Chap 008

Chapter 8

Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; andIntangibles

© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin

8-2

Understanding The Business

How much is enough?

Insufficient capacity results

in lost sales.

Costly excesscapacity reduces

profits.


8-3

TangiblePhysical

Substance

IntangibleNo PhysicalSubstance

Expected to Benefit Future Periods

Actively Used in Operations

Classifying Long-Lived Assets


8-4

TangiblePhysical

Substance




Land Assets subject to depreciation

Buildings and equipmentFurniture and fixtures

Natural resource assets subject to depletion

Mineral deposits and timber

Examples



8-5

TangiblePhysical

Substance




Value represented by rights that produce benefits

PatentsCopyrightsTrademarksFranchisesGoodwill

Subject to amortization

Examples



8-6

Fixed Asset TurnoverFixedAsset

Turnover

Net Sales RevenueAverage Net Fixed Assets

=

This ratio measures a company’s ability to generate sales given an

investment in fixed assets.

For the year 2000, Delta Airlines had $16,741 ofrevenue. End-of-year fixed assets were $14,840and beginning-of-year fixed assets were $12,450.

(All numbers in millions.)


8-7

Fixed Asset Turnover

FixedAsset

Turnover

$16,741($14,840 + $12,450) ÷ 2

= = 1.23

FixedAsset

Turnover

Net Sales RevenueAverage Net Fixed Assets

=

Delta Southwest United1.23 1.04 1.47

2000 Fixed Asset Turnover Comparisons


8-8

Measuring and Recording Acquisition Cost

Acquisition cost includes the purchase price and all expenditures needed to prepare the asset for

its intended use.

Acquisition cost does not includefinancing charges and cash discounts.


8-9

Purchase price Architectural fees Cost of permits Excavation costs Construction costs

Acquisition CostBuildings


8-10

Purchase price Installation costs Modification to building

necessary to install equipment

Transportation costs

Acquisition CostEquipment


8-11

Purchase price Real estate commissions Surveying fees

Land is not depreciable.

Acquisition CostLand


8-12

Acquisition for Cash

On June 1, Delta Air Lines purchasedaircraft for $60,000,000 cash.

GENERAL JOURNAL Page 8

Date Description Debit CreditJune 1


8-13

Acquisition for Cash


Date Description Debit CreditJune 1 Flight equipment 60,000,000

Cash 60,000,000

On June 1, Delta Air Lines purchasedaircraft for $60,000,000 cash.


8-14

Acquisition for DebtOn June 14, Delta Air Lines purchased

aircraft for $1,000,000 cash and a $59,000,000 note payable.


Date Description Debit CreditJune 14


8-15


Date Description Debit CreditJune 14 Flight equipment 60,000,000

Cash 1,000,000Note payable 59,000,000

Acquisition for DebtOn June 14, Delta Air Lines purchased

aircraft for $1,000,000 cash and a $59,000,000 note payable.


8-16

Acquisition by Construction

Asset cost includes:

All materials andlabor traceable tothe construction.

A reasonableamount ofoverhead.

Interest on debtincurred during

the construction.


8-17

Date Description Debit CreditFlight equipment 2,000,000

Cash 2,300,000Interest expense 300,000

Acquisition by Construction

Delta constructed a new plane, paying $ 600,000in labor costs, $ 1,300,000 in materials and $ 400,000 in interest expense, of which $ 100,000 was related to the

construction project.


8-18

Capital and Revenue expenditures

Most assets require expenditures to mantain or enhance their productive capacity.

REVENUE EXPENDITURES (recorded as expenses)

To mantain the productive capacity of the asset

CAPITAL EXPENDITURES (recorded as increases in the asset account)

To increase the productive life, operating efficiency or capacity of the asset


8-19

Repairs, Maintenance,and Additions

Type of Capital orExpenditure Revenue Identifying Characteristics

Ordinary Revenue 1. Maintains normal operating conditionrepairs and 2. Does not increase productivity

maintenance 3. Does not extend life beyond original estimate

Extraordinary Capital 1. Major overhauls or partialrepairs replacements

2. Extends life beyond original estimate

Additions Capital 1. Increases productivity2. May extend useful life3. Improvements or expansions


8-20

Capital and Revenue Expenditures

Many companies have policies expensing all expenditures below a certain amount.

Financial Statement Effect

Current Current

Treatment Statement Income Taxes

Capital Balance sheet

Expenditure account debited Higher Higher

Revenue Income statement

Expenditure account debited Lower Lower


8-21

Depreciation is a cost allocation process that systematically and rationally matches

acquisition costs of operational assets with periods benefited by their use.

