Chapter 7 PDF

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Chapter 7 notes. Intro to Financial Accounting ...

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Chapter 7: Property, Plant, and Equipment; Intangibles and Natural Resources Capital Assets – long lived assets used by the company in normal operations, that are not sold to customers, and used to generate revenue within the company Three Categories of Capital Assets: 1. Property, Plant and Equipment a. land b. buildings c. machines d. automobiles 2. Intangible Assets a. patents b. copyrights c. trademarks d. licenses e. goodwill 3. Natural Resources a. timberlands b. deposits (coal, oil, and gravel) • capital assets represent future economic benefits, or service potential that will be used in the normal course of operations • recorded at cost, including the cost of acquiring the asset and the cost of preparing it for use (cost principle) • part of the cost of the asset is written off as an expense in each accounting period (matching principle) • this allocation is called: o depreciation for property, plant and equipment assets o amortization for intangible assets o depletion for natural resources • land has an unlimited life and service potential, which means it is NOT subject to depreciation Interest on Loans: • interest on loans taken out to purchase a capital asset is NOT capitalized but rather expensed in the period incurred • interest on loans taken out to construct a capital asset over a period of time IS capitalized

Basket Purchases: a purchase of more than one capital asset in one transaction *the purchase price is allocated to individual assets based on fair market value Example: purchases land with buildings for a total of $1,200,000. Appraisals show the land is worth $500,000 and the building $1,000,000. Dr. Land ($1,200,000 X ($500,000/$1,500,000) Dr. Building ($1,200,000 X ($1,000,000/$1,500,000) Cr. Cash

$400,000 $800,000 $1,200,000

Depreciation • process of allocating, the cost of a tangible capital asset to expense over the asset’s useful life • matching principle requires the part of the cost of a depreciable asset to be written off to expense in each accounting period in which the asset is used to generate revenue • the amount of depreciation recorded each period, or depreciation expense, is reported on the income statement • accumulated depreciation, which is the total amount of depreciation expense that has been recorded since the asset was acquired, recorded on the statement of financial position as a CONTRA-ACCOUNT o accumulated depreciation is deducted from the cost of the asset to get the asset’s book value (or carrying value)

Information Required for Measuring Depreciation • cost of the asset o includes any expenditure necessary to acquire the asset and to prepare the asset for use • useful life (or expected life) of the asset o period over time which the company will use the asset to earn revenues • residual value (salvage value) of the asset o amount of cash or trade-in consideration that the company expects to receive when an asset is retired from service

Depreciation Methods: standardized calculations required to determine periodic depreciation expense Straight Line • allocates equal amount of an asset’s depreciable unit cost to depreciation expense for each year of the asset’s useful life Straight-Line Depreciation= (Cost – Residual Value) X 1 / Estimated Useful Life Example: Jan., 1, 2014, Logan Inc. acquired a machine for $50,000. Logan expects the machine to be worth $5,000 at the end of its five-year useful life. Logan uses the straight-line method of depreciation. 1. Compute the straight-line rate of depreciation for the machine Straight-line Rate= 1/Useful Life = 1/5 years = 20% 2. Compute the annual amount of depreciation expense Straight-line Depreciation Expense= $50,000-$5,000 / 5 years = $9,000 per year OR Straight-line Depreciation Expense= $45,000 X 20% = $9,000 per year 3. Prepare a depreciation schedule that shows the amount of depreciation expense for each year of the machine’s life End of Year

Depreciation Ex.

Accum. Depre.

2014 2015 2016 2017 2018

$9,000 9,000 9,000 9,000 9,000 $45,000

$9,000 18,000 27,000 36,000 45,000

Book Value $50,000 41,000 32,000 23,000 14,000 5,000

4. Prepare the journal entry required to record depreciation expense in 2014 Dec. 31, 2014

Depreciation Expense 9,000 Accum. Depre. Machinery 9,000

Declining Balance • accelerated depreciation method that multiplies the declining book value of an asset by constant depreciation rate • generates larger amount of depreciation expense in the early years Declining Balance Rate= (m) X 1 / Estimated Useful Life Declining Balance Depreciation Expense= Declining Balance Rate X Book Value Example: Jan., 1, 2014, Logan Inc. acquired a machine for $50,000. Logan expects the machine to be worth $5,000 at the end of its five-year useful life. Logan uses the double-declining balance method of depreciation. 1. Compute the double-declining balance rate of depreciation for the machine Double Declining Balance Rate= 1/Useful Life X 2 = 1/5 X 2 = 2/5 = 40% 2. Prepare a depreciation schedule that shows the amount of depreciation expense for each year of the machine’s life End of Year

Depreciation Ex.

Accum. Depre.

2014 2015 2016 2017 2018

$20,000 $12,000 $7,200 $4,320 $1,480 $45,000

$20,000 $32,000 $39,200 $43,520 $45,000

Book Value $50,000 $30,000 $18,000 $10,800 $6,480 $5,000

3. Prepare the journal entry required to record depreciation expense in 2014 Dec. 31, 2014

Depreciation Expense 20,000 Accum. Depre. Machinery 20,000 - record declining balance depreciation expense

Units-of-Production Method • can be used when the decline in an asset’s service potential is proportional to the usage of the asset and usage can be measured Depreciation Cost Per Unit=

(Cost – Residual Value) Expected usage of the asset over useful life

Then, depreciation expense equals: Units-of-Production = Depreciation Expense

Depreciation Cost Per Unit

X

Actual Usage of Asset

Example: Jan., 1, 2014, Logan Inc. acquired a machine for $50,000. Logan expects the machine to be worth $5,000 at the end of its five-year useful life. Logan expects the machine to run for 30,000 machine hours. Logan uses the units-ofproduction method of depreciation. The actual machine hours follow: Actual Usage 2014 3,000 2015 9,000 2016 7,500 2017 4,500 2018 6,000 30,000 1. Depreciable Cost / Est. Usage= ($50,000-$5,000) = $1.50 per machine hour 30,000 machine hours 2.

3.

Dec. 31, 2014

Depreciation Expense 4,500 Accum. Depre. Machinery 4,500 -record units-of-production depreciation expense

Depreciation and Income Taxes • A company can choose between the three depreciation methods discussed earlier as it prepares its financial statements, but the depreciation method used in preparing its tax return is usually not the same. • The Income Tax Act of Canada specifies which rates and methods a company must use to prepare tax returns. Tax depreciation rules are designed to stimulate investment in capital assets and, therefore, are not guided by the matching concept. • Tax depreciation rules provide for the rapid (accelerated) expensing of depreciable assets, which lowers the income tax payable....