Chapter 8 PDF

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Chapter notes for financial accounting with David Deeds...

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Chapter 8: Reporting and Analyzing Long-Term Assets

Plant Assets ● Plant assets: tangible assets used in a company’s operations that have a useful life of more than one accounting period. ○ Also called plant and equipment; property, plant and equipment, or fixed assets ● Plant assets make up the single largest class of assets in most companies. ● Plant assets are used in operations. ○ Useful lives extending over more than one accounting period ● Try to match costs against the revenues they generate. ○ Since plant assets useful lives extend over more than one period, matching of costs and revenues must extend over several periods. ● Land cost is not allocated to expense when we expect it to have an indefinite life. ● Four issues in accounting for plant assets: ○ Computing the costs of plant assets ○ Allocating the costs of most plant assets (less any salvage amounts) against the revenues for the periods they benefit ○ Accounting for expenditures such as repairs and improvements to plant assets ○ Recording the disposal of plant assets Cost Determination ● Plant assets are recorded at cost when acquired ○ Consistent with cost principle ○ Cost includes all normal and reasonable expenditures necessary to get the asset in place and ready for its intended use ● Expenditures included in cost:

○ Invoice cost less any cash discount ○ Freight costs ○ Unpacking costs ○ Assembling costs ○ Installing and testing costs ● Examples of costs that are included to get the asset in place and ready: ○ Costs of building a base or foundation for a machine ○ Providing electrical hookups ○ Testing the asset before using it operations ● But in order for an expenditure to be recorded as cost, it MUST be normal, reasonable, and necessary in preparing it for its intended use ● Cases when it is not included in costs: ○ If an asset is damaged during unpacking, the repairs are not added to its cost ■ Instead it is charged to an expense account ○ Traffic fines for moving heavy machinery on city streets without a proper permit ● If charges are incurred to modify or customize a new plant asset, these charges are added to the asset’s cost. How to Determine Costs for the 4 Major Plant Assets Machinery and Equipment ● Costs included (must be normal and necessary): ○ Purchase price ○ Taxes ○ Transportation charges

○ Insurance while in transit ○ Installing fees ○ Assembling ○ Testing of the machinery and equipment Buildings ● A building account is charged for the costs of purchasing or constructing a building that is used in operations. ● Buildings cost consists of: ○ Purchase price ○ Brokerage fees ○ Taxes ○ Title fees ○ Attorney fees ○ All expenditures to ready it for its intended use ○ Necessary repairs or renovations such as wiring, lighting, flooring, and wall coverings ● Costs included when constructing a building or any plant asset: ○ Materials and labor ○ Indirect overhead costs ■ Heat ■ Lighting ■ Power ■ Depreciation on machinery used to construct the asset

○ Design fees ○ Building permits ○ Insurance during construction ● Costs such as insurance to cover the asset after it is placed in use are put into operating expenses Land Improvements ● Additions to land and have limited useful lives ● Charged to land improvement account ● Costs include: ○ Parking lot surfaces ○ Driveways ○ Walkways ○ Fences ○ Landscaping ○ Sprinkling ○ Lighting systems Land ● Earth’s surface and has an indefinite life ● Costs included: ○ Total amount paid for the land ○ Any real estate commissions ○ Title insurance fees ○ Legal fees

○ Accrued property taxes paid by the purchaser ○ Payments for surveying ○ Clearing ○ Grading ○ Draining ● Government assessments are also included: ○ Public roadways ○ Sewers ○ Sidewalks ■ These assessments are included because they permanently add to the land’s value ● Land purchased as a building site sometimes includes structures that must be removed Lump-Sum Purchase ● Lump-sum purchase: when plant assets are purchased as a group in a single transaction for a lump-sum price ● Allocate the cost of the purchase among different types of assets acquired based on the relative market values ○ Estimated by appraisal or by using tax-assessed valuations of the assets

