Chapter 8
Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles
Understanding The Business
How much is enough?
Insufficient capacity results in lost sales.
Costly excess capacity reduces profits.
Classifying Long-Lived Assets
Tangible
Physical Substance
Intangible
No Physical Substance
Expected to Benefit Future Periods
Actively Used in Operations
Classifying Long-Lived Assets
Tangible
Physical Substance
Intangible
No Physical Substance
Expected to Benefit Future Periods
Actively Used in Operations
Land
Assets subject to depreciation
Buildings and equipment
Furniture and fixtures
Natural resource assets subject to depletion
Mineral deposits and timber
Examples
Classifying Long-Lived Assets
Tangible
Physical Substance
Intangible
No Physical Substance
Expected to Benefit Future Periods
Actively Used in Operations
Value represented by rights that produce benefits
Patents
Copyrights
Trademarks
Franchises
Goodwill
Subject to amortization
Examples
Fixed Asset Turnover
Fixed Asset Turnover
Net Sales Revenue Average Net Fixed Assets
=
This ratio measures a company’s ability to generate sales given an investment in fixed assets.
For the year 2000, Delta Airlines had $16,741 of revenue. End-of-year fixed assets were $14,840 and beginning-of-year fixed assets were $12,450. (All numbers in millions.)
Fixed Asset Turnover
Fixed Asset Turnover
$16,741 ($14,840 + $12,450) ÷ 2
=
=
Fixed Asset Turnover
Net Sales Revenue Average Net Fixed Assets
=
Measuring and Recording Acquisition Cost
Acquisition cost includes the purchase price and all expenditures needed to prepare the asset for its intended use.
Acquisition cost does not include financing charges and cash discounts.
Acquisition Cost
Buildings
Purchase price
Architectural fees
Cost of permits
Excavation costs
Construction costs
Acquisition Cost
Equipment
Purchase price
Installation costs
Modification to building necessary to install equipment
Transportation costs
Purchase price
Real estate commissions
Title insurance premiums
Delinquent taxes
Surveying fees
Title search and transfer fees
Land is not depreciable.
Acquisition Cost
Land
Acquisition for Cash
On June 1, Delta Air Lines purchased aircraft for $60,000,000 cash.
Acquisition for Cash
On June 1, Delta Air Lines purchased aircraft for $60,000,000 cash.
Acquisition for Debt
On June 14, Delta Air Lines purchased aircraft for $1,000,000 cash and a $59,000,000 note payable.
Acquisition for Debt
On June 14, Delta Air Lines purchased aircraft for $1,000,000 cash and a $59,000,000 note payable.
Acquisition for
Noncash Consideration
Record at the current market value of the consideration given, or the current market value of the asset acquired, whichever is more clearly evident.
Acquisition for
Noncash Consideration
On July 7, Delta gave Boeing 400,000 shares of $3 par value common stock with a market value of $85 per share plus $26,000,000 in cash for aircraft.
Acquisition for
Noncash Consideration
On July 7, Delta gave Boeing 400,000 shares of $3 par value common stock with a market value of $85 per share plus $26,000,000 in cash for aircraft.
Acquisition by Construction
Asset cost includes:
All materials and labor traceable to the construction.
A reasonable amount of overhead.
Interest on debt incurred during the construction.
Repairs, Maintenance,
and Additions
Capital and Revenue Expenditures
Many companies have policies expensing all expenditures below a certain amount according to the materiality constraint.
Depreciation
Depreciation is a cost allocation process that systematically and rationally matches acquisition costs of operational assets with periods benefited by their use.
Cost
Allocation
(Unused)
Balance Sheet
(Used)
Income Statement
Expense
Acquisition
Cost
Depreciation
Depreciation Expense
Income Statement
Balance Sheet
Accumulated Depreciation
Depreciation for the current year
Total of depreciation to date on an asset
Depreciation on Delta’s
2000 Balance Sheet
Book Values
Book value = Market value
/
Depreciation Concepts
The calculation of depreciation requires three amounts for each asset:
Acquisition cost.
Estimated useful life.
Estimated residual value.
Alternative Depreciation Methods
Straight-line
Units-of-production
Accelerated Method: Declining balance
Straight-Line Method
At the beginning of the year, Delta purchased equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500.
Cost - Residual Value Life in Years
Depreciation
Expense per Year
=
SL
Straight-Line Method
Depreciation
Expense per Year
=
Depreciation
Expense per Year
=
$20,000
$62,500 - $2,500 3 years
Cost - Residual Value Life in Years
Depreciation
Expense per Year
=
SL
Straight-Line Method
Residual Value
SL
More than 95 percent of companies use the straight-line method for some or all of their assets disclosed in financial reports.
