ACCT 210 Notes Ch 9, Fall 2018

Chapter 9: Plant and intangible assets. T9-2 Plant assets are tangible assets that are used actively in the operations of an entity. It’s fully expected that these assets, sometimes referred to as property, plant, and equipment, will benefit future periods. When a plant asset is acquired, it is recorded at its historical cost. Once the asset is placed in service, a portion of the asset’s cost is allocated to depreciation expense as the asset becomes older. T9-3 There are three major categories of plant assets: Tangible plant assets are long-term assets that have physical substance. Examples include land, buildings, equipment, furniture, and fixtures. Intangible assets are non current assets with no physical substance. Examples include patents, copyrights, trademarks, franchises, and goodwill. Natural resources are acquired for extracting valuable resources to be used in the business. Examples include oil reserves, timber, and other minerals. T9-5 There are three accountable events to discuss. -When a plant asset is acquired, it is recorded at its historical cost. The next slide will show how this cost is determined. -Once the asset is placed in service, a portion of the asset’s cost is allocated to depreciation expense as the asset becomes older. -Finally, at the end of an asset’s useful life, it’s disposed of and removed from the books and records. The accounting for plant assets usually covers several accounting periods. Learning objective number 1 is to determine the cost of plant assets. T9-6 The cost of a plant asset includes the purchase price as well as all costs necessary to get the asset in place and ready for its intended use. The purchase price, net of any cash discounts available, is recorded. Some finance charges are not included in the cost of an asset. Ex: If a purchase is financed over a period of time (on an installment plan), the interest cost is charged as an expense when incurred. EX: If a company constructs a plant asset for its own use, the interest charges during construction period are viewed as part of the asset cost. T9-7 When purchasing land, the cost includes the purchase price and other costs generally incurred in connection with land acquisitions (commissions to real estate brokers, escrow fees, fees for surveying draining, clearing and grading the property, legal fees for examining and insuring the title , delinquent taxes paid by the purchaser.. Many of these costs are related to obtaining legal title to the land. Also remember that land is not a depreciable plant asset. Land improvements include parking lots, driveways, fences, sidewalks, landscaping, sprinkler systems and any outdoor lighting systems. Land improvements are depreciated over their useful life. T9-8 Whether we purchase or construct a building, the cost should include the purchase price plus any attorney fees, title fees, and repairs made prior to using the building(remodeling ,repair to roof, floors ,wiring and plumbing). If the building is built, the cost will include all the necessary construction costs as well as the costs just mentioned. Machinery and equipment are recorded at their purchase price less any available cash 1 discount. If the company pays delivery charges on a truck, these costs are included in the cost of the truck. If any special parts need to be installed to make the machinery or equipment ready for its intended use, these costs will be included in the price of these assets. NB: they are not part of the acquisition cost of an asset. Once the equipment has been placed in operation , maintenance costs (including interest, insurance, and property tax) are treated as expenses in the current period. T9-9 It is not uncommon to have a lump-sum purchase of assets. The most common example may be when purchasing a building and land. Remember, the land is not depreciable but a building is. A portion of the purchase price must be assigned separately to the building and to the land. When faced with this type of problem, accountants normally divide the cost between the assets on the basis of relative fair market values. Learning objective number 2 is to distinguish between capital and revenue expenditures. T9-10 After a plant asset is purchased, the company may incur additional expenditures on that asset. These expenditures may be for repairs and maintenance, overhauls, upgrading the asset, and similar expenditures. One way to handle these types of expenditures is to treat them as Capital Expenditures and charge the amounts to an asset account on the balance sheet. In some cases, the expenditures may be treated as Revenue Expenditures and charged to current period income as expenses. For each expenditure subsequent to acquisition of a plant asset, decide if the expenditure is to be treated as a Capital or Revenue expenditure. NB: generally, subsequent expenditures for ordinary repairs that are aimed simply to maintain the operating efficiency and expected productive life are treated as revenue expenditures and charged to current period income as expenses. Those are usually small amounts that occur frequently Ex: motor tune ups, oil changes , small repairs. Subsequent expenditures that are for betterments ie aimed to increase the operating efficiency or expected useful life are classified as extraordinary repairs. These are usually material in amount and occur infrequently-> should be treated as capital expenditures and charged to the asset account. Ex: new wing to building or paneling of open pickup