(problems on page 356, if you want) Depreciation

● Depreciation: process of allocating the cost of plant asset to expense in the accounting period benefiting from its use. ○ Does not measure the decline in the asset’s market value each period, nor does it measure the asset’s physical deterioration ● Depreciation only reflects the cost of using a plant asset ○ Only recorded when the asset is in service Factors in Computing Depreciation ● Three factors that determine depreciation: cost, salvage value, and useful life ● Cost: ○ Cost of a plant asset consists of all necessary and reasonable expenditures to acquire it and to prepare it for intended use ● Salvage Value ○ Salvage value: also called residual value or scrap value, it is an estimate of the asset’s value at the end of its benefit period ■ This is the amount the owner expects to receive from disposing the asset and the end of its benefit period ○ If the asset is expected to be traded in on a new asset, its salvage value is the expected trade-in value ○ Total amount of depreciation to be charged off over an asset’s benefit period equals the asset’s cost minus its salvage value Useful Life ● Useful life: length of time it is productively used in a company’s operations ● Trading in plant assets is its cost minus its expected trade-in values and then it is charged

to depreciation expense ● Two variables that make the useful life of a plant asset hard to predict: ○ Inadequacy: the insufficient capacity of a company’s plant assets to meet its growing production demands ○ Obsolescence: condition of a plant asset that is no longer useful in producing goods or service with a competitive advantage because of new inventions and improvements ● Company usually disposes of an inadequate or obsolete asset before it wears out Depreciation Methods ● Depreciation methods are used to allocate a plant asset’s cost over the accounting periods in its useful life ● Most frequently used method- straight line method Straight-line Method ● Charges the same amount of expense to each period of the asset’s useful life. ● Two -step process: ○ Find the depreciated cost of the asset ■ Total cost - salvage value ○ Depreciable cost / useful life ● Cost - salvage value / useful life ● Book value = asset’s total cost - accumulated depreciation Units of Production Method ● Used when equipment varies from period to period ● Better matches expenses with revenues when the use of some plant assets vary greatly

● Units of production charges a varying amount to expense for each period of an asset’s useful life depending on its usage ● Two step process: ○ Depreciation per unit = cost - salvage value / total units of production ○ Depreciation expense = depreciation per unit x units produced in period Declining- Balance Method (double-declining balance method) ● Accelerated depreciation method ● Yields larger depreciation in the early years of an asset’s life and less depreciation in later years. ● Amount of depreciation declines each period because book value declines each period ● Three step process: ○ Straight line rate = 100% / useful life ○ Double- declining balance rate = 2 x straight line rate ○ Depreciation expense = double declining rate x beginning-period book value Comparing Depreciation Methods ● Total depreciation expense is the same for all methods ● Book value of an asset when using straight-line is always greater than the book value from using double-declining balance, except at the beginning and end of the asset’s useful life, when it is the same ● Straight-line yields steady pattern of depreciation expense ● Units of production depends on number of units produced ● Modified Accelerated Cost Recovery System (MACRS): allows straight-line depreciation for some assets but requires accelerated depreciation for most kinds of assets

○ MACRS is not acceptable for financial reporting because it often allocates costs over an arbitrary period that is less than the asset’s useful life and fails to estimate salvage value Partial-Year Depreciation ● When an asset is purchased at a time other than the beginning or end of an accounting period, depreciation is recorded for part of a year ● Purpose is so that the year of purchase or the year of disposal is charged with its share of depreciation ● Assets purchased on days 1-15 of a month are recorded as purchased on the 1st ● Assets purchased on days 16 through the month end are recorded as if purchased on the 1st of next month ● Example: a machine that cost $10,000 is purchased and placed in service on October 8, 2015 and the accounting period ends on December 31. Salvage value of $1,000

Changes in Estimates for Depreciation ● New information may indicated that the useful life is inaccurate and that the estimates and salvage value must be revised ● Must revise the depreciation expense computation by spreading the cost yet to be depreciated over the remaining useful life ● Example: at the beginning of this asset’s third year, its book value is $6,400, computed as $10,000 - $3,600 (accumulated depreciation) ○ Assume at the beginning of the third year, the estimated number of years

remaining in its useful life changes from three to four years and its estimate of salvage changes from $1,000 to $400

