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10 Jan 2011
Chapter 9 Reporting and Analyzing Long-Lived Assets Notes
Property, Plant, and Equipment
x long-lived resources that company owns that have physical substance (definite size and shape), are used in operations of
business, and are not intended for sale to customers
x provide benefits over many years, which arise from their use for production and sale of goods or services to customers, for rental
to others, or for administrative purposes
x critical to company’s success because they determine companys production capacity and ability to satisfy customers
Determining the Cost of Property, Plant, and Equipment
x cost principle requires that PPE be recognized (recorded) at cost, which includes the following: the purchase price, less any
discounts or rebates; the expenditure 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 PPE) rather than expensed, if it is probable that company will receive an economic
benefit in the future from the asset
x operating expenditures—expenditures that benefit only current period; they are immediately matched against revenue as
expense; they are required to maintain asset in its normal operating condition and often recur, although not always annually
x capital expenditures—expenditures that benefit future periods; they are recorded as long-lived assets; normally larger than
operating expenditures and occur less frequently
x PPE are often subdivided into 4 classes: land, land improvements, buildings, equipment
x all costs related to purchase of land, including such costs as survey and legal fees for closing the 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 site suitable for construction of new building, all demolition and removal
costs, less any proceeds from salvaged materials, are added to Land account
x when land has been purchased to construct a building, all costs that are incurred up to the time of excavation for the new building
are considered to be part of the costs that are necessary to prepare the land for its intended use
x once land is ready for its intended use, recurring costs, such as annual property taxes, are recorded as operating expenditures—in
other words, these costs are matched against the revenues that the land helps generate
Land Improvements
x land improvements are structural additions made to land, such as driveways, sidewalks, fences, and parking lots
x land improvements decline in service potential over time and require maintenance and replacement due to which, 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 the cost of a building includes all costs that are directly related to its purchase or construction
x when building is purchased, its cost includes purchase price, closing costs, and all costs to make building ready for its intended
use including expenditures for remodelling rooms and offices, for replacing or repairing roof, floors, electrical wiring, plumbing
x when new building is constructed, its cost consists of contract price plus payments made for architect fees, building permits,
excavation costs, interest costs that are incurred specifically to finance construction project (interest that could not be avoided)
x can include delivery equipment, office equipment, machinery, vehicles, furniture and fixtures, and other similar assets
x includes the purchase price and all costs that are necessary to get equipment ready for its intended use
x freight charges, insurance during transit that is paid by purchaser, and expenditures that are required in assembling, installing,
and testing the equipment are all charged to Equipment account
x 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 the asset account and the 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
To Buy or Lease?
x in a lease, a party that owns an asset agrees to allow another party to use the asset for an agreed period of time at an 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 the party using the asset (the lessee) to exchange the asset for a
more modern or technologically capable asset if it becomes outdate. This is much easier than trying to sell an obsolete asset.
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.
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3. Income tax advantages. When a company owns a depreciable asset, it can only deduct the depreciation 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 is 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—arrangement allowing lessee to use asset of another party (lessor); arrangement is accounted for as rental
x finance lease—long-term agreement allowing lessee to use asset of lessor; arrangement is accounted for as purchase
x on the lessee’s balance sheet, the leased item is shown as an asset and the obligation owed to the lessor is shown as a liability
x in addition, the leased asset is depreciated by the lessee just as other long-lived assets are
x companies often incur costs when they renovate 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 the lease expires, they are depreciated over the
remaining life of the lease or the useful life of the improvements, whichever is shorter
x under international financial reporting standards, companies will have 2 models they can choose between to account for their
PPE: cost model and revaluation model
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 the systematic allocation of the cost of PPE (and certain other long-lived assets) over the asset’s useful life
x the cost is allocated to expense over the asset’s useful life so that expenses are properly matched with the expected use of the
asset’s future economic benefits
x depreciation is the process of cost allocation, not a process of determining an asset’s fair value
x under cost model, increase in asset’s current fair value is not considered relevant, because PPE are not held for resale (fair values
are only relevant if impairment loss has occurred), as a result, carrying amount of PPE may be very different from its fair value
x in fact, if an asset is fully depreciated, it can have a carrying amount of 0, but still have a large fair value
x depreciation does not provide cash to replace the asset as balance in Accumulated Depreciation only represents the total amount
of the asset’s cost that has been allocated to expense to date: it is not a cash fund
Factors in Calculating Depreciation
x there are now 3 factors that affect the calculation of depreciation:
1. Cost—The cost of PPE includes the purchase price plus all costs necessary to get the asset ready for use. Costs also include
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 (such as machine hours) 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 valueResidual value is an estimate of the amount that a company would obtain from the disposal of the 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. Residual
value is not depreciated, since the amount is expected to be recovered at the end of the asset’s useful life.
x residual value—estimate of amount that company would obtain from disposal of asset if asset were already as old as it will be
and in condition it is expected to be in at end of its useful life
x depreciable amount—cost of depreciable asset (e.g., PPE) less its residual value
Depreciation Methods
x depreciation is generally calculated using 1 of these 3 methods: straight-line, diminishing-balance, units-of-production
x management must choose depreciation method that it believes will best reflect pattern in which asset’s future economic benefits
are expected to be consumed and depreciation method must be reviewed at least once a year
x if the expected pattern of consumption of the future economic benefits has changed, the depreciation method must be changed
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 asset is purchased during year, it is necessary to prorate annual depreciation for part of year when asset is available for use
x appropriate to use straight-line method when asset is used quite uniformly through its useful life
x examples of assets that deliver their benefit primarily as a function of time (and therefore uniformly) include office furniture and
fixtures, buildings, warehouses, and garages for motor vehicles
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 residual value is not used in determining amount that diminishing-balance rate is applied to, however, depreciation stops when
the asset’s carrying amount equals its expected residual value
x when asset is purchased during year, it is necessary to prorate diminishing-balance depreciation in 1st year, based on time
x methods such as the diminishing-balance method that producer higher depreciation expense in early years than in later years are
known as accelerated depreciation methods
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