Financial Accounting II - Lecture 001

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Department
Financial Accounting
Course
MGAB02H3
Professor
G.Quan Fun
Semester
Winter

Description
10 January 2013 CHAPTER 9: REPORTING AND INTERPRETING LONG-LIVED ASSETS To classify as a long-term asset it must satisfy two conditions:  Actively used in operations (production or sale of other assets or services)  Expected to benefit future periods greater than 1 year NOTE: Assets held for sale or for future use are NOT classified as plant and equipment, but as long term investment. There are two types of long term assets (both subject to amortization):  Tangible as having physical substance o Non-depreciable asset (IE: Land) o Assets subject to amortization (IE: Building and equipment, furniture and fixtures) o Natural resource assets subject to depletion (IE: Mineral deposits, timber)  Intangible as having no physical substance o Value represented by rights that produce benefits (IE: Patents, copyrights, trademarks, franchises, goodwill) WHAT IS INCLUDED IN THE COST OF AN ASSET Acquisition Cost includes the purchase price and all expenditures needed to prepare the asset for its intended use. NOTE: Does not include financing charges except for self constructed assets. Invoice Price: (–)Less cash discount (+)Plus freight, duty, unpacking and assembling costs, special foundation, power connections, legal costs (x)Excludes sales tax (HST) Examples of acquisition costs: Building Land – All adds permanent value to land o P.P., architectural fees, permit o P.P., legal, accrued and delinquent taxes o Construction and excavation costs o Real estate commissions o Interest costs during construction o Title insurance premiums o Removable of old building included in o Surveying, clearing, grading, draining land o Title search and transfer fees Equipment Land Improvement o Purchase price, including taxes o Fences, parking lot surface and outside o Installation and testing costs lighting are recorded separately from o Modification to building land o Transportation costs o Improvements have limited lives Example #1 Acquisition for Cash, Non-Cash and Debt On June 14, WestJet Air Lines purchased aircraft for $1,500,000 cash, 2,000,000 common shares at a market value of $5 each and a $59,000,000 note payable. NOTE: Transaction must be recorded at the current market value of the consideration given, or the current market value of the asset acquired, whichever is more clearly evident. June 14 Flight Equipment 76,500,000 Cash 1,500,000 Note Payable 59,000,000 Common Shares 10,000,000 CONSTRUCTION AND BASKET PURCHASE Construction Assets costs include:  All materials (architectural and design fees, building permit) and labour traceable to the construction  A reasonable amount of overhead (L, H and W).  Interest on debt and insurance incurred ONLY during the construction Basket Purchase The total cost of a combined purchase of land and building is separated on the basis of their relative market or appraised values. Some assets will depreciate and some will not. Example #2 Basket Purchase WestJet purchased land and building for $300K cash. The appraised values are building: $189K, and land: $126K. How much of the $300K purchase price will be charged to the building and land accounts? Asset Appraised Value % of Value Purchase Price Assigned Cost a b c b x c Land $126,000 40% x $300,000 = $120,000 Building $189,000 60%_______ x $300,000 = $180,000 Total $315,000 100% $300,000 NOTE: $126,000 (land appraised value) / $315,000 (total appraised value) = 40% SITE RESTORATION COSTS AND FUTURE REMOVAL Companies are required to record the obligation associated with the retirement of an asset as the legal obligation arises (usually at time of purchase). It must be accrued over the life of a capital asset affected:  Minor Amount is when they are netted with residual value  Major Amount are the costs are accrued as a liability and separately disclosed  If not reasonably determinable a contingent liability may exist REPAIRS, MAINTENANCE, AND ADDITIONS SUBSEQUENT TO ACQUISITION Type of Expenditure Capital/Rev Identifying Characteristics Ordinary Repairs and Maintenance Revenue Maintains normal operating condition Does not increase productivity Does not extend life beyond original estimate Extraordinary Repairs Capital Major overhauls or partial replacements Extends life beyond original estimate Betterments Capital Increases productivity May extend useful life Improvements or expansions Example #3 Status Check Which of the following items is a capital