Needles Powers Crosson Financial and Managerial Accounting 10e Long-Term Assets 9 C H A P T E R © human/iStockphoto ©2014 Cengage Learning. All Rights

NeedlesPowersCrosson

Financial and Managerial Accounting

10e

Long-Term Assets9C H A P T E R

© human/iStockphoto©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Concepts Underlying Long-Term Assets

Long-term assets have the following characteristics:– They have a useful life of more than one year.– They are used in the operation of a business.– They are not intended for resale to

customers.

Under accrual accounting, the cost of these assets, with the exception of land and some intangible assets, is allocated to the periods they benefit.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Valuation and Disclosure of Long-Term Assets

Long-term assets are generally reported and valued at carrying value. – Carrying value (or book value) is the

unexpired part of an asset’s cost.– Asset impairment occurs when the

carrying value of a long-term asset exceeds its fair value—i.e., when an asset loses some or all of its potential to generate revenue before the end of its useful life.


Recognition of the Acquisition Cost of Long-Term Assets (slide 1 of 2)

An expenditure is a payment or an obligation to make a future payment for an asset or a service. Expenditures are classified as capital expenditures or revenue expenditures.– A capital expenditure is for the purchase

or expansion of a long-term asset. Capital expenditures are recorded in asset

accounts.

– A revenue expenditure is for the ordinary repairs and maintenance needed to keep a long-term asset in good operating condition. Revenue expenditures are recorded in expense

accounts.


Recognition of the Acquisition Cost of Long-Term Assets (slide 2 of 2)

Capital expenditures include:– outlays for plant assets, natural resources,

and intangible assets– additions—enlargements to the physical

layout of a plant asset– betterments—improvements to a plant

asset but not an addition to the plant’s physical layout

– extraordinary repairs—repairs that significantly enhance a plant asset’s estimated useful life or residual value; recorded by reducing the Accumulated Depreciation account


Acquisition Cost of Property, Plant, and Equipment

The acquisition cost of property, plant, and equipment includes all expenditures reasonable and necessary to get an asset in place and ready for use.Cost of Asset = Purchase Price + Additional Expenditures

(freight, installation, etc.)

– Interest charges incurred in purchasing an asset are not a cost of the asset, but an operating expense.

– Small expenditures for long-term assets may be treated as expenses if they are not material.


Determining the Acquisition Cost of Property, Plant, and Equipment: Land and Land Improvements

Land: Expenditures that should be debited to the Land account include: purchase price of the land; commissions to real estate agents; lawyer’s fees; accrued taxes paid by the purchaser; costs of preparing the land to build on, such as costs of tearing down old buildings and grading the land; assessments for local improvements; and landscaping.

Land Improvements: Improvements to real estate, such as driveways, parking lots, and fences, that have a limited life are subject to depreciation. They are recorded in an account called Land Improvements.


Determining the Acquisition Cost of Property, Plant, and Equipment: Buildings

When a company buys a building, the cost includes the purchase price and all expenditures required to put the building in usable condition.

When a company constructs its own building, the cost includes: costs of materials, labor, and overhead; architects’ fees and lawyers’ fees; insurance during construction; interest on construction loans during construction; and building permits.


Determining the Acquisition Cost of Property, Plant, and Equipment: Leasehold Improvements

Improvements to leased property, such as the installation of carpet or walls, on the books of the lessee that become the property of the lessor (the owner of the property) at the end of the lease are called leasehold improvements. – These are usually classified in the property, plant,

and equipment section of the balance sheet.– The cost of these improvements is depreciated

over the remaining term of the lease or the useful life of the improvement, whichever is shorter.


Determining the Acquisition Cost of Property, Plant, and Equipment: Equipment and Group Purchases

Equipment: The cost of equipment includes all expenditures connected with purchasing the equipment and preparing it for use. These expenditures include: invoice price less cash discounts; freight, including insurance; excise taxes and tariffs; buying expenses; installation costs; and test runs to ready the equipment for operation.

