AFM101 Lecture and textbook Notes on Chapter 9: Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles.docx

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Department
Accounting & Financial Management
Course Code
AFM 101
Professor
Donna Psutka

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Notes on Chapter 9 – Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles Acquisition and maintenance of plant and equipment Classification of Long-lived Assets - Tangible: have physical substance. Most often called Plant, Property, and Equipment o Land – cannot become obsolete; never depreciated. Can be impaired. o Buildings, fixtures, and equipment – reported in stmt of financial position or the notes o Natural resources – mineral deposits, oil wells, timber tracts - Intangible assets o Examples: name, logo, slogans, computer software, landing rights o Often arise from intellectual effort (intellectual property) o Typical exams: copyrights, patents, licences, trademarks, software, franchises, subscription lists Fixed Asset Turnover Ratio - Fixed asset turnover = Net sales (or operating revenues) / Average Net Fixed Assets o Measures effectiveness of utilizing PPE to generate revenues o High rate normally suggests effective management o Increasing rate signals more efficient fixed asset use o A lower or declining rate may indicate expansion by acquiring additional productive assets in anticipation of higher sales o An increasing ratio could also signal cut backs because anticipation of downturn Measuring and Recording Acquisition Cost - Building o Cost principle; purchase price of asset includes all costs incurred in acquiring a long-lived asset, placing it in its operational setting, and preparing it for use o Costs are capitalized when recorded as assets rather than recorded as expenses o Include: sales taxes, legal fees, transportation costs, installation costs o Exclude: special discounts and interest charges associated with purchase - Land o Typically with intent to build a new factory or building o Cost includes all incidental costs paid by the purchaser: title fees, sales commissions, legal fees, title insurance, delinquent taxes, surveying fees o Not subject to depreciation; therefore recorded as a separate asset - Old building or used machinery o Renovation and repair costs prior to asset’s use is included as part of its cost Various Acquisition Methods - For cash - For debt (note payable) - For Equity (or Other Non-cash Consideration) o Giving shares to pay for asset - By Construction Ex: Barrick Gold must construct extraction facilities o Acquisition cost includes all direct and indirect costs of construction, including interest on loans obtained to construct asset o Capitalized Interest reduces the company’s total interest expense every year until the facility is ready for use - As a Basket Purchase of Assets o Purchase price must be apportioned among the land, building, and equipment on a rational basis o Use appraised market value of each item / total appraised market value = percentage of the cost of the asset o Multiply this percentage by the lump sum paid to find the acquisition cost Repairs, Maintenance, and Betterments - Expenditure: payment of money to acquire goods or services - Expenditures made after an asset is acquired o Ordinary repairs and maintenance  Expenditures that maintain the productive capacity of the asset during the current accounting period are recorded as expenses  Ordinary repairs and maintenance, revenue expenditures, are for the upkeep of long-lived assets (do not lengthen the useful life of asset)  They are recurring in nature  Relatively small amounts at each occurrence  Ex. Changing oil in engines, replacing lights in control panels, fixing torn fabric o Extraordinary repairs and betterments  Increase the productive life, operating efficiency, or capacity of asset  Added to appropriate asset account  Occur infrequently  Large amounts of money  Increase an asset’s economic usefulness in the future through either increased efficiency or longer life  Ex. Additions, complete reconditioning, major overhauls and replacements  Betterments are costs incurred to enhance the productive or service potential of a long-lived asset - Some companies develop simple policies to govern the accounting for these expenditures o Ex: expense all individual items that cost less than $1000  Acceptable because immaterial (relatively small) amounts will not affect users’ decisions when analyzing statements Use, Impairment, and Disposal of Plant and Equipment Depreciation Concepts - Depreciation is an allocation of the acquisition cost of using buildings and equipment that generate revenue over time - Depletion is the allocation of the acquisition cost of natural resources - Amortization is the allocation of the acquisition cost of intangible assets - Depreciation is a process of cost allocation, not a valuation method o It’s a distribution of the acquisition cost over the same time period in which the asset is expected to generate revenue - The carrying amount or book value is the cost minus accumulated depreciation and any write downs in asset value - Calculation of depreciation expense requires: 1. Acquisition cost 2. Estimated