truck. T9-11 After initial recognition, an entity is required to choose either the cost model or the revaluation model as its accounting policy to an entire class of PPE assets. . If an entity chooses the cost model as its accounting policy in subsequently measuring its PPE assets, the book value of a PPE asset is its cost less the related accumulated depreciation and accumulated impairment losses. Alternatively, if the fair value of a PPE asset can be reliably measured , an entity can choose the revaluation model, under which the book value of a PPE asset is its revalued amount (being its fair value at the date of the revaluation) less any subsequent accumulated depreciation and any subsequent accumulated impairment losses. NB: revaluation is not required for every financial reporting period ,but must be frequent enough to ensure that the book value of the asset(ie its revalued amount less accumulated does not differ materially from what it would be if determined by fair value at the end 0f the financial reporting period. 2 T9-12 Depreciation is a process of cost allocation, not a process of asset valuation. Accounting records do not attempt to show the current market values of PPE assets. The cost of an asset is allocated to expense over its useful life in some rational and systematic manner. Do not confuse asset valuation, an economic concept, with allocation. The unused portion of the asset’s cost appears on the balance sheet. A portion of the cost is allocated to expense on the income statement each accounting period. NB: depreciation is a non cash expense. T9-13 When dealing with depreciation, there are several terms and concepts to understand. Book value is calculated as the historical cost of the asset minus the accumulated depreciation. Book value is the undepreciated cost of the asset. Accumulated depreciation represents the depreciation taken on the asset since its purchase. Accumulated depreciation is a contra-asset account and is subtracted from the asset account to determine book value. Assets are depreciated as we use them to help earn revenue. As assets are used, they incur physical deterioration and obsolescence. Now, let’s look at some common methods of calculating depreciation expense. NB: the basic purpose of depreciation is to offset revenue of an accounting period with the costs of the goods and services being consumed in effort to generate that revenue. Learning objective number 3 is to compute depreciation by the straight-line and declining- balance methods. T9-14 Regardless of the method used to calculate depreciation expense, three variables must be known: (1) the asset’s cost; (2) the estimated residual value expected to be received at the end of its useful life, and (3) the estimated useful life of the asset. When using the straight-line method, depreciation expense is calculated by taking cost minus residual value and dividing by the years of useful life. Let’s see how this works. T9-15 On 2 January, S&G Supermarket acquires a new delivery truck. The truck cost $340,000, has an estimated residual value of $40,000, and an estimated useful life of 5 years. Compute annual depreciation using the straight-line method under the cost model. annual depreciation = $60,000. Now let’s look at a schedule of the annual depreciation over the life of the asset. T9-16 Notice that depreciation expense is the same amount in each of the 5 years. If this amount was plotted on a graph, it would be a straight-line. That is how the name for this method was determined. Depreciation rate=1/5 which is always constant for the SLM. Accumulated depreciation increases by sixty thousand dollars each year. The cost of the asset less accumulated depreciation at the end of any year is called book value. Book value decreases by sixty thousand dollars each year. NB: The depreciation expense over the life of the trucks totals $300,000-the cost of the truck minus the estimated residual value. NB: At the end of the asset’s useful life, the book value is equal to the estimated residual value. This should be true regardless of the method used. Under the cost model , total depreciation expense = Depreciable basis. 3 T9-17 Now assume S&G adopts the revaluation model for subsequent measurement and the delivery truck is revalued with a fair value of $243,000 and a residual value of $42,000 at the end of Year 2. For simplicity, we further assume that the revalued amounts remain the same throughout Year 3 to Year 5. Compute annual depreciation before adjusting for revaluation in Year 2 using the straight-line method. The schedule in next slide summarizes the effects of straight-line depreciation over the entire life of the delivery truck under the revaluation model. T9-18 Up to 31st Dec, Year 2 before adjusting for revaluation, the straight-line depreciation provided to the truck is $60,000 per year. At 31sr December, Year 3, the depreciation subsequent to the revaluation was recognised based on the revalued amounts (fair value of $243,000 and residual value of $42,000). Notice that the depreciation expense over the life of the truck totals $321,000 NB : Under the reevaluation model the total depreciation over the life of asset = Initial cost + revalued amount – estimated salvage value. Ie 321,000= 243,000 +23,000-42,000. where 23,000=243,000-220,000. T9-19. Thus far, this chapter has covered the depreciation of an asset purchased on January 1st. However, relatively few assets will actually be purchased on January 1st. One way to determine depreciation for assets