Chapter 8 - Long-Lived Assets and Depreciation | Depreciation | Book Value

Learning Objectives (LO

)
After studying this chapter, you should be able to

Long-Lived Assets and Depreciation

CHAPTER

8

1. Distinguish a company’s expenses from expenditures that it should capitalize 2. Measure the acquisition cost of tangible assets such as land, buildings, and equipment 3. Compute depreciation for buildings and equipment using various depreciation methods 4. Recalculate depreciation in response to a change in estimated useful life or residual value 5. Differentiate financial statement depreciation from income tax depreciation 6. Explain the effect of depreciation on cash flow
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Learning Objectives (LO)
After studying this chapter, you should be able to
7. Account for expenditures after acquisition 8. Compute gains and losses on disposal of fixed assets and consider the impact of these gains and losses on the statement of cash flows 9. Determine the balance sheet valuation of tangible assets for companies who use the revaluation method allowed under IFRS 10. Account for the impairment of tangible assets 11. Account for intangible assets, including impairment 12. Explain the reporting for goodwill 13. Interpret depletion of natural resources
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Introduction to Financial Accounting, 10/e

Overview of Long-lived Assets
• Long-lived assets are assets that are used over a period longer than one operating cycle. • Tangible (physical, plant) assets are the assets that can seen and touched (e.g. land, natural resources, buildings, equipment). • Intangible assets lack physical substance (e.g. contractual or legal rights, such as patents, trademarks, copyrights).

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Overview of Long-lived Assets
• Spreading the cost of long-lived assets to the periods that benefit from these assets to follow the matching principal:
– Depreciation – plant assets (except land) – Depletion – natural resources – Amortization – intangible assets

LO 1 – Contrasting Long-lived Asset Expenditures with Expenses
• Expenditures – purchases of goods or services, whether for cash or credit. Expenditures result in acquisition of assets. • Expenditures on assets, that benefit the company at the time of acquisition, are expensed (utilities, advertising). • Expenditures on assets, that benefit the company within a year, are classified as current assets (prepaid rent). • Expenditures on assets, that benefit the company beyond an operating cycle or a year, are capitalized. • Capitalization – adding the purchase price to a longterm asset account and recognizing part of the purchase price as an expense each year as the asset is used.

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LO 1 – Contrasting Long-lived Asset Expenditures with Expenses
• Expenditures for basic maintenance of an asset should be expensed. • Expenditures to increase the capacity, efficiency or the useful life of the asset should be capitalized. • Wherever doubts exist, it is better to expense, as expensing results in a more conservative presentation of the bottom-line. • Oftentimes, expensing is also justified through costbenefit analysis and immateriality of the expenditures.
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LO 2 - Tangible Assets Acquisition Cost
• Long-lived asset costs that are capitalized should include all necessary costs to prepare the asset for its intended use. • U.S. GAAP requires recording land at its original historical cost, unless the fair value of the land has fallen below that original cost. • Fair value of an asset is the price for which the asset could be sold to an independent third party • Non-monetary exchange is recorded at the fair value of the asset surrendered or the fair value of the consideration received, whichever is easier to determine.
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LO 2 - Tangible Assets Acquisition Cost
• Accounting alternatives subsequent to acquisition: – Cost method: required by US GAAP; carrying cost of the asset is the cost less depreciation; asset value maybe written-down, but can never be increased. – Revaluation method: allowed by IFRS; assets are carried at their fair value.

LO 3 – Depreciation of Buildings and Equipment
• Depreciation – system of cost allocation; not a technique for estimation of current values. • Companies are free to choose depreciation methods as long as it is systematic and rational. • Depreciable Value – cost to be allocated as depreciation over the total useful life of the asset; acquisition cost less residual value • Residual (Salvage, Scrap) Value – the value expected to be received at the time the asset is disposed of • Useful life – the shorter of the physical life (years to wear out) or the economic life of the asset • Accumulated Depreciation - the cumulative amount of depreciation expense recorded over the life of the asset

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LO 3 – Depreciation of Buildings and Equipment
Symbols Amounts for Illustration

LO 3 – Depreciation of Buildings and Equipment
• Straight-line depreciation
– Spreads the depreciable value evenly over the useful life of an asset – Most popular method for financial reporting purposes
Depreciation expense = (C – R) / n = ($41,000 – 1,000) / 4 = $10,000 per year

C = total acquisition cost December 31, 20X2 $41,000 R = estimated residual value $1,000 n = estimated useful life (in years or miles) 4 years 200,000 miles D = amount of depreciation Various

Depreciation Expense 10,000 Accumulated Depreciation 10,000

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LO 3 – Depreciation of Buildings and Equipment
• Activity (Units-of-Production) Method depreciation based on units of service or units of production; physical wear and tear determines the useful life of the asset
Depreciation expense = (C – R) / n (in this case units of service) = ($41,000 – 1,000) / 200,000m = $.20/mile = 65,000 miles (yr 1) x $.20 = $13,000

LO 3 – Depreciation of Buildings and Equipment

Straight line rate of depreciation = ¼ year = 25% per year Double the straight line rate = 25% x 2 = 50% Book value at the begin. of the year = Acquisition cost less – Accumulated Depreciation

Depreciation Expense 13,000 Accumulated Depreciation 13,000

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LO 4 - Changes in Estimated Useful Life or Residual Value
• Asset’s useful life and residual value are estimated when acquired. • If material changes to those estimates become known, the company must use the new estimate to revise the depreciation schedule. • Revisions are applied to the period in which they are determined and future periods; they cannot be applied retroactively.

