Principles of financial accounting 12e by needles crosson chapter 10

– Asset impairment occurs when the carrying value of a long-term asset exceeds its fair value—i.e., when an asset loses some or all of its potential to generate revenue before the end

Concepts Underlying Long-Term Assets

 Long-term assets have the following

characteristics:

– They have a useful life of more than one year – They are used in the operation of a business – They are not intended for resale to

customers.

 Under accrual accounting, the cost of

these assets, with the exception of land

and some intangible assets, is allocated

to the periods they benefit.

Valuation and Disclosure of Long-Term Assets

reported and valued at carrying value

– Carrying value (or book value) is the

unexpired part of an asset’s cost.

– Asset impairment occurs when the

carrying value of a long-term asset exceeds its fair value—i.e., when an asset loses

some or all of its potential to generate revenue before the end of its useful life.

Recognition of the Acquisition Cost of

Long-Term Assets (slide 1 of 3)

 An expenditure is a payment or an obligation

to make a future payment for an asset or a

service Expenditures are classified as capital

expenditures or revenue expenditures.

– A capital expenditure is for the purchase

or expansion of a long-term asset

 Capital expenditures are recorded in asset accounts.

– A revenue expenditure is for the ordinary repairs and maintenance needed to keep a long-term asset in good operating condition

 Revenue expenditures are recorded in expense

Recognition of the Acquisition Cost of

Long-Term Assets (slide 2 of 3)

 Capital expenditures include:

– outlays for plant assets, natural resources, and intangible assets

– additions —enlargements to the physical layout

of a plant asset

but not an addition to the plant’s physical layout

significantly enhance a plant asset’s estimated useful life or residual value; recorded by

reducing the Accumulated Depreciation account

Recognition of the Acquisition Cost of

Long-Term Assets (slide 3 of 3)

revenue expenditures is important in

applying accrual accounting.

Acquisition Cost of Property, Plant, and

Equipment

 The acquisition cost of property, plant, and equipment includes all expenditures

reasonable and necessary to get an asset

in place and ready for use.

Cost of Asset = Purchase Price + Additional Expenditures

(freight, installation, etc.)

– Interest charges incurred in purchasing an

asset are not a cost of the asset, but an operating expense.

– Small expenditures for long-term assets may

be treated as expenses if they are not material.

Determining the Acquisition Cost of Property, Plant, and Equipment: Land and Land Improvements

 Land: Expenditures that should be debited to the

Land account include: purchase price of the land;

commissions to real estate agents; lawyer’s fees;

accrued taxes paid by the purchaser; costs of

preparing the land to build on, such as costs of

tearing down old buildings and grading the land;

assessments for local improvements; and

landscaping.

 Land Improvements: Improvements to real estate,

such as driveways, parking lots, and fences, that

have a limited life are subject to depreciation They

are recorded in an account called Land

Improvements.

Determining the Acquisition Cost of Property, Plant, and Equipment: Buildings

 When a company buys a building, the cost

includes the purchase price and all

expenditures required to put the building

in usable condition

 When a company constructs its own

building, the cost includes: costs of

materials, labor, and overhead; architects’ fees and lawyers’ fees; insurance during

construction; interest on construction loans during construction; and building permits.

Determining the Acquisition Cost of Property, Plant, and Equipment: Leasehold Improvements

 Improvements to leased property, such as

the installation of carpet or walls, on the

books of the lessee that become the

property of the lessor (the owner of the

property) at the end of the lease are called

Determining the Acquisition Cost of Property, Plant,

and Equipment: Equipment and Group Purchases

 Equipment: The cost of equipment includes all

expenditures connected with purchasing the

equipment and preparing it for use These

expenditures include: invoice price less cash

discounts; freight, including insurance; excise

taxes and tariffs; buying expenses; installation

costs; and test runs to ready the equipment for

operation.

 Group Purchases: Companies sometimes purchase land and other assets for a lump sum The lump sum must be apportioned between the land and other assets.

 Depreciation refers to the allocation of the

cost of a plant asset over its estimated useful life, not to the asset’s physical deterioration

or to its decrease in market value.

– The major factors that limit a depreciable asset’s useful life are:

 Physical deterioration —the result of use or exposure

to the elements, such as sun or wind

 Obsolescence —the process of becoming out of date

– Depreciation is recorded even if an asset

increases in value.

Factors in Computing Depreciation

 Factors in computing depreciation include:

– Cost —the net purchase price of an asset plus all

expenditures to get it in place and ready for use – Residual value (or salvage, disposal, or trade-in

value)—the portion of an asset’s cost that a company

expects to recover when it disposes of the asset – Depreciable cost —an asset’s cost less its residual value

– Estimated useful life —the total number of service units expected from a long-term asset (may be years used, units produced, or miles driven)

Computing Depreciation:

Declining-Balance Method

 An accelerated method of

depreciation results in larger amounts

of depreciation in the early years of an asset’s life than in later years.

– Thus, depreciation charges will be

highest in years when the asset is newest and when revenue generation from the asset is likely to be highest.

