS) for tax purposes.

MACRS provides for rapidMACRS provides for rapidwrite-off of an asset’s cost inwrite-off of an asset’s cost inorder to stimulate investmentorder to stimulate investmentin modern facilities. in modern facilities.


End of Lecture 5

The EndThe End

Documents

Fixed Assets LECTURE 5 Issah Hamdu Faculty of Business Management and Globalization Tel : 603 8317 8833 (Ext 8403) Email: [email protected] BACCT1201