CostAllocation

(Unused)

Balance Sheet

(Used)

Income Statement

Expense

Depreciation

AcquisitionCost


8-22

Depreciation

DepreciationExpense

IncomeStatement

BalanceSheet

AccumulatedDepreciation

Depreciation forthe current year

Total of depreciationto date on an asset

CONTRA-ASSET ACCOUNT


8-23

Book Values

Depreciation on Delta’s2000 Balance Sheet

Property and Equipment: Flight equipment 17,565$ Less: Accumulated depreciation 5,173 12,392$

Ground property and equipment 4,371 Less: Accumulated depreciation 2,313$ 2,058

Advance payments for equipment 390 Total property and equipment 14,840$

Acquisition cost-Accumulated depr.=Book value


8-24

The calculation of depreciation requires three amounts for each asset:

Acquisition cost. Estimated useful life. Estimated residual value.

Depreciation Concepts


8-25

Useful life:The estimate of the asset’s useful economic life

(expressed in years or units of capacity)Residual value:

The estimated amount to be recovered at the end of the asset’s estimated useful life

(expressed as a % of the cost of the asset)

Depreciation Concepts


8-26

Alternative Depreciation Methods

Straight-line

Units-of-production

Accelerated Method: Declining balance


8-27

At the beginning of the year, Delta purchased equipment for $62,500 cash. The equipment has

an estimated useful life of 3 years and an estimated residual value of $2,500.

Cost - Residual ValueUseful life

DepreciationExpense per Year

=

Straight-Line Method

1Useful life

Straight line rate

=


8-28


=


= $20,000

$62,500 - $2,5003 years


Cost - Residual ValueLife in Years


=


8-29

Depreciation Accumulated Accumulated UndepreciatedExpense Depreciation Depreciation Balance

Year (debit) (credit) Balance (book value)62,500$

1 20,000$ 20,000$ 20,000$ 42,500 2 20,000 20,000 40,000 22,500 3 20,000 20,000 60,000 2,500

60,000$ 60,000$

Residual Value


SL More than 95 percent of companies use the

straight-line method for some or all of theirassets disclosed in financial reports.


8-30

Units-of-Production Method

Depreciation Rate

= Cost - Residual Value Life in Units of Production

Step 1:

Step 2:

Depreciation Expense = Depreciation

Rate ×Number of

Units Producedfor the Year


8-31

Units-of-Production Method At the beginning of the year, Delta purchased

ground equipment for $62,500 cash. The equipment has a 100,000 mile useful life and

an estimated residual value of $2,500.

If the equipment is used 30,000 miles in the first year, what is the amount of depreciation

expense?


8-32


$62,500 - $2,500 100,000 miles = $.60 per mileDepreciation

Rate=

Step 1:

Step 2:

$.60 per mile × 30,000 miles = $18,000

Depreciation Expense =


8-33

Units-of-Production MethodAccumulated Undepreciated

Depreciation Depreciation BalanceYear Miles Expense Balance (book value)

62,500$ 1 30,000 18,000$ 18,000$ 44,500 2 50,000 3 20,000

100,000


8-34

Accumulated UndepreciatedDepreciation Depreciation Balance

Year Miles Expense Balance (book value)62,500$

1 30,000 18,000$ 18,000$ 44,500 2 50,000 30,000 48,000 14,500 3 20,000 12,000 60,000 2,500

100,000 60,000$

Residual Value



8-35

Accelerated Depreciation

Depreciation RepairExpense Expense

Early Years High LowLater Years Low High

Accelerated depreciation matches higher depreciation expense with higher revenues

in the early years of an asset’s useful life when the asset is more efficient.

Used by companies which expect a rapid obsolescence of the equipment


8-36Double-Declining-Balance Method

AnnualDepreciation

expense

NetBookValue ( )Useful Life in Years

2= ×

Cost – Accumulated Depreciation

Declining balance rate of 2 isdouble-declining-balance (DDB) rate.

Annual computation ignores residual value.


8-37

At the beginning of the year, Delta purchased equipment for $62,500 cash. The equipment has an estimated useful life of 3 years and an estimated residual

value of $2,500.

Calculate the depreciation expense for the first two years.

