Chapter 9Reporting and Analyzing Long-Lived Assets After studying Chapter 9, you should be able to: • Describe how the cost principle applies to plant assets. • Explain the concept of depreciation. • Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods. • Describe the procedure for revising periodic depreciation.
Chapter 9Reporting and Analyzing Long-Lived Assets After studying Chapter 9, you should be able to: • Explain how to account for the disposal of plant assets. • Describe methods for evaluating the use of plant assets. • Identify the basic issues related to reporting intangible assets. • Indicate how long-lived assets are reported on the balance sheet.
Types of Expenditures • Revenue Expenditure - immediately charged against revenue as an expense. • Capital Expenditure - increase the company’s investment in productive activity.
Plant Assets... • Are resources that: • have physical substance; • are used in the operations of a business • are not intended for sale to customers. • Are recorded at cost. • cost consists of all expenditures necessary to acquire the asset and make it ready for its intended use.
Plant Assets • Cost is measured by: • the cash paid in a cash transaction, or • the cash equivalent price paid when noncash assets are used in payment. • The cash equivalent price is equal to: • the fair market value of the asset given up, or • the fair market value of the asset received, whichever is more clearly determinable.
Plant Assets • Land - a building site, manufacturing site, office site • Land improvements • Buildings • Equipment
Cost of Land Includes: • the cash purchase price • closing costs such as title and attorney's fees • real estate brokers commissions • accrued property taxes and other liens on the land assumed by the purchaser • Costs of clearing the land
Cost of Land ImprovementsInclude: • All expenditures necessary to make the improvements ready for their intended use. Examples: • Drive ways • Parking lots • Fences • Underground sprinklers
Buildings Include: • All necessary expenditures relating to the purchase or construction of a building. • Examples • Stores • Offices • Factories • Warehouses • Airplane Hangers
Cost of Buildings Include: • All necessary expenditures relating to the purchase or construction of a building. • When a building is purchased such costs include the: • purchase price • closing costs (attorney's fees title insurance) • real estate broker's commissions.
Cost of Buildings Include: • Cost of making a building ready for its intended use consist of: • expenditures for remodeling rooms or offices • replacing or repairing • roof • floors • electrical wiring • plumbing
Buildings When a building is constructed, its cost consists of: • the contract price • architect's fees • building permits • excavation cost • interest costs during construction.
Examples of Equipment • Store check-out counter • Office furniture • Factory Machinery • Delivery Equipment • Trucks • Airplanes
Cost of Equipment Includes: • purchase price • sales tax • freight charges and insurance during transit paid by the purchaser • expenditures required in assembling, installing and testing the unit.
Equipment • Two criteria apply in determining the cost of equipment: • the frequency of cost - one time or recurring • the benefit period - the life of the asset or 1 year.
Advantages of Leasing an Asset Versus Puchasing • Reduced risk of obsolescence • Little or no down payment • Shared tax advantages • Assets and liabilities not reported
Depreciation • Applies to three classes of plant assets: • Land improvements • Buildings • Equipment. • NOT LAND!
A decline in revenue- producing ability may also occur because of obsolescence. Depreciable Assets The revenue-producing ability of an asset declines during its useful life because of wear and tear.
Depreciation is… • The process of allocating to expense the cost of a plant asset over its useful life in a rational and systematic manner. • A process of cost allocation, not a process of asset valuation.
Land Does not depreciate since its usefulness and revenue producing ability generally remain intact, or increase.
CASH Depreciation & cash flow • Depreciation does not require the outlay of cash.
New ART Factors in Computing Depreciation
Affects of Depreciation • Depreciation affects the balancesheet through accumulated depreciation, which is reported as a reduction from plant assets. • Depreciation affects the incomestatement through depreciation expense.
Depreciation Methods • Straight-line • Declining-balance • Units-of-activity
Straight-line Method Depreciable Cost* ________________________________________________________________________________________________________ The asset's useful life measured in years *(cost of the asset less its salvage value)
2001 2002 2003 2004 2005 Year Straight-line Method • Is the most widely used method of depreciation. • Depreciation is the same for each year of the asset's useful life.