Group Purchases: Companies sometimes purchase land and other assets for a lump sum. The lump sum must be apportioned between the land and other assets.


Depreciation

Depreciation refers to the allocation of the cost of a plant asset over its estimated useful life, not to the asset’s physical deterioration or to its decrease in market value.– The major factors that limit a depreciable

asset’s useful life are: Physical deterioration—the result of use or

exposure to the elements, such as sun or wind Obsolescence—the process of becoming out of date

– Depreciation is recorded even if an asset increases in value.


Factors in Computing Depreciation

Factors in computing depreciation include:– Cost—the net purchase price of an asset plus all

expenditures to get it in place and ready for use

– Residual value (or salvage, disposal, or trade-in value)—the portion of an asset’s cost that a company expects to recover when it disposes of the asset

– Depreciable cost—an asset’s cost less its residual value

– Estimated useful life—the total number of service units expected from a long-term asset


Computing Depreciation: Straight-Line and Production Methods

When the straight-line method is used, the asset’s depreciable cost is spread evenly over the estimated useful life of the asset. Under this method, depreciation is calculated as follows:

The production method is based on the assumption that depreciation is solely the result of use and that the passage of time plays no role in the process. Under this method, depreciation is calculated as follows:


Computing Depreciation:Declining-Balance Method

An accelerated method of depreciation results in larger amounts of depreciation in the early years of an asset’s life than in later years.– Thus, depreciation charges will be highest in years when the

asset is newest and when revenue generation from the asset is highest.

The declining-balance method is the most common accelerated method of depreciation. With this method, depreciation is computed by applying a fixed rate to the declining value of a long-term asset. – The most common rate is a percentage equal to twice the

straight-line depreciation percentage. When this rate is used, the method is usually called the double-declining-balance method.


Special Issues in Determining Depreciation

Group Depreciation: Large companies group similar assets, such as machines, to calculate depreciation.

It is often necessary to calculate depreciation for partial years because assets are often purchased mid-year.

The tax law allows rapid write-offs of plant assets, which differs from the depreciation methods most companies use for financial reporting. As a result of the Economic Stimulus Act of 2008, the tax law allows a small company to expense the first $250,000 of equipment expenditures.

Sometimes the estimate of useful life is revised, so that the depreciation changes over the asset’s remaining useful life.


Disposal of Depreciable Assets

When plant assets are no longer useful because they have physically deteriorated or become obsolete, a company can sell them, discard them, or trade them in on the purchase of a new asset.– A company must record depreciation expense

for the partial year up to the date of disposal.– The carrying value of a fully depreciated asset

is zero if it has no residual value. When the asset is discarded, no gain or loss results.

– For an asset with a carrying value, a loss equal to the carrying value should be recorded when it is discarded.


Exchanges of Plant Assets

Exchanges may involve similar assets, such as an old machine traded in on a newer model, or dissimilar assets, such as a cement mixer traded in on a truck.– In both cases, the purchase price is reduced

by the amount of the trade-in allowance. If the trade-in allowance is greater than the

asset’s carrying value, the company realizes a gain.

If the allowance is less, it suffers a loss.


Natural Resources

Natural resources are long-term assets that are converted to inventory by cutting, pumping, mining, or other extraction methods.– They are recorded at acquisition cost. As these

resources are converted to inventory, their asset accounts must be proportionately reduced.

– The useful life of the plant assets used to extract the natural resources may be longer than the time it will take to extract the resources. If a company plans to abandon these assets after all the

resources have been extracted, they should be depreciated on the same basis as depletion of the natural resources.


Depletion

Depletion refers not only to the exhaustion of a natural resource but also to the proportional allocation of the cost of a natural resource to the units extracted.– When a natural resource is purchased or

developed, the total units that will be available, such as tons of coal, must be estimated.

– The depletion cost per unit is computed as follows.