expenditure? A. Replacement of manual controls on a machine with automatic controls that improve efficiency significantly but do not alter the life of the machine B. The fine paid for violating the traffic rules while transporting equipment C. The cost of repairing damage incurred during the unpacking of a machine D. The cost of spare parts for maintenance of a machine AMORTIZATION Amortization is a cost allocation process that systematically and rationally matches acquisition costs with periods benefit. NOTE: Land is not depreciated, except for forestry. Balance Sheet: Acquisition Cost  Cost Allocation  Income Statement: Expense DR: Amortization Expense (SE) XX CR: Accumulated Amortization (XA) XX Amortization calculation requires three amounts for each asset:  Acquisition Cost  Estimated Useful Life versus potential life  Estimated Residual Value which is the value at the end of service life Alternative amortization methods:  Straight Line  Units of Production  Accelerated Method: Declining Balance or Double Declining STRAIGHT LINE METHOD Most companies (about 90%) use the straight-line method to amortize some or all of their assets for financial reporting. It allocates the cost evenly over the life of the asset. AMORTIZATION EXPENSE PER YEAR = (COST – RESIDUAL VALUE) / LIFE IN YEARS UNITS OF PRODUCTION METHOD Benefits derived are related to the output or use of an asset. It requires that the useful life is expressed as units of output. AMORTIZATION RATE = (COST – RESIDUAL VALUE) / ESTIMATED TOTAL PRODUCTION AMORTIZATION EXPENSE = AMORTIZATION RATE X ACTUAL ANNUAL PRODUCTION DOUBLE DECLINING BALANCE METHOD Accelerated amortization matches higher amortization expense with higher revenues in the early years of an asset’s useful life when the asset is more efficient. Annual computation ignores residual value, except in the last year of the amortization. ANNUAL AMORTIZATION EXPENSE = NET BOOK VALUE X (2 / USEFUL LIFE IN YEARS) NBV = COST – ACCUMULATED AMORTIZATION AMORTIZATION AND FEDERAL INCOME TAX For tax purposes, most corporations use the Capital Cost Allowance (CCA). CCA provides rapid write-off of an asset’s cost in order to stimulate new investments. Example #4 Status Check For income tax purposes, what amortization method should be used? A. Units-of-production method B. Declining-balance method C. Capital cost allowance method D. Double-declining-balance method Example #5 Status Check Which of the following statements is true for equipment with a useful life of more than 3 years and a zero salvage value at the end of its useful life? A. The net book value of the asset will be more in the first year under the double-declining- balance method of amortization than under the straight-line method of amortization. B. The net book value of the asset will decrease by the same amount every year under the double- declining-balance method of amortization. C. The amortization expense in the last year of the asset’s life will be higher under the double- declining method than under the straight-line method. D. Each year, the net book value will decrease by a smaller amount than the decrease in the previous year under the double-declining method of amortization. Example #6 Status Check What is the purpose of recording amortization? A. To allocate the cost of the asset to the periods benefiting from its use B. To provide funds for the replacement of the asset C. To reduce the asset to its estimated market value D. To approximate the replacement value of the asset CHANGES IN AMORTIZATION ESTIMATES Over the life of an asset, new information may come to light indicating that the original estimates were inaccurate. If original estimates change, amortization is [DOC = Date of Change]: (NBV AT DOC – REVISED RESIDUAL VALUE AT DOC) / REMAINING USEFUL LIFE AT DOC Example #7 Changes in Amortization Estimates After owning aircraft costing $45,000,000 for five years, WestJet revised estimates of residual value and useful life: Acquisition Cost of Aircraft $45,000,000 Acquisition Cost $45,000,000 Original Estimated Useful Life 20 Years Accumulated Amortization Original Estimated Residual Value $ 1,400,000 ($2,180,000 x 5 years) $10,900,000 Original Annual Depreciation Book Value $34,100,000 ($45,000,000 – $1,400,000) / 20 $ 2,180,000 Less New Residual Value $ 750,000 Revised Estimated Useful Life 25 Years New Amount to be Amortized $33,350,000 Revised Estimated Residual Value $ 750,000 Divide by Remaining Life 20 Years___ Revised Annual Amortization $ 1,667,500 Example #8 St
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