purchased throughout the year is to use the half-year convention. The half year convention record one half year ‘depreciation on all assets acquired during the year. This approach is based on the assumption that the actual purchases will average out to approximately mid year. Using this convention, in the year of acquisition, a company would record half a year, or six months, of depreciation, and a one half -year’s depreciation is also taken in the last year of the asset’s life. NB: under this method the date of acquisition is ignored and we simply recognize one half year ‘s depreciation in both the first year and the last year of the depreciation schedule. The half year convention enables us to treat similar assets(office equipment, machinery and automobiles) acquired at different dates during the year as a single group. Let’s see how this works. T9-20 In this example, a company purchased equipment for $75,000 on some date in 2013.. The equipment has a useful life of 10 years and an estimated residual value of $5,000. This company uses straight-line depreciation for all of its plant assets. Let’s calculate depreciation expense for 2013 using the half-year convention. Using straight-line depreciation, the depreciation expense for an entire year would be $7,000. This amount is determined by taking cost less residual value and dividing it by the useful life. Since the company uses the half-year convention, divide the annual depreciation in half for the first year. The depreciation expense for 2013would be $3,500. T9-21 There are several appealing reasons to use a declining-balance method for depreciation. One reason to consider the declining-balance method is to better match depreciation expense with revenue generated. The idea is that a newer asset will generate more revenue in early years rather than later years, so depreciation expense should be higher in the early years of ownership and less in later years. Another reason that the declining-balance method is appealing to use for financial statement reporting is that it is similar to the depreciation method used for tax purposes. Calculating depreciation expense under the double-declining-balance 4 method is a three step process. The first step is to calculate the straight-line depreciation rate. Do this by dividing one hundred percent by the asset’s useful life. The second step is to calculate the double-declining-balance rate, which is done by multiplying the straight-line rate times two. The third and final step is to determine depreciation expense. Multiply the double- declining rate times the book value of the asset at the beginning of the period. Under the double-declining-balance method estimated residual value is ignored but is used in limiting the depreciation expense in the last year (plug in number) to cause BV= residual value. T9-22 On 2 January, S&G purchased a truck for $340,000. The estimated useful life is 5 years and the estimated residual value is $40,000.Can you calculate the amount of annual depreciation using the double-declining-balance method under the Cost Model? The first step is to calculate the straight-line depreciation rate. Recall that this is done by dividing 100% by the asset’s useful life. In this case divide 100% by the 5-year useful life to get a straight-line rate of 20%. The second step is to calculate the double-declining-balance rate. Do this by multiplying the straight-line rate times 2. In this case that would be 20% times two, or 40%. The third and final step is to determine depreciation expense. Multiply the double-declining rate times the book value of the asset at the beginning of the period. In this case, multiply the beginning book value (cost less accumulated depreciation) of $340,000 by 40%. Depreciation expense is thus $136,600. Remember, under the double-declining-balance method ignore estimated salvage value. T9-23 NB: While book value should always be equal to the estimated salvage value at the end of an asset’s useful life, it just will not work properly using the double-declining-balance method. In this case, the book value at the end of fifth year needs to be equal to $40,000, the estimated residual value. The only way that can work is to force depreciation expense in the last year to be the amount needed to bring book value down to residual value. (plug in number).In Year 5, depreciation expense will be recorded at $4,064. This amount is determined by subtracting the salvage value of $40,000 from the book value at the end of the fourth year, $44,064 or 300,000- 295,936. Depreciation in early years under the DD method is higher than under the straight line – method .NB: Notice that no matter which depreciation method is used, the total depreciation taken at the end of an asset’s life will be the same. In this case, for both the straight-line method and the double-declining-balance method, total depreciation taken is $300,000. T9-24 Now assume S&G adopts the revaluation model for subsequent measurement and the delivery truck is revalued with a fair value of $131,400 and a residual value of $43,000 at the end of Year 2. For simplicity, we further assume that the revalued amounts remain the same throughout Year 3 to Year 5. Compute annual depreciation before adjusting for revaluation in Year 2 using the double-declining method. The schedule in next slide summarizes the effects of double -declining depreciation over the entire life of the delivery truck under the revaluation model. 