Chapter 9 notes

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9 Jan 2011
Chapter 9 Reporting and Analyzing Long-Lived Assets Notes
Property, Plant, and Equipment
x long-lived resources that the company owns that have physical substance (a definite size and shape), are used in the operations of
a business, and are not intended for sale to customers
x their benefits (which are for many years) arise from their use for the production and sale of goods or services to customers, for
rental to others, or for administrative purposes
x critical to a companys success because they determine the companys production capacity and ability to satisfy customers
Determining the Cost of Property, Plant, and Equipment
x cost principle requires that property, plant, and equipment be recognized (recorded) at cost, which includes the following:
1. the purchase price, less any discounts or rebates
2. the expenditures necessary to bring the asset to its required location and to make it ready for its intended use
x these costs are capitalized (recorded as property, plant, and equipment), rather than expensed, if it is probable that the company
will receive an economic benefit in the future from the asset
x operating expenditures : expenditures that benefit current period; they are immediately matched against revenues as expense
x capital expenditures : expenditures that benefit future periods; they are recorded as long-lived assets
x PPE are often subdivided into four classes: land, land improvements, buildings, equipment
x all costs related to the purchase of land, including such costs as survey and legal fees for closing deal, are added to Land account
x if additional work is required to prepare land for its intended use, such as clearing, grading, and filling, these costs are also
recorded as capital expenditures in Land account
x if land has building on it that must be removed to make the site suitable for construction of a new building, all demolition and
removal costs, less any proceeds from salvaged materials, are added to the Land account
x when land has been purchased to construct a building, all costs that are incurred up to the time of excavation for new building are
considered to be part of the costs that are necessary to prepare land for its intended use
Land Improvements
x land improvements are structural additions made to land, such as driveways, sidewalks, fences, and parking lots
x land improvements, unlike land, decline in service potential over time and require maintenance and replacement
x because of this, land improvements are recorded separately from land and are depreciated over their useful lives
x when classifying costs, it is important to remember that one-time costs that are required for getting the land ready to use are
always charged to Land account, not Land Improvements account
x cost of building includes all costs that are directly related to its purchase or construction
x when building is purchased, its cost includes purchase price, closing price, and all costs to make building ready for its intended
use, which can include expenditures for remodelling rooms and offices, and for replacing or repairing the roof, floors, electrical
wiring, and plumbing, which are all capitalized to the Building account
x when new building is constructed, its cost consists of the contract price plus payments made for architect fees, building permits,
and excavation costs; in addition, interest costs that are incurred specifically to finance a construction project (i.e., interest that
could not be avoided) are also included in the cost of the asset
x in these circumstances, interest costs are considered as necessary as materials and rules
x “equipment” classification is broad one that can include delivery equipment, office equipment, machinery, vehicles, furniture
and fixtures, and other similar assets
x cost of equipment includes purchase price and all costs that are necessary to get equipment ready for its intended use, such as
freight charges, insurance during transit paid by the purchaser, and expenditures that are required in assembling, installing, and
testing equipment are all charged to Equipment account
x because they are recurring expenditures that do not benefit future periods, annual costs such as licences and insurance are treated
as operating expenditures when they are incurred
Asset Retirement Costs
x cost of PPE must include estimate of cost of any obligation to dismantle, remove, or restore long-lived asset when it is retired
x costs such as these must be estimated (using present-value concepts) and added to asset account
x other side of entry records liability for asset retirement obligation
x these costs, and liability, are recorded in period when legal obligation is created, which can be at time asset is acquired, or later
when asset is used
To Buy or Lease?
x in a lease, a party that owns an asset agrees to allow another party to use asset for agreed period of time at agreed price
x lessor : a party that has agreed contractually to let another party use its asset
x lessee : a party that has made contractual arrangements to pay for the use of another party’s asset
x here are some advantages of leasing an asset versus purchasing it:
1. Reduced risk of the negative impact of obsolescence. Obsolescence is the process by which an asset becomes out of date
before it physically wears out. Frequently, lease terms allow party using the asset (lessee) to exchange the asset for a more
modern or technologically capable asset if it becomes outdated. This is much easier than trying to sell an obsolete asset.
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2. 100% financing. If a company borrows to purchase an asset, it is usually required to make a down payment of at least 20%.
Leasing an asset does not require any money down, which helps to conserve cash. In addition, interest payments are often
fixed for the term of the lease, unlike other financing which often has a floating interest rate.
