Act 211, Chapter 7

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Chapter 07:

Chapter 07 Long-Term Assets McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Categories of Long-Term Assets:

Categories of Long-Term Assets Property, Plant and Equipment Intangible Assets Land, land improvements, buildings, equipment, and natural resources Patents, trademarks, copyrights, franchises, and goodwill Physical substance Lacks physical substance 7- 2

Plant Assets:

Plant assets are critical to a company’s success Plant Assets

Part A:

Part A Acquisition and Improvements 7- 4

LO1 Identify and record the major types of Property, plant, and equipment:

LO1 Identify and record the major types of Property, plant, and equipment Record a long-term asset at Cost + All expenditures necessary to get the asset ready for use 7- 5

Land and Land Improvements:

Land and Land Improvements Land - represents property a company is using in its operations Capitalize costs – all expenditures necessary to get the land ready for its intended use. includes the purchase price of the land plus closing costs such as attorney fees; real estate commissions etc. Any additional amount spent to improve the land by adding a parking lot, paving, temporary landscaping, lighting systems, fences, sprinklers etc. are recorded separately as Land Improvements , which are subject to depreciation. 7- 6

Buildings:

Buildings Include offices, retail stores, storage warehouses, and manufacturing facilities Cost of acquiring a building usually includes: the purchase price; realtor commissions; legal fees; other costs incurred to remodel the building Cost of constructing a building usually includes: architect fees; material costs; construction labor; officer supervision; overhead and “capitalized interest” 7- 7

Equipment:

Equipment Includes machinery used in manufacturing, computers and other office equipment, vehicles, furniture, and fixtures. Cost of equipment includes: actual purchase price; sales tax; shipping; delivery; insurance during delivery; assembly; installation; testing; legal fees incurred to establish title. Recurring costs such as insurance and property taxes are expensed as they are incurred in order to properly match them with revenues. 7- 8

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Basket Purchase (Lump-Sum Acquisition):

Basket Purchase ( Lump-Sum Acquisition) Purchasing more than one asset at the same time for one purchase price. Often the estimated fair values of the individual assets exceed the total purchase price. Total purchase price is allocated to each asset’s separate account based on their relative fair value of the asset. 7- 10

Basket (Lump-Sum) Purchase:

11 Basket (Lump-Sum) Purchase *This approach is also known as the “Lump-Sum Acquisition Method” For $700,000 in cash, we purchased some land, a building, and some equipment: How to allocate the $700,000 among the three assets? What if you knew appraised values were: Land $500,000 Building 300,000 Equipment 200,000 Total $1,000,000 50% of total 30% of total 20% of total

Basket (Lump-Sum) cont.:

12 Basket (Lump-Sum) cont. Land 350,000 (50% x 700,000) Building 210,000 (30% x 700,000) Equipment 140,000 (20% x 700,000) Cash 700,000 So entry would be:

Natural Resources:

Natural Resources We can physically use up, or deplete, natural resources. For example, Exxon Mobil’s oil reserves are a natural resource that decreases as the firm extracts oil. Oil, Natural Gas, and Timber 7- 13

LO2 Identify and record the major types of intangible assets:

LO2 Identify and record the major types of intangible assets Purchased intangible assets like patents, copyrights, trademarks, or franchise rights from other entities. Record purchased intangible assets at their original cost plus all other costs, such as legal and filing fees, necessary to get the asset ready for use. Created intangible assets internally through research and development or advertising. Most of the costs for internally developed intangible assets are expensed to the income statement as they are incurred. Companies can either purchase or create intangible assets internally 7- 14

Patents:

Patents An exclusive right to manufacture a product or to use a process (normally granted for a period of 20 years). Cost of a patent includes: When it is purchased - purchase price; legal and filing fees to secure the patent; any attorney fees and other costs of successfully defending the patent in court When it is internally developed - research and development costs (expensed as incurred); legal and filing fees to secure the patent (recorded in the patent asset account) 7- 15

Copyrights:

Copyrights An exclusive right of protection given by the U.S. Copyright Office to the creator of a published work such as a song, film, painting, photograph, book, or computer software. Gives the creator (and his or her heirs) the exclusive right to reproduce and sell the work for the life of the creator plus 70 years. Accounting for the costs of copyrights is virtually identical to that of patents. 7- 16

Trademarks:

Trademarks A word, slogan, or symbol that distinctively identifies a company, product, or service. Can be registered for a period of 10 years. Registration can be renewed for an indefinite number of 10-year periods (useful life can be indefinite). Firms often acquire trademarks through acquisition. When a firm develops a trademark internally through advertising, it records the advertising costs as expenses in the income statement. The firm can record attorney fees, registration fees, design costs, successful legal defense, and other costs directly related to securing the trademark as an intangible asset in the trademark asset account. 7- 17

Types of Intangible Assets:

Trademarks and Trade Names Word, phrase, jingle, or symbol that identifies a particular enterprise or product. Wheaties , Monopoly, Sunkist, Kleenex, Coca-Cola, Big Mac, ChapStick , Google, and Jeep . Trademark or trade name has legal protection for indefinite number of 20 year renewal periods. Capitalize acquisition costs and No Amortization Types of Intangible Assets

Franchises:

Franchises Local outlets that pay for the exclusive right to use the franchisor company’s name and to sell its products within a specified geographical area. Many franchisors provide other benefits to the franchisee, such as participating in the construction of the retail outlet, training employees, and purchasing national advertising. The franchisee records the initial fee as an intangible asset and then expenses it over the life of the franchise agreement. Additional periodic payments by the franchisee usually are for services the franchisor provides on a continuing basis. These are expensed by the franchisee as incurred. 7- 19

Goodwill:

Goodwill Represents the value of a company as a whole, over and above the value of its identifiable net assets. Recorded as an intangible asset in the balance sheet only when purchased as part of the acquisition of another company. Goodwill is equal to the purchase price minus the fair value of the net assets acquired. 7- 20

LO3 The accounting treatment of expenditures after acquisition:

LO3 The accounting treatment of expenditures after acquisition Expenditures after Acquisition Repairs and maintenance, additions, improvements, or litigation costs Capitalize as an asset if it increases future benefits Expense if it benefits only the current period 7- 21

Repairs and Maintenance:

Repairs and Maintenance Expensed if repairs maintain a given level of benefits in the period incurred Capitalize as assets more extensive repairs that increase future benefits EXPENSE Cost of an engine tune-up or the repair of an engine part CAPITALIZE Cost of a new transmission or an engine overhaul For a delivery truck 7- 22

Additions:

Additions Occurs when we add a new major component to an existing asset CAPITALIZE the cost of additions because they increase, rather than maintain, the future benefits from the expenditure DEPRECIATE the capitalized cost over the remaining useful life of the original asset or the addition, whichever is shorter. 7- 23

Improvements:

Improvements The cost of replacing a major component of an asset A new component with the same characteristics as the old component A new component with enhanced operating capabilities CAPITALIZE Replace an existing refrigeration unit in a delivery truck With a new and improved refrigeration unit With a new but similar unit 7- 24

Legal Defense of Intangible assets:

Legal Defense of Intangible assets The cost of legally defending the right that gives the asset its value If the defense of an intangible right is Successful Unsuccessful CAPITALIZE Litigation costs and amortize them over the remaining useful life of the related intangible EXPENSE The litigation costs as incurred because they provide no future benefit and remove the intangible from the books 7- 25

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Part B:

Part B Cost Allocation (i.e., Depreciation) 7- 27

LO4 Calculate depreciation of property, plant, and equipment:

LO4 Calculate depreciation of property, plant, and equipment Dictionary definition = Decrease in value. Accounting definition = Allocation of an asset’s cost $Cost $Benefit $Benefit $Benefit $Benefit Time Periods Depreciation = Allocation of a portion of the asset’s cost to an expense over all periods benefited. Cost incurred to purchase an asset (future benefit) 7- 28

Depreciation Example:

Depreciation Example Starbucks pays $1,200 for a computer expected to have value for four years and allocates the cost equally over the years in that period. The entry to record annual depreciation is: Depreciation Expense 300 Accumulated Depreciation 300 ( Depreciate equipment ) ( $1,200 ÷ 4 years = $300 ) Rather than credit the equipment account directly, we instead credit its contra account i.e. Accumulated Depreciation which is then offset against the equipment account in the balance sheet. After one year, we have Equipment (cost) $1,200 Less: Accumulated depreciation ($300 x 1 year) (300) = Book value $ 900 7- 29

Depreciation Terminology:

Depreciation Terminology Accumulated depreciation is a contra-asset account representing the total depreciation taken to date. Book value is equal to the original cost of the asset minus the current balance in accumulated depreciation . Service life (or useful life) is how long the company expects to receive benefits from the asset before disposing of it; can be measured in units of time or in units of activity. Residual value (or salvage value) is the amount the company expects to receive from selling the asset at the end of its service life. Depreciable Cost is the original cost less the residual value 7- 30

Depreciation of Tangible Assets:

Depreciation of Tangible Assets Depreciation No Depreciation Land Improvements Buildings Equipment Land 7- 31

Depreciation Methods:

Depreciation Methods Depreciation Methods Straight-line Declining-balance Activity-based 7- 32

Straight-Line Depreciation:

Straight-Line Depreciation Allocates an equal amount of the depreciable cost to each year of the asset’s service life Asset cost - Estimated residual value Straight-Line Depreciation = Asset’s service life 7- 33

Accounting for Plant Assets:

Illustration: Bill’s Pizzas purchased a small delivery truck on January 1, 2010. Required: Compute depreciation using the following. (a) Straight-Line. (b) Units-of-Activity. SO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods. Accounting for Plant Assets

Accounting for Plant Assets:

Straight-Line Expense is same amount for each year. Depreciable cost is cost of the asset less its salvage value. Illustration 9-8 SO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods. Accounting for Plant Assets

Accounting for Plant Assets:

Illustration: (Straight-Line Method) 2010 $ 12,000 20% $ 2,400 $ 2,400 $ 10,600 2011 12,000 20 2,400 4,800 8,200 2012 12,000 20 2,400 7,200 5,800 2013 12,000 20 2,400 9,600 3,400 2014 12,000 20 2,400 12,000 1,000 2010 Journal Entry Depreciation expense 2,400 Accumulated depreciation 2,400 Illustration 9-9 SO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods. Accounting for Plant Assets

Accounting for Plant Assets:

SO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods. Accounting for Plant Assets Partial Year Illustration: (Straight-Line Method) Assuming the delivery truck was purchased on April 1, 2010 .

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Declining-Balance Depreciation:

Declining-Balance Depreciation An accelerated depreciation method Will be higher than straight-line depreciation in earlier years, but lower in later years Both declining-balance and straight-line will result in the same total depreciation over the asset’s service life The most common declining-balance rate is 200%, which we refer to as the double -declining-balance method since the rate is double the straight-line rate 7- 39

Depreciation Methods:

Radford University - M. Chatham - Financial Accounting 211 40 Depreciation Methods Data Items Amount Cost of truck $41,000 Estimated residual value ( 1,000) Depreciable cost $40,000 Estimated useful life 5 years Units of production 100,000 miles

Double-Declining-Balance Method:

Radford University - M. Chatham - Financial Accounting 211 41 Double-Declining-Balance Method Straight-line rate per year: 100% ÷ 5 = 20% Book value of truck at the end of the first year: $41,000 × 40% = $16,400 (Depr. for Year 1) $41,000 – $16,400 = $24,600 (new Book Value) Double-declining balance: 2 times the straight-line rate = 40% Rate times BOOK VALUE = Depreciation Expense

Activity-Based Depreciation:

Activity-Based Depreciation Allocate an asset’s cost based on use rather than time Step 1 Compute the average depreciation rate per unit Depreciable Cost Total units expected to be produced Step 2 Multiply the average depreciation rate per unit by the number of units each period 7- 42

Accounting for Plant Assets:

Companies estimate total units of activity to calculate depreciation cost per unit. Expense varies based on units of activity. Depreciable cost is cost less salvage value. Units-of-Activity SO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods. Accounting for Plant Assets Illustration 9A-3

Accounting for Plant Assets:

Illustration: (Units-of-Activity Method) 2010 15,000 $ 0.12 $ 1,800 $ 1,800 $ 11,200 2011 30,000 0.12 3,600 5,400 7,600 2012 20,000 0.12 2,400 7,800 5,200 2013 25,000 0.12 3,000 10,800 2,200 2014 10,000 0.12 1,200 12,000 1,000 Depreciation expense 1,800 Accumulated depreciation 1,800 2010 Journal Entry Illustration 9-11 SO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods. Accounting for Plant Assets

Accounting for Plant Assets:

Comparison of Depreciation Methods Illustration 9-12 Illustration 9-13 SO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods. Accounting for Plant Assets Each method is acceptable because each recognizes the decline in service potential of the asset in a rational and systematic manner.

Accounting for Plant Assets:

IRS does not require taxpayer to use the same depreciation method on the tax return that is used in preparing financial statements. IRS requires the straight-line method or a special accelerated-depreciation method called the Modified Accelerated Cost Recovery System (MACRS). MACRS is NOT acceptable under GAAP. Depreciation and Income Taxes Accounting for Plant Assets SO 3 Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods.

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LO5 Amortization of Intangible Assets:

LO5 Amortization of Intangible Assets Allocation of the cost of intangible assets Intangible assets subject to amortization Intangible assets not subject to amortization Assets having a finite useful life that we can estimate Assets having indefinite useful lives Goodwill, Trademarks Patents, Copyrights, Franchises 7- 48

Amortization of Intangible Assets:

Amortization of Intangible Assets Estimate the intangible asset’s service life (usually is limited by legal, regulatory, or contractual provisions) Estimate its residual value (for most intangible assets, it is zero) Allocate the asset’s cost less any estimated residual value to periods in which we expect the intangible asset to contribute to the company’s revenue-generating activities…under the straight-line method. 7- 49

Amortization Example:

Amortization Example In early January, Little King Sandwiches acquires franchise rights from University Hero for $800,000. The franchise agreement is for a period of 20 years. In addition, Little King purchases a patent for $72,000. The original legal life of the patent was 20 years; there are 12 years remaining. However, due to expected technological obsolescence, the company estimates that the useful life of the patent is only 8 more years. Little King uses straight-line amortization for all intangible assets. The company’s fiscal year-end is December 31. The amortization expense for the franchise and the patent is recorded as: Amortization Expense 40,000 Franchise 40,000 ( Amortize franchise) ($800,000 ÷ 20 years ) Amortization Expense 9,000 Patent 9,000 ( Amortize patent) ($72,000 ÷ 8 years ) 7- 50

Intangible Assets not subject to Amortization:

Intangible Assets not subject to Amortization Do not amortize intangible assets with indefinite useful lives. Goodwill is the most common intangible asset with an indefinite useful life. Another example is a trademark. Review these assets for a potential write-down when events or changes in circumstances indicate the amount recorded in the accounting records might not be recoverable. 7- 51

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Note: the ratings for the 2010 ESPN Colts/Texans MNF game exceeded the market share for the 5 th (and final) game of the MLB World Series

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Part C:

Part C Asset Disposition THE FOOD STORE 7- 54

LO6 Disposal of Long-Term Assets:

LO6 Disposal of Long-Term Assets Disposal of Long-Term Assets Sale Retirement Exchange Can result in either a gain or a loss Occurs when a long-term asset is no longer useful but cannot be sold Occurs when two companies trade assets 7- 55

Recording Long-Term Asset Disposals:

Recording Long-Term Asset Disposals Little King Sandwiches purchased a new delivery truck, which will be depreciated under the straight-line method. Here are the specific details: Cost of the new truck $40,000 Estimated residual value $5,000 Estimated service life 5 years 7- 56

Sale:

Sale If we assume that Little King sells the delivery truck at the end of year 3 for $22,000, we can calculate the gain as $3,000. Note that both the delivery truck and the related accumulated depreciation account are removed. The entry to record the gain on sale is: Cash 22,000 Accumulated Depreciation 21,000 Delivery Truck 40,000 Gain on sale 3,000 ( Record gain on sale ) Sale amount $22,000 Less: Cost of the new truck $40,000 Less: Accumulated depreciation (3 years x $7,000/year) (21,000) Book value at the end of year 3 19,000 Gain on sale $3,000 7- 57

Retirement:

Retirement If we assume that the delivery truck is totaled in an accident at the end of year 3, we have a $19,000 loss on retirement. Sale amount $0 Less: Cost of the new truck $40,000 Less: Accumulated depreciation (3 years x $7,000/year) (21,000) Book value at the end of year 3 19,000 Loss on retirement ($19,000) The entry to record the loss on retirement is: Accumulated Depreciation 21,000 Loss on Retirement 19,000 Delivery Truck 40,000 ( Record loss on retirement ) 7- 58

Exchange:

Exchange Assume that Little King exchanges the delivery truck at the end of year 3 for a new truck valued at $45,000. The dealership gives Little King a trade-in allowance of $23,000 on the exchange, with the remaining $22,000 payable in cash. We have a $4,000 gain. The entry to record the gain on exchange is: Delivery Truck (new) 45,000 Accumulated Depreciation 21,000 Cash 22,000 Delivery Truck (old) 40,000 Gain on Exchange 4,000 ( Record gain on exchange ) Trade-in allowance $23,000 Less: Cost of the new truck $40,000 Less: Accumulated depreciation (3 years x $7,000/year) (21,000) Book value at the end of year 3 19,000 Gain on exchange $4,000 7- 59

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LO7 Asset Analysis:

LO7 Asset Analysis Analyze the relation between Return on Assets, Profit Margin and Asset Turnover to analyze the profitability of a company’s assets. Return on Assets = Profit Margin x Asset Turnover Net Income = Net Income x Net Sales Average Total Assets Net Sales Average Total Assets To maximize profitability, a company ideally strives to increase both net income per dollar of sales (profit margin) and sales per dollar of assets invested (asset turnover). 7- 61

Analyzing Plant Assets:

Return on Asset Ratio indicates the amount of net income generated by each dollar of assets. Analyzing Plant Assets

Analyzing Plant Assets:

Asset Turnover Ratio indicates how efficiently a company uses its assets to generate sales. Analyzing Plant Assets

Analyzing Plant Assets:

Profit Margin Ratio Illustration 9-20 Analyzing Plant Assets Tells how effective a company is in turning its sales into income—that is, how much income each dollar of sales provides. You can evaluate the return on assets ratio by evaluating its components.

Appendix:

Appendix Asset Impairment 7- 65

LO8 Asset Impairment:

LO8 Asset Impairment Impairment occurs when the future cash flows (future benefits) generated for a long-term asset is < its book value (cost minus accumulated depreciation) Impairment loss = Asset’s book value - its fair value. 7- 66

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Good Luck on the Chapter 7 Homework!

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