Depletion Cost per Unit = Cost − Residual Value Estimated Number of Units


Development and Exploration Costsin the Oil and Gas Industry

Successful efforts accounting—Under this method, the cost of successful exploration is a cost of the resource. – It is recorded as an asset

and depleted over the resource’s estimated life. The cost of unsuccessful exploration is written off immediately as a loss.

Full-costing method—Under this method, all costs of exploration are recorded as assets and depleted over the estimated life of the resources.– This includes the costs

of unsuccessful exploration, such as the cost of dry wells.


Exploring and developing oil and gas resources can be accounted for under one of two methods:

Intangible Assets(slide 1 of 2)

An intangible asset’s value comes from the long-term rights it affords its owner.– Common types of intangible assets are:

Copyright Patent Leasehold Software Noncompete covenant Franchise, License Customer list Goodwill Trademark, Brand name


Intangible Assets(slide 2 of 2)

Intangible assets are accounted for at the amount that a company paid for them and should be included on a company’s balance sheet only if purchased from another party at a price established in the marketplace.– The useful life of an intangible asset is the period over

which the asset is expected to contribute to the company’s future cash flows. It may be:

Definite—subject to a legal limit or can be reasonably estimated

Indefinite—not limited by legal, regulatory, contractual, competitive, economic, or other factors (and not amortized)

– All intangible assets are subject to an annual impairment test to determine if the assets justify their value on the balance sheet.


Research and Development Costs

Research and development (R&D) activities include development of new products, testing of existing and proposed products, and pure research.

– The FASB requires that all R&D costs be charged to expense in the period in which they are incurred.

– Costs that companies incur in developing software for sale or lease or for their own use are considered R&D costs until the product has proved feasible.

– Once proved feasible, all software production costs are recorded as assets and amortized over the software’s estimated useful life, using the straight-line method.


Goodwill

From an accounting standpoint, goodwill exists when a purchaser pays more for a business than the fair market value of the business’s net assets.

– Goodwill may reflect customer satisfaction, good management, efficiency, having a monopoly, good locations, and good employee relations.

– The FASB requires that purchased goodwill be reported as a separate line item on the balance sheet and that it be reviewed annually for impairment.

– A company should record goodwill only when it acquires a controlling interest in another business.


Management Decisions Relating to Long-Term Assets

A company may need to finance major acquisitions of long-term assets with the issue of stock, long-term notes, or bonds.

A measure of a company’s success in funding these acquisitions is free cash flow. - Free cash flow is the amount of cash that

remains after deducting the funds a company must commit to continue operating at its planned level. These commitments include: current or continuing

operations, interest, income taxes, dividends, and net capital expenditures (purchases of plant assets minus sales of plant assets).


Free Cash Flow

Free cash flow is computed as follows: Free Cash Flow = Net Cash Flows from Operating Activities − Dividends − Purchases of Plant Assets + Sales of Plant Assets

– A positive free cash flow means that a company has met all its cash commitments and has cash available to reduce debt or to expand operations.

– A negative free cash flow means that it will have to sell investments, borrow money, or issue stock to continue at its planned level.


Ethics in Acquiring and Financing Long-Term Assets (slide 1 of 2)

When a company acquires a long-term asset, it defers some of the asset’s cost to later periods.– Thus, the current period’s profitability looks

better than it would if the asset’s total cost had been expensed.

To avoid fraudulent reporting of long-term assets, a company’s management must apply accrual accounting in resolving two important issues:– The amount of the total cost of a long-term asset

to allocate to expense in the current period.– The amount to retain on the balance sheet as an

asset.


Ethics in Acquiring and Financing Long-Term Assets (slide 2 of 2)

– To resolve these issues, management must answer four important questions: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?


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Needles Powers Crosson Financial and Managerial Accounting 10e Long-Term Assets 9 C H A P T E R © human/iStockphoto ©2014 Cengage Learning. All Rights