Double-Declining-Balance Method


8-38

AnnualDepreciation

expense

NetBookValue ( )Useful Life in Years

2= ×

( ) $62,500 × 3 years 2

= $41,667

( ) ($62,500 – $41,667) × 3 years 2

= $13,889


Year 1 Depreciation:

Year 2 Depreciation:


8-39

Depreciation Accumulated UndepreciatedExpense Depreciation Balance

Year (debit) Balance (book value)62,500$

1 41,667$ 41,667$ 20,833 2 13,889 55,556 6,944 3 4,629 60,185 2,315

60,185$

( ) ($62,500 – $55,556) × 3 years 2

= $4,629

Below residual value



8-40

Depreciation expense is limited to the amount thatreduces book value to the estimated residual value.

Depreciation Accumulated UndepreciatedExpense Depreciation Balance

Year (debit) Balance (book value)62,500$

1 41,667$ 41,667$ 20,833 2 13,889 55,556 6,944 3 4,444 60,000 2,500

60,000$



8-41Depreciation Methods: how to calculate Depreciation Expense

UNITS OF PRODUCTION =

Cost - Residual Value Life in Units of Production

X Annual Production

STRAIGHT-LINE METHOD = Cost - Residual Value

Useful life

DOUBLE-DECLINING BALANCE

= 2 Useful life

X Cost-Accumulated Depreciation


8-42

Asset ImpairmentImpairment is the loss of a significant portion

of the utility of an asset through . . .Casualty.Obsolescence.Lack of demand for the asset’s services.

The estimated future cash flows of the asset falls below the book value.

A loss should be recognized when anasset suffers a permanent impairment.


8-43

Asset ImpairmentThe net book value of Delta aircraft is 8,320 mln $.

Future cash flows are estimated to be 8,000 mln $. The asset is impaired and a fair value of the

asset is determined (8,000 mln $). The loss is of 320 mln $.

LOSS DUE TO IMPAIRMENT=NET BOOK VALUE-FAIR VALUE


8-44

Asset Impairment

GENERAL JOURNAL Page 34Date Description Debit Credit

Loss due to impairment 320Equipment 320


8-45

Voluntary disposals: SaleTrade-in

Involuntary disposals:Fire Accident

Disposal of Property, Plant,and Equipment


8-46


Update depreciation to the date of disposal.

Journalize disposal by:

Writing off accumulateddepreciation (debit).

Writing off the asset cost (credit).

Recording cashreceived (debit)or paid (credit).

Recording again (credit)

or loss (debit).


8-47

If Cash > BV, record a gain (credit).If Cash < BV, record a loss (debit).If Cash = BV, no gain or loss.



8-48

Delta Airlines sold flight equipmentfor $5,000,000 cash at the end of its

17th year of use. The flight equipment originally cost $20,000,000, and was depreciated using the straight-line

method with zero salvage valueand a useful life of 20 years.



8-49

The amount of depreciation recorded at the end of the 17th year to bring

depreciation up to date is:

a. $0.b. $1,000,000.c. $2,000,000.d. $4,000,000.


1. RECORD THE ADJUSTING ENTRY TO UPDATE DEPRECIATION EXPENSE


8-50

The amount of depreciation recorded at the end of the 17th year to bring depreciation up to date is:

a. $0.b. $1,000,000.c. $2,000,000.d. $4,000,000.

Annual Depreciation: ($20,000,000 - $0) ÷ 20 Years. = $1,000,000



8-51


Date Description Debit CreditDepreciation Expense 1,000,000Accumulated Depreciation 1,000,000

Adjusting entry to update depreciation expense for the 17th year.



8-52

After updating the depreciation,the equipment’s book value at the end of

the 17th year is:

a. $3,000,000.b. $16,000,000.c. $17,000,000.d. $4,000,000.


2. COMPUTE THE EQUIPMENT BOOK VALUE


8-53

After updating the depreciation,the equipment’s book value at the

end of the 17th year is:

a. $3,000,000.b. $16,000,000.c. $17,000,000.d. $4,000,000.

Accumulated Depreciation =

(17yrs. × $1,000,000) = $17,000,000

BV = Cost - Accumulated Depreciation

BV = $20,000,000 - $17,000,000 = $3,000,000



8-54

The equipment’s sale resulted in:

a. a gain of $2,000,000.b. a gain of $3,000,000.c. a gain of $4,000,000.d. a loss of $2,000,000.


3. RECORD THE DISPOSAL


8-55

The equipment’s sale resulted in:

a. a gain of $2,000,000.b. a gain of $3,000,000.c. a gain of $4,000,000.d. a loss of $2,000,000.