Partial Year Depreciation If an asset is purchased during the year rather than on January 1, the annual depreciation is prorated for the proportion of a year it is used.
2001 2002 2003 2004 2005 Year Declining-Balance Method • Is an accelerated method. • Accelerated methods of depreciation result in more depreciation in the early years of an asset's life and less depreciation in the later years.
2001 2002 2003 2004 2005 Year Units-of-Activity Method The life of an asset is expressed in terms of the total units of production or the use expected from the asset.
Depreciation and Income Taxes • The IRS allows corporate taxpayers to deduct depreciation when computing taxable income. • The IRS does not require the taxpayer to use the same depreciation method on the tax return that is used in preparing financial statements.
Depreciation and Income Taxes • Many large corporations use straight-line depreciation in their financial statements to maximize net income. • At the same time they use a special accelerated-depreciation method on their tax returns to minimize their income taxes.
Depreciation and Income Taxes • For tax purposes: • the straight-line method or • a special accelerated-depreciation method called the • Modified • Accelerated • Cost • Recovery • System • The choice of depreciation method must be disclosed in the notes to financial statements.
Revising Periodic Depreciation • When a change in an estimate is required, the change is made in current and future years but not to prior periods. • Significant changes in estimates must be disclosed in the financial statements. • Extending an asset's estimated life reduces depreciation expense and increases net income for the period.
Ordinary Repairs • Expenditures to maintain the operating efficiency and expected productive life of the asset. • Are usually small in amount that occur frequently throughout the service life.
Ordinary Repairs • Examples: • motor tune-ups • oil changes • the painting of buildings • the replacing of worn-out gears Ordinary repairs increase Repair Expense and are revenue expenditures.
Additions and Improvements • Costs incurred to increase the: • operating efficiency • productive capacity or • expected useful life of the plant asset • Are usually material in amount and occur infrequently during the period of ownership • Are capital expenditures
Impairment • A permanent decline in the market value of an asset is written down to the new market value during the year in which the decline occurs.
Plant Asset Disposals The depreciation for the fraction of the year to the date of disposal must be recorded. Depreciation Expense 8,000 Accumulated Depreciation 8,000 Compute Book Value: Book Value = Cost - Accumulated Depreciation
Sale of Plant Assets • In the sale of an asset, the book value of the asset is compared with the proceeds from the sale. • If the proceeds exceed the book value, a gain on disposal occurs. • Conversely, if proceeds from the sale are less than the book value, a loss on disposal occurs.
Retirement of Plant Assets • Is recorded by decreasing Accumulated Depreciation for the full amount of depreciation taken over the life of the asset. • The asset account is reduced for the original cost of the asset. • The loss is equal to the asset's book value at the time of retirement.
Analyzing Plant Assets The two measures by which plant assets are evaluated are: • Returns on Asset Ratio • Asset Turnover Ratio
Return on Assets Ratio • Indicates the amount of net income • generated by each dollar invested in assets Net Income Average Assets
Asset Turnover Ratio • Indicates: • How efficiently a company uses its assets? • How many dollars of sales are generated by each dollar invested in assets? Net Sales Average Total Assets
Asset Turnover Ratio Two ways a company can increase its return on assets: • Increase profit per sale--measured by profit margin ratio. • Increase its volume of sales--measured by the asset turnover ratio= Net Sales Average Total Assets
Intangible Assetsare • rights • privileges • competitive advantages that result from ownership of long-lived assets that do not possess physical substance
Amortization... Allocation of the cost of an intangible asset to expense over the shorter of: • its useful (economic) life • its legal life • No amortization if life is unlimited
PATENT Types of Intangible Assets • Patents • Copyrights • Trademark or Trade Names • Franchises and Licenses • Goodwill
Patents An exclusive right issued by the U.S. Patent Office that enables the recipient to manufacture, sell, or control a patent for 20 years from the date of grant.