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Teal Mc Ateer

R EPORTING AND NTERPRETING PROPERTY , PLANT , AND E QUIPMENT ; NATURAL R ESOURCES ;AND INTANGIBLES STUDOBJECTIVES 1. Describe how the cost principle applies to property, plant, and equipment. 2. Explain the concept of, and calculate amortization. 3. Impairment and change in estimates. 4. Explain how to account for the disposal of property, plant, and equipment. 5. Identify the basic issues related to accounting for intangible assets. C OST OF O PERATIONAL A SSETS Operational assets are used in the business operations to generate revenues. The future benefits of these assets extend beyond the current year; therefore some call them Long-lived assets. These assets are not intended for sale to custom ers. They are also known by various names: property, plant, and equipment; fixed assets,capital assets, long-term assets, and operational assets. Long-lived assets can be either tangible or intangible. Tangible assets have physical substance. They are usua lly classified as property, plant, and equipment (fixed assets). They include: – Land used in operations (underlying the plant). Land is not amortizable. – Buildings, fixtures, furniture, machinery, a nd equipment used in operations. These are subject to amortization. – Natural resources (such as ore or mineral deposits, timber, and natural gas) used in operations. These are subject to depletion. Intangible assets are without physical substance. These assets confer rights on the owner. They are evidenced by legal documents. Examples include patents, copyrights, trademarks, leaseholds, and goodwill. Those that have limited lives are amortized over this term. Those with an indefinite life are not amortiz ed however, they are regularly te sted for impairment to their value. C OSTS OF LONG -LIVED ASSETS Recall from Week 2 that long-lived assets are non-monetary assets that are reported at historical costs. Historical cost includes all expenditures necessary to get the asset ready for its intended use. These costs include the acquisition price,shipping, insurance, closing fees, legal fees, installation and preparation costs, and testing cost s. All these costs must be incurred prior to using the assets in operations. Once in operations , costs related to the asset can be classified either as capital expenditures or revenue expenditure. The cost principle dictates that once in operations, the cost of the asset reported on the balance sheet should not be adjusted for changes in market value. The only exception is when the asset is permanently impaired. Example ABC Inc. purchased a tract of land to construct an office building. ABC hi red contractors to do the fencing, paving, lighting, and landscaping of the property. Here is the information about the transactions related to the acquisition. 1. The purchase price of the land is $80,000. 2. ABC paid $4,000 for seller's back property taxes. 3. ABC paid a builder $180,000 to design and build the office building. 4. ABC paid a contractor $10,000 to make the land ready the building. What is the cost of the land and the building? The cost of the land is $94,000 (80,000 + 4,000 + 10,000). The cost of the building is $180,000 B ASKET PURCHASES When multiple operational assets are acquired ia single transaction for a single lump sum (basket purchase), an allocation of costs must be made to each individual asset. This is a common situation when purchasing real estate and entire businesses. It is also appropriapurchases from auctions and estatesales. Thisapportionmentisnecessary because some assets are amortizable and some are not. Further, not all of the acquired asse ts will be disposed of at the same time. The allocation of costs from basket purchases must be determined on a rational basi s. The most logical basis for the apportionment is the relative market value approach. Appraisals ortax assessment valuations are frequently used as indicators of the market values. The computation determines the percent of value of each asset to the total value. These percentages are then applied to the total basket cost to derive the assigned purchase cost of each asset. Example XYZ Inc. paid $2,000,000 in a basket purchase of land, a building, and equipment. An appraisal indicated the following market values at the time of the purchase: Land 800$,000 Building 1,250,000 Equipment 250,000 Prepare the journal entry to record transaction. Solution Total appraised value = 800,000 + 1,250,000 +250,000 = $2,300,000 Cost of the land = 2,000,000 x (800,000 / 2,300,000) = $695,652 Cost of the building = 2,000,000 x (1,250,000 / 2,300,000) = $1,086,957 Cost the equipment = 2,000,000 x (250,000 / 2,300,000) = $217,391 695,652 Land Building 1,086,957 Equipment 217,391 Cas2h,000,000 SUBSEQUENT EXPENDITURES Once operational assets are in operation, subs equent expenditures can be classified as capital expenditures or revenue expenditures. Capital expenditures are those expenditures that provide benefits for one or more accounting periods beyond te current period; therefore, they are debited to appropriate asset accounts and depreciated, depleted, or amortized over their us eful. Capital expenditures are incurred to incr ease the productive life, operatin g efficiency, or capacity of long-lived assets. Revenue expenditures are those expenditures that provide benefits during the current accounting period only; therefore, they are debited to appropriate current expense accounts when incurred. Revenues expenditures are incurred to maintain the productive capacity of the asset. There are three types of subsequent expenditures: 1. Ordinary repairs and maintenance are expend itures incurred to main tain the productive capacity of the asset. These expenditures are recurring in nature, involve relatively small amounts and do not further the useful life of the asset. 