● We do not go back and restate prior years financial statements for this new information ● We adjust only the current and future periods’ statements to reflect this new information ● Revising the estimate of the useful life or salvage value of a plant asset is called a change in an accounting estimate ○ Reflected in current and future financial statements NOT in prior statements Reporting Depreciation ● Reporting both the cost and accumulated depreciation of plant assets helps users compare the assets of different companies ● Plant assets are reported on the balance sheet at their book value (cost - accumulated depreciation), not at market values ● Going - concern assumption emphasises costs rather than fair values ○ This assumption states that, unless there is evidence to the contrary, we assume that a company continues in business ○ Implies that plant assets are held and used long enough to recover their cost through the sale of products and services ● Because plant assets are not for sale, their fair values are not reported. The only exception is when there is permanent decline in the fair value of an asset relative to its book value, called an impairment. ● Accumulated depreciation is a contra asset account with a normal credit balance ○ Does not reflect funds accumulated to buy new asset when the assets currently

owned are replaced ● Impairment loss example: assume equipment carries a book value of $800 and a fair (market) value of $750. This $50 decline is recorded as an impairment loss

Additional Expenditures ● Revenue expenditures: income statement expenditures, that are additional costs of plant assets that do not materially increase the asset’s life or productive capabilities ○ Recorded as expenses and deducted from revenues in the current period’s income statement ■ Cleaning ■ Repainting ■ Adjustments ■ lubricants ● Capital expenditures: balance sheet expenditures, are additional costs of plant assets that provide benefits extending beyond the current period ○ Debited to assets accounts and reported on the balance sheet ■ Roofing replacement ■ Plant expansion ■ Major overhauls of machinery and equipment Ordinary Repairs ● Ordinary repairs: expenditures to keep an asset in normal, good operating condition

○ Necessary if an asset is to perform to expectations over its useful life ○ Do not extend an asset’s useful life beyond its original estimate or increase its productivity beyond original expectations ■ Cleaning ■ Lubricating ■ Adjusting ■ Oil changes ■ Replacing small parts of a machine ○ Treated as revenue expenditures, reported as expenses ○ Example: Brunswick’s current-year repair costs are $9,500

Betterments ● Accounting for betterments and extraordinary repairs are treated as capital expenditures ● Betterments (improvements) are expenditures that make plant assets more productive and efficient ● Involves adding a component to an asset or replacing one of its old components with a better one and does not always increase an asset’s useful life ○ Replacing manual controls on a machine with automatic controls ○ Additions, such as adding a new wing or dock to a warehouse ● Since betterments benefits future periods it is debited to the asset account as capital expenditure ● The new book value (less salvage value) is then depreciated over the asset’s remaining

useful life ● Example: a company pays $8,000 for a machine with an eight-year useful life and no salvage value. After three years and $3,000 of depreciation, it adds an automated control system to the machine at a cost of $1,800

● After the betterment is recorded, the remaining cost to be depreciated is $6,800, computed as $8,000 - $3,000 + $1,800 ○ Depreciation expense for the remaining 5 years is $1,360 per year ($6,800/5) Extraordinary Repairs (Replacements) ● Expenditures extending the asset’s useful life beyond its original estimate ● Capital expenditures ● Costs are debited to the asset account (or to accumulated depreciation) ● Both extraordinary repairs and betterments require revising future depreciation Disposal of Plant Assets ● Plant assets are disposed because they wear out or become obsolete ● Disposal of plant assets occur in three ways ○ Discarding ○ Sale ○ Exchange ● General steps in accounting for a disposal of plant assets:

Discarding Plant Assets ● A plant asset is discarded when it is no longer useful to the company and has no market value ● Example: a machine costing $9,000 with accumulated depreciation of $9,000 is discarded

● How do we account for discarding an asset that is not fully depreciated? ○ Step 1, first you must bring the depreciation up to date ○ Example: there is equipment costing $8,000 with accumulated depreciation of $6,000 on December 31. The equipment is being depreciated using straight-line method over eight years with zero salvage value. On July 1 of the current year it is discarded

○ Step 2-4 is reflected in the second entry ○ This loss is computed by comparing the equipment’s $1,500 book value ($8,000 $6,000 - $500) with the zero net cash proceeds

■ The loss is reported in Other Expenses and Losses on the income statement Selling Plant Assets ● Companies often sell plant assets when they restructure or downsize operations ● Example: a companies sale of equipment on March 31, costing $16,000 and accumulated depreciation of $12,000 at December 31 (3 months) of the prior calendar year-end ○ Annual depreciation is $4,000 computed using straight-line depreciation ○ Step 1: record depreciation expense and update accumulated depreciation