5 T9-25 While book value should always be equal to the estimated salvage value at the end of an asset’s useful life, it just will not work properly using the double-declining-balance method. In this case, the book value at the end of fifth year needs to be equal to $43,000, the estimated residual value. The only way that can work is to force depreciation expense in the last year to be the amount needed to bring book value down to residual value. In Year 5, depreciation expense will be recorded at $4,304. This amount is determined by subtracting the salvage value of $43,000 from the book value at the end of the fourth year, $47,304.NB: Notice that the depreciation expense over the life of the truck totals $306,000 — the initial cost of the truck plus revaluation surplus minus the estimated revalued residual value ($340,000 + ($131,400 – 122,400) - $43,000). T9-26 Which depreciation methods do most businesses use? Many businesses use the straight line method of depreciation in their F/S since they want to appear as profitable as possible and accelerated methods in their income tax returns since the latter results in higher charges to depreciation expense early in the asset’s life and therefore lower reported net income than straight line method.à accelerated depreciation methods can substantially reduce both taxable income and tax payments for a period of time. Accelerated methods result in more conservative (lower) balance sheet amounts of plant assets and measurement of net income.NB: accounting principles and income tax laws both permits to use different depreciation methods in their F/S and their income tax returns. Estimating the useful lives and residual values of plant assets is the responsibility of management. They are based on the company’s experience with similar assets. The estimated lives of plant assets affect the amount of net income reported each period. Auditors review management’s estimates for useful lives and residual values for reasonableness. Ex: Automobiles are depreciated over short estimated lives(3-5) equipment(5-15) Buildings(30-50).The principle of consistency ensures that companies avoid switching depreciation methods from period to period, unless there is a compelling reason for the change. Auditors review management’s estimates for useful lives and residual values for reasonableness. T9-27 You know that salvage value and useful life of a plant asset are both estimates. Like all estimates, new information may come to light that will warrant a revision of a previous estimate. In that case we need to spread the remaining undepreciated cost of the asset (BV of equipment during the year of revision)-salvage value over the remaining useful life. T9-28 In this example, a company purchased equipment on January 1st, 2010, for $30,000. The equipment is estimated to have a 10-year useful life and no salvage value at the end of its useful life. The company uses the straight-line method for all plant assets and begins recording depreciation on this equipment in 2010. The original computations for 2010 through 2012 are continued. During 2012, new information is learned about the equipment that causes a revision of the estimate of the equipment’s useful life. The equipment is now believed to have a total useful life of eight years. Depreciation expense for three years has already been recorded (2010, 2011, and 2012), so there are five years remaining in the equipment’s useful life In this case, accountants take the book value at 6 the date of revision of the estimate, that is, 2013, and subtract any estimated salvage value at the time of revision. This total is to be divided by the remaining useful life of the asset at the date of revision. Let’s calculate the proper depreciation expense for 2013. T9-29 The asset had a cost of $30,000 and a ten-year useful life with no salvage value. Under straight-line depreciation, $3,000 of expense is recorded in each of the years 2010, 2011, and 2012. Let’s calculate the depreciation expense at 31st December, 2013. The original cost of the asset was $30,000. Accumulated depreciation has a balance of $9,000 at the beginning of 2013. The remaining book value is $21,000 and the remaining useful life of the asset is five years, so depreciation for each of those five years will be $4,200. T9-30 If an asset’s value decreases and cannot be recovered through future use or sale, the asset is considered to be impaired and should be written down to its net realizable value. If the carrying amount of an asset cannot be recovered through future use or sale, the asset should be written down to its fair valueà the offsetting debit is to an impairment loss account. New technology, underperformance relative to historical or projected operating results, significant changes in the manner of the use of the assets and changes in the overall business strategies., may render an equipment obsolete or it becomes less than the amount at which equipment is carried in the accounting records ,an impairment loss (e:xcess of carrying value or BV of the asset over its fair value) is recorded. Learning objective number 4 is to account for disposals of plant assets. T9-31 When a plant asset is disposed of, the first thing to do is update depreciation to the date of disposal. After completing the update, the journal entry can be created. NB: 1.if depreciable assets are disposed of at any date other than the end of year ,an entry should be made to record depreciation for the fraction of the year ending with the date of disposal. If the half year convention is in use, six month depreciation should be recorded on all assets disposed of during the year. 2-The journal entry begins by the recording of a debit to the cash account, if cash was received, or credit to the cash account, if cash was paid by the company. In addition, it must be determined whether a gain or loss is associated with the disposal. A gain is recorded with a credit, just like revenue, and a loss is recorded with a debit, just like an expense account. 