Special Issues in Determining Depreciation

 Group Depreciation : Large companies group similar assets, such as machines, to calculate depreciation

 It is often necessary to calculate depreciation for partial years because assets are often purchased mid-year.

 The tax law allows rapid write-offs of plant assets, which differs from the depreciation methods most companies use for financial reporting A a result of the Economic Stimulus Act of 2008 , the tax law allows a small

company to expense the first $250,000 of equipment expenditures.

 Sometimes the estimate of useful life is revised, so that the depreciation changes over the asset’s remaining

Disposal of Depreciable Assets

 When plant assets are no longer useful because they have physically deteriorated or become

obsolete, a company can sell them, discard them,

or trade them in on the purchase of a new asset – A company must record depreciation expense for the partial year up to the date of disposal – The carrying value of a fully depreciated asset

is zero if it has no residual value When the asset is discarded, no gain or loss results

– For an asset with a carrying value, a loss equal

to the carrying value should be recorded when

it is discarded.

Exchanges of Plant Assets

such as an old machine traded in on a newer model, or dissimilar assets, such

as a cement mixer traded in on a truck.

– In both cases, the purchase price is reduced

by the amount of the trade-in allowance.

 If the trade-in allowance is greater than the asset’s carrying value, the company realizes a gain.

 If the allowance is less, it suffers a loss.

Natural Resources

 Natural resources are long-term assets that are converted to inventory by cutting, pumping,

mining, or other extraction methods.

– They are recorded at acquisition cost As these

resources are converted to inventory, their asset accounts must be proportionately reduced.

– The useful life of the plant assets used to extract the natural resources may be longer than the time

it will take to extract the resources.

 If a company plans to abandon these assets after all the resources have been extracted, they should be

depreciated on the same basis as depletion of the natural resources.

 Depletion refers not only to the exhaustion

of a natural resource but also to the

proportional allocation of the cost of a

natural resource to the units extracted.

– When a natural resource is purchased or

developed, the total units that will be available, such as tons of coal, must be estimated.

– The depletion cost per unit is computed as

follows.

Depletion Cost per Unit = Cost − Residual Value

Estimated Number of Units

Development and Exploration Costs in the

Oil and Gas Industry

—Under this method, all costs of exploration are recorded as assets and depleted over the estimated life of the resources.

– This includes the costs

of unsuccessful exploration, such as the cost of dry wells.

Exploring and developing oil and gas resources can be accounted for under one of two methods:

Intangible Assets

the long-term rights it affords its owner.

Purchase of Intangible Assets

 Intangible assets are accounted for at the amount that a company paid for them and should be included on a company’s balance sheet only if purchased from another party

at a price established in the marketplace.

– The useful life of an intangible asset is the period over which the asset is expected to contribute to the

company’s future cash flows It may be:

estimated

competitive, economic, or other factors (and not amortized)

Research and Development Costs

 Research and development (R&D) activities

include development of new products, testing

of existing and proposed products, and pure research.

– The FASB requires that all R&D costs be charged to expense in the period in which they are incurred.

– Costs that companies incur in developing software for sale or lease or for their own use are considered R&D costs until the product has proved feasible

– Once proved feasible, all software production costs are recorded as assets and amortized over the

 From an accounting standpoint, goodwill exists when a purchaser pays more for a business than the fair market value of the business’s net

assets.

– Goodwill may reflect customer satisfaction, good

management, efficiency, having a monopoly, good locations, and good employee relations.

– The FASB requires that purchased goodwill be reported

as a separate line item on the balance sheet and that it

be reviewed annually for impairment

– A company should record goodwill only when it

acquires a controlling interest in another business

Management Decisions Relating to

Long-Term Assets

 A company may need to finance major

acquisitions of long-term assets with the issue of stock, long-term notes, or bonds

 A measure of a company’s success in funding

these acquisitions is free cash flow

remains after deducting the funds a company must commit to continue operating at its planned level

 The commitments include: current or continuing operations, interest, income taxes, dividends, and net capital expenditures (purchases of plant assets minus sales of plant assets).

Free Cash Flow

 Free cash flow is computed as follows:

− Dividends − Purchases of Plant Assets + Sales of Plant Assets

– A positive free cash flow means that a company has met all its cash commitments and has cash available to reduce debt or to expand

operations.

– A negative free cash flow means that it will

have to sell investments, borrow money, or issue stock to continue at its planned level.

Ethics in Acquiring and Financing

Long-Term Assets

 When a company acquires a long-term asset, it

defers some of the asset’s cost to later periods.

– Thus, the current period’s profitability looks

better than it would if the asset’s total cost had been expensed.

 To avoid fraudulent reporting of long-term assets, a company’s management must apply accrual

accounting in resolving two important issues:

– The amount of the total cost of a long-term asset

to allocate to expense in the current period.

– The amount to retain on the balance sheet as an asset.

Ethics in Acquiring and Financing

Long-Term Assets

– To resolve these issues, management

must answer four important questions:

1 How is the cost of the long-term asset determined?

2 How should the expired portion of the cost

of the long-term asset be allocated against revenues over time?

3 How should subsequent expenditures, such

as repairs and additions, be treated?

4 How should disposal of the long-term asset

be recorded?