2. Extraordinary repairs are major, high-cost, long-term repairs that increase the economic usefulness of the asset in term s of greater e fficiency or longer life. These repairs are classified as capital expenditures since they bring benefit to one or more accounting periods beyond the current period. 3. Betterments are essentially improvements to an asset that do not necessarily extend the useful life of that asset; rath er they improve the efficiency of the asset. Betterments are also classified as capital expenditures. T HE C ONCEPT AND C ALCULATION OF D EPRECIATION Depreciation is the process of allocating the cost of a long-lived asset over its useful (service) life in a rational and systematic manner. Depreciation is a process of cost allocation, not a process of asset valuation. Depreciation applies to three classes of property, plant, and equipment: ƒ Land improvements ƒ Buildings ƒ Equipment. Factors in calculating depreciation: ƒ Cost—historical cost of the asset. ƒ Useful life—estimate of the expected productive life, also called service life, of the asset. ƒ Salvage value—an estimate of the asset's value at the end of its useful life. Depreciable cost (or depreciable base) is the difference between cost and salvage value. Depreciation methods Depreciation is generally calculated using one of these methods: ƒ Straight-line ƒ Declining-balance ƒ Sum-of-the-years’-digits ƒ Units-of-activity Straight-line depreciation It is the most widely used me thod of depreciation. Under thestraight-line method, an equal amount of depreciation is expensed each year of the asset’s useful life. Annual depreciation expense = (cost – salvage value) / useful life Declining-balance depreciation The declining-balance method produces a decreasing annual depreciation expense over the useful life of the asset. ƒ The calculation of periodic de preciation is based on a declining book value of the asset (cost less accumulated depreciation). ƒ Annual depreciation expense = beginning book value * depreciation rate ƒ The depreciation rate remains constant from year to year, but the book value to which the rate is applied declines each year. ƒ Depreciation that is often used is double the straight-line rate , often referred to as the double declining-balance method. Sum-of-the-years-digits The sum-of-the-years’-digits also produces a decreasing annua l depreciation expense over the useful life of the asset. ƒ The calculation of periodic depreciation multiplies deprecia ble base by a declining fraction whose denominator is the constant sum of the digits from one to n where n is the number of years in the asset's service lifThe sum of the digits from 1 to n = (n * n+1)/2. For example, if the asset’s useful life is 5 years, then the sum of the years’ digits = (5 * 6)/2 =15 (it equals 1 + 2 + 3 + 4 + 5). Units-of-activity Under the units-of-activity method, useful life is expressed in terms of the estimated total units of production or use expected from the asset. ƒ It is ideally suited to equi pment whose activity can be m easured in units of output, kilometres driven, or hours in use. ƒ The calculation of periodic depreciation is ba sed on the estimated total units of activity for the entire useful life and this amount is divided into the depreciable cost to determine the depreciation cost per unit. The deprecia tion cost per unit is th en multiplied by the units of activity during the year to arrive at annual depreciation. Example Calculate the annual depreciation expense for the following asset: Cost$100,000 ylie5l Salalge0,000 Estimated total output 1,000,000 units Annual output Year Output 1 200,000 2 300,000 3 400,000 4 100,000 5 0 Solution Straight-line method Annual depreciation expense = (100,000 – 20,000) / 5 = $16,000 Since the straight line method pr oduces the same annual depreci ation expense every year, the accumulated depreciation at the end of nyear of the asset’s useful life = annual depreciation * n. For example, the book value of this asset at the end of the third year = 100,000 – 16,000 * 3 = $52,000. Double-declining balance Annual depreciation rate = 2 / useful life = 2 / 5 = 0.40 Year Depreciation AA Bovalue 0 $ 100,000 1 $40,000 $40,000 $ 60,000 2 $24,000 $64,000 $ 36,000 3 $14,400 $78,400 $ 21,600 4 $1,600 $80,000 $ 20,000 5 $0 $80,000 $ 20,000 Notice that the depreciation expense for Year 4 does not equal the product of beginning book value times the annual depreciation rate. The rulis that you cannot am ortize more than the depreciable cost. In this example, the asset has a salvage value of $20,000, therefore you should not allow the book value to fall below $20,000. Thus, the depreciation expense is $1,600 in Year 4 and zero in Year 5. Sum-of-the-years’-digits Sum-of-the-years’-digits = 5 * 6 / 2 = 15 Depreciable base = 100,000 – 20,000 = $80,0000 To calculate the annual depreciation in years 1, 2, 3, 4, and 5, multiply the depreciable base by 5/15, 4/15, 3/15, 2/15, and 1/15, respectively. Year DepreciationAA Bvalue 0 $ 100,000 1 $26,667 $26,667 $ 73,333 2 $21,333 $48,000 $ 52,000 3 $16,000 $64,000 $ 36,000 4 $10,667 $74,667 $ 25,333 5 $5,333 $80,000 $ 20,000 Units-of-activity Depreciation per unit of output = (100,000 – 20,000) / 1,000,000 = $0.08 / unit Year Output epreciationAA Bov
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