Units-of-Production Method
Depreciation
Rate
=
Cost - Residual Value
Life in Units of Production
Step 1:
Step 2:
Depreciation
Expense
=
Depreciation
Rate
×
Number of Units Produced for the Year
Units-of-Production Method
At the beginning of the year, Delta purchased ground equipment for $62,500 cash. The equipment has a 100,000 mile useful life and an estimated residual value of $2,500. If the equipment is used 30,000 miles in the first year, what is the amount of depreciation expense?
Units-of-Production Method
$62,500 - $2,500
100,000 miles
= $.60 per mile
Depreciation
Rate
=
Step 1:
Step 2:
$.60 per mile × 30,000 miles = $18,000
Depreciation
Expense
=
Units-of-Production Method
Units-of-Production Method
Residual Value
Accelerated Depreciation
Accelerated depreciation matches higher depreciation expense with higher revenues in the early years of an asset’s useful life when the asset is more efficient.
Depreciation
Repair
Expense
Expense
Early Years
High
Low
Later Years
Low
High
Double-Declining-Balance Method
Annual Depreciation expense
Net Book Value
(
)
Useful Life in Years
2
=
×
Cost – Accumulated Depreciation
Declining balance rate of 2 is double-declining-balance (DDB) rate.
Annual computation ignores residual value.
Double-Declining-Balance Method
At the beginning of the year, Delta purchased equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual value of $2,500.
Calculate the depreciation expense for the first two years.
Double-Declining-Balance Method
Annual Depreciation expense
Net Book Value
(
)
Useful Life in Years
2
=
×
(
)
$62,500 ×
3 years
2
= $41,667
(
)
($62,500 – $41,667) ×
3 years
2
= $13,889
Year 1 Depreciation:
Year 2 Depreciation:
Double-Declining-Balance Method
(
)
($62,500 – $55,556) ×
3 years
2
= $4,629
Below residual value
Double-Declining-Balance Method
Depreciation expense is limited to the amount that reduces book value to the estimated residual value.
Depreciation and
Federal Income Tax
For tax purposes, most corporations use the Modified Accelerated Cost Recovery System (MACRS).
MACRS depreciation provides for rapid write-off of an asset’s cost in order to stimulate new investment.
Depreciation Methods
in Other Countries
Many countries, including Australia, Brazil, England, and Mexico, use other methods such as depreciation based on the current fair value of assets.
Asset Impairment
Impairment is the loss of a significant portion of the utility of an asset through . . .
Casualty.
Obsolescence.
Lack of demand for the asset’s services.
A loss should be recognized when an asset suffers a permanent impairment.
Disposal of Property, Plant,
and Equipment
Voluntary disposals:
Sale
Trade-in
Retirement
Involuntary disposals:
Fire
Accident
Disposal of Property, Plant,
and Equipment
Update depreciation to the date of disposal.
Journalize disposal by:
Writing off accumulated depreciation (debit).
Writing off the asset cost (credit).
Recording cash received (debit)
or paid (credit).
Recording a gain (credit)
or loss (debit).
Disposal of Property, Plant,
and Equipment
If Cash > BV, record a gain (credit).
If Cash < BV, record a loss (debit).
If Cash = BV, no gain or loss.
Disposal of Property, Plant,
and Equipment
Delta Airlines sold flight equipment for $5,000,000 cash at the end of its 17th year of use. The flight equipment originally cost $20,000,000, and was depreciated using the straight-line method with zero salvage value and a useful life of 20 years.
The amount of depreciation recorded at the end of the 17th year to bring depreciation up to date is:
a. $0.
b. $1,000,000.
c. $2,000,000.
d. $4,000,000.
Disposal of Property, Plant, and Equipment
The amount of depreciation recorded at the end of the 17th year to bring depreciation up to date is:
a. $0.
b. $1,000,000.
c. $2,000,000.
d. $4,000,000.
Annual Depreciation:
($20,000,000 - $0) ÷ 20 Years.
= $1,000,000
Disposal of Property, Plant, and Equipment
After updating the depreciation, the equipment’s book value at the end of the 17th year is:
a. $3,000,000.
b. $16,000,000.
c. $17,000,000.
d. $4,000,000.