3. Income tax advantages. When a company owns a depreciable asset, it can only deduct the deprecation expense (called
capital cost allowance for income tax purposes) on its income tax return. If the company has borrowed to purchase an asset,
it can also deduct the interest expense. When a company leases an asset, it can deduct 100% of the lease payment on its
income tax return.
4. Off-balance sheet financing. Many companies prefer to keep assets and, especially, liabilities off their books. A certain
type of lease called an operating lease allows the lessee to account for the transaction as a rental and therefore not record an
asset or liability on the companys books. This is known as off-balance sheet financing.
x operating lease : an arrangement allowing one party (the lessee) to use the asset of another party (the lessor); the arrangement is
accounted for as a rental
x finance lease : a long-term agreement allowing one party (the lessee) to use the asset of another party (the lessor); the
arrangement is accounted for as a purchase
x companies often incur costs when renovating leased property, charged to separate account called Leasehold Improvements
x since leasehold improvements are attached to leased property, they belong to lessor at end of lease
x because benefits of these improvements to the lessee will therefore end when lease expires, they are depreciated over remaining
life of lease or useful life of improvements, whichever is shorter
x cost model : a model for accounting for a long-lived asset that carries the asset at its cost less accumulated depreciation or
amortization, which includes any impairment losses
x depreciation is systematic allocation of cost of PPE (and certain other long-lived assets) over asset’s useful life
x depreciation is process of cost allocation, not a process of determining an asset’s fair value
x depreciation does not provide cash to replace asset as balance in Accumulated Depreciation only represents total amount of
asset’s cost that has been allocated to expense to date: it is not a cash fund
Factors in Calculating Depreciation
x there are three factors that affect calculation of depreciation:
1. Cost—cost of property, plant, and equipment includes the purchase price plus all costs necessary to get the asset ready for
use. Cost also includes retirement costs, if there are any.
2. Useful life—Useful life is (a) the period of time over which an asset is expected to be available for use or (b) the number of
units of production or units of output that are expected to be obtained from an asset. Useful life is an estimate based on such
factors as the intended use of the asset, repair and maintenance policies, and how vulnerable the asset is to wearing out or
becoming obsolete. The company’s past experience with similar assets is often helpful in estimating a particular assets
useful life.
3. Residual valuenot depreciated, since the amount is expected to be recovered at the end of the asset’s useful life.
x residual value : an estimate of the amount that a company would obtain from the disposal of an asset if the asset were already
as old as it will be and in the condition it is expected to be in at the end of its useful life
x depreciable amount : the cost of a depreciable asset (e.g., PPE) less its residual value
Depreciation Methods
x depreciation is generally calculated using one of these three methods: straight-line, diminishing-balance, units-of-production
x straight-line method : a depreciation method in which the depreciable amount of an asset is divided by its estimated useful life;
this method produces the same depreciation expense for each year of the asset’s useful life
x if an asset is purchased during the year, rather than on January 1, it is necessary to prorate the annual depreciation for the part of
the year when the asset is available for use
x diminishing-balance method : depreciation method that applies constant rate (straight-line rate, which is 100% divided by
useful life) to carrying amount of asset; this method produces decreasing annual depreciation expense over useful life of asset
x carrying amount for 1st year is cost of asset, because balance in Accumulated Depreciation at beginning of asset’s useful life is 0
x in subsequent years, the carrying amount is the difference between cost and accumulated depreciation at beginning of year
x unlike other depreciation methods, diminishing-balance method does not use depreciable amount
x thus, residual value is not used in determining the amount that the diminishing-balance rate is applied to
x residual value does limit total deprecation that can be taken as depreciation stops when asset’s CA equals its expected RV
x when an asset is purchased during year, it is necessary to prorate diminishing-balance depreciation in 1st year, based on time
x units-of-production method : a depreciation method in which useful life is expressed in terms of total units of production or
total use expected from asset; depreciation expense is calculated by multiplying depreciable amount by actual activity during
year divided by estimated total activity; method will produce expense that will vary each period depending on amount of activity
x this method is easy to apply when assets are purchased during the year
x in such cases, the productivity of the asset for the partial year is used in calculating the depreciation
x units-of-production method, therefore, does not require adjustments for partial periods as calculation already reflects how much
asset was used during specific period
Other Depreciation Issues
x several other issues related to depreciation include how certain assets are separated into their significant components for
depreciation purposes, how assets are depreciated for income tax purposes, how the impairment of assets is recorded when the
fair value declines, and under what circumstances depreciation is revised
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