Gain = Cash Received - Book ValueGain = $5,000,000 - $3,000,000 = $2,000,000



8-56


Date Description Debit CreditCash 5,000,000Accumulated Depreciation 17,000,000

Gain on Sale 2,000,000Flight Equipment 20,000,000


Prepare the journal entry to record Delta’s sale of the equipment at the end of the 17th year.


8-57

Natural Resources

Examples: oil, coal, gold

Extracted fromthe natural

environment.

A noncurrentasset presented

at cost lessaccumulated

depletion.


8-58

Natural Resources

Depletion is like depreciation.

Total cost of asset is the cost

of acquisition, exploration,

and development.

Total cost isallocated over

periods benefitedby means of

depletion.

Depletion: it is the process of allocating a natural resource cost over the period of exploitation (when a natural resource is consumed).


8-59

Depletion of Natural ResourcesDepletion is calculated using the

units-of-production method.

Unit depletion rate is calculated as follows:

Estimated Recoverable Units

Acquisition and ResidualDevelopment Cost Value–


8-60

Total depletion cost for a period is:

UNIT DEPLETION RATE

NUMBER OF UNITSEXTRACTED IN PERIOD×

Depletion of Natural Resources

Totaldepletion

cost

Inventoryfor sale

UnsoldInventory

Cost ofgoods sold

NOT EXPENSED!!!!! BUT ADDED TO THE COST OF THE INVENTORY


8-61

Specialized plant assets may be required to extract the natural resource.

These assets are recorded in a separate account and depreciated.

Natural Resources


8-62

Intangible AssetsNoncurrent assetswithout physical

substance.

Useful life isoften difficultto determine.

Usually acquired for operational

use.

Often provideexclusive rights

or privileges.

IntangibleAssets


8-63

Goodwill Trademarks Patents Copyrights Franchises Leaseholds

Record at current cash equivalent cost, including purchase

price, legal fees, and filing fees (if purchased).

Intangible Assets

If developed internally, they are expensed as incurred.


8-64

Intangible AssetsDEFINITE LIFE: the cost of an intangible is allocated on a straight-line basis over its useful life (AMORTIZATION).Amortization Expense is included in the Income StatementIntangible assets are reported at cost-accumulated amortization on the balance sheet

INDEFINITE LIFE: the cost of an intangible is not amortized They can be subject to impairment (book value> future CFs)


8-65

Intangible AssetsA company purchases for 120,000 $ cash a copyright (indefinite life). At the end of the year it is determined that future cash flows will be 100,000 $. The asset is impaired. The management determines that the fair value of the asset is 90,000 $. The loss is therefore of 30,000 $.


Date Description Debit CreditLoss due to impairment 30,000Copyright 30,000


8-66

Amortize over shorter of economic life or legal life, subject to rules specified by GAAP.

Use straight-line method.Research and development costs are

normally expensed as incurred.

Intangible Assets


8-67

Occurs when onecompany buys

another company.

The amount by which thepurchase price exceeds the fair

market value of net assets acquired.

Only purchased goodwill is an

intangible asset.

Goodwill

Goodwill


8-68

Not amortized.Subject to assessment

for impairmentvalue and may be

written down.

Goodwill

Goodwill


8-69

Goodwill

Eddy Company paid $1,000,000 to purchaseall of James Company’s assets and assumed liabilities of $200,000. The acquired assets were appraised at a fair value of $900,000.


8-70

What amount of goodwill should be recorded on Eddy Company books?

a. $100,000b. $200,000c. $300,000d. $400,000

Goodwill


8-71

What amount of goodwill should be recorded on Eddy Company books?

a. $100,000b. $200,000c. $300,000d. $400,000

FMV of Assets 900,000$ Debt Assumed 200,000 FMV of Net Assets 700,000$ Purchase Price 1,000,000 Goodwill 300,000$

Goodwill


8-72

It is an exclusive right to use a name, image, logo, slogan.

Purchasedtrademarks

are recordedat cost

(on the balance sheet).

Internallydevelopedtrademarks

have norecorded

asset cost. Recorded as expenses

Trademarks


8-73

Patents

Exclusive right grantedto sell or manufacture an invention

(for 20 years).

Recorded at purchaseprice (if purchased)

Recorded at their registration/legal cost

(if developed internally)

Amortize costover the shorter of

useful life or 20 years.


8-74

Copyrights

Exclusive right granted to protect artistic or intellectual

properties.

Amortize costover the period

benefited.

Legal life islife of creatorplus 70 years.


8-75

Legally protected right to sell products or provide services purchased by franchisee from

franchisor.

Purchase price is an intangibleasset that is amortized.

Franchises

Chap 008

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