LO 5 - Contrasting Income Tax and Shareholder Reporting
• Tax reporting - prepared according to IRS rules
– Assets divided into property classes – Each class has prescribed lives and permissible depreciation methods – Modified Accelerated Cost Recovery System (MACRS) prescribes zero salvage value and allows use of accelerated depreciation (more deprecation/lower taxable income) to motivate investment in long-lived assets

• Financial reporting – prepared per FASB/SEC rules
– Straight-line depreciation is the most used method – Matches portions of the asset’s cost to the periods of revenue generation
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LO 6 - Depreciation and Cash Flow
• Depreciation does not generate cash. • It simply allocates the original cost of an asset to the periods in which the asset is used. • The higher the depreciation, the lower the taxable income and the lower the cash paid in income tax. • Depreciation does not create cash, but it does have a cash benefit if it results in lower taxes.

LO 7 - Expenditures After Acquisition
• Maintenance - Sustain LLA original performance level (oiling, polishing, painting, adjusting, etc.) • Repairs – Restore LLA to original performance level after breakdowns, accidents or damage. • Improvements (betterments) – improve LLA’s life, quantity/quality of output or reduce operating costs; results in increased future benefits from the asset. • U.S. GAAP – Maintenance and repair expenditures – expensed – Improvements • If immaterial or cost/benefit applies – expensed • If material – capitalize
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LO 8 – Sales of Tangible Assets
• Example
– Original cost - $41,000 – Accumulated Depreciation at time of sale $20,000 – Book Value at time of Sale - $21,000

LO 8 – Sales of Tangible Assets
• Sale for more than its book value (41,000 – 20,000 = 21,000)
Cash Accumulated Depreciation Equipment Gain 25,000 20,000 41,000 4,000

• Sale at book value
Cash Accumulated Depreciation Equipment 21,000 20,000 41,000

• Sale for less than its book value (41,000 – 20,000 = 21,000)
Cash Accumulated Depreciation Loss Equipment 14,000 20,000 7,000 41,000

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LO 8 – Sales of Tangible Assets
• Asset sales and the Cash Flow Statement
– Direct Method – asset sales affects only the Investing activities; no impact on the Operating activities – Indirect Method – asset sales affects both the Investing and the Operating activities • Net income includes investing gains and losses • To remove them from net income – Subtract gains – Add losses • Show the proceeds from the sale of fixed asset at the cash value that was received in the investments section, similar to the direct method – Net cash provided by operating activities is the same in both methods.
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LO 9 – Revaluation of Tangible Assets
• Downward revaluations mandated by both U.S. GAAP and IFRS • Upward revaluations prohibited by U.S. GAAP • Optional under IFRS
– – – – Assets are carried at fair market value Revalued assets are not depreciated Once started, must continue to do so Must be done for all assets in the same class

• Fair Market Value - Amount the asset could be exchanged between willing knowledgeable parties in an arm’s length transaction; usually determined by appraisers based on market-based evidence.
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LO 10 - Impairment of Tangible Assets
• Impairment – reduction of the economic value of the asset relative to its book value (significant decline in asset’s fair market value, change in legal or business environment, obsolescence or physical damage) • Recoverability test - compares undiscounted expected cash flows from operations plus its eventual disposal value to the current book value of the asset
• If cash flows > book value, no impairment • If cash flows < book value, compute impairment loss

LO 10 - Impairment of Tangible Assets
• US GAAP allows writing up assets, for which impairment loss has previously been recognized only for assets held for resale, up to the net book value of the assets at the time of the original impairment. • Impairment under IFRS
– Compare the net book value to the recoverable value and recognize impairment loss if the latter is bigger than the net book value.

• Impairment loss
• Active market: Book value – fair market value • Inactive market: Book value – net discounted cash flows associated with future benefits

• Recoverable value – the higher of fair market value minus the cost to sell and the value in use (present value of expected future cash flows).

• Once an impairment loss is recorded it cannot be restored.
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LO 11 - Intangible Assets
• Intangible assets – are not physical in nature; they are rights or claims to expected benefits that are often from contractual rights • Accounting for intangible assets depends on whether the asset
– – was acquired externally or developed internally has a finite or infinite life

LO 11 - Intangible Assets
• Patents - exclusive right granted by government to produce or sell a product, or use a process for up to 20 years. • Copyrights – exclusive rights to reproduce and sell a book, musical composition, film, or similar creative item for the life of the creator plus 70 years. • Trademarks - distinctive identifications of a manufactured product or a service, taking the form of a name, sign, slogan, logo, or emblem • Franchises/licenses - legal contracts that grant the buyer the right to sell a product or service in accordance with specified conditions • Leasehold - right to use a fixed asset for a specified period of time beyond one year • Leasehold improvements - lessee spends money to improve leased property; improvements become part of the leased property and are classified as fixed assets; amortized over the shorter of the lease term or the physical life of the improvement.
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• US GAAP only allows externally acquired assets on the balance sheet, as the internally developed ones are difficult to value honestly and objectively (except for computer software) • IFRS does not allow capitalization of the research costs, but requires capitalization of the development costs • Assets with indefinite life are not amortized; they are evaluated periodically for impairment • Assets with finite life are amortized similar to tangible assets • Useful life – shorter of economic useful life or legal life
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LO 12 - Goodwill
• Goodwill – an intangible asset that cannot be separated from the firm
– Can be recognized only when one company buys another – Is the excess of the cost of the acquired company over the sum of the fair market value of its identifiable individual assets less the liabilities – Goodwill is not amortized – It is reviewed annually for impairment

LO 13 - Depletion of Natural Resources
• Natural resources - LLAs such as minerals, oil, and timber (wasting assets) • Depletion expense is the amount of the acquisition cost of natural resources allocated to this period
– Depletion is measured on a units -of-production basis – Annual depletion may be recorded as • A direct reduction of the asset (credit the asset) • Or by using an Accumulated Depletion (contraasset) account
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