useful life to the company 3. Estimated residual/salvage value o Two of these three amounts are estimates, so depreciation expense is an estimate o Estimated useful life is estimate of the asset’s useful economic life to the company rather than of its total economic life to all potential users o Determination of estimated useful life of a long-lived asset must conform to the continuity assumption o Residual value is estimated value of asset if sold to another user. Salvage or scrap value is usually negligible but is also a residual value o Residual value = estimated amount recovered – estimated costs of dismantling, disposal, and sale Alternative Depreciation Methods - Managers should choose a depreciation method that reflects the anticipated reduction in future cash flow as a result of the wear and tear from using the asset over time - Depreciation method should be applied consistently over time to enhance comparability 1. Straight-Line Method o Equal portion of an asset’s depreciable cost is allocated to each accounting period over its estimated useful life o (Cost – Residual Value) x 1/useful life = Depreciation Expense o Cost – Residual Value = depreciable cost o Carrying amount decreases by the same amount each year until it equals the estimated residual value o Depreciation expense in this case is a fixed expense because it is constant each year, irrespective of the actual air miles flown by the aircraft 2. Units-of-Production (Activity) Method o (Cost – Residual value) / Estimated Total Production x Actual production = Depr. Exp. o Depreciable amount / estimated total production = depreciation rate per unit of activity o Depreciation expense in this case is a variable expense because it varies directly with production or use o If the total estimated productive output differs from actual output, the final adjusting entry to depreciation expense should be for the amount needed to bring the asset’s carrying amount to equal the asset’s estimated residual value 3. Declining-Balance Method o Sharper reduction in the economic benefits (cash flow) expected to be derived from the asset in the earlier rather than later years (accelerated depreciation) o Ex. Special equipment acquired to produce a patented drug o The most frequently used is the declining-balance method o Method is based on multiplying the asset’s carrying amount by a fixed rate that exceeds the straight-line rate. Often double the SL rate, hence called double-declining-balance rate. o (Carrying amount) x (declining-balance Rate) = Depreciation expense o Carrying amount = cost – accumulated depreciation o Declining-balance rate = 2/useful life o Asset’s carrying amount cannot be depreciated below residual value o If the annual computation reduces carrying amount below residual value, a lower amount of depreciation expense must be recorded so that carrying amount equals residual - The depreciation method selected by management informs external users of management’s expectation of the pattern of economic benefits that the company will derive from the asset over time - Companies will use different depreciation methods for different types of assets - Acquisitions made during the year instead of at the beginning of the year can be depreciated for the number of months the asset is actually in use, or it can be computed for half a year - Half-year rule is acceptable as long as the amount of depreciation expense for the year is not materially misstated Changes in Depreciation Estimates - When it’s clear that either estimate of useful life or residual life should be revised to a material degree or the asset’s cost has been changes, the undepreciated asset balance (less residual value at date) should be apportioned over the remaining estimated life from the current year into the future; change in estimate - To calculate the new depreciation expense o Substitute the carrying amount for the original acquisition cost o Sub new residual value for original residual o Sub estimated remaining life in place of original estimated life o (Carrying amount – New residual value) / estimated remaining life = depr. Exp. - Companies may change depreciation methods, but requires significant disclosure since consistency principle is violated o Changes in accounting estimates and depreciation methods should be made only when the new estimate or accounting method “better measures” the periodic profit of the business Managers’ Selection Among Accounting Alternatives - Financial Reporting o Managers select depreciation method that provides the best matching of revenues and expenses for any given asset o If assets are expected to provide benefits evenly over time, straight-line method o During early years of an asset’s life, the straight line method reports higher profit than accelerated methods do. Straight-line method is by far the most common. o Certain assets produce more revenue in their early lives -> accelerated method to allocate cost o As assets age, repair costs likely to increase -> total of depreciation expense and repair expense for any given period is likely to provide a nearly constant amount of expenses each period - Tax Reporting o Most public companies m
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