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Chapter 3

ACTG 2010 Chapter 3: ACTG2010 - Chapter 8

Course Code
ACTG 2010
Douglas Kong

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John Friedlan, Financial Accounting: A Critical Approach, 4th edition Page 8-1
Solutions Manual Copyright © 2013 McGraw-Hill Ryerson Ltd.
Capital Assets
(The list of assets isn’t comprehensive. Students could identify other reasonable choices).
a. A gas station has gas pumps, a cash register, reservoirs (for gas) and other fixtures, signs,
racks, and potentially a building and land.
b. A university has student residences, various buildings with classrooms and offices for
faculty, desks and other furniture, library books, computers, land, trucks and equipment
for maintaining the grounds.
c. A convenience store has a cash register, counters, display shelves for merchandise, signs,
and refrigeration units for dairy products and ice cream.
d. A hotel has the hotel building, beds and furnishings for the rooms, carpeting, elevators,
office equipment, decorations and furnishings for the lobby, cleaning equipment.
e. A dairy farm has pasture, fencing, a barn, tractors, storage buildings, milking machines,
tanks to store milk, a loader to handle manure and feed, a silo to store feed, cows.
f. An electric utility has generating stations, office furniture and wiring, transmission wires,
computer equipment.
g. A golf course has land, a clubhouse building, golf carts, lawnmowers, irrigation systems,
and other maintenance equipment.
An intangible asset is an asset that doesn’t have physical substance. Intangible assets differ from
tangible assets in that tangible assets can be touched and seen; they have physical substance.
Examples of intangible assets are patents, trademarks, taxi licences, copyrights, and franchises.
Tangible assets include buildings, furniture, machinery, and motor vehicles.
In accounting, goodwill is the amount a purchaser of an entity pays for an entity over and above
the fair value of the purchased entity’s identifiable assets and liabilities on the date the entity is
purchased. Goodwill can represent many things: reputation, earning power, synergies,
efficiencies, management, and other difficult to identify and measure intangible assets of a
company that the acquired company has built up by carrying on businessassets that are real
and valuable but that traditional accounting doesn’t attempt to measure. It isn’t possible to know
what goodwill is because it’s calculated as a residual. Goodwill could also represent
overpayment for an acquired entity. Conceptually, an entity doesn’t have to be purchased for it to
have goodwill. However, under IFRS/ASPE an entity must be purchased if the goodwill is to
appear on the financial statements.
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John Friedlan, Financial Accounting: A Critical Approach, 4th edition Page 8-2
Solutions Manual Copyright © 2013 McGraw-Hill Ryerson Ltd.
Capital assets are depreciated because they contribute to the earning of revenue over more than
one period and are used up in the process. Depreciation represents the using up of capital assets
over their useful lives. Capital assets are used up by the passage of time and obsolescence. To
properly measure income under accrual accounting, it’s necessary to allocate the cost of capital
assets to expense over time to match the cost of the assets to the revenues in the periods when the
asset contributed to earning revenues.
Inventories are held for sale or to be included in the production of goods that will be sold while
capital assets are purchased for use in providing or producing goods and services to customers. A
company could have identical assets, some of which are inventory and some of which are capital
assets. For example, a truck dealer could have one truck that is used for parts delivery and is a
capital asset. The company could also have many identical trucks that are for sale and are
included in inventory. The difference is the purpose for which the asset is being held.
Depreciation has no effect on an entity’s cash flow. It’s just the allocation of the cost of a capital
asset to expense over its useful life. Depreciation is added back to net income under the indirect
method of determining cash from operations because it has been deducted from revenues when
calculating net income. Since depreciation doesn’t represent a cash flow, the amount is added
back to net income. The idea is that we are trying to adjust net income for non-cash items. Since
depreciation is a non-cash amount that was deducted when calculating net income, it’s
eliminated by adding it back when determining cash from operations.
The stock price of a company isn’t affected by the depreciation method used because the market
understands that different methods of depreciating capital have no economic impact on the
entity, its performance, or its cash flows. However, stock price is only one consideration in
assessing whether or not the depreciation method of the firm matters. The depreciation method
will affect net income and other financial statement measurements and, therefore, could affect
contracts and decisions that explicitly require the use of financial statement numbers, for
example, management bonuses, employee contract demands, compliance with covenants, etc.
A capital asset (or asset group) is impaired (under IFRS) when the carrying amount of the assets
exceeds the recoverable amount of the assets. The recoverable amount is the greater of the fair
value less selling cost of the asset and the present value of the assets future cash flows (value in
use). If an asset is impaired it’s written down to the recoverable amount. Two examples of
impairment includes 1) change in property value due to neighbourhood conditions translating to
lower earning potential from future rentals. 2) A particular drug patent that has reduced earning
potential due to the release of a new drug that is more effective. Under ASPE an asset is
impaired if the carrying amount is greater than the undiscounted cash flow the asset is expected
to generate over its useful life.
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John Friedlan, Financial Accounting: A Critical Approach, 4th edition Page 8-3
Solutions Manual Copyright © 2013 McGraw-Hill Ryerson Ltd.
When tax minimization is the main objective of financial reporting the selection of a depreciation
method is never an issue because the Canada Revenue Agency specifies its own method, called
Capital Cost Allowance (CCA), for calculating depreciation of capital assets for tax purposes.
No matter what method of depreciation is used for financial reporting purposes the method
prescribed by the Income Tax Act must be used for tax purposes. As a result, an entity can
pursue whatever objective it wants for financial reporting.
The problem with knowledge assets is that their future benefit’s difficult to assess. Many
intangible assets develop over timefor example, brand names, trademarks, patents, human
resources—and it’s difficult to know as the investments in these assets are being made whether
they will lead to resources that provide benefits to the entity. The problem is uncertainty. There
is a great deal of uncertainty about the future benefits of expenditures that may lead to intangible
assets so accounting takes a conservative approach and expenses these costs. Tangible assets are
less problematic because even for an asset that is being constructed, the entity knows that it will
have an asset that can be used (a building, machine, etc.). It isn’t as clear with intangibles.
The $32,000 initial cost of knocking down the wall should be considered part of the cost of
installing the new equipment and should be capitalized. The $44,000 cost of replacing the second
wall that was knocked down accidentally doesn’t contribute to getting the new equipment ready
for use and shouldn’t be included in the amount capitalized. Instead, the amount should be
expensed when incurred. The extra cost doesn’t make the asset better or allow it to be used so it
shouldn’t be capitalized.
Repairs are expensed because they don’t provide any future benefits to the entity. In other words,
they don’t meet the definition of an asset. Or, repairs simply help the asset perform as intended.
Betterments are expenditures that provide additional future benefits to the entitythey extend
the life of the asset or make the asset more efficient or effective.
First, it’s important to recognize that the price a buyer will pay for a capital asset isn’t strictly a
managerial decision. The price is determined by market forces. A gain or loss on disposal of a
capital asset is the difference between the proceeds of sale and the carrying amount of the asset
(cost accumulated depreciation). The carrying amount at any time depends on the useful life,
residual value, and the depreciation method selected by management. If a shorter useful life and
a lower residual value are selected the depreciation expense will be higher each year, which
means that carrying amount will be lower. In sum, the choices that affect the carrying amount of
a capital asset affect the amount of gain or loss when the asset is sold, assuming the actual selling
price isn’t affected by the amount of gain or loss.
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