○ Steps 2-4: can be reflected in one final entry that depends on the amount received from the asset's sale ○ Example: Sale at Book Value ○ BTO receives $3,000 cash, an amount equal to the equipment’s book value as of March 31 (book value = 16,000 - 12,000 - 1,000), no gain or loss occurs on this disposal

○ Example: Sale above book value ○ BTO receives $7,000, an amount $4,000 above the equipment's $3,000 book value as of March 31, a gain on disposal occurs

○ Example: Sale below book value ○ BTO receives $2,500, an amount that is $500 below that equipments $3,000 book value as of March 31, a loss on disposal occurs

○ (more practice problems on page 368) Natural Resources ● Natural resources: assets that are physically consumed when used ○ Standing timber ○ Mineral deposits ○ Oil and gas field ● Since they are consumed when used, they are often called wasting assets ● These assets represent soon-to-be inventories of raw materials that will be converted into one or more products by cutting, mining, or pumping ○ Until that conversion takes place, they are noncurrent assets on the balance sheet

with titles such as Timberlands, mineral deposits, or oil reserves Cost Determination and Depletion ● Natural resources are recorded at cost, which includes all expenditures necessary to acquire the resource and prepare it for intended use ● Depletion: process of allocating the cost of a natural resource to the period when it is consumed ● Recorded on balance sheet as cost - accumulated depreciation ● Depletion expense per period is usually based on units extracted from cutting, mining, or pumping ● Example: a mineral deposit with an estimated 250,000 tons of available ore. It is purchased for $500,000 and we expect 0 salvage value. The depletion charge per ton of ore is $2 ($500,000 / 250,000 tons available). If 85,000 tons are mined and sold in the first year, the depletion charge for that year is $170,000 ($2 x 85,000 units of ore)

● Depletion expense is recorded as: ● In this case, all the ore mined were sold as well during the year. However, if some ore

remains unsold at year-end, the depletion to the unsold ore is carried forward on the balance sheet and reported as ore inventory, a current asset. ○ Example (go off from previous example) : 40,000 tons are mined in the second year, but only 34,000 sold. We record the depletion expense of $68,000 (34,000 tons x $2 depletion per unit) and the remaining ore inventory of $12,000 (6,000 tons x $2 depletion per unit)

Plant Assets Tied into Extracting ● Conversion of natural resources by mining, cutting, or pumping usually requires machinery, equipment, and buildings ● When the usefulness of these plant assets are directly related to the depletion of natural resource, their costs are depreciated using the units-of-production method in proportion to the depletion of the natural resource ● (more examples on page 370) Intangible Assets ● Intangible assets: nonphysical assets (used in operations) the confer on their owners long term rights, privileges, or competitive advantages ○ Examples: ■ Copyrights ■ patents ■ Licenses ■ Leaseholds

■ Franchises ■ Goodwill ■ Trademarks ● Notes and accounts receivables may lack physical substance but they ARE NOT intangibles Cost Determination and Amortization ● Intangibles are separated into those with limited lives or indefinite lives ● If an intangible has limited life, its cost is systematically allocated to expense over its estimated useful life through the process of amortization (consistent reduction in the recorded value of an intangible asset over time) ● If it has an indefinite life, there are no legal, regulatory, contractual, competitive, economic, or other factors that limit its useful life- it should not be amortized ● Only the straight-line method is used for amortizing intangibles unless the company can show that another method is preferred ● Recorded in a contra account (Accumulated Amortization) ● Many intangibles have limited lives due to laws, contracts, or other asset characteristics ○ Examples: ■ Patents ■ Copyrights ■ Leaseholds ● The values of some intangible assets such as goodwill continue indefinitely into the future and are not amortized ○ An intangible that is not amortized is tested annually for impairment

Types of Intangibles Patents ● Federal government grants patents to encourage the invention of new technology, mechanical devices, and production processes ● Patent is an exclusive right granted to its owner to manufacture and sell a patented item or to use a process for 20 years ● A patent’s cost is amortized over its estimated useful life ● Example: we purchase a patent costing $25,000 with a useful life of 10 years, we make the adjusting entry at the end of each of the 10 years to amortize one-tenth of its cost (use straight-line to calculate)

Copyrights ● Copyrights give its owner the exclusive right to publish and sell a musical, literary, or artistic work during the life of the creator plus 70 years, although the...