Disposal of Property, Plant, and Equipment
After updating the depreciation, the equipment’s book value at the end of the 17th year is:
a. $3,000,000.
b. $16,000,000.
c. $17,000,000.
d. $4,000,000.
Accumulated Depreciation =
(17yrs. × $1,000,000) = $17,000,000
BV = Cost - Accumulated Depreciation
BV = $20,000,000 - $17,000,000 = $3,000,000
Disposal of Property, Plant, and Equipment
The equipment’s sale resulted in:
a. a gain of $2,000,000.
b. a gain of $3,000,000.
c. a gain of $4,000,000.
d. a loss of $2,000,000.
Disposal of Property, Plant, and Equipment
The equipment’s sale resulted in:
a. a gain of $2,000,000.
b. a gain of $3,000,000.
c. a gain of $4,000,000.
d. a loss of $2,000,000.
Gain = Cash Received - Book Value
Gain = $5,000,000 - $3,000,000 = $2,000,000
Disposal of Property, Plant, and Equipment
Disposal of Property, Plant,
and Equipment
Prepare the journal entry to record Delta’s sale of the equipment at the end of the 17th year.
Disposal of Property, Plant,
and Equipment
Prepare the journal entry to record Delta’s sale of the equipment at the end of the 17th year.
Natural Resources
Examples: oil, coal, gold
Extracted from the natural environment.
A noncurrent asset presented at cost less accumulated depletion.
Natural Resources
Depletion is like depreciation.
Total cost of asset is the cost of acquisition, exploration, and development.
Total cost is allocated over periods benefited by means of depletion.
Depletion of Natural Resources
Depletion is calculated using the
units-of-production method.
Unit depletion rate is calculated as follows:
Estimated Recoverable Units
Acquisition and Residual Development Cost Value
–
Depletion of Natural Resources
Total depletion cost for a period is:
UNIT DEPLETION
RATE
NUMBER OF UNITS
EXTRACTED IN PERIOD
×
Total depletion cost
Inventory for sale
Unsold Inventory
Cost of goods sold
Specialized plant assets may be required to extract the natural resource.
These assets are recorded in a separate account and depreciated.
Natural Resources
Intangible Assets
Noncurrent assets without physical substance.
Useful life is often difficult to determine.
Usually acquired for operational use.
Often provide exclusive rights or privileges.
Intangible Assets
Intangible Assets
Record at current cash equivalent cost, including purchase price, legal fees, and filing fees.
Goodwill
Trademarks
Patents
Copyrights
Franchises
Leaseholds
Intangible Assets
Amortize over shorter of economic life or legal life, subject to rules specified by GAAP.
Use straight-line method.
Research and development costs are normally expensed as incurred.
Intangible Assets
Goodwill
Occurs when one company buys another company.
The amount by which the purchase price exceeds the fair market value of net assets acquired.
Only purchased goodwill is an intangible asset.
Goodwill
Intangible Assets
Goodwill
Not amortized.
Subject to assessment for impairment value and may be written down.
Goodwill
Intangible Assets
Goodwill
Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed liabilities of $200,000. The acquired assets were appraised at a fair value of $900,000.
What amount of goodwill should be recorded on Eddy Company books?
a. $100,000
b. $200,000
c. $300,000
d. $400,000
Intangible Assets Goodwill
What amount of goodwill should be recorded on Eddy Company books?
a. $100,000
b. $200,000
c. $300,000
d. $400,000
Intangible Assets Goodwill
Intangible Assets
Trademarks
A symbol, design, or logo associated with a business.
Purchased trademarks are recorded at cost.
Internally developed trademarks have no recorded asset cost.
Intangible Assets
Patents
Exclusive right granted by federal government to sell or manufacture an invention.
Cost is purchase price plus legal cost to defend.
Amortize cost over the shorter of useful life or 20 years.
Intangible Assets
Copyrights
Exclusive right granted by the federal government to protect artistic or intellectual properties.
Amortize cost over the period benefited.
Legal life is life of creator plus 70 years.
Intangible Assets
Franchises
Legally protected right to sell products or provide services purchased by franchisee from franchisor.
Purchase price is an intangible asset that is amortized.
Intangible Assets
Leaseholds
A lease is a contract to use property granted by lessor to lessee and rights granted under the lease are called a leasehold.
A leasehold is recorded only if advance payment is involved. Otherwise periodic payments are rent expense.
Intangible Assets
Leasehold Improvements
Long-lived alterations made by lessee to leased property.
Leasehold improvements are recorded at cost and amortized over their useful life.
This computer is about to become fully depreciated!
End of Chapter 8