3-The entry is completed by removing the plant asset’s cost from the books with a credit, and removing the related accumulated depreciation with a debit. T9-32 If the amount of cash received is greater than the book value of the asset (cost less accumulated depreciation), a gain is associated with the disposal. If the cash received is less than the book value of the asset, a loss will be recorded. When the amount of cash is exactly equal to the book value of the asset, there will be no gain or loss in connection with the disposal. 7 T9-33 Assume that a machine costing $10,000, had accumulated depreciation of $8,000, accumulated impairment loss of $0, and book value of $2,000 (10,000 - $8,000 - $0) at the time it was sold for $3,000 cash. Determine the gain or loss on sale of this machine. Remember that to determine gain or loss on disposal of an asset we compare the asset’s book value to the proceeds from the disposal(FMV). In our case, the cash received was more than the book value of the asset, so we have a gain on the sale of this machine of $1,000. Now, let’s look at the entry to record the sale of the assets. NB: since the residual values and useful lives of plant assets are only estimates , it is not uncommon for a plant asset to be sold at a price that differs from its BV at disposal. T9-34To record the disposal of the machine we debit Cash for $3,000, debit to Accumulated Depreciation on the machine for $8,000, a credit to Gain on Disposal of PPE Assets for $1,000, and a credit to Machinery for $10,000. Whenever we dispose of a depreciable asset, the entry to record the disposal will always have a debit to accumulated depreciation and a credit to the asset. T9-35 A trade in is viewed as both the sale of the old asset and a purchase of a new one. Transactions of this type are usually considered to have commercial substance and give rise to the recognition of a gain and loss. NB: for financial reporting purposes, gains and losses on routine trade ins are recorded in the accounting records whenever the transaction also involves the payment of a significant amount of cash. Income tax rules do not permit recognition of gains or losses on exchanges of assets that are used for similar purpose. Assume that Essex Company exchanges a used earthmover and $350,000 cash for a new earthmover. The old earthmover given up has a historical cost of $400,000 dollars, accumulated deprecation to the date of exchange of $300,000, accumulated impairment loss of $0, and a fair value of $40,000. The first thing we need to determine is whether a gain or loss will result. T9-36 Because there were no cash proceeds from the disposal of this equipment, we determine the gain or loss by comparing the asset’s book value to its fair market value. In our case, the earthmover has a book value of $100,000 and a fair market value of $40,000. Because fair market value is lower than book value, we have a $60,000 loss on the disposal of the old earthmoving equipment. Now let’s look at the entry to record the disposal. Begin by recording the parts of the journal entry that are known. The old earthmover is being given up, so we debit Accumulated Depreciation for $300,000, and credit the old Equipment account for $400,000. Next, we credit Cash for $350,000 because it is being given up in the exchange, and we debit Loss on Disposal of Asset for $60,000. Now, just debit the new Equipment account for $390,000. This $390,000 represents the fair value of the assets given up in the exchange: Cash of $350,000 plus the fair market value of the old earthmover of $40,000. 8 NB: IFRS versus GAAP Under US GAAP the emphasis is on cost and depreciation primarily due to the importance of including expense a portion cost of the cost of the plant asset which contributed to the earnings of the company’s income. Cost –accumulated depreciation is the amount shown in the statement of financial position without regard to the current value of the asset than situations where an impairment in value is recorded. Under IAS ,companies have an option to follow a revaluation process, rather than continuing to use historical costs throughout the asset life .NB: revaluation requires that an asset fair value can be reliably measured and it must be applied to the entire class of plant assets. Revaluation must be frequent to ensure the carrying amount (revalued amount less acc dep) does not differ materially from what it would be if determined by fair value at the end of the financial reporting period. NB: if an asset carrying value is increased as a result of revaluation, the increase is recorded in other comprehensive income and accumulated equity. PPE Transactions and the Statement of Cash Flows In conclusion : remember that Cash payments for PPE assets appear as cash outflows for investing activities on the statement of cash flows. A disposal of a PPE asset for cash results in a cash inflow to the company. Remember, depreciation is a non-cash charge to profit and is added back to profit under the indirect method of calculating cash flows from operating activities. 9